Review of the Securities and Exchange Commission’s Rules on Crowdfunding
Capital is one of the most important requirements for running a successful business. Without the inflow of a significant amount of capital, it is believed that a venture would be unable to “scale” and would remain small.
In a 2020 survey conducted by PwC, 22% of SMEs in Nigeria said that obtaining finance was the greatest challenge they faced in carrying on their business.
Options such as traditional debt or equity exist but the former is often fraught with tough requirements and high cost while the latter is usually subject to the discretion of High Net Worth Investors or Investment Firms. To help democratize the fund-raising process and make it possible for a wider section of businesses to access funds, business owners began to use crowdfunding as a means of raising the much-needed finance to scale their businesses.
What is Crowdfunding?
Crowdfunding is a method that allows a person desiring to raise funds for a business venture, project or charitable objective to introduce the project to the public, leverage on the power of the collective and raise a larger amount of money usually through smaller contributions. According to Ethan Mollick, it refers to “the efforts by entrepreneurial individuals and groups – cultural, social, and for-profit – to fund their ventures by drawing on relatively small contributions from a relatively large number of individuals using the internet, without standard financial intermediaries.”
While business owners enjoy the benefits of access to an easy pool of investors, crowdfunding is not without its risks to society. Though business persons with sincere intentions can use crowdfunding genuinely with positive results, crowdfunding may also allow unscrupulous or fraudulent individuals or organizations to come up with fake or ponzi schemes to defraud innocent people of their hard-earned money. They could publicize fictitious businesses with false financial projections: the innocent public would invest and lose their capital, pouring their money into the proverbial “basket with holes”.
There are 2 options in dealing with this risk – ban crowdfunding entirely or put checks in place that would allow only genuine businesses raise funds. The second option is what I refer to as the innovation approach to regulation.
Noting the risks that come with crowdfunding, the Securities and Exchange Commission (SEC) of Nigeria has decided to use the innovative approach and come up with Rules on Crowdfunding (“the Rules”). Having reviewed the draft rules released in 2020, I decided to do another review now that the Rules have been executed and now have the force of law.
1. What type of crowdfunding do the Rules apply to?
The Rules only apply to investment-based crowdfunding (crowdfunding for charity is excluded) which is defined as “a round of funding for a specific project, business or venture hosted on a crowdfunding portal to raise funds from a large number of people in exchange for shares, debt securities or other investment instruments approved by the SEC.”
2. Which Entities are covered by the SEC Rules?
· Crowdfunding Intermediaries
· Fundraisers
· Investors
3. Who is a Crowdfunding Intermediary?
A Crowdfunding Intermediary is an entity that registers under the Rules to operate investment-based crowdfunding via a crowd funding portal.
4. Who can register as a Crowdfunding Intermediary?
An entity may be registered as a crowdfunding intermediary when the SEC is satisfied that it is able to operate an orderly, fair and transparent system and it fulfils certain requirements provided in Section 6 of the Rules.
5. What are the requirements for registration as a Crowdfunding Intermediary?
In addition to the requirement of a minimum paid up share capital of ₦100 million and a cash asset ratio of 30% liquid assets and 70% fixed and other assets), the Rules require the entity to submit certain key documents including Certified True Copies of Incorporation documents (Certificate of Incorporation, Memorandum and Articles of Association and other CAC Forms showing share capital, allotment and particulars of directors) and audited accounts.
Only fit and proper persons are allowed to serve as promoters, directors or officers of a Crowdfunding Intermediary. The definition of a fit and proper person is contained in Section 7 of the Rules.
From the requirement for certificate of incorporation and Memorandum and Articles of Association, it is safe to say that only companies and not business names or limited partnerships can register as Crowdfunding Intermediaries. Another important observation is the requirement allowing only persons of upright character to promote or administer a Crowdfunding Intermediary. This is one of the safeguards that prevent fraudulent persons from being allowed to benefit from crowdfunding.
6. What are the Post registration Requirements?
By the Rules (Section 12 and 13), the Crowdfunding Intermediary must do the following amongst others:
6.1 Carry out due diligence on prospective Fundraisers intending to use the Portal including
a) conducting background checks on Fundraiser’s Board of Directors, shareholders etc.
b) verifying the accuracy of the business proposition and solvency of the Fundraiser
c) conducting Know Your Customer and Anti-Money Laundering and Countering Financial Terrorism Regulations
6.2 Include the following information on the crowdfunding portal:
a) details of ownership, management, control structure and measures to guard against losses
b) General risk waring about participating in funding through the portal
c) Warning statement which must include certain key information prominently displayed at 3 points on the Portal - the home page for visitors; the subscription page for investors and on all application forms
6.3 Ensure that every investor confirms among other things that he/she understands that the proposed investment is risky and that he/she can economically absorb loss of the investment via a risk acknowledgment form.
6.4 Inform investors of any material adverse change to a Fundraiser’s proposal as set out under this rule
6.5 Ensure Fundraisers comply with their responsibilities under the Rules
6.6 Establish appropriate safeguards for data protection, ensuring the security and confidentiality of information received and published.
6.7 Appoint a custodian (similar to the requirements from Pension Fund Administrators) that would be required to maintain a separate trust account for each funding round.
6.8 Ensure that it files a written undertaking by any third party involved in helping the Crowdfunding Portal to manage its information. This most likely refers to cloud service providers and website providers.
6.9 Ensure that it does not allow Fundraisers to raise funds on its Portal if the Crowdfunding Intermediary or any of its officers, directors or shareholders own more than 5% of the shares or other securities of that Fundraiser.
