Johannesburg, 13 Oct 2016
Crowdfunding seems to be the trend that is stealing the spotlight at the moment, say Lerato Lamola (Senior Associate) and Anel De Meyer (Candidate Attorney) at Webber Wentzel. From raising US$40 000 for Zach Brown's potato salad, funding the Oscar winning film Innocente in 2013 or simply providing start-up capital for a small business which could not have done so otherwise, crowdfunding purports to be the answer to everyone's unfunded dreams without the general hassle involved in obtaining traditional funding.
Crowdfunding simply refers to the pitching of an idea by a person (an originator) via a platform (normally a Web site, run by a facilitator) to a large number of people (the crowd) in order to finance a project, a business venture or to raise monetary contributions incidental thereto.
Contrary to popular belief, the idea of crowdfunding is not as new as one might think. Crowdfunding's roots can be traced back to as early as 1713 when Alexander Pope set out to translate poetry written in Greek into English. Pope asked the public (the crowd) to donate "two gold Guineas" to the cause, and in turn a funder was mentioned as a contributor to the publishing of the book. Similarly some of Mozart's earliest performances and even the Statue of Liberty were financed by way of crowdfunding.
In modern times crowdfunding has gained more traction, especially as a result of the financial crisis throwing the global economy into turmoil in 2008. Banks have introduced more stringent credit criteria, and tightened the noose around lending to clients such as small businesses and possible entrepreneurs who are flagged as "high risk" consumers. Therefore, crowdfunding has emerged as a plausible alternative source of funding for the said high risk consumers who previously could not access traditional forms of funding for their businesses or projects.
In general, reference is made to two categories of crowdfunding namely donation crowdfunding or investment crowdfunding. Donation crowdfunding encompasses either rewards-based or donations-based funding. Rewards-based crowdfunding entails the funding of a project by virtue of contributions sourced from the crowd, whilst a funder receives something in return for making a contribution. The reward can be anything from a voucher to a keychain. Normally, the prestige of the award is dependent on the amount contributed. The funding of digitising the Labia Theatre in Cape Town serves as a typical example. In this instance funders could be rewarded with a tour of the theatre, tickets to see a show or having their names flash on the screen before a showing.
Donations-based crowdfunding envisages the crowd donating funds for munificent reasons without receiving or expecting something in return for giving a donation. Furthermore, with regard to donation crowdfunding, the funders' money will be returned to them should the project or business venture not reach its target value within a specified amount of days.
On the other hand, investment crowdfunding is based on equity or lending (peer-to-peer lending). Equity crowdfunding pertains to contributors receiving equity instruments or entering into profit share arrangements with originators. Peer-to-peer lending refers to a circumstance where an originator asks for loans in respect of a business or idea, whilst promising fixed interest rates on return payments.
The question however remains: How is crowdfunding regulated and is it regulated in terms of South African law?
Abroad, great strides have been made to create a legal framework, wherein crowdfunding may operate validly. In America we have seen the promulgation of the infamous Jumpstart our Business Startups Act (JOBS Act), under which Title III thereof makes provision for the regulation of investment crowdfunding by creating a federal exemption therefore under the securities laws. Title III addresses amongst other things, compliance guidelines for issuers (originators), disclosure interpretations for issuers and the registration of crowdfunding platforms. In the United Kingdom, the Financial Conduct Authority explicitly regulates investment crowdfunding through various measures, such as licencing requirements and rules relating to information disclosures and marketing practices. Both of the mentioned Regulators mean that this regulation is aimed at protecting the crowd, whilst also trying to facilitate crowdfunding in itself.
The regulation of crowdfunding has been criticised by many as "stifling" in respect of its aim: to act as a conduit for funding in terms of business ventures or projects that have no other alternative financing options. However, it must be submitted that crowdfunding cannot be left unchecked, especially with regard to investment based crowdfunding which could hold market risk that affects not only the contributors from the crowd, but also the market itself.
The regulation of crowdfunding in terms of the South African regulatory landscape is still uncharted territory. The Financial Services Board ("the FSB"), which is the responsible authority for promoting and maintaining a sound financial market is currently on the fence about specific legislation or regulations for the purposes of regulating crowdfunding.
