The Act for the Amendment of the Securities and Exchange Act, etc. promulgated on May 30, 2014 (the “Amendment”) deregulates entry into financial instruments business in order to promote use of the so-called “investment-type crowdfunding.” A correct understanding of this Amendment, however, requires familiarity with “crowdfunding,” a concept that remains relatively unknown. This alert offers a broad overview of crowdfunding and an explanation of the content of the Amendment based on practical examples.
1 What is Crowdfunding?
(1) Current Situation of Crowdfunding
Growth of the internet has led to the emergence of web services primarily in U.K. and U.S. which use such collection as a tool for financing. Many of these services initially focused on charitable donations and loans to companies in developing countries, but have gradually become known as a method of financing for companies or projects having difficulty raising funds through loans, etc. Social networking services such as Facebook and Twitter are prominent examples of venture companies using such web services for fundraising, and both the users of and amount of funds raised through crowdfunding are rapidly on the rise.
As evidenced by cases of Japanese venture companies successfully collecting funds through the well-known U.S. crowdfunding site “Kickstarter,” awareness regarding crowdfunding is gradually increasing and various crowdfunding services have emerged in Japan.
(2) How Crowdfunding Works
Crowdfunding, as the name indicates, is generally used as a term meaning the “collection of funds through small contributions from many parties.” General usage of the term would indicate that the Japanese Red Cross Society’s collection of donations through its own website, for example, represents one form of “crowdfunding” in the sense that it is collecting funds through small contributions from many parties via the internet. Unlike this example, however, the crowdfunding that has been the focus of recent attention means the realization of financing by enabling a start-up venture or other such company or project, which by itself would have financial and technical difficulty fundraising from the general public, to easily collect funds from many parties using a web-based platform provided by a crowdfunding service provider. The main focus of the Amendment is also on crowdfunding which employs such services.
The above is a simplified illustration of the typical flow of information and funds in the collection of funds using a web-based platform provided by a crowdfunding service provider. Generally speaking, a fund-seeking party is matched with fund contributors through the following three steps.
(a) Provision of a platform
As a financing intermediary, the service provider provides a web-based platform for the fund raising party to disseminate information.
(b) Posting of information by the fund raising party
In accordance with the prescribed procedures set forth by the service provider, the party collecting funds using the service posts the amount of necessary funding, how the funds will be used and other information on the website, and collects funds.
(c) Viewing of information and contributions by fund contributors
In the case that interested users view the posted information and agree and empathize with the posted information and conditions, these users contribute funds using the prescribed method.
To comply with laws and regulations, differentiate the service, or for other such reason, crowdfunding services are quite diverse in terms of the extent of assessing the fundraising party which posts information; whether restrictions are placed on the qualifications of contributors; the type of contributions; and how the platform provider is involved.
(3) Types of Crowdfunding
The broad concept of “fundraising” in reality involves a variety of legal relationships which serve as the basis for contributions, including the following patterns: receiving donations, borrowing funds, receiving investment, or even receiving assistance under the promise of providing products and/or services in the future.
Given that these legal relationships upon which contributions are based affect the risk and return for the contributors, the obligations of the fund collector, the handling of tax, and the legal restrictions to be applied, it is necessary to distinguish and consider the basis upon which the user of the service contributes funds to the fund collector. This classification could be separated into even more types, but, as described below, it is generally explained by focusing on the method of fundraising and dividing into the following four types: “donation-type,” “purchase and sale-type,” “loan-type,” and “investment-type.”
The contributor contributes funds as a donation, and there is no monetary return.
(ii) Purchase and sale-type
The contributor provides funds for the purpose of completing unfinished products and/or services under the promise that the fund collector will provide products and/or services upon completion. This is frequently explained using the names of “purchase and sale-type” or “purchase-type,” but differs from general mail-order sales in that the risk that the product/service will not be completed remains at the stage of contribution.
The contributor contributes funds as a loan under the promise that the prescribed interest and principal will be returned by the fund collector in the future.
The contributor acquires stock in exchange for the provision of funds (“stock-type”) or obtains the right to receive distribution of profit of the business (share of the collective investment scheme) based on a tokumei kumai (silent partnership) or other investment agreement (“fund-type”), and receives distribution of profit of the business operated by the fund collector in the future in accordance with the type of stock or content of the tokumei kumai agreement.
