Special post to NCFA Canada  |  Brian Koscak  |  Sept 3, 2013

On July 13, 2013, Professor Jeffrey Macintosh lambasted investment crowdfunding in his commentary “Extraordinary popular delusions and the madness of crowdfunding” in the National Post. Professor Macintosh evoked visions of dusty old-fashioned securities lawyers clutching at their hearts when the word ‘crowdfunding’ is mentioned. Professor Macintosh argues that investment crowdfunding is a bad idea and is likely to hurt investors. So why is investment crowdfunding such a hot button and getting certain individuals so exercised?  Unfortunately, it’s not as straightforward as Professor Macintosh suggests. To borrow from Facebook, “it’s complicated”.

Let’s examine some of the arguments put forward by Professor MacIntosh.

Many, if not most, crowdfunded endeavours will head straight for the scrap heap

It’s true that many investment crowdfunding endeavours will not work out for many reasons that have nothing to do with investment crowdfunding. No one said all crowdfunded investments would succeed.  Many, if not most, will fail ― just like traditional investments. However, just because businesses fail does not mean that investment crowdfunding is a bad idea. Businesses need access to capital, especially in today’s tough economic climate. Investors want greater access to investment opportunities and believe, with more information, they can fend for themselves and make informed investment decisions. So let them.  Remember, many regulated dealers and advisors have recommended various investments that have not worked out. Think no further than Sino-Forest.

What is wrong if some investors want to democratize investment opportunities and access private deals like pension funds or private equity and venture capital firms? Obviously, I am not recommending that it be done blindly, but when jurisdictions around the world are doing it, including the United States under the JOBS Act, we better pay close attention or risk having our best and brightest flock south of the border to finance their businesses, a fact politicians in Canada worry about. Think of Pebble Watch and how a University of Waterloo graduate could not find any financing in Canada and had to go to Silicon Valley where he raised over $10 million in a matter of weeks from his campaign on Kickstarter (a non-investment crowdfunding site).

No one is advocating a regime where many businesses will fail and no one is advocating ‘widows and orphans’ pouring their life savings into crowdfunded companies. We believe the right balance needs to be struck between protecting investors and fostering fair and efficient capital markets. Readers are encouraged to review the Ontario Securities Commission’s (OSC) December 2012 and August 2013 proposals which examine new capital raising exemptions, including investment crowdfunding. The OSC’s concept crowdfunding proposal includes caps on investments (i.e., an investor cannot invest more than $2,500 per issuer/$10,000 per annum and issuers cannot raise more than $1.5 million in any 12-month period). Rather than sitting on the sidelines and crying the ‘sky is falling’ with investment crowdfunding, we commend the OSC for engaging in a dialogue with investors and capital market participants to strike the right balance. Even FAIR Canada, who has publicly come out against investment crowdfunding, set out what it believes to be a viable investment crowdfunding regime in its comment letter to the OSC in response to its concept proposal.

Investment crowdfunding is the precursor of investment scams and fraud

Professor MacIntosh raises the spectre of fraud with investment crowdfunding. Fraud concerns everyone, whether you are for or against investment crowdfunding. Unfortunately, no one can prevent or eliminate fraud on the Internet. Think of debit and credit card fraud despite all the measures designed to prevent it. That experience has not stopped financial institutions or governments from the use of debit or credit cards. Instead of shutting it down, they built it up and introduced more processes and safeguards to reduce the risk of fraud.

At a recent crowdfunding conference in Orlando, Florida, sponsored by the Crowdfunding Professionals Association, Paul Niederer, the C.E.O of the Australian Small Scale Offerings Board (ASSOB), discussed ‘fraud and the crowd’ in his presentation. His thesis was simple, investment crowdfunding will not stop fraud; however, a properly managed crowdfunding portal will lessen the chance of fraud. ASSOB is the granddaddy of investment crowdfunding which has been legal in Australia for years. To date, Mr. Niederer stated, ASSOB has raised over $135 million with no incidences of fraud.

There are many ways to mitigate fraud.  For example, there are companies such as U.S. based Early IQ, which is in the fraud detection business.  It offers a service to help issuers and portals weed out the rogues and con-artists by doing background checks. A Canadian company, Boardsuite Corp., also offers a crowdfuding infrastructure platform (CfIP) whose purpose is to manage the crowd and introduce various corporate governance tools for private companies. These types of investor protection safeguards are critical components in the development of any investment crowdfunding regime. Some might even say that the use of the Internet, with its transparency and the electronic record generated through online access, may actually make fraud easier to detect and monitor, particularly if the activity is channeled via portals.

