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IS CROWDFUNDING BAD FOR INVESTORS? Anita Anand* With the passing of the Jwnpstart Our Business Startups ( JOBS) Act , U.S. companies and their investors will soon be able to participate in "equity crowdf unding" ( ECF), a process that allows individuals to buy equity securities in a company over the Internet. After assessing arguments both for and against ECF, this article concludes that the benefits of ECF, on the whole, outweigh its disadvantages. ECF provides small and mid-size companies with an economical system for raising capital, decreases costs incurred to invest in these companies, offers investment opportunities to a greater population, and pairs companies with intetested investots. The article makes some proposals for the regulation of ECF, such as requiring the distribution of securities to occur through portals that are registered with the securities regulator and it briefly addresses the Ontario Securities Comm .ission 's recently proposed crowdfunding prospectus exemption. I. INTRODUCTION A trend known as "equity crowdfunding'' (ECF) is becoming popular as a means by which firms and individuals raise capital by selling securities to investors over the Internet. Some argue that this novel type of financing, endorsed and perhaps spawned by the Jumpstart Our Business Startups (JOBS) Act, 1 is contrary to investor interests because the benefits of the proposed regulation do not outweigh the costs. 2 Others contend that ECF advances the interests of investors, and of retail investors especially, by increasing the nmnber of investment opportunities available to them. 3 ls it possible for a particular policy proposal to be simultaneously good and bad for investors? "' I. 2. Professor of Law and Academic Director, Centre for the Legal Profession, The University of Toronto. Contact: < anita.a nand@utoronto.ca> . Deep Lhanks to Vlad Calina and Michael Trebilcock for helpful comments and to John Chapman, Dylan Cox, Anthony Mouchanlaf and Parsa Pezeshki for their valuable research assistance in the preparation of this article. Funding from the Social Sciences and Humanities Research Council is greatly apprecialed. Jumpslart Our Business Startups Act, Pub. L. No 112-106, §§301 -305, 126 Stat. 306 (2012). See, for e.g., Jeffrey Macintosh, (untitled. unpublished draft on file with author). Macintosh argues thal lhe marginal costs of equity crowd fonding are outweighed by its marginal benefits. 215

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Page 1: IS CROWDFUNDING BAD FOR INVESTORS? · grows-81-per-cent-in-2012/article 10841800/ > and Crowdsourcing LLC, "Crowd funding Industry Report: Market Trends, ... 2014] Is Crowdfunding

IS CROWDFUNDING BAD FOR INVESTORS?

Anita Anand*

With the passing of the Jwnpstart Our Business Startups ( JOBS) Act, U.S. companies and their investors will soon be able to participate in "equity crowdf unding" ( ECF), a process that allows individuals to buy equity securities in a company over the Internet. After assessing arguments both for and against ECF, this article concludes that the benefits of ECF, on the whole, outweigh its disadvantages. ECF

provides small and mid-size companies with an economical system for raising capital, decreases costs incurred to invest in these companies, offers investment opportunities to a greater population, and pairs companies with intetested investots. The article makes some proposals for the regulation of ECF, such as requiring the distribution of securities to occur through portals that are registered with the securities regulator and it briefly addresses the Ontario Securities Comm.ission 's recently proposed crowdfunding prospectus exemption.

I. INTRODUCTION

A trend known as "equity crowdfunding'' (ECF) is becoming popular as a means by which firms and individuals raise capital by selling securities to investors over the Internet. Some argue that this novel type of financing, endorsed and perhaps spawned by the Jumpstart Our Business Startups (JOBS) Act, 1 is contrary to investor interests because the benefits of the proposed regulation do not outweigh the costs.2 Others contend that ECF advances the interests of investors, and of retail investors especially, by increasing the nmnber of investment opportunities available to them.3 ls it possible for a particular policy proposal to be simultaneously good and bad for investors?

"'

I.

2.

Professor of Law and Academic Director, Centre for the Legal Profession, The University of Toronto. Contact: < [email protected]> . Deep Lhanks to Vlad Calina and Michael Trebilcock for helpful comments and to John Chapman, Dylan Cox, Anthony Mouchanlaf and Parsa Pezeshki for their valuable research assistance in the preparation of this article. Funding from the Social Sciences and Humanities Research Council is greatly apprecialed. Jumpslart Our Business Startups Act, Pub. L. No 112-106, §§301-305, 126 Stat. 306 (2012). See, for e.g., Jeffrey Macintosh, (untitled. unpublished draft on file with author). Macintosh argues thal lhe marginal costs of equity crowd fonding are outweighed by its marginal benefits.

215

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216 Canadian Business LawJournal [Vol. 55

This article examines these divergent viewpoints, and argues that ECF is not only an effective means for small and mid-size firms to raise capital, but also a viable avenue through which investors can access investment opportunities. Reviewing the advantages and disadvantages of crowdfunding, the article concludes that, on the whole, ECF is beneficial, not harmful, for investors. Within certain regulatory boundaries, ECF can be consistent with the objectives of securities regulation and should be permitted to proceed as a means by which issuers can raise capital.

