Crowd-sourced equity funding: what the Bill and the Innovation Statement mean for Australia

On 3 December, the Federal Government tabled in Parliament the Corporations Amendment (Crowd sourced Funding) Bill 2015 (the Bill), which provides for the addition of new fundraising provisions to the Corporations Act.

Days later on 7 December, the Government released its National Innovation and Science Agenda.

Both the Bill and the Agenda contain important measures aimed at encouraging the development of a vibrant and innovative Australian economy by transitioning Australia away from the mining boom and towards an “ideas boom”.

This Alert discusses the Government’s proposals, embodied in the Bill, to enable companies to gain access to crowd sourced equity funding to develop their innovative ideas.

Subsequent alerts will deal with the Government’s insolvency and tax proposals.

Crowd‑sourced funding

Crowd‑sourced funding (CSF) is a type of corporate capital raising whereby a company seeks funds in small amounts from a large number of individual investors in return for securities of the company. CSF involves:

• companies (issuers) that propose to raise funds
• intermediaries that host the platform through which offers are made to crowd investors
• crowd investors.

CSF has developed over the last few years as an online phenomenon, utilised particularly by small start–up companies seeking seed capital, as a complement to more established financing options involving professional investors, such as angel investing and venture capital.

However, the current legislative framework in Australia presents barriers to CSF. Proprietary companies are limited to 50 non‑employee shareholders and are prohibited from making public offers of securities, while public companies are subject to governance, reporting and disclosure requirements that may be too onerous for a small business. Also, the fundraising requirements in the Corporations Act 2001 (Cth) (Corporations Act) may be too expensive and onerous to be of any use to small start–up companies.

Overview of the Crowd‑sourced Funding Bill

On 3 December 2015, the Government tabled in Parliament the Corporations Amendment (Crowd‑sourced Funding) Bill 2015 (the Bill). Draft regulations setting out further detail of the CSF scheme will be released shortly.

The Bill provides for the addition of a new Part 6D.3A to the fundraising provisions of the Corporations Act. The new Part provides for a disclosure regime that can be used instead of the existing fundraising disclosure requirements for certain offers of securities for issue in small unlisted companies.

Under the CSF regime proposed in the Bill, small unlisted companies could raise up to $5 million a year, with no more than $10,000 coming from any one investor.

Only public companies would be able to use CSF. However, eligible companies would be exempt from various requirements otherwise applicable to public companies (the annual general meeting requirement, as well as various reporting and audit requirements).

An issuer would only be able to make an offer of CSF securities (a CSF offer) by publishing a CSF offer document on the offer platform of a single CSF intermediary, which would have to be licensed. The intermediary would provide the means for investors to apply for securities in a company. It would also provide a communication facility to allow investors, the company issuing the securities and the intermediary itself to communicate with each other.

The intermediary would have a key role in providing investor protections, including a warning about the risk of investing in small start‑up companies and information about ‘cooling off’ rights for retail investors to back out of an investment during an initial period.

The Bill builds on recommendations of the Corporations and Markets Advisory Committee (CAMAC) in its report Crowd sourced equity funding (May 2014) (CAMAC report), as well as responses to a Treasury Discussion Paper Crowd‑sourced Equity Funding (December 2014) and a Treasury Consultation Paper Facilitating crowd-sourced equity funding and reducing compliance costs for small businesses (August 2015).

The potential for CSF to provide new and innovative businesses with access to finance was also identified in:

• the Government’s Industry Innovation and Competitiveness Agenda (October 2014)
• the Final Report of the Financial System Inquiry (November 2014) (the Murray Report)
• the Productivity Commission Report Business Set‑up, Transfer and Closure (September 2015).

The remainder of this Alert summarises the Bill in greater detail.

CSF issuers

Prerequisites for a CSF offer

The requirements for a CSF issuer to make a CSF offer are:

