Kramer Levin and the Regulatory Stakes of Crowdfunding

Paris, April 18, 2013 - French-government sponsored working groups on entrepreneurship have recently drawn to a close, and yet possibilities for traditional financing remain unfavorable, leading entrepreneurs to turn to alternative financing methods. Among these, crowdfunding - or participative financing - is making disciples. Despite very real benefits, however, this model raises significant regulatory issues, calling into question the fundamental structures governing the financial system, i.e. the banking monopoly and public offering rules.

Hubert de Vauplane, the former Legal and Regulatory Director of the banking group Crédit Agricole and Reid Feldman, both partners in the Banking and Finance department of Kramer Levin, are combining their knowledge of banking and financial regulations in France, in Europe and in the United States to assist the principal actors in this sector in developing a French – and European – system which, currently, is incompatible with their model.
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The legal environment in France and in Europe is currently incompatible with the development of crowdfunding.

The first, and obvious, reason is due to the fact that it concerns a new activity whose practices fit poorly within existing financial regulations. Further – and it is without a doubt the most delicate point in considering the regulatory framework -- crowdfunding can take on many forms. Often referred to as “participative financing,” crowdfunding is a mode of financing or alternative banking credit investment which also invests in capital risk or in the development of creative and innovative projects by resorting to the internet to collect funds.

This mode of alternative financing has taken, over time, very diverse forms falling within three general categories:

• internet platforms that offer their members the ability to donate to project leaders;
• platforms that propose projects, donations for donations ;
• platforms that allow the financing of projects via a loan, with or without interest; and finally,
• platforms that authorize direct investment in capital by Internet users.

Each type of financing has its own constraints. Issues arising from donations differ greatly from those affecting loans, and even more from those arising from equity participation. So do we need a new law, generally applicable to all market players, such as a law on the "establishment of participative financing", of which some are starting to speak? Or would it be preferable to adapt existing legislation and regulations? Given the scope and complexity of the issues involved, there is no clear response.

Two main difficulties are apparent: the application of the banking monopoly and the rules relating to public offerings. In both cases, existing regulations, intended to protect borrowers or investors, hinder initiative or force participative financing proponents to resort to ill-adapted schemes.

1. Public offerings

Whether within member states of the European Union or in the United States, public offerings of securities are well supervised and cannot be carried out without complying with strict conditions.

The American legislator, favorable to the development of crowdfunding, has chosen to adapt the existing rules to accommodate this new kind of financing. The JOBS ACT of April 2nd, 2012 gave a legal framework to crowdfunding, at least as it applies to its "investment" dealings, by creating a new exception to the application of public offering rules based on amount each investor can commit, while at the same time requiring platforms to register with SEC.

In the European Union on the other hand, and particularly in France, crowdfunding still lacks a dedicated regulatory framework, and, for better or worse, must find its place in the public offering regime set out in the Prospectus Directive (2010 / 73 / EU). It question then becomes to what extent the already existing exceptions in the Directive authorize the development of crowdfunding. In essence, an offer to the public does not constitute a public offering if the amount is below certain thresholds, or is placed with no more than 150 qualified investors.

Investments falling outside these exceptions must comply with public offering rules, which are particularly burdensome and ill-fitted to crowdfunding practices.

Most platforms offering the opportunity to invest in companies via crowdfunding have opted for "Financial Investment Counsel" (CIF) status, which corresponds poorly to their activities.

Besides issues arising from the Prospectus Directive, there are also aspects of solicitation and placement rules to be taken into account.

2. Banking monopoly

The question here relates to the financing side (loans with or without interest), i.e. whether crowdfunding platforms can allow Internet users to lend sums of money without having the status of a banking establishment, and outside the supervision of the Bank of France and the French banking regulator, the ACP.

Several difficulties exist. The first, relating to the banking monopoly definition, since these platforms are ''collecting" funds. Should crowdfunding platforms request authorization as a payment establishment, or electronic currency manager?

But these platforms also offer their members the ability to "lend" money. In this regard, the obligation to use a banking establishment for lending activity has to be considered. Exceptions to this obligation already exist under French law, in particular for “micro-credit” activities, but these exceptions don’t fit the crowdfunding model.

In addition to banking monopoly issues, supervisory and anti-money laundering obligations would also seem ill-adapted for these new actors.

Further, while donations would at first seem to escape the problems cited above – because, as gifts, they remain free from legal constraints – as soon as a “counter-donation” is involved they, too, can lead to questions as to their nature and legal treatment.

The issues are numerous and all this uncertainty dampens the enthusiasm of new actors. The entrepreneurship working groups should be proposing recommendations in the coming days, but it is likely that these will fall short of the expectations of participative finance platforms.

As for the relevant government bodies, France’s government has announced some initiatives, the European Commission has taken up the topic, and the SEC will soon be publishing implementing regulations under the JOBS ACT: the momentum is favorable to reform proposals.

With this in mind, the AMF and the ACP have announced they will soon publish a common press release setting out the limits in which crowdfunding activities can be exercised in France.