Generally, "crowdfunding" or "rewards crowdfunding" is a means of selling any product or service over the Internet to a broad group of consumers. 4 In an ECF transaction, an issuer makes a direct offer of securities to a large number of potential investors with the aim of raising a small amount from each one. The principles of crowdf unding are a contrast to traditional methods of raising capital, where issuers turn to small groups of investors to complete the offering. The conduit of information fron1 issuer to investor is a website, rather than an underwriter or intermediary. 5

The website houses information regarding the proposed project, the means by which investors can "buy in" or contribute to the project, and the issuer's objectives.6

The absence of an underwriter may appear to be a significant disadvantage for the investor, and the unsophisticated investor

3. See publication by the Chairman of the Exempl Market Dealers Association. Brian Koscak, "Securities Law Considerations in Legalizing Equity Crowd Funding in Canada" (November, 2012), online: New Brunswick Securities Commission < http://www. n bsc-cvrnn b.ca /n bsc/emag/2012 _Making_ Headway­Crowd _Funding/ pu bData/source/ MH-Newsletter-Crowdfunding-web-EN .pdf> at p. 2.

4. Rewards crowdfunding grew 81% to $2.7 billion in 2012, fol1owing a 64% growth in 201 I. While rewards crowdfunding is the most widespread type of financing, equity crowdfunding is lhe fastest growing. See Kyie MacEUan, "Crowdfunding Market Grows 81 per cent in 2012", The Globe and Mail, April 8, 2013, online: The Globe and Mail <http://www.theglobeandmail.com/report-on­business/small-busin~ss/sb-money/business-funding/crowdfunding-market­grows-81-per-cent-in-2012/article 10841800/ > and Crowdsourcing LLC, "Crowd­funding Industry Report: Market Trends, Composition, and Crowdfunding Platforms" (May, 2012), on1ine: Crowdfunding.n1 <http://www.crowdfun­d i ng. n 1 /wp-con ten t/upl oads/2012/05/92834651 -Masso Ju ti on-abridged-Crowd­Fu nding-T ndustry-Report 1 .pdf>.

5. See Ronald J. Gibson and Reinier H. Kraakman, "The Mechanisms of Market Efficiency" (1984), 70 Va. L. Rev. 549, at p. 610 and discussion of the role of underwriters in online offerings in Anita Anand, "The Efficiency of Direct Public Offerings" (2003), 7 J. Small & Emerging Bus. L. 433.

6. This return is usual1y a reward related to the proposed project. For instance, if the project is seeking to build a phone, the contributor might get a discounted or advanced copy of the phone in return for the donation.

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especially. In any securities distribution, investors face costs from the acquisition, consolidation, evaluation and verification of the issuer's information,7 which usually require the e1nployment of skilled persons such as underwriters, accountants and lawyers. Investors also seek to ensure that the information is credible; they rely heavily on underwriters to absorb the verification costs inherent in the fact-finding mission. The underwriter, together with a prospectus, serves to reduce these costs for investors and to 1nake the information gathered readily available to investors.

Even though investors have neither a prospectus nor an underwriter in an ECF transaction, ECFs can be advantageous for them, especially where the investment occurs via a portal registered with a securities regulator. In such cases, investors' costs (including the potential for fraud) are lowered, thereby increasing the potential for an efficient ECF transaction. Furthermore, ECF transactions increase investment opportunities for investors; these opportunities are, generally speaking, benefits, though perhaps unquantifiable ones.

For issuers, the cost savings are obvious: the issuer can raise capital more quickly than under the traditional prospectus method because it does not need to compile a lengthy disclosure document. Furthermore, the absence of an underwriter means that there is no "spread" (i.e., the net profit between the proceeds of the issue and the .amount the issuer receives) payable to the underwriter. The issuer "speaks to" investors directly by selling its securities over the Internet.

In further probing the pros and cons of ECFs, this article questions the meaning of "investor protection." Does the term mean shielding investors from financing opportunities that may be fraudulent? Or is it purely the provision of disclosure, to ensure that investors have the ability to be well-informed prior to making investment decisions? Part 2 outlines the regulatory regime that governs ECF proposals. Part 3 then examines the advantages and disadvantages of ECFs, arguing that investors can benefit from ECFS. Part 4 examines policy options, and proposes an ECF

exe111ption from the prospectus requirement. The addendmn briefly addresses the Ontario Securities Commission's recently proposed crowdfunding prospectus exemption.

7. C. Steven Bradford, "Crowdfunding and the Federal Securities Laws" (2012), 10 Colum. Bus. L Rev. L See also Anita Anand, 'The Efficiency of Direct Public Offerings" (2003), 7:3 J. Small & Emerging Bus. L. 433, PP- 433-466.