• primary issue only: the offer must be for a primary issue of securities of the company making the offer: it cannot be for a secondary sale of those securities
• CSF eligibility criteria: at the time of the offer, the company making the offer must be an ‘eligible CSF company’, which is a company that satisfies the following conditions:
  • it is a public company limited by shares, with its principal place of business and a majority of its directors in Australia
  • the value of the consolidated gross assets of it and its related parties must be less than $5 million at the time it is determining its eligibility to crowd fund (the assets test) (a related party, for the purpose of the CSF provisions, is a related body corporate or an entity controlled by a person who controls the company or an associate of that person)
  • the consolidated annual revenue of it and its related parties must be less than $5 million (the turnover test)
  • neither it nor a related party is a listed corporation (as listed corporations generally have access to other forms of equity raisings such as rights issues and share purchase plans)
  • neither it nor a related party has a substantial purpose of investing in securities or interests in other entities or managed investment schemes
• type of securities: the securities must satisfy the eligibility conditions specified in the regulations
• issuer cap: the offer must comply with an ‘issuer cap’ of $5 million in any 12 month period, calculated taking into account:
  • the amount sought to be raised under the current offer
  • all amounts raised from previous CSF offers made within the 12 month period preceding the current offer
  • all amounts raised from small scale personal offers exempt from disclosure pursuant to s 708(1) within the 12 month period preceding the current offer
  • all amounts raised from certain offers made through the holder of an Australian Financial Services Licence (AFSL), and exempt from disclosure pursuant to s 708(10), within the 12 month period preceding the current offer.

Fundraising in addition to a CSF offer

In addition to the $5 million that can be raised under the CSF regime, a company can raise funds from:

• sophisticated investors
• professional investors.

Fundraising from these persons does not require a disclosure document under the current fundraising disclosure provisions in Chapter 6D of the Corporations Act (ss 708(8), 708(11)).

The process of making a CSF offer

An issuer must, for each CSF offer:

• prepare a CSF offer document containing clear, concise and effective information, as specified in the regulations (for instance, information about the company and its business, the securities on offer, how the proceeds from the offer will be used)
• obtain the consents of persons associated with the offer document
• publish the offer document (including, or together with, the offer itself) on the platform of a single CSF intermediary
• have only one CSF offer open at any one time
• not have a CSF offer open at the same time as a CSF offer of a related party (this avoids circumvention of the issuer cap).

An issuer has the power to withdraw a CSF offer at any time before the offer is complete by notifying the intermediary. Other stages of a CSF offer are mostly under the control of the intermediary and are discussed below under CSF intermediaries.

Issuers have particular responsibilities when a CSF offer document is found to be defective. These are set out below under Defective CSF offer documents.

Corporate governance

The Bill would provide a CSF issuer with corporate governance concessions for five years from the date of registration as a public company if it:

• satisfies the CSF eligibility criteria at the time of registration as a new public company and at the end of the relevant financial year, and
• intends to crowd fund at the time it is registered, and
• completes a CSF offer within 12 months of registration.

The corporate governance concessions are:

• an exemption from holding an annual general meeting
• the option to provide financial reports to shareholders online only
• not being required to appoint an auditor
• not being required to have audited financial reports until more than $1 million has been raised from CSF offers or other fundraising offers requiring disclosure.

The CAMAC report recommended other corporate governance concessions, which were not incorporated into the Bill, for instance, relief from some obligations regarding a company’s registered office and place of business.

CSF intermediaries

Financial services licensing requirement

A CSF intermediary must hold an AFSL to provide a crowd‑funding service, which is a new category of financial service created under the Bill. A person provides a crowd‑funding service if:

• a CSF offer document relating to securities of a company is published on a platform operated by the person
• applications may be made to the person for the issue, by an issuer company, of securities pursuant to the offer.

The crowd‑funding service is provided to:

• potential investors who apply for CSF securities through the intermediary’s platform (when the investors first use the intermediary’s application facility to apply)
• the issuer (when the issuer enters into the hosting arrangement for the offer of securities with the intermediary).

Financial market licensing requirement

In some circumstances, the operations of a CSF intermediary may require it to hold an Australian Market Licence (AML).

The Bill provides the Minister with powers to tailor the financial market licensing provisions to facilitate specialised and emerging financial market and clearing and settlement facility operators, including those relating to CSF securities. In particular, the Minister will be able to exempt particular holders of an AML from specified AML obligations. Currently, the Minister cannot adopt this targeted approach, but must either grant a total exemption from the obligation to hold an AML or refuse an exemption (s 791C).

