The EU crowdfunding regulation
Crowdfunding is an innovative way of fundraising that enables prospective fundraisers to obtain necessary financing through small contributions from a large group of investors.
In the US, the first regulation on crowdfunding was introduced back in 2015. However, the EU has lagged behind and individual Member States have created national crowdfunding frameworks that differ from one another. The lack of a harmonised regulatory framework has been a significant impediment to the provision of crowdfunding services on a cross-border basis.
The idea of a sole EU Regulation on crowdfunding that would bridge these gaps was set out in the EU Commission's FinTech Action Plan. However, the first draft of the future EU regulatory framework on crowdfunding was followed by a relatively long co-decision procedure of the European Parliament and the Council, during which various amendments to the original proposal were made. After more than two years of long and intense discussions between EU lawmakers, the final compromise text of the EU Regulation ((EU) 2020/1503) on Crowdfunding Service Providers (ECSPR) was adopted and published on 20 October 2020.
The ECSPR creates a level-playing field for operators of crowdfunding platforms in the EU by introducing a harmonised set of rules that will enable European crowdfunding service providers (CSPs) to explore the full potential of the EU Single Market.
The ECSPR will start to apply as of 10 November 2021. CSPs already operating under national regimes have been provided with a 12-month transitional period to ensure compliance with the new rules.
The ECSPR covers two of the most common practices used by crowdfunding platforms:
- Lending-based crowdfunding
- Investment-based crowdfunding.
Some other types of crowdfunding practices, like donation-based crowdfunding or reward-based crowdfunding (where investors receive a non-financial consideration for their investment) will not be directly covered by the ECSPR.
Only crowdfunding offers with a consideration not exceeding EUR 5,000,000 per project owner over a 12-month period will be within the scope of the ECSPR. Offers exceeding this threshold will need to be made in accordance with general requirements on the issuing of financial instruments and the provision of regulated financial services (eg under the Prospectus Regulation, MiFID II etc).
The EU legislator has emphasised that this crowdfunding practice should be clearly distinguished from the activities of regulated credit institutions that grant credits for their own account and take deposits or other repayable funds from the public. The operator of a crowdfunding platform acts as an intermediary who merely facilitates the execution of a loan agreement between the borrower (project owner) and the lender (investor) without acting as a lender or a borrower itself.
Under the ECSPR, the term 'loan' refers to an agreement in which a defined amount of money is made available to the project owner:
- for an agreed duration
- which creates an unconditional repayment obligation of the advance (together with accrued interest) to the investor
- in accordance with the instalment payment schedule.
Despite seeming quite straightforward, this definition excludes certain types of loan agreements, e.g. qualified subordinated loan agreements.
In addition to the simple facilitation of granting of loans via their platform, CSPs will also be allowed to provide individual portfolio management services in relation to loans. To that end, they will be allowed to allocate a pre-determined amount of funds of an investor to one or more crowdfunding projects marketed on their platform, in accordance with an individual mandate given by the investor.
Bearing in mind the ever increasing deployment of innovative technologies in the financial sector, the EU legislator has stipulated explicitly that the use of auto-investing tools by crowdfunding platforms that enable automatic allocation of investors' funds in different projects is deemed to be the individual portfolio management of loans within the meaning of the ECSPR.
Legal entities that provide crowdfunding services within the meaning of the ECSPR will need to obtain authorisation from the national competent authority (NCA) in their Member State of establishment. Once authorised, they will be able to provide crowdfunding services across the EU on a cross-border basis.
Crowdfunding platforms located outside the EU - including the ones that have found their comfort zone in (until recently) the biggest FinTech centre of the European Union, London - will either need to relocate or establish subsidiaries in the EU to obtain authorisation in accordance with the new rules under the ECSPR.
Apart from an EU location, the prospective CSPs will also be required to fulfil a number of operational regulatory requirements for the purposes of authorisation. These include, among others, requirements on credit risk assessments and due diligence in relation to crowdfunding offers, requirements on complaints handling and management of conflict of interest etc. Furthermore, following in the footsteps of MiFID II, the ECSPR stipulates certain investor protection requirements that CSPs will be required to comply with. These include requirements on the:
- mandatory provision of a short information sheet on each crowdfunding offer, called a Key Investor Information Sheet to investors (KIIS)
- content and accuracy of marketing communications and
- mandatory entry knowledge test based on which the CSPs will ensure that the prospective investor can bear potential losses attached to a particular investment.
CSPs that provide portfolio management are also required to draw up a KIIS at platform level containing relevant information about fees, about the available crowdfunding projects, responsible persons within the CSP's organisation and guidance as regards the complaints handling process.
On 10 June 2021, the German Parliament officially adopted the law that transposes the ECSPR and Directive (EU) 2020/1504 into national law.
Given that the ECSPR is a Regulation, which is directly applicable in all EU Member States without the need for national transposition, one may ask why the German legislator came up with an idea to adopt such national transposition law in the first place? The reason for this lies in the fact that several provisions of the ECSPR permit individual Member States to define certain rules at national level, enabling smoother integration of the new rules into existing regimes.