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II. REGULATORY BACKGROUND

Historically, securities regulators have operated under the dual mandate of protecting investors and promoting market efficiency. 8

In executing this mandate, they seek to: ensure that issuers make adequate disclosure so that investors can make informed decisions; oversee capital market stakeholders such as issuers, dealers and sdf-rt:!gulalory organizations; and, enforce regulations by investi­gating possible violations of the law, prosecuting those who violate the law and applying penalties in the case of breach. 9

In order to distribute securities, issuers are required to prepare a mandatory disclosure called a registration statement (in the United States) or a prospectus (in Canada). They tnust file the relevant document with the respective securities commission and obtain a receipt for it prior to issuing the securities.10 In fact, the issuer must prepare and clear both a preliminary and final version of the document, which must contain full, true and plain disclosure of all inaterial facts .11 One of the most challenging aspects of the public offering process for the issuer is isolating an investor base and ensuring that investors purchase the securities being distributed. Issuers will usually retain an underwriter to assist with the marketing of the securities, as underwriters lend their reputational capital to the distribution and serve as a gatekeeper of information in the offering process. 12

The main problem with the public offering process is that it is expensive. 13 Drafting and compiling the prospectus comprise part of the issuer's total cost, but underwriting commissions of up to 12°/o, as well as legal, accounting and listing fees, can push the cost of an Initial Public Offering (IPO) above $1 million. 14 For smaller firms in particular, these expenses can be prohibitive. In light of these costs, securities regulation permits firms to issue securities without a prospectus, provided that the issuer (and/or investors 8. Securities Act, R.S.0. 1990, c. S.5, s. 1.1 (osA). 9. Ibid. s. 2.1. . 10. Jb;d 11. /Md. s. 56(1); sec 15 U.S.C. § 77g (2013) for the U.S. equivalent. 12. Gibson and Kraakman, supra, footnote 5. 13. While a typical prospectus in Ontario can cost around $250,000 to prepare and

receive approval, a securities offering compleled lhrough a prospectus exemption usually costs between $5,000 and $75,000. See William P. Lambert, "Prospectus Exemptions in Ontario", lnnoi•ative Finance News, November, 2010, online: Gardiner Roberts LLP <http://www.gardiner-roberls.com/documen ts/articles/ Gardiner%20Roberts_Innovative%20Finance%20News_ Winter.pdf>, al p. I.

14. TMX Group, "TSx and TSX Venture Exchange Listing Costs" (January 13, 2013), on Ii ne: TMX Group < h Up:/ /www.tmx.com/en/Jis tings/listing_ with_ us/costs/> .

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who are purchasing its securities) meets conditions of pre­established exemptions from the prospectus requirement.'~

Exemptions are based on various rationales, one of which is the sophistication of the investor. The "accredited investor" exemption permits issuers to sell any amount or type of securities to individuals who, either alone or with their spouse, have financial assets exceeding $1 million or net assets exceeding $5 million. Issuer~ can also sell any amount or type of securities to those individuals who have a net income before taxes exceeding $200,000, or who have a net income before taxes exceeding $300,000 in combination with their spouse. 16 Under the minin1un1 amount exemption, to cite another example, -investors must invest at least $150,000 in the issuer in exchange for the issuer's securities. 17 These financial thresholds are proxies for investors' sophistication; the legislation assumes that these individuals do not require the protection (via info1mation or statutory right of action for misrepresentation) that the prospectus provides.

A second type of exemption relates to those who have close relationships with the issuer, such as family men1bers, friends and business associates .. 18 The idea is that these investors have close ties to the issuer and can glean more information, if they need to, by speaking or corresponding with the issuer's representatives,

. including directors, founders and promoters. A further assumption underlying this exemption, and perhaps not a legitimate one, is that individuals who are associated with the issuer would not commit fraud against close relations who decide to invest.

A third type of exemption allows private companies to distribute securities to a maximum of 50 persons. 19 The rationale underlying this particular deviation from the prospectus requirement is that

15. Prospectus and Registration Exemptions, O .S.C. NI 45-106 (September 18, 2009) 2.1-2.43; see Securities Act or 1933, 15 U .S.C. ch. 2A, § 77c (20 t 2) for the U.S. equivalent.

16. Ontario Securities Commission, Considerations for New Capital Raising Pro­spectus Exemptions, OSC Staff Consultation Paper 45-710 (December 14, 2012), online: Ontario Securities Commission < http://www.osc.gov.on.ca/documents/ en/Securities-Category4/sn_20J 21214_ 45-710_exempt-market-review.pdf>, at p. 7. The vast majority of Ontario exempt market trades occur under the accredited investor exemption. For instance, in 20 J I , over 50% of securities purchased, over 70% or distributions, and over 80% of funds raised in the exempt market in Ontario rell under this exemption (at p. 73).

17. Ontario Securities Commission, ibid.; NI 45-106, supra, footnote 15. 18. Ontario uses the "founder, control person and family" exemption, whereas other

jurisdictions permit investments from " ramily, friends and business associates." Ibid. at 2.5-2.7.

19. Ibid.

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small finns often require capital quickly and should be able to raise it from investors who have a close association with the firm, including directors, officers and employees. The ceiling on the number of investors is meant to prevent "backdoor underwriting," or the practice of effectively distributing securities to the public without a prospectus.