The obligations of a CSF intermediary

The obligations of the intermediary include:

• gatekeeper obligations, which require the intermediary to conduct certain checks (which will be prescribed in the regulations) to a reasonable standard before publishing an issuer’s offer document on its platform and not to publish an offer if the intermediary:
  • is not satisfied about the identity of the company making the offer, or of any of the company’s directors or other officers
  • has reason to believe that any of the company’s directors or other officers are not of good fame or character
  • has reason to believe that the company, or any of its directors or officers, has knowingly engaged in misleading or deceptive conduct in relation to the offer, for instance, by providing misleading information in response to a post on the communications facility
  • has reason to believe that the offer is not eligible to be a CSF offer (for instance, if it does not comply with the issuer cap)
• to have adequate arrangements, recorded in writing, to ensure that it complies with its gatekeeper obligations
• to provide an application facility, reject applications not made via that facility (to ensure that applicant investors are aware of, and receive, the various investor protections) and not allow an application to be made while an offer is suspended or when it has closed
• to provide a communication facility to allow potential investors, the issuer and the intermediary to communicate with each other about a particular CSF offer. This facility should enable:
  • investors to make and see posts relating to the offer and ask the issuer or the intermediary questions relating to the offer
  • the company or the intermediary to make posts responding to questions and other posts (officers, agents and employees of the issuer or the intermediary must disclose their status when making posts on the facility)
• to display prominently on the offer platform:
  • the CSF risk warning (the terms of which, to be specified in the regulations, will include the potential risks associated with, and high failure rates of, start‑ups and emerging companies)
  • information on investors’ cooling‑off rights (including the means by which investors can exercise these rights)
  • fees charged to, and interests that the intermediary has or intends to take in, an issuer company (the ability of intermediaries to take interests in an issuer is more liberal than the approach proposed by CAMAC, which recommended that conflicts of interest should be avoided, rather than merely disclosed)
• to comply with the prohibition on giving financial assistance to a retail client to purchase securities pursuant to the CSF offer
• to close or suspend the offer as required
• to deal with application money appropriately.

The provision of a crowd‑funding service includes all these intermediary obligations. This wide meaning of ‘crowd‑funding service’ will ensure that all the intermediary’s activities will be subject to the general obligations of a licensee (s 912A), such as the obligation to provide the service ‘efficiently, honestly and fairly’.

Intermediaries have particular responsibilities when a CSF offer document is found to be defective. These are set out below under Defective CSF offer documents.

Stages of a CSF offer

CSF intermediaries play a key role in determining when CSF offers are made, open, closed, suspended and complete.

The maximum duration for a CSF offer is three months from the time the offer was made. This maximum offer period ensures that the information contained in the CSF offer document remains current and is consistent with the notion of CSF as a simpler, faster way of raising funds with streamlined disclosure.

When an offer is complete (that is, when the minimum subscription condition is met, disregarding any withdrawn applications), the intermediary must pay application money to the issuer following the issue of the securities. If the minimum subscription amount is not raised, the intermediary must refund application money to the applicants.

CSF investors

Investor steps in the offer process

CSF investors must:

• make their applications in response to a CSF offer via the intermediary’s offer platform, to ensure that they have the various protections of the CSF regime (such as the communication facility, the risk warning and cooling‑off rights)
• provide the application money via the intermediary, to ensure that the money is handled according to the client money provisions and is subject to the CSF rules for when money is paid to the issuer and refunded to applicants.
• General investor protections

Issuers and intermediaries must comply with stipulated advertising rules. For instance, an advertisement or publication about a CSF offer must include a statement that a person should, in deciding whether to make an application under the offer, consider the CSF offer document and general CSF risk warning. In contrast with the advertising rules currently applicable in the case of an unlisted company, the same rules apply whether the advertisement relates to an open CSF offer or an intended CSF offer, given that an investor can only make an application via a platform that must prominently display important information.

There is an exception from the advertising rules for publishers and the publication of certain reports and notices.

There is also an exception for statements made in good faith on the intermediary’s communication facility. However, the onus is on the person making the statement to show that it is made in good faith. Although the argument for this onus is that the question of good faith involves the person’s state of mind and knowledge, persons may be reluctant to use the communication facility if they risk having to prove why they have not committed an offence. There seems to be no good reason why the prosecution should not have the onus of proving lack of good faith, given that the very purpose of the communication facility is to promote the sharing of information in relation to an offer.

Persons will also be prevented from offering securities for issue or sale through an unsolicited meeting or telephone call (a practice known as securities hawking), regardless of whether the offer is identified as a CSF offer.

ASIC will have stop order powers in relation to advertising and publications that are misleading or deceptive or that do not draw attention to the CSF offer document or the general CSF risk warning.

