Is the FSR Bill a fly on the crowd-funding wall? October 2016

By LERATO LAMOLA AND ANEL DE MEYER, Published in Financial Law

Crowdfunding seems to be the trend that is stealing the spotlight at the moment. From raising US$40 000 for Zach Brown's potato salad, funding the Oscar winning film Innocente in 2013 or simply providing start-up capital for a small business, crowdfunding purports to be the answer to everyone's unfunded dreams – without the hassle involved in obtaining traditional funding.

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Crowdfunding refers to an idea pitched by someone (an originator) via a platform (normally a website, run by a facilitator) to a large number of people (the crowd) to finance a project, a business venture or to raise incidental monetary contributions.

Contrary to popular belief, the idea of crowdfunding is not new. In fact, crowdfunding's roots can be traced back to as early as 1713 when Alexander Pope set out to translate poetry written in Greek into English. Pope asked the public (the crowd) to donate "two gold Guineas" to the cause, and in turn a funder was mentioned as a contributor to the publishing of the book. Similarly, some of Mozart's earliest performances, and even the Statue of Liberty, were financed by way of crowdfunding. In modern times, crowdfunding has gained more traction, especially as a result of the financial crisis in 2008. Banks have introduced more stringent credit criteria and tightened the noose around lending to clients such as small businesses and possible entrepreneurs, who are flagged as "high risk". Crowdfunding has emerged as a plausible alternative for high risk consumers who are unable to access traditional forms of funding for their projects.

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In general, reference is made to two categories of crowdfunding – donation crowdfunding or investment crowdfunding. Donation crowdfunding encompasses either rewards-based or donations-based funding. Rewardsbased crowdfunding entails funding a project by contributions sourced from the crowd, whilst a funder receives something in return for making a contribution. The reward can be anything from a voucher to a keychain. Normally, the award is dependent on the amount contributed. The funding of digitising the Labia Theatre in Cape Town serves as a typical example. In this instance funders could be rewarded with a tour of the theatre, tickets to see a show or having their names flash on the screen before a showing. Donations-based crowdfunding envisages that the crowd will donate funds for munificent reasons without receiving anything in return.

The funders' money will be returned to them should the project or business venture not reach its target value within a specified time. Investment crowdfunding, on the other hand, is based on equity or lending (peer-to-peer lending). Equity crowdfunding contributors receive equity instruments or enter into profit share arrangements with originators. Peer-to-peer lending refers to a circumstance where an originator asks for loans in respect of a business or idea, and promises fixed interest rates on return payments. However, the question is: how is crowdfunding regulated and is it regulated in terms of South African law?

Abroad, great strides have been made to create a legal framework, wherein crowdfunding may operate validly. In America, there is the infamous Jumpstart Our Business Startups Act (JOBS Act), under which Title III makes provision for the regulation of investment crowdfunding by creating a federal exemption under the securities laws. Title III addresses, amongst other things, compliance guidelines and disclosure interpretations for originators, and the registration of crowdfunding platforms. In the United Kingdom, the Financial Conduct Authority regulates investment crowdfunding through various measures, such as licencing requirements and rules relating to information disclosures and marketing practices. This regulation is aimed at protecting the crowd, while also trying to facilitate crowdfunding. The regulation of crowdfunding has been criticised by many as "stifling". However, it is submitted that crowdfunding cannot be left unchecked; especially investment-based crowdfunding which could hold market risk that affects not only the contributors from the crowd but also the market itself.

The regulation of crowdfunding in terms of the South African landscape is still uncharted territory. The Financial Services Board (FSB), the authority responsible for promoting and maintaining a sound financial market, is currently "sitting on the fence" about specific legislation or regulations for the purposes. In an article in the FSB Bulletin for the first quarter of 2016, the FSB stated that crowdfunding is not as yet regulated in terms of South African law. However, since crowdfunding may already fall within the regulatory ambit of other existing financial services sector legislation, the article suggested that possible or existing crowdfunders and platforms first assess the activity they are performing against these pieces of legislation in order to determine the scope of regulation to which they may be subject.

Possible relevant legislation includes the Banks Act, Companies Act, Collective Investment Schemes Control Act (CISCA), the Financial Advisory and Intermediary Services Act (FAIS Act), the Financial Markets Act (FMA) and the National Credit Regulation Act. In terms of the Banks Act, crowdfunding activities could classify as a deposit-taking action. In particular, investment crowdfunding could be ensnared in regulation under the Companies Act (71 of 2008) in terms whereof public offerings necessitate disclosure requirements. In this regard the National Credit Act could also come into play with reference to peerto-peer lending platforms. Where a platform acts as an "intermediary" the FAIS Act becomes applicable. Furthermore, it is understandable that investment crowdfunding may also be subject to anti-money laundering and Know Your Client requirements under the Financial Intelligence Centre Act (38 of 2001).

The more interesting issue is whether crowdfunding will be explicitly regulated with reference to the looming enactment of the Financial Sector Regulation Bill (the FSR Bill). The FSR Bill forms part of the Twin Peaks model of financial regulation. This model will allow for (amongst other things) the creation of the Prudential Authority and the Financial Sector Conduct Authority who will be responsible for the overarching regulation of the financial services sector in South Africa through various regulatory instruments.

In terms of clause 32 of the draft FSR Bill, the Prudential Authority will be administered by the South African Reserve Bank. The objective, under clause 33, is to maintain financial stability, while promoting and enhancing the soundness of financial institutions. The current FSB will don the mantle of the Financial Sector Conduct Authority (FSCA), as provided for in clause 56 of the FSR Bill. As per clause 57 of the Bill, the FSCA will aim to supervise market conduct of financial institutions, with the underlying premise of protecting financial customers.