2 Focus and Content of the Amendment
(1) Focus of the Amendment: “Investment-type” Crowdfunding
Of the types of crowdfunding described above, the focus of the Amendment’s deregulation is on “investment-type” crowdfunding.
For the operator of an investment-type crowdfunding service to solicit investment in stock or shares of a collective investment scheme through the internet on behalf of a fund collector, it must register as a “financial instruments business operator” under the Financial Instruments and Exchange Act (“FIEA”). The Amendment eases the requirements of such registration to encourage the entry of new business operators. In addition, under the FIEA and self-regulatory regulations of the Japan Securities Dealers Association (“JSDA”), crowdfunding services which target unlisted stock cannot in fact be provided except for certain designated stocks. Although the Amendment does not directly change this restriction, the JSDA is currently examining in the direction of deregulation. The following is a general overview of the Amendment.
(2) Content of the Amendment
(i) Easing of Entry Restrictions
Under the FIEA, the solicitation of applications to acquire stock on behalf of the stock issuer by an investment-type (stock-type) crowdfunding service provider as a business falls under “financial instruments business,” and conducting such business accordingly requires registration as a “Type I Financial Instruments Business Operator” (Article 28, paragraph 1, item (i) and Article 29 of the FIEA). Requirements for this registration, in turn, include capital of at least JPY50 million (Article 29-4, paragraph 1, item (iv), and Article 15-7, paragraph 1, item (iii) of the FIEA Enforcement Order); compliance with the restriction on subsidiary business (Article 29-4, paragraph 1, item (v) c of the FIEA); and a capital adequacy ratio above a certain level (Article 29-4, paragraph 1, item (vi) a of the FIEA). Similarly, solicitation by an investment-type (fund-type) crowdfunding service provider regarding shares of a collective investment scheme requires registration as a “Type II Financial Instruments Business Operator” (Article 28, paragraph 2, item (ii) and Article 29 of the FIEA), and this registration requires capital of at least JPY10 million (Article 29-4, paragraph 1, item (iv), and Article 15-7, paragraph 1, item (iv) of the FIEA Enforcement Order).
The Amendment eases these requirements to facilitate registration for crowdfunding service providers as follows.
(a) Fund-type crowdfunding
With respect to parties attempting to handle only public offerings or private placement of unlisted stock in small amounts (expected at less than JPY100 million for the total issued amount and less than JPY500,000 for the investment per person under government ordinance) through the internet and etc. (“Type I Small Electronic Offerings”), the amount of required capital for receiving registration as a Type I Financial Instruments Business Operator is expected to be lowered to JPY10 million under the government ordinance, and the aforementioned grounds for rejecting the application (subsidiary business and capital adequacy ratio) will also not be imposed (Article 29-4, paragraph 2, item (ii) of the FIEA after the Amendment). In addition, after such registration is complete, the restrictions regarding subsidiary business, the obligation to put aside financial instruments transaction liability reserves, the capital adequacy ratio, and the obligation to post signs at the place of business and etc. will not be applied (Article 29-4-2, paragraph 3, paragraph 4, paragraph 5, and paragraph 6 of the FIEA after the Amendment).
(b) Stock-type crowdfunding
With respect to parties attempting to handle only public offerings or private placement of shares of a collective investment scheme in small amounts (expected at less than JPY100 million for the total issued amount and less than JPY500,000 for the investment per person under the government ordinance) through the internet and etc. (“Type II Small Electronic Offerings”), the amount of required capital for receiving registration as a Type II Financial Instruments Business Operator is expected to be lowered to JPY5 million, and the restriction regarding the obligation to post signs at the place of business and etc. will similarly not be applied (Article 29-4-3, paragraph 2 of the FIEA after the Amendment).
(ii) Reviewing Behavior Regulations to Protect Investors
In addition to the aforementioned deregulation, the Amendment requires service providers to establish systems to inspect the content of the business operation and provide appropriate information through websites in order to prevent the increase of fraudulent behavior, as described below.
(a) Obligation to Review Systems for Inspecting Business
The Amendment newly establishes an obligation to review the operational control system of the financial instruments business operator (Article 35-3 of the FIEA after the Amendment). This stipulation is based on the December 25, 2013 Report by the Financial System Council’s “Working Group regarding the Provision of Risk Money to New and Growing Companies” (“Working Group Report”), which serves as the foundation of the Amendment. While the details are to be provided for in a Cabinet Office Ordinance, it is expected to require a review of systems for due diligence and information provision in the case that fundraising intermediation services are to be conducted through the internet.
