Mondaq | Wang Peng and Chen Shaozhu | May 5, 2015

1. The potential for the development of equitybased crowd-funding under the current legal framework

Similar to P2P lending (peer-to-peer lending), equity-based crowd-funding is a kind of public capital raising. Equity-based crowd-funding is a collective effort to provide finance in support of third party projects with a certain portion of equity as reward, incentivizing investors by allowing them a piece of the pie in a budding startup. Crowd-funding is the practice of raising money from the public and is subject to relevant laws governing fundraising, such as The Securities Law, the Criminal Law and various interpretations and opinions on the handling of criminal cases involving illegal fundraising (Fundraising Regulations) by the Supreme People's Court and other organs. Equity-based crowd-funding generally involves the transfer of equity in corporations, and is also regulated by the Corporate Law and other relevant regulations.

a. Possible legal space of equity-based crowdfunding under the Fundraising Regulatory framework

Certainly, Article 6 of Interpretation of the Supreme People's Court of Several Issues on the Specific Application of Law in the handling of Criminal Cases about Illegal Fund-raising (Interpretation) is the most directly relevant clause defining equity-based crowdfunding. It states that "whoever, without the approval of the relevant competent department of the state, issues shares or corporate or enterprise bonds to unspecified people, or does so in such disguised form as transferring equities, or issues shares or corporate or enterprise bonds or does so in disguised form to a specified 200 persons or more cumulatively shall be deemed to have 'issued shares or corporate or enterprise bonds without authorization' as prescribed by Article 179 of the Criminal Law. If a crime has been committed, the offender shall be convicted of and punished for the crime of issuing shares or corporate or enterprise bonds without approval." Article 6 of the Interpretation is derived from the definition of the public issue of securities stipulated in Article 10 of the Securities Law¹ . Since investors aim to gain a benefit from their investments, crowdfunding is in theory also regulated by the Securities Law² . The transfer of equity to nonspecific persons and/or to more than 200 specific targets is deemed to be an issue of securities to the public and is subject to approval by state administration. Pursuant to Article 179 of the Criminal Law, constituting the crime of the "issue of shares or company and enterprise bonds without authorization" requires an element of huge amounts or with severe consequences or other serious acts. Based on the relationship among the seven crimes dealing with illegal fundraising,³ issuing shares or company and enterprise bonds in a disguised form not fulfilling the requirements of huge amounts or with severe consequences or other serious acts may still constitute taking deposits illegally from the general public under Article 176 of the Criminal Law.

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In China, the qualification requirements and approval standards for the public issue of securities are highly rigorous and thus, it is unlikely that small and medium-sized enterprises (SMEs) and start-up enterprises will be eligible for the public issue of securities. Furthermore, the cost of publicly issuing securities is far too high to be borne by SMEs and start-ups, and is too expensive compared with the amount of the capital raised. Thus, it is unrealistic for SMEs and start-ups, to conduct fundraising by strictly complying with the requirements for a public issue of securities because the approval standards required by the state administration are unlikely to be met. For the purpose of avoiding the risk of being an illegal fundraising, equity-based crowd-funding is better to use private placement, instead of public advertising of the offering. This means the number of investors will be specific and no more than 200.

b. Possible legal space of equity-based crowd-funding under the Corporate Law framework

The transfer of shares is also governed by the Corporate Law. Article 24 of the Corporate Law states that "a limited liability company shall be established by no more than 50 shareholders that make capital contributions." In other words, the number of shareholders in a limited liability company cannot exceed 50. Upon the completion of a shares transfer, the transferee will immediately be a new shareholder of the company. So if a company raising funds is a limited liability company, even if it is raising equity privately, at no time can the number of investors exceed 50.

c. Summary

Based on the aforesaid laws and regulations, it is almost impossible to conduct equitybased crowd-funding in China as the country's laws have limited the number of investors to no more than 200, which is a fewer number than the number defining an entity required for equity-based crowd-funding. The purpose of crowd-funding is to raise small amount of funds from a large number of people with each person contributing only a small amount to the whole project. It is highly unlikely that a public fundraising can be conducted via a public issue in accordance with the laws and regulations. For that reason, there are only two routes that SMEs and start-up enterprises can take for equity-based crowd-funding, namely through legal private equity funding or an illegal public issue of securities. Assuming that both ways satisfy the financial demands of SMEs and start-up enterprises, entrepreneurs would rationally choose the legal option. However, the main issue is that capital raised by private equity is not usually sufficient for the financial needs of SMEs and start-ups.

