— Att. Irem Sultan Gulden, LL.M

Nov 22, 2023

1. Introduction

For the financial markets, a well-established investor protection regime ensured by law is crucial to encourage investors to finance firms.[1] The financial markets and the economy grow where investors are protected effectively by regulations. This is also significant in the crowdfunding market. Given the high ratio of natural person involvement in project financing on crowdfunding platforms, investor protection becomes an essential element. Natural persons, contrary to institutional investors, are less experienced, less knowledgeable, and more vulnerable. They are prone to make less wise decisions in the absence of sufficient investor protection mechanisms. However, for the crowdfunding market, it is equally important to facilitate small and medium-sized enterprises (“SMEs”) to access funds in a budget way, without burdensome procedures. Having investor protection on the one hand and finance accessibility of SMEs on the other, a disproportionate rise of any of them may cause an impediment on the other. Therefore, a delicate balance is crucial to achieve these objectives as widely as possible. The European Crowdfunding Regulation (“ECSPR”) sets down specific investor protection rules, such as disclosure requirements, classification of investors, risk warnings, etc., taking into account the vulnerable investor profile in the crowdfunding market and the need for a balance between the aforementioned objectives.

In this blog post, I will explore the EU’s investor protection mechanisms in investment and lending-based crowdfunding models. Hence, I will focus on the investor protection rules provided for in ECSPR, highlighting underlying ideas and aimed results, together with some reflections.

2. Requirements imposed on crowdfunding service providers

Crowdfunding can be described as a ‘trilateral network’[2] between the investor, project owner, and an intermediating organisation. Crowdfunding service providers (“CSPs”) wear many hats in the crowdfunding market. As the platform operator facilitating a crowdfunding transaction, the gatekeeper for crowdfunding projects on its platform, and the only intermediator between project owners and investors, CSPs shoulder a great responsibility in terms of investor protection. Therefore, ECSPR entrusted CSPs to maintain key values by fulfilling specific obligations that will be analysed in this section.

2.1. Neutrality

The intermediator role of CSPs requires them to act neutrally. In order to ensure the neutrality of CSPs, conflicts of interest between CSPs and other actors in the crowdfunding market should be eliminated as much as possible. To this end, CSPs are prohibited from having any participation in the crowdfunding offers on their platform.[3]

Article 3(3) of ECSPR prohibits CSPs from paying or accepting any monetary/non-monetary benefit for routing investors’ orders to a particular crowdfunding offer, in order to eliminate the risk of favouring a particular offer. However, CSPs are allowed to apply specific parameters or risk indicators in the proposition of projects to a particular investor, according to the communication in advance by the investor.[4] While the type of business and credit rating are non-exhaustively specified in ECSPR as such selection criteria of projects to be offered to an individual investor, CSPs are prohibited from providing individual or collective asset management services.[4] Further, the allocation of funds automatically in accordance with such parameters and risk indicators is considered individual portfolio management, which is not an allowed activity in ECSPR.[5] This may only be possible if the CSP is also authorised under MiFID II, to provide asset management services.

2.2. Transparency

Transparency is another key element for the activities of CSPs. According to Article 19(1) of ECSPR, all information provided by CSPs should be fair, clear and not misleading. The information may contain disclosure about themselves, about the costs, financial risks and charges related to crowdfunding services or investments, about the crowdfunding project selection criteria, and about the nature of, and risks associated with the crowdfunding services. CSPs should inform their clients that their crowdfunding services are not covered by the deposit guarantee scheme or investor compensation scheme.[6] Those CSPs who facilitate the granting of loans should disclose default rates in accordance with Article 20 of ECSPR.

They are required to conduct the project selection procedures on their platform in a professional, fair, and transparent way.[7] If a CSP applies credit scores to projects, suggests the pricing of crowdfunding offers, or determines the interest rate, it should disclose key elements of its methodology and publish its policies and procedures.[8] For transparency purposes, CSPs should ensure proper documentation of communications with clients and keep all appropriate records related to their services and transactions.[9]

In order to ensure transparency and flow of information in the crowdfunding market, CSPs may enable investors on their platform to advertise their interests in loans, securities, or other admitted instruments which were offered on their platform.[10]

