This week, the Ontario Securities Commission published a progress report in which it indicated that it will consider a crowdfunding exemption. This is good news for investors and issuers.
“Crowdfunding” is a means of selling any product or service over the Internet to a broad group of consumers. The cost savings for the issuer are obvious: the issuer can raise capital more quickly than under the traditional prospectus method. 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. Non-pecuniary benefits include an investor’s ability to purchase securities in a startup that is connected to social causes that he or she supports.
Two major objections to crowdfunding warrant comment. First, Internet-based transactions can lead to fraud and abuse. But Ethan Mollick examined 381 successful Kickstarter projects and found that only 14/381 (0.37%) had stopped responding to funders “and could potentially have given up on delivering entirely.” Admittedly, the potential for fraud cannot be assessed in a vacuum, but must be examined relative to the incidence of fraud in the exempt market generally as well as in traditional IPOs. But in terms of the exempt market, there is currently no data on the incidence of fraud in the Canadian exempt market.
Regarding IPO data, Wang et al. studied over 3000 IPOs from 1995 to 2005, and found that fraud occurred either before or shortly after the IPO in over 11 percent of the cases. Bohn & Choi found that between 1975 and 1985, 3.5 percent of all IPOs ended in security fraud lawsuits. Current levels of fraud in traditional IPOs, combined with Mollick’s findings of little fraud in crowdfunding generally, at least suggest that crowdfunding may not actually increase fraud.
A second objection is that investors are unable to understand what is in their interests. This claim should be examined closely so as not to exaggerate investors’ supposed incompetence. 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. In other words, investors in a crowdfunded transaction have the ability to distinguish between successful and unsuccessful investment opportunities just as well as venture capitalists.
The next step forward should be to allow crowdfunding via registered portals. These portals are not traditional intermediaries but websites run by separate stakeholders. It would be the role of the regulator to ensure that these portals are permitted to operate only if they abide by certain conditions and procedures, as is the case with registrants who are required to act fairly, honestly and in good faith with their clients.
The term “investor protection” does not mean that securities regulators remove all risk from an investment. It involves the provision of protections, such as adequate disclosure and, in the case of crowdfunding, registered portals, so that investors can make informed decisions. It is not the role of securities regulators to ensure that all risk associated with a purchase is removed. Such a level of paternalism would be unprecedented in consumer protection of any sort.
Anita Anand is a Professor of Law at the University of Toronto.
August 30, 2013