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2. Possible solutions for equity-based crowd-funding under the current legal framework

SMEs and start-up enterprises almost always experience difficulties raising funds publicly and thus private placement tends to be the only legitimate way for equity-based crowd-funding. Private equity has strict requirements regarding promotion, the objects of the fundraising and the number of investors. Firstly, it cannot be promoted in public. Secondly, the fund can only be raised from specific investors, instead of from the public. Lastly, the sum of specific investors must not exceed 200 in total. As discussed previously, for private equity fundraising by a limited liability company, due to the restriction on the number of shareholders, the number of the investors cannot exceed 50.

a. Possible solutions to circumvent the restrictions on promoting a fundraising

Subject to the restrictions of non-public promoting and the specific target of placement, most equity-based fundraising platforms are applying a membership system to investors. Investors have to be qualified as members of the platform and must obtain approval before being given information about projects. Approval requirements may vary between different membership systems.

b. Possible solutions to circumvent the restriction on the number of investors

Most platforms generally hold shares in the form of a special propose vehicle (SPV), given that the number of specific investors is limited to no more than 200 and because there is also a limit on the number of shareholders in a limited liability company. Unlike investors in private investment funds who are wealthier, more experienced with investments and have greater capability in managing risk, most investors that invest in SMEs and start-up enterprises are ordinary people with limited funds, limited investing experience and poorer capability in managing risk. Given that the typical amount invested per investor in SMES and start-ups is not substantial, the financial needs of SMEs and start-ups are unlikely be met given that there is a restriction on the number of investors allowed.⁴ As a result, many platforms will use the SPV to evade regulations such as the Securities Law, the Corporate Law , etc.

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The Coin Telegraph | Juan S. Galt | Apr 30, 2015

New U.S. SEC Regulation A+ rules regarding equity crowdfunding coming to effect at the end of May 2015 are set to open the gates for crypto-equity and small business crowdfunding, no investor accreditation necessary.

In what can only be called the deregulation of the securities rules that affect equity crowdfunding, the U.S. federal government's SEC voted on key changes to the JOB's Act passed by Obama in 2013.

The changes, which have been called Regulation A+, lower the barrier of entry for investors, who no longer have to be accredited investors, or those with a net worth of US$1 million, or a history and expectation of annual income above US$200K per year. Come the end of May, there will be no requirements whatsoever.

This is equivalent to opening Troy's gates to anyone who wants to waltz in and set up shop inside. No longer do the gates only open to aristocrats, very successful entrepreneurs or well-connected politicians.

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Though, as you might expect, there is a catch. A toll at the gates requires issuers to submit reviews of their finances to the relevant authorities, depending on how investors file for compliance.

In short, issuers can raise up to US$50 million in a 12-month period for Tier II filings and up to US$20,000,000 for Tier 1. Those under Tier II are subject to review from the SEC and are not subject to individual state law. Those under Tier I are subject to a coordinated review effort called NASAA, conducted on behalf of individual states.

The good news is that while issuers will need to be cleared by the relevant authorities before sales are deemed compliant, issuers also have some leeway to test the waters. As Crowdfund Insider put it:

“An issuer can ‘test the waters’ and see if there is interest in the offering prior to spending the time and money to [be approved by authorities].  This would be ‘Preview’ mode on SeedInvest where investors can express interest, but can’t yet invest. This is important so that companiesdon’t have to gamble on their fundraise and can see if there is interest prior to investing in legal and accounting fees.”

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