2.3. Fairness

The fairness of CSPs is associated with their neutrality as they should be at an equal distance from every participant in the market. Article 3(2) of ECSPR obliges CSPs to act honestly, fairly and professionally in accordance with the best interest of their clients. CSPs are obliged to ensure fair and non-discriminatory treatment of clients.[11] As the correct understanding of the nature of crowdfunding services and the risks, costs, and charges by prospective investors and project owners is very important, CSPs should facilitate fair, clear and not misleading information to their clients.[12] Marketing communications, as well, should include fair, clear and not misleading information.[11]

2.4. Prudence

By their role in the trilateral nature of crowdfunding,[2] CSPs operate crowdfunding platforms to enable the other two parties to participate in the market. In order to ensure the proper functioning of the crowdfunding platform, which facilitates a safe investment experience for investors and provides the ability to access a wide range of people for project owners, CSPs are under the obligation to act prudently in their conduct and management. They are expected to conduct effective and prudent management by having in place governance arrangements.[13] Prudent management activities should include the segregation of duties, business continuity and the prevention of conflicts of interest, and establishment/overseeing of appropriate systems and controls to assess the risks related to the loans on their platform.[14] In case a CSP determines the price of a crowdfunding offer, it should conduct a credit risk assessment in accordance with Article 4(4) of ECSPR. Prudential safeguards requirements in the form of one of the options laid down in Article 11 of ECSPR should be fulfilled.

Natural persons responsible for the CSPs’ management are required to be of good repute and have sufficient knowledge, skills, and experience.[13] Sufficient procedures to receive and handle possible complaints from their clients, free of charge, should also be established.[15],[13] Business continuity plans addressing the risks associated with the failure of a CSP should be developed.[16]

2.5. Due diligence

According to Article 5 of ECSPR, CSPs should undertake at least a minimum level of due diligence for project owners, including: (i) that the project owner has no criminal record in respect of infringements of national rules in fields of commercial law, insolvency law, financial services law, anti-money laundering law, fraud law or professional liability obligations; and (ii) that the project owner is not established in a non-cooperative jurisdiction, as recognised by the relevant Union policy, or in a high-risk third country pursuant to Article 9(2) of AMLD IV. This know-your-customer process is not only relevant to project owners in the crowdfunding market but also to investors. CSPs should also conduct KYC process for investors in order to have knowledge about “an investor’s financial situation, knowledge, experience, and or motivations”.[17] The KYC process for investors is necessary for the purpose of determining the degree of protection for an individual investor.

3. Categorisation of investors as sophisticated and non-sophisticated investors

The crowdfunding market contains different investor profiles who have various experience levels, investment motivations, income rates, and risk appetite. This diversity requires different investor protection levels in order to ensure appropriate investor protection for each category of investor. Therefore, ECSPR categorises investors as sophisticated and non-sophisticated investors. This classification in ECSPR is similar to the classification designed in MiFID II which distinguishes between professional and retail investors.[18]

A sophisticated investor is defined as “an investor who possesses the awareness of the risks associated with investing in capital markets and adequate resources to undertake those risks without exposing itself to excessive financial consequences” in Section I of Annex II to ECSPR. Being a natural or legal person per se is not considered a determining factor to qualify as a sophisticated investor. Instead, ECSPR sets down the following identification criteria to qualify as a sophisticated investor for natural and legal persons differently:

• Legal persons meeting at least one of the following criteria qualify as a sophisticated investor: (a) own funds of at least EUR 100 000; (b) net turnover of at least EUR 2 000 000; (c) balance sheet of at least EUR 1 000 000.
• Natural persons meeting at least two of the following criteria qualify as a sophisticated investor: (a) personal gross income of at least EUR 60 000 per fiscal year, or a financial instrument portfolio, defined as including cash deposits and financial assets, that exceeds EUR 100 000;(b) the investor works or has worked in the financial sector for at least one year in a professional position which requires knowledge of the transactions or services envisaged, or the investor has held an executive position for at least 12 months in a legal person as referred to in point (1); (c) the investor has carried out transactions of a significant size on the capital markets at an average frequency of 10 per quarter, over the previous four quarters.