In an article in the FSB Bulletin for the first quarter of 2016, the FSB stated that crowdfunding is not as yet regulated in terms of South African law. However, since crowdfunding may already fall within the regulatory ambit of other existing financial services sector legislation, the article suggested that possible or existing crowdfunders- and platforms first assess the activity they are performing against these pieces of legislation in order to determine the scope of regulation they may be subject to.
Legislation which may be relevant includes the Banks Act, Companies Act, Collective Investment Schemes Control Act (CISCA), the Financial Advisory and Intermediary Services Act ("FAIS Act"), the Financial Markets Act (FMA) or the National Credit Regulation Act.
In terms of the Banks Act, crowdfunding activities could classify as a deposit-taking action. In particular, investment crowdfunding could be ensnared in regulation under the Companies Act, 71 of 2008 in terms whereof public offerings necessitate disclosure requirements. In this regard the National Credit Act could also come into play with reference to peer-to-peer lending platforms. Where a platform acts as an "intermediary" the FAIS Act becomes applicable. Furthermore, it is understandable that investment crowdfunding may also be subject to anti-money laundering- and Know Your Client requirements under the Financial Intelligence Centre Act (38 of 2001).
Pursuant to the above, the more interesting issue is whether or not crowdfunding will be explicitly regulated with reference to the looming enactment of the Financial Sector Regulation Bill ("the FSR Bill"). The FSR Bill forms part of the Twin Peaks model of financial regulation. This model will allow (amongst other things) for the creation of the Prudential Authority and the Financial Sector Conduct Authority whom will be responsible for the overarching regulation of the financial services sector in South Africa through various regulatory instruments.
The Prudential Authority in terms of clause 32 of the draft FSR Bill* ("the FSR Bill") will be administered by the South African Reserve Bank, and their objective under clause 33 is to maintain financial stability, whilst also promoting and enhancing the soundness of financial institutions. The current FSB will don the mantle of the Financial Sector Conduct Authority (FSCA), as provided for in terms of clause 56 of the FSR Bill. With regard for their objectives as per clause 57 of the Bill, the FSCA will aim to supervise market conduct of financial institutions, with the underlying premise of protecting financial customers.
To determine the regulation of crowdfunding under the FSR Bill, a few considerations need to be taken into account. In order for the provisions of the FSR Bill to have any tract regarding an entity or product, it must qualify either as a "financial institution", a "financial product", a "financial product provider," a "financial service" or a "financial service provider" as set out under the Bill. How or as what a "crowdfunding venture" will qualify in terms of these concepts, will also be subject to what the regulator intends to regulate: the platform, the originator, the project or all of the aforementioned?
In terms of clause 1 of the FSR Bill, a financial service provider, a financial product provider, a market infrastructure, a holding company of a financial conglomerate or a person licensed or required to be licensed in terms of a financial sector law are all considered to be a "financial institution".
That which constitutes "financial products" is set out under clause 2 of the FSR Bill. Currently, crowdfunding or anything incidental thereto is not specifically named under "financial products". However investment crowdfunding may well fit under clause 2(2) of the Bill, which determines that: "The Regulations may designate as a financial product, any facility or arrangement that is not regulated in terms of a specific financial sector law if - (a) doing so will further the object of this Act set out in section 7;and (b) the facility or arrangement is one through which, or through the acquisition of which, a person conducts one or more of the following activities:(i) lending; (ii) making a financial investment; and (iii) managing financial risk".
Similarly, crowdfunding could be shelved under clause 3(1)(a) of what a "financial service" constitutes: "(a) any of the following in relation to a financial product, a foreign financial product or a financial instrument: (i) Offering, promoting, marketing or distributing; (ii) providing advice, recommendations or guidance; (iii) operating or managing (iv) providing administration services". It is also noteworthy that clause 3(3) determines that the Regulations promulgated in terms of the Bill may deem unregulated services to be a financial service if doing so will be incidental to the objects of the Bill or if such a service relates to a financial product, market infrastructure or arrangements concerning lending or investments.