7. What activities are prohibited for Crowdfunding Intermediaries?
A crowdfunding Intermediary cannot:
a) provide financial assistance to investors for the purpose of investing in an offer hosted on its portal
b) compensate referrers for providing information on potential investors
c) solicit investments or make recommendations about investment
8. What are the reporting obligations for Crowdfunding Intermediaries?
Crowdfunding Intermediaries are required to file the following returns with the SEC:
a) Quarterly and Annual Capital Market Operators Returns
b) Monthly reports on activities of Fundraisers and investors on the portal
c) Quarterly reports which among other things should include a record of breaches or risk incidents in the reporting period and steps taken to address same.
d) Annual reports on all crowdfunding transactions on the crowdfunding portal to be filed within 30 days after year end.
9. What records are Crowdfunding Intermediaries to keep?
Records relating to investor and fundraising activities on the crowdfunding portal in a non-alterable format for at least seven (7) years. All records required by SEC should be available for examination. See Section 18 of the Rules for details.
10. When can the SEC close down your crowdfunding business?
The SEC may revoke a Crowdfunding Intermediary’s business if it:
a) fails to meet the requirements under the Rules;
b) does not operate the Crowdfunding Portal for a consecutive period of 6 months;
c) fails to pay fees required by the SEC
d) fails to comply with the Investment and Securities Act or Code of Conduct for capital market operators;
e) Is guilty of fraud
This would mean that crowdfunding intermediaries should not only be considering the Rules but must also be conversant with the provisions of the Investment and Securities Act and the Code of Conduct for Capital Operators.
11. Which entities are prohibited from acting as Fundraisers?
a) A public listed company and their subsidiaries
b) Companies with no specific business plan
c) Companies that propose to use the funds raised to provide loans or invest in other entities
12. What are the Obligations of Fundraisers
Fundraisers are required to amongst others:
a) only offer its investment instruments via a registered Crowdfunding Intermediary
b) file a standardized offering document with the Crowdfunding Intermediary which shall include details of the Fundraiser and its directors, risks associated with the investment, and warnings to investors.
c) maintain an accurate list and details of all investors after issuing the securities
d) allow investors to withdraw from an offer to purchase up to 48 hours before the close of the offer
e) offer investments within the limits set out by the SEC. The Rules categorise enterprises into 3 (three) – Micro, Small and Medium enterprises as defined by the Small and Medium Enterprises Development Agency of Nigeria (SMEDAN).
f) submit annual audited financial statements to the Crowdfunding Intermediary
13. What is a Fundraiser prohibited from doing?
Fundraisers cannot:
a) pay finder’s fee or referral fee to any other person except to the Crowdfunding Intermediary except payments such as legal fees or for preparation for materials
b) host offers concurrently on multiple crowdfunding portals
c) offer any other instrument other than ordinary shares, plan vanilla bonds or debentures and simple investment contracts
d) arrange loans or financing for investors
14. What are the obligations of Investors?
Investors are allowed to invest subject to the investment limit. Retail investors may not invest a sum of more than 10% of their net annual income in a calendar year. This means that if your income is ₦10 million in the period of one year, you can only invest ₦1 million in a year on a crowdfunding portal. On one hand, this could be considered a low threshold for investors especially because financial freedom proponents often suggest that the pathway to better finances is more aggressive savings and investments. However, one can also argue that the rationale for this particular provision is to encourage investors to diversify their risk and not to concentrate it on one asset class.
15. How about AgriTech/Commodity Investment Platforms?
The Rules also make provisions for Commodities Investment Platforms. Commodity Investment Platforms are portals enabling fundraisers to access funding for agricultural or commodities projects. A key point to remember is that a crowdfunding intermediary registered to operate a commodities investments platform cannot source for funds for non-agricultural projects.
Crowdfunding Intermediaries that host commodities investment platforms must meet certain important requirements including:
a) Maintaining a cash asset ratio of 60% liquid assets and 40% fixed and other assets.
b) Conducting proper due diligence on all projects and project executors
c) Providing information to investors displayed prominently prior to making an investment including:
o the location (city, town and Local Government Authority) of the project and
o a disclosure document containing details of expected profit, kind of title to project site, species of commodity to be cultivated, information on the custodian of funds to be raised and a link to the Terms and conditions of sponsorship for each project.
d) Ensuring that the Fundraiser does not guarantee a Return on Investment
e) Specifically stating details of insurance offered for the project including name of the insurance company, amount of insurance coverage and copy of the insurance policy
CONCLUSION
From a review of the Rules, it can be clearly seen that the SEC has provided the appropriate risk management framework for the investment crowdfunding process. Even though persons may opine that the regulations impose a heavy burden of compliance, when comparing with the loss that can be occasioned if fraudulent persons are allowed to utilize crowdfunding, I submit that the burden as they say is light. Consider the MMM example; ₦28.97 billion is estimated to have been spent on the platform. When the platform crashed, many Nigerians were unable to recover their “investment” and this is why the crowdfunding space must be regulated. The Rules ensure that investors are aware of the real face behind any particular investment they desire to participate in and as such fraudulent websites would be unable to spring up and defraud innocent investors of their hard-earned money. I look forward to more regulators taking this approach to the technological innovation that is ahead of us in days to come.
REFERENCES
1. Securities and Exchange Rules on Crowdfunding, https://nairametrics.com/wp-content/uploads/2021/01/Jan-2021-Executed-Rules-1.pdf
2. Ethan Mollick, The dynamics of crowdfunding: An exploratory study, https://doi.org/10.1016/j.jbusvent.2013.06.005.
3. PwC’s MSME Survey, 2020, Building To Last https://www.pwc.com/ng/en/assets/pdf/pwc-msme-survey-2020-final.pdf