When a natural or legal person meets the envisaged identification criteria above, it should also be approved by the CSP upon the request of the investor to be treated as a sophisticated investor.[19] That is to say, a sophisticated investor can qualify as such if it meets the identification criteria and receives approval to be treated as a sophisticated investor from the CSP. The identification of an investor as sophisticated maintains its validity for two years.[19]

In contrast, a specific investor profile is directly considered sophisticated investors under ECSPR. This type of investor does not have to either meet the identification criteria or hold the approval. The ‘professional’ clients under MiFID II, entities referred to in points (1) to (4) of Section I of Annex II to MiFID II, are considered sophisticated investors provided that they prove their status of professionals to the CSP.[20]

Any natural or legal person who is not a sophisticated investor is considered a non-sophisticated investor according to point (k) of Article 2(1) of ECSPR. Various mechanisms are set out for non-sophisticated investors differently from sophisticated investors, such as entry knowledge test, simulation of the ability to bear loss, maximum amount of capital to invest without further safeguards, and pre-contractual reflection period.

4. Entry knowledge test and simulation of the ability to bear loss

On a crowdfunding platform, non-sophisticated investors encounter a test before being given access to invest in crowdfunding projects on that platform. An ‘entry knowledge test’ should be conducted by the CSP for the purpose of assessing whether and which crowdfunding services are appropriate for an individual non-sophisticated investor.[21] The test should aim to gather information about the investor’s experience, objectives, financial situation and basic understanding of risks involved in investing in general and in investing in the types of investments offered on the crowdfunding platform.[22] An assessment should be reviewed every two years by the CSP.[23]

The CSP after conducting the entry knowledge test, may consider that the prospective non-sophisticated investor does not have sufficient knowledge, skills or experience. In another case, the prospective non-sophisticated investor may prefer not to provide the required information for the assessment. These situations cause CSPs to inform the non-sophisticated investors that the services may be inappropriate for them and issue them a risk warning, indicating a clear statement of the risk of losing the entirety of the money invested.[24] Upon the risk warning, prospective non-sophisticated investors should expressly acknowledge that they have received and understood the warning.[24] In the absence of such acknowledgement, the investment of the non-sophisticated investor should not be accepted by the CSP.[25]

Moreover, CSPs are obliged to require non-sophisticated investors to simulate their ability to bear loss. Based on the non-sophisticated investors’ regular and total income, assets, and financial commitments, the simulation calculates 10% of their net worth.[26] The result of the simulation does not cause an individual investor to be prevented from having participation in the crowdfunding offers on that platform.[27] Rather, it is sufficient that non-sophisticated investors acknowledge that they have received the results of the simulation.[28] This simulation should be reviewed every year.[28]

In case a non-sophisticated investor, for an individual crowdfunding offer, exceeds the investment amount of € 1 000 or 5% of the net worth calculated by simulation, the CSP should ensure that such investor: (i) receives a risk warning; (ii) provides explicit consent; and (iii) proves that the investor understands the investment and its risks.[29]

In order to set out a uniform standard of application of the entry knowledge test, simulation, and the information to be provided, ESMA published ‘Draft technical standards under the European crowdfunding service providers for business Regulation‘.

5. Pre-contractual reflection period

Similar to the right of withdrawal granted to consumers from a distance or off-premises contract, ECSPR provides non-sophisticated investors with an opportunity to consider their investment decisions for the second time and change their minds. Article 22(2) lays down the pre-contractual reflection period for the non-sophisticated investors, to revoke, at any time, his/her offer to invest or expression of interest without giving a reason and without incurring a penalty. The reflection period starts when the offer to invest is made or interest is expressed, and expires after four calendar days.[30] CSPs are obliged to ensure that no money is collected from the investor or transferred to the project owner before the reflection period has expired.[31]

6. Key Investment Information Sheet

In the financial markets, investors should be provided with adequate information to be able to assess the investment options and make efficient investment decisions. The key investment information sheet (“KIIS”) in the crowdfunding market is intended to inform prospective investors and enable them to make informed investment decisions. The concept is similar to the prospectus when securities are offered to the public or admitted to trading on a regulated market. However, they are not the same, KIIS is designed for the needs and conditions of the crowdfunding market. CSPs are obliged to provide prospective investors with the KIIS for each crowdfunding offer.[32] While the KIIS should be drawn up by project owners as they have the full information required to be involved, CSPs remain responsible for providing the KIIS to the investors.