Current ECF reform proposals contemplate a distribution of securities over the Internet under an exemption, which means that no prospectus would accompany the distributed securities. A key question is: how to craft the exe1nption? One alternative would be to implement an exemption that permits ECF based on one of the rationales just discussed, by requiring that issuers ensure that the investor is sophisticated or that he or she has a close relationship with the issuer.20 Another alternative would be to create an ECF

exemption but include an oversight mechanism, such as a portal, so that transactions are vetted and monitored by the regulator. Before considering these policy choices, it is necessary to examine argtm1ents for and against ECF and, thereafter, to ask: is equity crowdfunding a good idea?

Ill. ANALYZING ECF

This section analyzes the advantages and disadvantages of ECF

from the standpoint of the two main parties in a securities transaction - issuers and investors - and asserts that there are significant advantages for both parties. For issuers, the advantages relate primarily to transaction costs, while the advantages for investors rest in opportunities to participate in investments to which they would not otherwise have access.

Distributing securities pursuant to an exemption is an attractive alternative for issuers that wish to raise capital, because exemp­tions typically do not require the issuer to file any disclosure, which can be both cumbersome and expensive.21 Furthermore, issuers that distribute securities under an exemption rather than through a

20. These rationales are in play by < AngelList.co > in collaboration with SecondMarket, for example, where accredited investors can crowdfund start­ups in exchange for equity.

21. It is true that the issuer may prepare some type of disc1osure document, such as a term sheet, but this disclosure is not mandatory. Investors may demand some disclosure, even if it is less rigorous than it would be under a prospectus. The list of exemptions includes an offering memorandum exemption, under which the issuer provides prospective investors with a . lengthy disclosure document containing some of the same information contained in a prospectus, as well as a statutory right of action for misrepresentation.

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prospectus can tap capital markets more quickly as they do not need to obtain regulatory approval before proceeding with the distribution. An ECF exemption for issuers is attractive to issuers for these reasons.

ECFs can also be advantageous for investors. As ECFS occur over the Internet, the costs of acquiring information are lower because investors do not need to rely on underwriters for information; rather, they can access it easily online from their homes. In order to ensure that the information on the Internet is consistently credible, securities regulators could mandate that securities must be distributed through a registered portal, as discussed below. The portal would enable the regulator to undertake a vetting process to ensure, for example, that only solvent issuers are able to issue securities via the portal and that the portal is a member of the country's dealer's association. 22 This stamp of approval provides information to investors - both sophisticated and unsophisticated - about the credibility of the issuer.

Further, ECF transactions can expand investor choice and "democratize" startup investing by allowing retail investors to participate in securities distributions to which they may not otherwise be privy. Andrew Schwartz argues that crowdf unding is beneficial because it extends the ability to invest in potentially high reward startups to everyone, not just to the wealthy and well­connected.23 While investing in startups is risky, some early investors can earn thousands of tin1es their money by backing the right company.24 Crowdfunding is one potential means to this end as it can expose investors to a wider range of investment opportunities than would otherwise be available.

Some of these opportunities may relate to a community project or investment initiative that meets the investor's social or moral objectives (e.g., environmental sustainability).25 For example, Thomas Martin discusses "social good projects," such as initiatives to provide microloans to entrepreneurs in developing countries. 26

22. This endorsement of portal based crowdfunding follows from the JOBS Act, which permits equity crowdfunding via a licensed intennediary (in the U.S. called a broker-dealer) or via a registered portal. See JOBS Act, supra, footnote I, § 304 discussed below.

23. Andrew A. Schwartz, "Crowdfunding Securities" (2013), 88 Notre Dame L. Rev. 1457.

24. Ibid. at P- 1475. 25. Ajay Agrawal, Christian Catalini and Avi Goldfarb, The Simple Economics of

Crowdfunding (June, 2013), 14 Jmwvation Poliq and the Economy - Working Paper Series, online: The National Bureau of Economic Research < hltp:// www.nber.org/chapters/c12946.pdf>, at pp. 8-9. ·

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Non-equity based crowdfunding has raised money for social causes. Indiegogo.com, one of the oldest crowdfunding plat­fonns,27 specifically identifies "social good" projects, allowing site users easy access to a wide variety of social causes seeking donations.28 Such opportunities - indeed, moral considerations that coincide with one's non-pecuniary preference and motivate one to invest - must also be balanced against the likelihood that a

· particular allowable venture is costly. 29

There are two n1ajor objections to ECF from an investor protection standpoint. The first is that ECF transactions can lead to fraud and abuse.30 Notably, however, the persistence of fraud in ECF has not been borne out by available evidence.31 Ethan Mallick has undertaken an empirical study of Kickstarter projects in the Design and Technology category. He examined 381 successful projects, and found that only 14/381 (0.37°/o) had stopped responding to funders "and could potentially have given up on delivering entirely."32 According to a U.K. report, the established evidence shows that little fraud actually occurs with crowdfunded transactions.33 This is not to say that fraud in these transactions cannot or will not occur; it suggests only that the available data undennines the criticism that there are significant investor protection issues with these transactions because of the potential for fraud.

The potential for securities fraud in ECF cannot be assessed in a vacumn, but must be examined relative to the incidence of fraud in

26. Thomas Martin, "The JOBS Act of 2012: Balancing Fundamental Securities Law Principles with the Demands of lhe Crowd" (April 12, 2012), online: Social Science Research Network <http:/ /papers.ssrn.com/solJ/papers.cfm?abstrac­l_id = 2040953 >,at pp. 30-31.