Can we seriously expect the hoi polloi to do better than the pros (e.g., venture capitalists)?

Professor MacIntosh posits that if venture capitalists (VCs) cannot pick great investments a majority of the time, how can we seriously expect the “hoi polloi” (the common investor) to get it right. No one doubts that VCs have excellent processes for finding winners and do this for a living. However, investment crowdfunding is not all about picking the hot technology company poised to be the next big thing. It is about start-ups and small and medium-sized enterprises helping their communities and, yes, making money for investors. Read Amy Cortese’s book on ‘Locavesting’, which discusses the revolution in local (i.e., community) investing. Crowdfunding also involves finding capital for public companies. Many reporting issuers in Canada listed on the TSX-V or CNSX, for example, are looking for capital but cannot raise it under existing securities laws since many investment dealers cannot do it in today’s tough economic climate. Maybe it is time for the crowd to help!

Investment crowdfunding is not looking to replace VCs. Rather, it seeks to embrace VCs as an important but different part of the investment ecosystem. In fact, some of the highest profile VCs in the world, such as Union Square Ventures, Google Ventures, Maveron and Rose Park Advisors have been quietly making investments in ― you guessed it ― crowdfunding platforms, such as U.S.-based Circle-Up. Fundamentally flawed business models are rarely successful. If VCs are investing in crowdfunding platforms, we should be paying attention.

VCs won’t invest in companies with many small and unknowledgeable outside investors

The idea of having hundreds of investors is daunting for any company unless they are somehow managed. Although this is a common criticism of investment crowdfunding, it is not an insurmountable hurdle. For example, investors in Symbid, a Dutch investment crowdfunding portal, invest in a co-operative which in turn makes a single investment in the crowdfunded issuer. Similarly, Seedrs, a United Kingdom investment crowdfunding portal, holds securities for investors through a nominee structure. Similar structures should be contemplated for Canada.  Thought leaders, such s Professor MacIntosh, should consider the preferred legal structure to group investors, rather than dismissing investment crowdfunding outright because of a perceived challenge in managing the crowd.

Securities laws need to evolve in step with the Internet and social media

Most of our securities laws dealing with private investments were written before the Internet became ubiquitous.  Human beings have a natural tendency to understand new technologies not as “new things” but as tweaked versions of the technologies that preceded them:  a car is a “horseless carriage”; movies are “moving pictures”.  In this way, our current securities laws treat the Internet and social media as simple advertising vehicles – like the TV, radio and newspaper – and users as passive recipients that need to be protected from hyped investments.  The fact is the Internet and social media are radically different channels that allow users to create, curate, vet, question and critique content.  Given this, does allowing investors to learn about opportunities over the Internet really create risks?  Or does it reduce risks by exposing companies to scrutiny by an engaged audience – the crowd?  The answer depends on whether you think Internet users are capable of sorting out credible content (like analyst reports) from useless dreck (like stock message boards, which have lost all credibly and power to influence markets). To those who oppose change like those “dusty old securities lawyers” referred to by Professor MacIntosh, it reminds us of the Luddites – the 19th-century English textile artisans who were against newly developed labour-saving machinery during the Industrial Revolution and who destroyed factories that introduced such technologies. Now ask yourself, is this “dusty old securities lawyer” the Neo-Luddite of the 21^st century?

The borderless Internet

Other countries, including the United States, Australia, Italy and the United Kingdom, have taken steps to open up investment crowdfunding. In fact, come September 23, 2013, the United States will be eliminating the prohibition against general solicitation and general advertising in certain types of U.S. private offerings; provided that all purchasers of the securities are accredited investors (AIs) and the issuer takes reasonable steps to verify that such purchasers are AIs.  Although Canadian AIs will not be permitted to invest unless the issuer complies with Canadian securities law, there is nothing stopping Canadian investors from turning their eyes to a U.S.-based crowdfunding platform.  This creates a potential cross-border enforcement nightmare for securities regulators.  If we take a hard line against investment crowdfunding, we may also have to live with draconian measures to stop cross-border activity, such as requiring investment crowdfunding platforms to block IP Canadian addresses. If so, is Canada keeping abreast of capital raising developments to remain competitive and relevant in the world capital markets or is it marginalizing itself further by comforting itself in the world of the nanny-state?

