Search This Blog

Monday, 3 September 2012

Unpacking The Term "Crowdfunding"

The term "crowdfunding" is being used a lot in legal circles these days, but it can mean a number of different things to different people - from many people buying shares in a single company to any form of peer-to-peer financing or donations. So for the sake of clarity I thought I'd explain my own understanding of the different types, as well as the overall policy context.  

Terminology

In its broadest sense, 'crowdfunding' describes a key impact of Web 2.0 on financial services (as discussed over on Pragmatist, and in print here). It's one aspect of the same trend towards greater consumer control that has swept through retailing, entertainment and so on. The critical point of distinction between the various forms of crowdfunding and 'traditional' forms of finance is that crowdfunding involves a finance marketplace comprising consumers and/or small businesses on both sides, whose direct interaction is facilitated by a neutral platform operator, rather than a single financial institution offering its products to its customers. Other key characteristics are set out in Annex 1 to this note. But when the term 'crowdfunding' is used in this broad sense, one should bear in mind that it actually encompasses a range of very different models, involving very different legal instruments, with very different legal and regulatory outcomes, as discussed below.

'Crowdfunding' first gained currency to describe 'rewards-based' peer-to-peer platforms like ArtistShare and Kickstarter.com, which were designed to raise money from many people to fund many small budget projects via the internet without infringing US laws that control the offer of 'securities' to the public. On those web sites, eligible people are enabled to post 'pitches' seeking funding for a project (e.g. to start a monthly magazine) in return for a 'reward' of some kind (e.g. a monthly copy of the magazine for a period). There is a range of similar platforms in the UK (e.g. Peoplefund.it, Crowdfunder and those mentioned here).

Independently of rewards-based crowdfunding, peer-to-peer platforms have also emerged in the markets for personal loans and small business loans. This activity was first called 'social lending', then 'person-to-person lending', 'peer-to-peer lending', 'P2P lending' and more recently 'crowd lending'. Examples include Zopa, Ratesetter and Funding Circle in the UK and, say, Comunitae in Spain. The peer-to-peer lending model has also been adapted to enable many people to fund numerous small businesses in developing countries, which is referred to as 'micro-finance' (e.g. Kiva, MyC4). When applied in the domestic not-for-profit or charity sector, the peer-to-peer lending model tends to be referred to as 'social finance' (e.g. Buzzbnk).

However, the term 'crowdfunding' has acquired a more formal regulatory meaning over the past year or so, as a result of the successful campaign in the US to introduce the JOBS Act to allow the crowdfunding model to be used in situations where 'securities' are the reward (Title III of  the JOBS Act is called the Crowdfund Act). This is apt to cause confusion outside the US, because the US Securities Exchange Commission has a broader interpretation of what constitutes a 'security', and narrower exemptions from the scope of its securities laws, than the UK and many other jurisdictions.

Prior to the JOBS Act, the SEC required an individual or small business borrower to comply with the same formal registration requirements for entering into a simple loan contract via a public web site that a major corporation must follow when offering its shares, bonds or debentures to the public. So US-based peer-to-peer lending programmes have had to be registered with the SEC at great expense and require a financial institution to act as an intermediary (e.g. Lending Club, Prosper).

But in the UK and many other jurisdictions such heavyweight requirements are applied to more complex debt instruments (bonds and debentures) and shares ('equities'). As a result, peer-to-peer lending (or 'crowd lending') using simple loan contracts has been established outside the scope of securities or investment regulation in the UK since Zopa launched in 2005 (later joined by Ratesetter and Funding Circle).

However, peer-to-peer models that involve shares and debentures ('crowd investing') have proved a lot more awkward to implement, given that traditional financial regulation is more intense in connection with those instruments. Exemptions have been more liberal than in the US (at least pre-JOBS Act), although fiendishly complex and expensive in time and money to interpret. As a result, there is a growing political consensus that the UK would also benefit from a US-style regulatory overhaul in this area. And it is in the context of this policy debate that use of the term 'crowdfunding' is most at risk of generating confusion between 'crowd investing' and other forms of  'crowdfunding' in the broader sense.

Policy Context

While 'crowd investing' is perhaps most under the regulatory spotlight currently, there are some common issues and operational risks across all types of 'crowdfunding' in the broadest sense (though less so with rewards-based crowdfunding). All types of plaforms involve a similar technological and operational 'architecture of participation'. And they all meet some difficulty under traditional regulation - and the more intense that regulation is, the more complex it is to innovate, launch, operate and grow. Small changes can trigger significant regulatory requirements, increase costs and inhibit marketing. Tax incentives favour products offered by traditional institutions and inhibit the ability of ordinary savers and investors to diversify.

As a result, the operators of both peer-to-peer lending and crowd investing platforms have been calling for proportionate regulation at the platform-level to enable rapid, responsible development, regardless of the type of instrument available on the platform. This process began when the leading UK peer-to-peer lenders launched the Peer-to-Peer Finance Association in July 2011, proposing a set of Operating Principles to address typical operational risks. They and several crowd investment operators have also participated in various government and private sector forums. The social finance sector has since added its support, with leading charity lawyers Bates Wells & Braithwaite citing the development of these types of platform as a necessary step in the development of social investment (which was also endorsed by the government-funded Community Shares Unit). And a meeting of wide variety of European industry participants took place in June 2012 to discuss the need for EU regulation. 

In the meantime, economic reality has also increased the pressure for clear and proportionate regulation to enable alternative finance. Banks and other traditional investors continue to conserve capital or offer finance on terms that are unduly onerous, while charging savers and investors high fees and/or failing to offer a decent return. There is a dawning recognition that it's down to entrepreneurs and private investors to connect the dots between low returns on savings and the fact that SMEs face a funding gap of £26bn - £52bn over the next 5 years, or that social sector organisations face an annual finance gap of £0.9bn  - £1.7bn

Against this backdrop, there have been numerous UK government reports and recommendations on the need to encourage the creation and development of both peer-to-peer lending and crowd-investing, with the weight of emphasis depending on the focus of the relevant initiative. These include the Cabinet Office's Red Tape Challenge on disruptive business models; NESTA's "Beyond the Banks" report; the Breedon Taskforce report (which the government largely accepted); Andrew Haldane's speech on forging a common financial language; and Lord Young's report to the Prime Minister on the start-up and development of small business. 

However, there has been little concrete action from the UK Treasury, prompting the debate of various amendments to the Financial Services Bill in the House of Lords. In essence, these amendments seek both greater engagement by the authorities in encouraging innovation generally, as well as specific regulation to encourage the growth of peer-to-peer models for a range of different instruments.

By way of comparison, it's interesting to note that the JOBS Act was the product of a US Presidential initiative in January 2011 which received bi-partisan support in the US Congress, and the new law was signed by the President on 5 April 2012.


Image from Lattice Capital.