27. Joachim Herner, "A Snapshot on Crowdfunding" (2011), Fraunhofer 1s1

Working Papers Firms and Region No. R2/2011, on1ine: Fraunhofer 1s1: <http:/ I www.isi.fraunhofer.de/isi-media/docs/p/de/arbpap_unternehmen_re­gion/ap_r2_2011.pdf? wsEssroNm=hreuynqf>, at p. 20.

28. "BearLove Good. Cancer Bad" is a campaign to help raise money both for the National Wildlife Federation and the American Cancer Society. See Matthew lnman, BearLove Good. Cancer Bad (2012), online: Indiegogo <http://www.in­diegogo.com/projects/bearlove-good-cancer-bad-3?c= pledges>.

29. Agrawal, Catalini and Goldfarb, supra, footnote 25, at pp. 8-9. 30. Ontario Securities Commission, supra, footnote 16, at p. 26. 31. Elhan Mol1ick, "Crowdfunding: Promise or Peril?" (April l, 2013), online:

Wharton Entrepreneurship Blog < http://beacon.wharton.upenn.edu/entrepre­neurship/2013/04/crowdfunding-promise-or-peril >.

32. Ibid. 33. Kathryn Curtis, "uK Group Targets Crowdfunding Compliance" (March 27,

2013), online: Crowdex <http:/ /crowdex.co/2013/03/27 /uk-group-targets-crowd­funding-compliance/>.

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the exempt market generally, as well as in traditional IPOs. Currently, there is no rigorous data on the incidence of fraud in the Canadian exempt market, 34 but studies suggest that fraud may be fairly common in the exempt market. In May, 2013, the Ontario Securities Commission ( osc) did a sweep of 45 exempt market dealers (EMDs), and found many cases of EMO non-compliance with osc regulations. Eighteen percent of EMDS were found to have sold securities to non-accredited investors who did not fit into any other exemption that would allow them to purchase securities Jegally. 35

With regard to IPO data, Wang et al. studied over 3,000 IPOS

from 1995 to 2005, and found that fraud occurred either before or shortly after the rro in over 11 °/o of the cases. 36 While the authors admit that they are estimating fraud, and studying a high fraud period, the results are surprising. Other researchers have found lower, but still significant levels of fraud. Bohn and Choi found that, between 1975 and 1985, 3.5% of all IPOs ended in security fraud lawsuits. 37 It remains unclear whether ECF will decrease the rates of fraud inherent in securities issuances, or whether dealing over the Internet will increase fraud. Current levels of fraud in traditional IPOs, however, combined with Mollick's frndings of little fraud in crowdfunding generally, at least suggest that ECF

transactions may not actually increase fraud. A second objection to ECF is that investors are unable to

understand what is in their best interests, and that they, therefore, require laws to ensure that they are protected. We should be

34. See Ermanno Pasculto, "Re: osc Exempt Market Review: osc Staff Consultalion Paper 45-710 Considerations for New Capital Raising Prospectus Exemptions" (March 8, 2013 ), on line: Canadian Foundation for Advancement or Investor Rights (FAIR Canada) <htlp://faircanada.ca/wp-content/uploads/2011/0l/F/\IR­Canada-submission-re-CP-45-710-Prospectus-Exemptions.pdf>, at pp. 11-12. Certain types of securities frauds are really commodities rrauds, as we11. Foreign exchange schemes are one example: see Empire Consulti11g Inc. , Re (2012), 35 O.S.C.B. 7775 (Ont. Securities Comm.). Other types of securities fraud involve exploitation of trust, or· a general community: see Hibbert, Re (2012), 35 O .S.C.B. 8583 (Ont. Securities Comm.), additional reasons 35 O.S.C.B. 9013 (Ont. Securities Comm.). These are rare cases. Most frauds are arm's-length transac­tions.

35. Report on the Results of the 2012 Targeted Review of Por(falio Managers and Exempt Market Dealers.to Assess Compliance with the Know-Your-Clie11t, Know­Your-Producl and Suitability Obligations, osc Staff Nolice 33-740, (May 30, 2013), online: Ontario Securities Commission < http://www.osc.gov.on.ca/en/ SecuritiesLaw_sn_20 I 30531_33-740_rpl-results-kyc-kyp.htm >.

36. Tracy Yue Wang, Andrew Winton and Xiaoyun Yu, "Corporate Fraud and Business Conditions: Evidence From 1ros" (2010), 65 J. Fin. 2255.

37. James Bohn and Stephen Choi, "Fraud in the New-Issues Market: Empirical Evidence on Securities Class Action" (1996), 144 U. Pa. L. Rev. 903.