Little or no mandatory disclosure

Professor MacIntosh states that investment crowdfunding will have little or no mandatory disclosure. This is incorrect. Investment crowdfunding will likely involve a mandatory disclosure document, a video presentation about the offering and responses from management to comments from investors on blogs hosted on the portal’s website. Just look at Crowdcube, a United Kingdom funding portal, and see how it works. The OSC concept proposal suggests that the required amount of disclosure is that set out in the summary pages of a prospectus subjecting an issuer to a claim of misrepresentation if they get it wrong. Professor MacIntosh is welcome to comment on the amount of disclosure that sufficiently protects investors while fostering fair and efficiently capital markets. However, does that 200 page prospectus really protect investors as Professor MacIntosh suggests?  Or is it unintelligible to investors, their advisers, and, perhaps, to the people who wrote and reviewed it?  Over the years, prospectuses have grown much longer and much less useful while at the same time our collective attention span has diminished. Perhaps we should be striving for disclosure that is more useful and understandable, not just more detailed and exhaustive.  In other words, in the case of disclosure, ‘less’ may actually be ‘more’, and too much may be the same as not enough. Perhaps the simpler disclosure model facilitated by investment crowdfunding platforms is not so bad.

Can investors protect themselves? 

Selling securities over the Internet or otherwise can only be done by registered securities dealers and advisors. Registered dealers and advisors need to carry out know-your-product, know-your-client and suitability reviews when they sell securities to Canadian investors. These reviews are designed to protect investors by preventing dealers and advisors from selling investors unsuitable products. Unfortunately, jurisdictions around the world are still trying to figure out how to carry out these reviews for an investment crowdfunding platform without completely losing the efficiencies that make on-line investment crowdfunding attractive.

All this begs the question:  what do Canadians expect of securities dealers and advisors?  Should you rely on someone who is selling you a product to safeguard your interests?  The CSA has posed this question in a concept proposal and is considering whether securities dealers and advisors should have a ‘best interest’ duty to investors. Perhaps this needs to be examined more closely in the context of investment crowdfunding, especially when low dollar amounts are involved (see reference to investment caps above) and arguably investors can fend for themselves and have the ability to withstand the loss of their entire investment. Moreover, certain existing investment crowdfunding portals educate investors about how investment crowdfuding works, the risks of investing and that investors can lose all of their money through videos, tests and self certification. Surely, with this much education, the “hoi polloi”, as the crowd is called by Professor MacIntosh, can make their own informed decisions to some extent, perhaps even more informed than investors are in the traditional investment system.  Either way, there is always the option not to invest!

What level of regulation facilitates capital formation?  

In theory, a tightly regulated market reduces investment risk, which in turn attracts capital and results in capital markets growth – in other words, a virtuous circle. Conversely, you can have a vicious circle: A loosely regulated market can result in the funding of weaker companies, reducing confidence in the markets and ultimately reducing available capital.  On the other hand, overly heavy regulation stifles innovation and risk-taking.  Achieving a correct regulatory balance requires constant recalibration.

Investment crowdfunding does not mean less regulation.  It means different and proportionate regulation based on new technological capabilities and methods of communicating.  True, this is a less sexy and a more complex message than simple fear-mongering around ‘fraud funding’, ‘widows and orphans’ losing all their money or, to quote Professor MacIntosh, “the madness of crowdfunding”. However, it is time the public looks beyond the salacious story headlines and educates themselves.

Is there a need for defibrillators for our wheezy old securities lawyer?  Probably not.  But there is a need for serious intellectual inquiry into investment crowdfunding and related issues – and for that we commend Professor MacIntosh and everyone contributing to the debate.

Brian Koscak is the Chair of the Exempt Market Dealers Association of Canada, a member of the Ontario Securities Commission’s Exempt Market Advisory Committee and a Partner at Cassels Brock & Blackwell LLP. Brian can be reached by telephone at 416-860-2955 or by e-mail at bkoscak@casselsbrock.com.

Resources and Links:
Canadian Crowdfunding Directory
Canadian Active Crowdfunding Polls – Vote Today!
National Post article:  Let the Crowd Raise Capital

The National Crowdfunding Association of Canada (NCFA Canada) is a cross-Canada crowdfunding hub providing education, advocacy and networking opportunities in the rapidly evolving crowdfunding industry.  NCFA Canada is a community-based, membership-driven entity that was formed at the grass roots level to fill a national need in the market place.   Join our growing network of industry stakeholders, fundraisers and investors.  Increase your organization's profile and gain access to a dynamic group of industry front runners.  Learn more eBrochure | Prezi or contact us at casano@ncfacanada.org.