(b) Obligation to Provide Information through the Internet
In the case that a Financial Instruments Business Operator, etc. solicits recipients of stock or shares of a fund through the internet, the Amendment requires that matters having important implications on the other party’s judgment regarding solicitation (the details of such matters are to be provided for in a Cabinet Office Ordinance) are made accessible to the other party using the internet, etc. for a certain period of time (Article 43-5 of the FIEA after the Amendment).
(iii) Self-Regulations of the JSDA
To handle public offerings as a Type I Financial Instruments Business Operator, a stock-type crowdfunding service provider is currently required to be a member of the JSDA in relation to FIEA restrictions. Except in certain cases, JSDA restrictions in principle prohibit investment solicitation regarding shares of unlisted companies, and unlisted shares other than those designated by JSDA cannot be handled (Article 3 of the Regulation of Over-the-Counter Securities).
The Working Group Report advises that it is appropriate to ease the JSDA’s self-regulatory regulations regarding the handling of public offerings or private placement of unlisted shares in small amounts through the internet, and remove prohibitive measures. In response, the JSDA has begun examinations in the direction of deregulation. The specifics of such deregulation, however, have not yet been stipulated, and a close eye should be kept on future developments.
The Amendment as it pertains to the aforementioned restrictions shall be enforced on the day set forth in the government ordinance, and no later than one year from the day of promulgation (May 30, 2014).
3 Points of Attention
In this way, the FIEA Amendment and amendment of the JSDA’s self-regulatory regulations have eased the requirements for entry into investment-type crowdfunding services, and it is expected that services focusing on investment in unlisted shares will become possible under certain restrictions. On the other hand, expanding crowdfunding services requires an accurate and widespread understanding of this concept, and we highlight two common misunderstandings with this in mind.
(1) Flexibility in the Design of Crowdfunding Services
While crowdfunding services are often separated in the aforementioned types and discussed in terms of the characteristics thereof, in reality the providers put much thought into various areas of the services to mitigate the concerns and burden of general investors and fund raisers.
For example, there is a common image that using stock-type crowdfunding services will lead to a multitude of people snatching up a majority of the voting rights. However, leading services such as “Crowdcube” and “Seedrs” which are already operational in the U.K. and elsewhere have not only adjusted the number of issued shares, but have designed it so that the shares issued are primarily nonvoting shares while voting shares are issued only to those who can conduct a sizable investment of at least a certain amount. In addition, the method of having the service provider hold the voting right instead of shareholders or the method of using an investment trust ensures that the entity which exercises rights is comprised of a small number of parties and that rights are exercised appropriately, and services offered in Japan are also expected to employ such methods. To expand users, it is important to explain these mechanisms and garner a broad understanding in a way that eliminates misguided concerns on the part of investors and fund raisers.
(2) Selecting Services which are Suited to the Fund Raiser
Fund collecting through investment-type crowdfunding, which is the focus of the Amendment, neither increases liabilities nor squeezes cash flow (through an interest burden), and can be used even without offering products or services in the future. In this sense, investment-type crowdfunding represents a method of collecting funds that is attractive to fund raisers in ways that loan-type and purchase and sale-type crowdfunding are not.
On the other hand, purchase and sale-type crowdfunding becomes an option for fund raisers already with a product at the prototype stage, and insofar as there are no language barriers in selling the product, using overseas services to both finance the product and market it overseas may be more effective. (The use of crowdfunding sites is recognized as an effective tool for marketing, and there are examples of Japanese venture companies finding success with U.S. services such as Kickstarter.) It may also be more advantageous for venture companies to use loans from existing financial institutions such as the Japan Finance Corporation. For crowdfunding to actually be used as an effective method of fund collecting, it is essential to realize such diversity in options and to create an environment in which venture companies can easily understand the utility of crowdfunding as a financing tool.
Fund collecting through crowdfunding in Japan is currently small in scale compared to in the U.S. and Europe. That the user base expanded rapidly once a certain number of success cases emerged in these countries indicates the potential for similar user growth in Japan. One hopes that the FIEA Amendment will be the impetus for better understanding of crowdfunding among the general public, and that this service will develop into a useful method of fundraising that meets financing needs in ways that loans and investment have been unable to in the past.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:Wells-Christopher
This article was originally published by Bingham McCutchen LLP.