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careful not to exaggerate the supposed incompetence of inves­tors. 38 Mollick examines both venture capitalism -and crowdfund­ing and finds that, in aggregate, crowdfunding investors look at the same signals of quality and risk that venture capitalists do. He also finds that the crowdfunding process reduces some of the biases often associated with venture capitalism, including geographic proximity bias and gender bias towards the entrepreneurs.39

Mollick's study suggests that ECF investors have the ability to distinguish between successful and unsuccessful investment op­portunities just as well as venture capitalists.40 But this conclusion surely does not pertain to the entire universe of investors, and the question arises, therefore, as to the proper role of the regulator in seeking to protect investors. Securities regulation is, and has historically been, concerned with the level of disclosure that should be provided to investors.41 Regulators rightly understand that they cannot be responsible for ensuring that jnvestors read and understand an issuer's disclosure. While "investor protection" couJd broadly mean ensuring that investors understand the products they purchase, such a regulatory obliga tion would be unwieldy, not to mention impractical.

ln sum, for issuers, the key advantage of ECF relates to cost savings in not having to prepare and qualify a prospectus, as well as being able to access capital markets more quickly. Investors may benefit from having access to a range of investment opportunities that allow them to place their funds in companies whose activities coincide with their moral preferences. The lack of a prospectus may mean that they may have less information about the issuer and its securities. Thus, the two major objections to ECF - lack of information and the potential for investors to be defrauded - can be addressed in the design of an exemption, a topic to which we now turn.

IV. POLICY PRESCRIPTIONS

The gist of the previous sections is that ECF provides investors with num~rous a<lvanlages but, at the same time, raises concerns 38. Ethan Mollick, "Swept Away by the Crowd? Crowdfunding, Venture Capital,

and the Selection of Entrepreneurs" (March 25, 2013), online: Social Science Research Network < http://ssrn.com/a bstract = 2239204 > or <http:// dx.doi.org/J 0.2139/ssrn.2239204 >.

39. Ibid. 40. Ibid. at p. 25. 41. Mary Condon, Mak;,1g Disclosure: Ideas and Interests in Ontario Securities

Regulatfon (Toronto, University of Toronlo Press, 1998).

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from an investor protection standpoint. This section probes the policy implications of this argument, contending .that ECF. should be permitted, but only within certain legally mandated parameters. We begin by examining the purposes of securities regulation and the role that regulators play in fulfilling these purposes.

As noted in Part II above, securities regulation seeks to achieve the twin goals of investor protection and market efficiency. The Securities Act (Ontario) explicitJy states that, "The purposes of this Act are to' provide protection to investors from unfair, improper or fraudulent practices; and to foster fair and efficient capital markets and confidence in capital markets. "42 If one surveys the panoply of legislation that comprises the securities regulatory regime, it is clear that the preponderance of rules relate to disclosure and, in particular, what issuers must disclose as "reporting" or public issuers. Disclosure rules are based on equity and reasonableness, rather than efficiency.43 They seek to create a level playing field so that investors and insiders alike have access to the same information prior to making decisions about whether to purchase or sell securities.

How should regulators craft an ECF exemption, given their mandate? One option endorsed by both the JOBS Act and proposals outside of the United States is to limit the amount an individual can invest. The JOBS Act caps overall investment at $1 million in a 12-month period.44 By contrast, the osc is considering imposing a limit of $2,500 per investment, together with a risk acknowl­edgement fonn to be signed by the investor. This conservative ceiling offsets risk involved in start-up investing. It also differs from other exemptions that impose a "floor" on the amount that an individua] can invest. For example, the minimum amount exemption applies to investments of at least $150,000, providing the purchaser purchases as principal.45 No risk acknowledgement form is required in the minimum amount exemption.

42. os.A, supra, footnote 8, s. 1.1. 43. Condon, supra, footnote 41. 44_ See JOBS Act, supra, footnote I, § 302(a)(6)(A). 45. Prospectus and Registration Exemptions, supra, footnote 15, § 2.10; Saskalch­

ewan 's Financial and Consumer Affairs Authority ( FCAA) has proposed a new equity crowdfunding exemption, which would enable companies to make lwo oflerings, of up lo $ 150,000 each, per year. Investors would be limited to making $1,500 investments, and both the business and the investor would have to be based in Saskatchewan. James Langton "Saskatchewan Reguhtlor Proposes Crowdfunding Exemption'', Investment Executive, October 7, 2013, online: <http://www.inves tmen texecu tive.com/-/saskatchewan-regul ator~proposes­crowdfunding-exemplion?redirect = %2Fnews %2Ffrom-the-regulators >.

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Caps on the amount an individual can invest are a good idea but they are insufficient to protect investors from fraud, as fraudsters may misrepresent the cap to potential investors. Further protec­tions may be necessary, including requiring issuers to make certain disclosure. This disclosure would not be as comprehensive as that found in a prospectus, or even an offering men1orandum, but would provide investors with basic information about the issuer and its financial condition. Along these lines, the osc has proposed that investors should be permitted to invest more than $2,500 in a single investment under the exemption, or more than $10,000 in total during any calendar year .46

To ensure that frequent ECF investors best understand the transaction and their rights, ECF securities could be governed by a set of standard conditions. In theory, standard form contracts reduce transaction costs by delineating the terms that the contracting parties will ultimately have to agree to, without requiring a lengthy bargaining process between the parties. 47 Such tenns, based on repeated interactions in the past, usually embody those clauses that sophisticated market actors have agreed to. Standard form contracts also provide parties with a common understanding of definitions of vague terms.48 For example, one proposal is that one single class of shares be issued containing standard terms that deal with a possible IPO, firm liquidation, etc.49