Investor protections for retail clients only

When providing a crowd‑funding service to a person, the intermediary must determine whether the person is a ‘retail client’, as retail clients have additional protections both under the current law (Financial Services Guide, access to dispute resolution and compensation arrangements) and under the CSF provisions.

The tests for determining whether an investor is a retail client are, for the most part, the same as under the current licensing provisions. The exception is that a CSF licensee, unlike other financial services licensees, will not be permitted to decide that an investor is a ‘sophisticated investor’, rather than a retail client, under s 761GA.

Additional protections applicable to retail clients only under the CSF provisions are:

• an investor cap of $10,000 per issuer via a particular intermediary’s platform within a 12 month period (this amount is to be apportioned equally if there are joint applicants for securities)
• an unconditional ‘cooling off’ right for a retail investor to withdraw from a CSF offer within 5 business days of making an application
• a prohibition on the company and its related parties, and the CSF intermediary and its associates, providing retail investors with financial assistance to acquire securities under CSF offers
• the requirement for a CSF intermediary to obtain a risk acknowledgement from a retail investor before accepting a CSF application from the investor.

Investors have particular rights when a CSF offer document is found to be defective. These are set out below under Defective CSF offer documents.

Defective CSF offer documents

When is a document defective?

A CSF offer document is defective where:

• it contains a misleading or deceptive statement
• it omits information that is required to be included
• since the document was published, a new circumstance has arisen that would have been required to be included if it had arisen before the document was published.

Obligations in relation to defective documents

The following obligations arise when the relevant person becomes aware, while a CSF offer is open, that the offer document was defective:

• the issuer must notify the intermediary as soon as practicable
• the intermediary must:
  • notify the issuer as soon as practicable
  • remove the offer document from the platform and either close or suspend the offer
• a person liable on the offer document must notify the issuer and the intermediary as soon as practicable.

The issuer need not do anything other than notify the intermediary: it has the option of providing a replacement or supplementary offer document, but no obligation. The intermediary is not obliged to publish a replacement or supplementary document, as the intermediary’s gatekeeper obligations apply to these types of document in the same way as to the original offer document.

Investor rights

Prospective investors who have already applied for securities under the document will either:

• receive a supplementary or replacement offer document that corrects the defect and then have the right, for one month, to withdraw their acceptance, or
• be refunded any application money paid as soon as practicable.

Criminal and civil liability

An issuer that offers securities under a defective CSF offer document is criminally liable if the relevant statement, omission or new circumstance is materially adverse from the point of view of an investor.

An intermediary that publishes an offer document that it knows to be defective is criminally liable.

Also, an investor can recover from various persons associated with a CSF offer the amount of loss or damage suffered (the categories of persons liable to investors on a prospectus are also liable on a CSF offer document, as is an intermediary that publishes an offer document that it knows to be defective). The investor has six years from the day the cause of action arose to commence recovery proceedings.

An issuer has a ‘lack of knowledge’ defence to criminal and civil liability if it did not know the document was defective. This defence places less onus on the issuer than the due diligence defence that applies to prospectus liability. The due diligence defence requires a person to make all reasonable inquiries and form a belief based on reasonable grounds (s 731).

An issuer also has a defence to both forms of liability of ‘reasonable reliance’ on information given by another person (other than an employee, agent or director).

An intermediary has no defence to either form of liability, given that it is only liable if it had knowledge.

ASIC stop order powers

Unlike other disclosure documents, a CSF offer document will not need to be lodged with ASIC. However, ASIC will have stop order powers where a company offers securities under a defective CSF offer document.

Conclusion

While the Bill provides various detailed requirements that must be met by issuers and intermediaries to be able to access CSF, for the most part these seem necessary to attract investment by providing investors with adequate protection. Some of the detail will be in the regulations, which have not yet been released (for instance, the types of securities that can be offered, the checks to be conducted by intermediaries, the CSF risk warning and the content requirements for a CSF offer document).

A key factor in determining the regulatory burden on issuers will be the content required for inclusion in a CSF offer document. The examples given in the Explanatory Memorandum of matters that might be covered in a CSF offer document are similar to those required to be included in a prospectus.

There are also two respects in which the Bill might be modified to create a better legislative environment for crowd‑sourced funding. First, the corporate governance concessions recommended by CAMAC, but not incorporated into the Bill, could be included. Secondly, persons who use a communication facility hosted by a CSF intermediary should not be faced with having to prove that they acted in good faith: the onus should be on those alleging lack of good faith.