As a widely developed world phenomenon and innovative funding method, crowdfunding has recently been incorporated into the Turkish legal system with Amendments to the Capital Markets Code.
CROWDFUNDING is a new generation of venture funding that operates by raising money from a large number of people who each contribute a relatively small amount of investment capital, typically via the internet. This new method of capital formation emerged after the 2008 financial crisis in response to the difficulties faced in general funding by early-staged enterprises. The bureaucratic disadvantages and cumbersome procedures and paperwork that are inherent in traditional financing systems have inevitably led both entrepreneurs and potential investors to seek alternative means of financing such as crowdfunding.
Aiming to be one of the few countries that have incorporated crowdfunding into its domestic laws, the Turkish Grand National Assembly recently accepted various Amendments to the Capital Markets Code (“the Amendments”) which provide a flexible but protected legal regime for financing. The Amendments were published in the Official Gazette on December 5, 2017.
Crowdfunding as an Attractive Option for Entrepreneurs
Financing through crowdfunding has two main advantages for project owners: (i) the project owners do not need to be large-scale professional managers or companies when the idea itself is already sufficient enough to be presented to the public for funding; and (ii) instead of incurring significantly large costs during new product launches, the pitching process provides proof of public opinion and market interest at inception or the prototype phase, which ultimately lowers entry barriers. The opportunity for public feedback is especially crucial for startup companies because the funding is a result of the project owner’s first interaction with target customers and investors. Even when an idea has not yet attracted angel investors, it still has a chance of generating capital during the project’s early stages through an interested customer base, small funders, family, friends, or other actors. Furthermore, this customer base might not only invest in new ideas monetarily, but may also spread the idea to their social environment creating a butterfly effect. This highly motivated group of customers can serve as product evangelists who introduce project owners to valuable connections.
Crowdfunding provides an opportunity for investors to investigate projects that fit their risk appetite while mitigating investment risks by allowing investors to contribute in small amounts. This is a progressive change from emerging venture capital which is typically risk averse and may leave a funding gap for innovative companies especially in developing nations. However, although crowdfunding provides many protections, these campaigns also bear the risk of failure, fulfillment, fraud, and money laundering.
Crowdfunding is divided into three parties: project owners, funders, and internet sites that act as intermediaries for transferring funds. The system is both a financial market activity and a direct financing method in which funders and project owners come together on one platform.
The crowdfunding system may operate under two main categories: “investment crowdfunding” or “donation crowdfunding”.
The investment crowdfunding system typically allows funders to receive company shares, debt instruments, or a share in revenue in return for their investments (respectively equity-based, lending-based, and royalty-based models). These investment models are not considered e-commerce activities or donations since they do not involve direct product sale or gratuitous support. Investment crowdfunding attracts both venture capital and angel investors because the funds raised on the crowdfunding platform are proof of market interest which mitigates the risk of failure in the eyes of the investor.
Donation crowdfunding may involve a philanthropic style donation without expecting monetary compensation in return (donation-based) or a token gift to be presented to the funders for their contributions (reward-based). Donation-based crowdfunding is not a capital market matter in Turkey, but it is governed by the Code on the Collection of Aid and is subject to a prior permission process.
Due to Turkey’s current donation regime, the Amendments focus on investment crowdfunding rather than donation crowdfunding aiming to loosen the traditional bureaucracy.
Suggested Regulatory Framework
The Amendments solely focus on equity-based crowdfunding and leaves the implementation details to be determined by the CMB through secondary legislation.
The Amendments define crowdfunding as: “the collection of funds from people through crowdfunding platforms in order to provide funds required by a project or venture company, without being subject to the provisions of the Capital Markets Code on investor compensation, within the principles to be determined by the CMB,” signaling the efforts of the legislature to release crowdfunding from the costs and bureaucracy that capital market transactions generally entail.
In order to save crowdfunding from the highly regulated capital market regime, the Amendments clearly distinguish crowdfunding from publicly-held corporations and issuers. Regardless of the number of investors, those raising funds via crowdfunding would not be deemed publicly held and therefore would not be subject to the strict requirements of publicly held companies. Crowdfunding activities would also not be categorized as investment activities or ancillary investment services in the classic sense of the term under the Capital Markets Code and Communiqué Principles Regarding Investment Services, Activities and Ancillary Services.