To determine the regulation of crowdfunding under the FSR Bill, a few considerations need to be taken into account. In order for the provisions of the FSR Bill to have any tract regarding an entity or product, it must qualify either as a "financial institution", a "financial product", a "financial product provider," a "financial service" or a "financial service provider". How a "crowdfunding venture" will qualify in terms of these concepts will be subject to what the regulator intends to regulate: the platform, the originator, the project or all of these.

In terms of clause 1 of the FSR Bill, a financial service provider, a financial product provider, a market infrastructure, a holding company of a financial conglomerate or a person licensed or required to be licensed in terms of a financial sector law are all considered to be a "financial institution". What constitutes "financial products" is set-out under clause 2 of the FSR Bill. Currently, neither crowdfunding nor anything associated to it are specifically named. However, investment crowdfunding may well fit under clause 2(2), which determines that:

The Regulations may designate as a financial product, any facility or arrangement that is not regulated in terms of a specific financial sector law if— (a) doing so will further the object of this Act set out in section 7;and (b) the facility or arrangement is one through which, or through the acquisition of which, a person conducts one or more of the following activities:(i) lending; (ii) making a financial investment; and (iii) managing financial risk".

Similarly, crowdfunding could be shelved under clause 3(1)(a) of what a "financial service" constitutes: "(a) any of the following in relation to a financial product, a foreign financial product or a financial instrument: (i) Offering, promoting, marketing or distributing; (ii) providing advice, recommendations or guidance; (iii) operating or managing (iv) providing administration services".

It is also noteworthy that clause 3(3) determines that the Regulations promulgated in terms of the Bill may deem unregulated services to be a financial service if doing so will be incidental to the objects of the Bill or if such a service relates to a financial product, market infrastructure or arrangements concerning lending or investments. Whatever the case may be, it can be accepted that for the purpose of the FSR Bill, and for the Twin Peaks regulatory system in general, in future crowdfunding will be regulated. Regulators will want to enhance the financial soundness of the market and protect financial sector participants.

Crowdfunding and crowdfunding activities can be regulated by various regulatory instruments provided for in terms of the FSR Bill. Firstly, the Prudential Authority under clause 105 may issue prudential standards to issues such as the soundness and safety of financial institutions, lowering the risk of key persons and financial institutions partaking in behaviour that may constitute financial crime and the maintenance of financial stability. It follows that the FSCA may also generate conduct standards as set out in clause 106. Conduct standards will aim to ensure the efficiency and integrity of financial markets, the fair treatment of customers or any matters incidental thereto. Provisions for issuing joint standards or standards in respect of "additional matters" are mentioned in clause 107 and 108 of the FSR Bill, and Guidance Notes or Interpretative Rulings under clauses 141 and 142 may also become applicable in regulating crowdfunding.

Given the nature of investment crowdfunding, it is understandable that it may cause some prudential concerns, which may necessitate prudential standards related to liquidity and capital adequacy requirements. Furthermore, this approach may also be beneficial to further crowdfunding as an alternative avenue of financing. Specifically, regulating investment crowdfunding in terms of prudential standards will prohibit it from getting entangled in the CISCA or FMA, and free it from the onerous regulatory compliance requirements that may stifle the potential of crowdfunding.

However, it is believed that the regulation of crowdfunding will fall mainly under the FSCA's wing. The FSCA's regulatory approach includes the TCF initiative, which purports to ensure that financial institutions treat customers fairly. Under the FSCA, anticipated regulation in terms of crowdfunding could be related to various aspects such as marketing and advertisement requirements, which may be issued by way of standards. For example, in order to protect consumers, the FSCA may determine that only certain types of funders may dabble in investment crowdfunding. In relation to marketing and advertising, the FSCA may issue standards echoing the current Policyholder Protection Rules. The requirement that the marketing a platform or funding an idea must be "fair, clear and not misleading" serves as an example.

The FSCA may well determine that, in terms of the FSR Bill, crowdfunding platforms will have to apply for a licence. The regulations already mentioned could then be attached as a licencing condition in terms of a crowdfunding platform or the licence may envisage some restrictive principles aimed at curbing any misconduct that may constitute a risk. A licencing condition could even determine that a project or business venture may only be financed up to an established maximum. It must be reiterated that the regulation of crowdfunding under the FSR Bill will also be dependent on the type of crowdfunding.

Although donation crowdfunding is not regulated abroad, and does not seem to pose any inherent risk, it is possible that the FSCA, in trying to promote market integrity and the fair treatment of customers, may issue conduct standards in this area. The premise that crowdfunding regulation will fall mainly under the FSCA further advances the notion that crowdfunding serves as a means of providing funding in a non-traditional, hassle-free manner. Particularly in developing countries such as South Africa, crowdfunding could serve the important purpose of kick-starting small and medium-sized enterprises that did not previously have access to the market.

It is important that crowdfunding is not over regulated or burdened with onerous regulatory requirements, as this would defeat its purpose. However, the protection of financial consumers is imperative and the correct balance between innovation and protection must be struck. The fact that the FSB is wary of promulgating legislation for the sake of regulation is at least indicative of their aim to achieve this balance. The FSB stated in the 1st Quarter Bulletin that it is considering a report by the International Organisation of Securities Commissions on the subject, which speaks to the challenge of creating a balance before considering the way forward in terms of crowdfund regulation. While we await the inevitable promulgation of the FSR Bill, one thing is certain: it will be a fly on the crowdfunding wall.

Lamola is a Senior Associate and De Meyer a Candidate Attorney with Webber Wentzel.