But there are problems with standard form contracts, including the fact that they are often misunderstood or unread. 50 They may not, therefore, serve to protect investors at all. A reform that is more likely to be effective is to require that ECF securities be sold only through an approved portal that is registered with the securities regulator. The portal should be independent and operate pursuant to a list of conditions or restrictions that has been established by the regulator. These conditions may require that purchasers respect the actual funding caps, that they only invest a

46. Ontario SecurWes Cornmission, supra, footnote 16. 47. Marcel Kahan and Michael Klausner, "Standardization and Innovation in

Corporate Conlracting (Or 'The Economics of Boilerplate')" (1997), 83 Va. L Rev. 713.

48. Ibid. 49. Michael Lee, "RE: osc Staff Consultation Paper 45-710: Considerations for New

Capital Raising Prospectus Exemptions" (March 8, 2013), online: Ontario Securities Commission < http://www.osc.gov.on.ca/documents/en/Securities-Ca­tegory4-Commen ts/com_ 20130308 _ 4 5-7.1 O _ leem. pdf >.

50. For a complele discussion see Margaret Jane Radin, Boilerplate: The Fine Print, Vanishing Rights and the Rule of Lail' (Princeton, New Jersey, Princeton University Press, 2011).

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maximum amount over a particular time period, and that they are provided with certain disclosure. Of course, registration would be granted only after the regulator has obtained background infonnatfon about the issuer and its directors, officers, and any significant shareholders, which is itself a response to fraud concerns. 51 The onus for compliance with conditions may rest on issuers selling shares through the portal, as well as those registered individuals who operate the portal itself. The portal may be required to follow up with the regulator reporting on its investment activities and the number of securities taken up, by whom, and under what conditions.

Portal usage is without question an area where the Internet provides a clear advantage over paper-based means traditionally used to distribute securities. Portals can include efficient regulatory oversight with additional investor assistance through effective web design. 52 For instance, the portal could link to relevant 1nedia reports on the issuer, 53 or show a list of high profile investors who have already invested in the project. 54 To ·combat fraud, a reporting system could be built into the portal, allowing for easy reporting to the regulator. Additionally, the portal could combine ECF with another form of fundraising. 55 An issuer could raise funds through equity crowdfunding for its initial startup or general operations from investors who are seeking long-term returns. Later, the issuer could turn to rewards-based funding for the production of a certain product by promising contributors first

51. Ontario Securities Commission, supra, footnote 16, at p. 54. 52. The osc has recently granted permission for the creation of a p1atform that will

a llow for crowdfunded equity and debt to be issued to accredited investors by companies with a socia) or environmental focus. T he platform consists of a public portal, where genera) information about the issuers will be listed, and a private portal accessible only to verified accredited investors. Issuers who have accessed the private porla) can receive financial information or management biographies. These investors then have to be granted access by the issuer to an additional "Deal Room" to receive the business p la n, detailed financial s tatements and other do~uments. AddilionaHy, the private portal will be supplemented with investor meet ings and presentalions in person. See In The M<lller of The Securities legislatum of Ontario ( The "Jurisdiction") and In The Matter Of Mars Vx ( The "Filer") (June 17, 2013), D. Foubert, Ont. Securities Comm., online: Ontario Securities Commission, < http://www.osc.gov.on.ca/en/SecuritiesLa­w_ord_20130620_215_mars-vx.htm > .

53. See, generally, < www.indiegogo.com > for examples of crowdfunding projects that link to news articles.

54. See, generally, <www.Angel.co>. 55. Paul Belleflamme et al., "Crowdfunding: Tapping the Right Crowd" (Ju)y 9,

2013 ), CORE Discussion Paper No. 2011 /32, online: Social Science Research Network < h Up ://papers. ssrn.com/so13 /papers .cf m?a bstract _id = I 578 t 7 5 > .

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access to the product. Combining both options into one portal would streamline the capital raising process. For example, investors might prefer the reward of a smartphone when investing in a consmner technology manufacturer, but prefer an equity stake if investing in a heavy equipment manufacturer.

A further refinement of the portal concept is to ensure an alignment of the portal with investors' interests. Instead of taking a commission of funds raised, portals could take a portion of the profit, thereby becoming investors in the issuers that they host. 56

The portal succeeds insofar as the issuers it hosts succeed, giving it an incentive to host legitimate, non-fraudulent issuers. An online portal in the United Kingdom called "Seedrs" performs a due diligence review before accepting issuers and again before closing, with investors receiving their funds back if the review is unsuccessful. Further, Seedrs holds all shares as nominee trustee on behalf of investors, and manages all dividend payments and disclosure through its online portal. It also earns a portion of the proceeds and future dividends, but only if the transactions close. 57

Seedrs' approach is consistent, though not perfectly aligned, with investors' interests; it charges issuers 7.5°/o of the money raised and investors 7 .5°/o of profits.