The rationale behind this legislation is to preserve the lightly regulated nature of investments involving risk return trade-off where higher risk is associated with a greater probability of higher return. If an investor has a tendency to invest small amounts into short-term projects that bear different kinds of risks instead of engaging in long-term investments, regulations must be formed such that the investor is encouraged to take risks with lower levels of bureaucratic burdens imposed by the law. This is why crowdfunding platforms are not regulated as tightly as publicly held corporations and are instead left loose to attract more investors even if only on a small scale.
Looking at the Amendments overall, the only area that the legislature has chosen to regulate is crowdfunding platforms. Establishment and operation of crowdfunding websites as an intermediary platform between funders and project owners would be subject to the CMB’s approval. The CMB is also authorized to determine the details of shareholder requirements, the maximum amount of funding permitted, control and use of the collected funds, and other measures. In any case, preparation of a prospectus (izahname) or issuance certificate (ihraç belgesi) would not be required since crowdfunding is not qualified as a public offering of shares.
Crowdfunding in the World
Several developed states, mostly those centered in North America and Europe, have opted for customized regulatory framework for crowdfunding, while a number of developing nations are either preparing or planning to introduce a similar regime.
The earliest application of donation crowdfunding before juridification procedures took place was seen in the United Kingdom in 1997, even though the first legislative steps were taken by the USA. Similar to the Amendments, the UK authorized the Financial Conduct Authority (“FCA”) to regulate crowdfunding platforms. The FCA has the same functions as the CMB in the Turkish legal system regarding secondary legislation creations and governance. Both entities have the authority to regulate investment crowdfunding under the scope of the relevant law. For example, equity offerings to the public either have to be authorized by the FCA or fall under a specified exemption otherwise the offering is deemed illegal under the current law.
Recognizing the limited financing options available to small-scale companies in the post-recession economy, the USA regulated crowdfunding in a more organized system. The US Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”) and established its implementation primarily on the rulemaking of the Securities and Exchange Commission (“SEC”) rather than the content of the Act itself. The SEC amended the Securities Act in a way which allows for benevolent giving through online platforms in the exchange for a limited amount of equity. In this new system, if a company is not specifically exempt from the registration process, stocks and other securities at issue must be sold through registered companies pursuant to the SEC provisions. The amount of investment allowed by the SEC is determined based on the investors’ income and net worth.
Other European Union countries like Italy, Austria, Belgium, Spain, France, Germany, and Portugal also have developed comprehensive provisions in favor of crowdfunding and its application. Crowdfunding has also reached Asia, Australia, and the Middle East through platforms that foster the spread of this new financing system.
Crowdfunding might be an alternative tool to generate money for small-scale companies in Turkey and can serve as a tool to foster innovative technology enterprises. While Turkey has recently been trending in technological development, investment culture and capital are currently Turkey’s weakest links. The introduction of this innovative system bears the risk of bringing along intellectual property infringements, fraud in security markets, and money laundering.
Crowdfunding becoming a viable investment and funding method in Turkey would be dependent on the technology, community engagement, entrepreneurial culture, and applicable regulations to be matured collectively.
Because the Amendments were approved in the Turkish Grand National Assembly, the ball is now in the CMB’s court since it has the duty to set secondary legislation in light of the Amendments’ framework. The CMB hints that work on secondary legislation is expected to be completed by the third quarter of 2018. As one of the key characteristics of the system tailored for Turkey, the secondary legislation is planned to introduce a withdrawal right for investors within seven days of the date of their contribution, and if the targeted amount cannot be raised within a specified period, contributions will be returned to investors. It is crucial to set a good balance between overregulation and coming up with an effective and efficient monitoring regime backed with carefully tailored rules in order to mitigate potential risk and contribute to maintaining support and trust of the general public in crowdfunding. Secondary legislation has yet to provide further guidelines regarding the possible model.