The inclusion of certain types of instruments within the scope of the ECSPR (like shares in private limited companies), national rules on the civil liability of certain persons and rules on the provision of regulated services related to crowdfunding activities are just some areas that the ECSPR does not regulate directly. Amendments of national rules are therefore necessary.
Changes to existing financial services regulation
Under existing rules in Germany, the roles of both the fundraiser and the investor in the crowdfunding structure could potentially fall under the scope of other regulated financial services.
First, the lending activity of the investor itself can (under certain conditions) constitute the regulated activity of the lending business within the meaning of the German Banking Act (KWG). On the investor side, fundraising via a crowdfunding platform can also trigger the need to be licensed for deposit-taking under the KWG.
To bridge this regulatory uncertainty, the German transposition law makes certain amendments to the KWG. Fundraisers and lenders that raise/invest funds via crowdfunding platforms authorised under the ECSPR will not be treated as lenders or deposit-takers for the purposes of those regulated activities.
Investment-based crowdfunding covers both the placement of transferable securities within the meaning of Art. 4 paragraph 1 Nr. 44 MiFID II as well as admitted instruments for crowdfunding purposes i.e. shares in private limited companies.
However, the ECSPR explicitly stipulates that its framework applies without prejudice to national laws of individual Member States that govern the transferability of such instruments e.g. by stipulating requirements for the transfer to be authenticated by a notary.
The German legislator has decided to exercise the discretionary power provided by the ECSPR to exclude shares in private limited companies from the scope of the new regime. This decision was taken because share transfers in private limited companies are subject to notarial authentication. The German legislator does not, therefore, consider them suitable instruments for crowdfunding purposes.
The ECSPR requires Member States to ensure that their national law imposes civil liability on natural and legal persons who prepare a KIIS (i.e. project owners) in cases where:
- its information is misleading or inaccurate; or
- when certain information is omitted that would be viewed negatively by investors.
The same applies to KIIS that CSPs providing individual portfolio management of loans need to prepare at platform level. In that case, civil liability will apply to the operator of the crowdfunding platform.
The German legislator has implemented this provision into national law by holding the members of the management board of a project owner (or CSP in the case of the KIIS prepared at platform level) personally liable for the accuracy and completeness of information provided in the KIIS. They will be held accountable for both intentional as well as negligent provision of inaccurate or incomplete information in the KIIS.
These provisions of the transposing law have attracted some criticism:
- where other information documents (like security prospectuses) only attract civil liability where false information is proffered through acts of gross negligence, the owners of crowdfunding projects will face civil liability even when the simple negligence threshold has been crossed. It may be challenging for small companies to summarise all the relevant risks and features of the offering on only six A4 pages, which is the prescribed maximum length of the KIIS. This could represent a competitive disadvantage in comparison with other more established financing models. For example, when securities are issued, the issuers have over 300 pages within a prospectus to make full disclosures
- prospective fundraisers may simply rely on established alternative finance models, commonly known in Germany as the grey capital market. They may seek to use qualified subordinated loans or issue investment products under the German Capital Investment Act. These carry a lower level of risk of personal liability for disclosure.
The market's reaction
It is fair to say that the national transposition law has attracted the widespread criticism of the FinTech industry. The onerous personal liability provisions and the exclusion of share placements in private limited companies from the scope of the framework are viewed as potential impediments to the development of the crowdfunding sector.
The Federal German Crowdfunding Association didn’t seem to be satisfied with the content of the transposition law either, calling it “the crowdfunding prevention law”.
Many believe that the exclusion of shares in private limited companies from the scope of the new regime will lead to the incorporation of fundraising SPVs in other EU jurisdictions. Project owners will still be able to place these instruments on a cross-border basis via authorised crowdfunding platforms back into Germany.
Prospective fundraisers can also be deterred from launching their crowdfunding offer from Germany because of the severe provisions on personal liability.
Nevertheless, the strong German FinTech industry based in hubs like Berlin and Munich will not fail to benefit from the new rules on crowdfunding, despite these drawbacks. The requirements on operators of crowdfunding platforms will be the same as in any other EU Member State and the importance of the German market as a source of funding across the EU will not be jeopardised by a few cumbersome legislative provisions.
The ECSPR has pioneered a level playing field for operators of crowdfunding platforms and it aims to boost the provision of crowdfunding services on a cross-border basis across the EU. Based on its provisions, it has the potential to bridge significant divergences in national regimes on crowdfunding in different Member States.
However, its practical effect on the industry remains to be seen. Answers to many questions that prospective fundraisers may need on the conditions under which they can leverage the new regime will still be found in the laws of individual Member States.
The FinTech Action Plan, the ECSPR and recently published legislative and non-legislative proposals under the Digital Finance Package prove the Commission’s strong commitment to the creation of a suitable legal and regulatory framework for the FinTech industry in the EU. In the months and years ahead, further development and detail will emerge from the framework.