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Crowdfunding in the light of new EU regulations (2020/1503)

The sector of modern technologies in the financial sector is developing very dynamically. On the one hand, the construction of digital tools has become the foundation of the operational action of many companies. On the other, consumers eagerly reach for financial technology and use financial services in remote channels. The development of FinTech has also changed the face of capital markets. New investment opportunities have arisen, such as e.g. crowdfunding, which is conquering new markets and sectors and uniting investors around joint projects.

The EU legislator also noticed the popularity of this new form of investing cash and launched a project to harmonize the law in this area in the European Union. After almost two years of work, on October 5, 2020, the text of the Regulation (EU) 2020/1503 on European Crowdfunding Service Providers (ECSP) for Business (“ECSP Regulation”) appeared. The market must adapt to that till November 2022.

What is crowdfunding?

Crowdfunding gives investors the opportunity to invest in a specific company or project and brings together investors around a specific initiative. There are two types of crowdfunding – non-financial and financial. The first one is based on a donation and reward system. Therefore, we are not talking about an investment, but rather about supporting a project in exchange for a product, e.g. an invitation to a beer in a subsidized regional brewery.

However, financial crowdfunding is more controversial. The investor takes the role of a shareholder or lender of the company which carries a risk. As a shareholder, an investor is responsible for the company up to the amount of the contribution made. In this case, investment failure may result in the loss of up to 100% of funds. The lender’s liability is negligible, he receives a guaranteed interest rate on the borrowed funds, but this does not exclude the possibility of losing them – the company may declare bankruptcy in the case of failure of the investment.

Legislation today

In the current reality, crowdfunding operators are not subjects of any specific regulations. They can freely offer investment in the projects of issuers with which they cooperate. Of course, it is in the interests of each platform to work with the most trusted issuers, conduct due-diligence of the issuer and investment project, and inform potential investors about the risks connected with acquiring shares or borrowing money. However, it is not regulated by law, which is currently causing a lot of controversy.

The activity of the crowdfunding platform operator is similar to that of investment companies and brokerage houses. And these are strictly supervised by European Securities and Markets Authority (ESMA) and national financial supervision authorities (in Poland, the Polish Financial Supervision Authority). The lack of clear legal regulations leads to a reduction in the safety of investors, for example in terms of the need to meet disclosure obligations.

The ECSP regulation - which crowdfunding type does it regulate and what does it introduce?

The ECSP regulation introduces regulations to financial crowdfunding, both equity and lending. The changes will affect fundamental areas of crowdfunding, focusing primarily on:

Market surveillance

From the end of the transitional period, from November 2022, each entity conducting business activity in the area of crowdfunding will have to obtain a permit to conduct business activity issued by the competent supervisory authority – in Poland by the Polish Financial Supervision Authority. Obtaining approval will require fulfilling formal requirements – the entity may only be a legal person established in the territory of the European Union. Each company that receives an authorization will be entered in the register by ESMA.

An entry in the register is both a restriction and a development opportunity for such a company. Restriction, because the entity will be under strict supervision. A chance for development, because obtaining an entry will enable cross-border activity, i.e. the possibility of entering all markets of the European Union Member States under the notification procedure.

Operator procedures

The ECSP Regulation strongly imposes on the operator the need to have appropriate policies and procedures and mechanisms enabling effective and prudent portfolio management of issuers and investors. Before accepting a company as a potential issuer, the crowdfunding platform will be required to verify not only the project and its attractiveness, but also legal information about the issuer, such as no criminal record or not being established in a high-risk third country.

Changes in the law also exclude the possibility of a conflict of interest between the operator and the issuer. At present, there are no restrictions on capital ties between these entities. After the new regulations come into force, the operator and the issuer will not be able to be dependent on each other. The regulation deals with one more important issue – the question of liability. The operator will be obliged to take preventive measures in the form of purchasing a third party liability insurance policy for its activity.

Know Your Customer

The idea of crowdfunding is based on people with a surplus of money. They become shareholders or lenders, which in each case involves some risk. Is the investor always aware of this risk? Is the investor aware enough to realize whether the investment will actually bring him the profit assumed by him? Is the investor aware of the scope of his / her shareholding obligations? The answer to these questions is: not always. Therefore, the new regulation imposes an obligation on the operator to profile the investor. The platform will have to ask the investor a number of questions that will check his awareness and allow him to refer only those investment offers that are adequate to the investor’s profile.

New regulations, new technology

The transition period ends in November 2022 – by then each operator will have to adapt to the changes. Each change of this type entails the need to create a technology that will enable the implementation of new processes. The investor’s onboarding system, with the possibility of verifying its credibility and profiling in terms of the investor’s profile, will become a need of every platform. On the other hand, we can expect technology that will allow you to get to know potential issuers even better and will support the due-diligence processes of crowdfunding projects.