In order to ensure that prospective investors access and understand the information on the KIIS conveniently, it is designed to be clearly distinguishable from marketing communications and to consist of a maximum of six A4-sized pages.[33] It is intended to give fair, clear and not misleading information about the crowdfunding project, the project owner, the crowdfunding process, risk factors, the instruments used for crowdfunding purposes, special purpose vehicles — if applicable, investor rights, fees and legal redress, and portfolio management — if applicable.[34] The KIIS should be sufficient to warn prospective investors about risks in the crowdfunding environment that are covered neither by deposit guarantee schemes nor by investor compensation schemes.[35] CSPs are responsible for ensuring the clarity, correctness and completeness of the KIIS.[36] In case the CSP identifies an omission, mistake or inaccuracy that could have a material impact on the expected return of the investment, it should signal that promptly to the project owner.[37] Upon such signal, the project owner should promptly complete or correct that information. The CSP should suspend the offer until the KIIS has been completed or corrected.[37] After 30 calendar days of suspension, if the KIIS has not been completed and corrected, the CSP should cancel the offer.[37]

CSPs providing individual portfolio management of loans should provide prospective investors with a KIIS at platform level.[38] In such a case, CSPs remain responsible for ensuring the completeness, correctness, and clarity of the information contained in KIIS at platform level.[39]

8. Conclusion

Crowdfunding markets have special characteristics as crowdfunding is an alternative finance way for SMEs and is publicly open to investors. Consumer-like investor profile in the crowdfunding market, notwithstanding the existence of institutional investors, requires high investor protection. However, costly requirements over project owners may derogate their ability to access funds. The need for a balance in order not to impede any of the benefits of crowdfunding for both investors and SMEs, led investor protection mechanisms in the crowdfunding market to rely mostly on CSPs. While the CSPs are entrusted to pursue key values in their activities to create a level playing field for all parties, they are also responsible for the information of investors to mitigate information asymmetries. Besides, given the diverse investor profiles involved in crowdfunding, ECSPR categorises investors as sophisticated and non-sophisticated and sets out varied levels of investor protection for each category. By providing higher investor protection for non-sophisticated investors, ECSPR aims to minimise adverse circumstances entailed by their low levels of experience and knowledge and their limited financial capacity.

References

[1] © La Porta, R., Lopez-de-Silanes, F., Shleifer, A., & Vishny, R. W. (1999), Investor protection: origins, consequences, and reform, available at https://www.nber.org/papers/w7428

[2] Ebers, M. & Quarch, B.M., “Chapter 5: EU Consumer Law and the Boundaries of the Crowdfunding Regulation” Crowdfunding and the Law edited by Ortolani, P. & Louisse, M., pending for publication, Oxford
University Press, Oxford 2022, 12, available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3822692.

[3] Recital (26) of ECSPR.

[4] Recital (19) of ECSPR.

[5] Recital (20) of ECSPR.

[6] Art. 19(2) of ECSPR.

[7] Recital (18) of ECSPR.

[8] Art. 4(4) and Recital (41) of ECSPR.

[9] Recital (56) of ECSPR.

[10] Recital (55) of ECSPR.

[11] Recital (57) of ECSPR.

[12] Art. 19, Recital (39) of ECSPR.

[13] Recital (23) of ECSPR.

[14] Art. 4(1)-(2) of ECSPR.

[15] Art. 7 of ECSPR.

[16] Recital (25) of ECSPR.

[17] Brejdak, J. (2022) How Does The Law Protect The Crowd? About Crowd Investor Protection Mechanisms Introduced By The EU Regulation 2020/1503, InterEULawEast: journal for the international and European law, economics and market integrations, 9(2), 184, available at https://hrcak.srce.hr/file/424617.

[18] Recital (42) of ECSPR.

[19] Section II of Annex II to ECSPR.

[20] Section III of Annex II to ECSPR.

[21] Art. 21(1) of ECSPR.

[22] Art. 21(2) of ECSPR.

[23] Art. 21(3) of ECSPR.

[24] Art. 21(4) of ECSPR.

[25] Recital (45) of ECSPR.

[26] Art. 21(5) of ECSPR.

[27] Subpara. 2 of Art. 21(6) of ECSPR.

[28] Art. 21(6) of ECSPR.

[29] Art. 21 (7) of ECSPR.

[30] Art. 22(3) of ECSPR.

[31] Recital (47) of ECSPR.

[32] Art. 23(2) of ECSPR.

[33] Art. 23(7) of ECSPR.

[34] Annex I to ECSPR.

[35] Recital (50) of ECSPR.

[36] Art. 23(11) and Recital (51) of ECSPR.

[37] Art. 23(12) of ECSPR.

[38] Art. 24(1) of ECSPR.

[39] Art. 24(6) of ECSPR.