As it is a website, the portal is not a traditional intermediary. It is the role of the regulator to ensure that these intermediaries are permitted to operate only if they abide by certain conditions and procedures, as is the case with individual dealers, called "registrants," who are required to act fairly, honestly and in good faith with their clients.58 This type of rulemaking is not new to securities regulators; it is the investor protection function they have fulfilled for decades. It is the medium that is somewhat new, and as Agrawal et al. have explained:59

56. This suggestion is an antidote to one problem with ECF and funding portals as the U.K. experience ~uggests: the alignment of portal and issuer interests to the detriment of investors. Derrick Auch, Don Collie and Marek Lorenc, "Equity­Based Crowdfunding: Coming to a Province Near You?" (July 10, 2013), online: Davis LLP < http://www.davis.ca/en/publicalion/will-equity-based-crowdfund­ing-work-in-canada/>.

57. Ibid. 58. Conditions of Registration, O.S.C. Rule 31-505 (September 18, 2009), s. 2.1. Such

registration would render the portal registration akin to the process that relates to self-regulatory organizalions (sRos).

59. Rotman School of Management, "Spectacular Failures, New Opportunities to be Expected from Equity Crowd funding" (July 15, 2013), online: Rotman School of Managemenl < hllp:/ /www.rotman.uloronto.ca/Connect/MediaCentre/News­Releases/20130716.aspx>; Lee, supra, footnote 49.

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It feels like we are being far more protective of people making mistakes buying small amounts of equity through crowd funding than we are of people making mistakes buying other goods and services on the internet that are sometimes fraudulent, of lower-quality, or overpriced.

These suggestions for reform - standard form contracts, exemptions and portal design - focus on ex ante measures that can be adopted in order to protect investors. Yet these measures will not prevent investors from losing the value of their investment if they lack legal remedies. 60 Remedies are important, as is an active regulator that monitors the exempt market, including portals, for abuse. and bringing actions in the public interest where necessary. Providing private protections in share conditions, such as anti-dilution protections and pre-etnptive rights, is also possible.61 These rights would presumably give rise to a private action for breach of contract ex post and may be in addition to regulatory action taken for the wrongdoing.

The JOBS Act ensures that companies issuing ECF securities can be held liable to investors for making material misstatements concerning securities they have issued, or for omitting to disclose 1naterial information regarding those securities. In these situations, individuals who have purchased the issuer's shares can bring legal action to recover their net losses: either in the form of consideration paid for the securities, if the securities are still owned, or damages if the securities are no longer owned.62 Because exemptions typically do not carry a disclosure requirement, civil remedies on which investors can rely in case of misrepresentation do not currently exist in the securities regulation, save for the right to sue issuers, and their directors and underwriters, for mis­representations contained in offering memoranda. 63 But this remedy could serve as a statutory template for a remedy to address misrepresentations in ECF disclosure.

60. See John Wroldsen, "The Social Network and Lhe Crowdfund Act" (2013), 15 Vand. J. Ent. & Tech. 583, at p. 583:

When success fol start-up companies raise additional fonds from professional venlure capital is ls, the value of ground-floor investments can be severely diluted ... when crowd funded companies are acquired in privale trnnsaclions, crowdfunders are al risk of being left out.

61. !hid. 62. See JOBS Act, supra, footnote l, § 4A(c). If the securities are still owned, the

person charged with delennining the extenl of damages must also take into account not only profits received from the shares, but also interest.

63. osA, supra, footnote 8. s. 130. l (I).

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V. CONCLUSION

The tenn "investor protection" does not mean that regulators will remove all risk from an investment; rather, it involves the provision of protections, such as adequate disclosure and, in the case of ECFs, registered portals, so that investors can make inf onned decisions. An ECF exen1ption would be a middle ground between full-blown prospectus offerings on the one hand, and exemptions that require no disclosure and carry little regulatory oversight on the other. The potential for fraud warrants careful consideration in the crafting of the ECF exemption, but should not . stand as the reason that investors are denied the investment opportunities otherwise available under ECF.

VI. ADDENDUM

After this article had been accepted for publication, the osc released a proposed crowdf uncling prospectus exemption. 64 The proposed exemption in Part IV of this article is similar, though not identical, to the osc proposal. Both proposals support the introduction of investment lhnits, portal registration, standardized disclosure and a contractual right of action in the event of a misrepresentation in disclosure documents. Unlike the recommen­dation in Part IV of this article, however, the osc proposal contains a maximum offering amount of $L5 million per issuer per year and other measures (including rights of withdrawal and resale restrictions). The author is, generally, in favour of these additional restrictions as means of ensuring that investors are protected in the course of making investments in the crowdfunding context.

64. Ontario Securities Commission, "Intr.oduction of Proposed Exemptions and Proposed Reports of Exempt Distribulion in Ontario" (March 20, 2014), online: < hltp:( /www .osc.gov .on.ca/en/Securities Law_ csa_20140320_ 45-106_rfc-pro­spectus-exemptions.htm >.

“Reproduced from - Anita Anand, "Is Crowdfunding Bad for Investors?” (2014) 55:2 Canadian Business Law Journal. by permission of Thomson Reuters Canada Limited.”