Whatever the case may be, it can be accepted with regard for the purpose of the FSR Bill, as well as the Twin Peaks regulatory system in general, that crowdfunding will be regulated in future as the Regulators would want to enhance financial soundness of the market, whilst also protecting financial sector participants.
Crowdfunding and crowdfunding activities can be regulated by virtue of various regulatory instruments provided for in terms of the FSR Bill. Firstly, the Prudential Authority under clause 105 may issue prudential standards in relation to issues such as the soundness and safety of financial institutions, lowering the risk of key persons and financial institutions partaking in behaviour that may constitute financial crime and the maintenance of financial stability. It follows that the FSCA may also generate conduct standards as set out in clause 106. Conduct standards will aim to ensure the efficiency and integrity of financial markets, the fair treatment of customers or any matters incidental thereto. Provisions for the issuing of joint standards or standards in respect of "additional matters" are also mentioned in clause 107 and 108 of the FSR Bill, and even Guidance Notes or Interpretative Rulings under clauses 141 and 142 may also become applicable in regulating crowdfunding.
Given the nature of investment crowdfunding, it is understandable that it may induce some prudential concerns which may necessitate the issuing of prudential standards related to liquidity and capital adequacy requirements. Furthermore, this approach may also be beneficial to further crowdfunding as an alternative avenue of financing. Specifically regulating investment crowdfunding in terms of prudential standards will prohibit it from getting entangled in the CISCA or FMA and free it from the onerous regulatory compliance requirements that may stifle the potential of crowdfunding.
However, it is believed that the regulation of crowdfunding will mainly fall under the FSCA's wing. The FSCA's regulatory approach includes the TCF initiative - which purports to ensure that financial institutions treat customers fairly.
Under the FSCA, anticipated regulation in terms of crowdfunding could be related to various aspects such as marketing and advertisement requirements which may be issued by way of standards. In order to protect consumers, the FSCA may, for example determine that only certain types of funders may dabble in investment crowdfunding. In relation to marketing and advertising, the FSCA may issue standards echoing something similar as is contained in relation thereto under the current Policyholder Protection Rules. The requirement that the marketing of a platform or the funding of an idea must be "fair, clear and not misleading" serves as an example in this regard.
The FSCA may well determine that crowdfunding platforms necessitate the requirement of applying for a licence in terms of the FSR Bill. The above mentioned regulations could then be attached as a licencing condition in terms of a crowdfunding platform, or the licence may envisage some restrictive principles aimed at curbing any misconduct that may be a risk related to crowdfunding. A licencing condition could even determine that a project or business venture may only be financed up to an established maximum amount. It is reiterated that the regulation of crowdfunding under the FSR Bill, will also be dependent on the type of crowdfunding operated.
Although donation crowdfunding is not regulated abroad, and does not seem to pose any risk inherently, the FSCA in trying to promote market integrity and the fair treatment of customers may still issue conduct standards in relation to such crowdfunding activities.
The premise that crowdfunding regulation will fall mainly under the FSCA further advances the notion that crowdfunding serves as a means of providing funding in a non-traditional, hassle-free manner. Particularly in a developing country such as South Africa, crowdfunding could serve the very important purpose of supplementing the economy by kick-starting small and medium-sized enterprises, which did not previously have access to the market.
As such, it remains important that crowdfunding is not over regulated or burdened with onerous regulatory requirements, as this would completely defeat the purpose of such a venture. However, the protections of financial consumers are imperative and therefore the correct balance must be struck when the legislature issues legislative requirements in this regard, in order to promote both innovation and protection in terms of crowdfunding. The fact that the FSB is wary of promulgating legislation just for the sake of regulating crowdfunding is at least indicative of their aim to achieve this balance. As the FSB stated in the 1st Quarter Bulletin mentioned above, it is considering a report by the International Organisation of Securities Commissions on the subject, which speaks to the challenge of creating this given balance before considering the way forward in terms of regulating crowdfunding.
Whilst we await the inevitable promulgation of the FSR Bill, one thing is certain: It will be a fly on the crowdfunding wall.
* References to clauses in the FSR Bill are as they appeared in draft at the time of writing this article.
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