The Promise and Perils of Crowdfunding: Between Corporate Finance and Consumer Contracts
| Date | 01 January 2018 |
| Published date | 01 January 2018 |
| DOI | http://doi.org/10.1111/1468-2230.12316 |
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The Promise and Perils of Crowdfunding: Between
Corporate Finance and Consumer Contracts
John Armour and Luca Enriques∗
‘Crowdfunding’ is a burgeoning phenomenon. Its still-evolving status is reflected in diversity
of contracting practices: for example, ‘equity’ crowdfunders invest in shares, whereas ‘reward’
crowdfunders getadvance units of product. These practices occupy a hinterland between existing
regimes of securities law and consumer contract law. Consumer protection law in the UK (but
not the US) imposes mandatory terms that impede risk-shar ing in reward crowdfunding,
whereas US (but not UK) securities law mandates expensive disclosures that hinder equity
crowdfunding. This article suggests that while crowdfunding poses real risks for funders, the
classical regulatory techniques of securities and consumer law provide an ineffective response.
Yet, a review of rapidly-developing market mechanisms suggests they may provide meaningful
protection for funders. An initially permissive regulatory approach, open to learning from
market developments yet with a credible threat of intervention should markets fail to protect
consumers, is justified.
INTRODUCTION
Start-up firms – with untr ied products,and often untested founders – frequently
find it difficult to obtain finance.1This difficulty has arguably been exacerbated
by constriction in bank lending since the financial crisis.2Because start-up
firms are disproportionately associated with innovation and job creation,3the
∗John Armour is Professor of Law and Finance, University of Oxford; Luca Enriques is the Allen &
Overy Professor of Corporate Law at the same University; both areECGI Fellows. We areg rateful for
feedback received at presentations at an OxfordBusiness Law Workshop; the University of Auckland
Law Faculty; Universidad Carlos III de Madrid Department of Business; the ETH-NYU Law &
Banking/Finance Conference 2015 in Zurich; Munich University’s Center for Advanced Studies;
the NUS-ETH Law and Banking Colloquium 2016 in Singapore; the University of Hong Kong;the
AEDE 7th Conference at Catolica Global Law School, Lisbon; Durham Law School the European
Commission (DG-FSMA); the University of Virginia Law School; and Harvard Law School. We
thank in particular Doug Cumming, Quinn Curtis, Horst Eidenm ¨
uller, Talia Gillis, Lars Hornuf,
Tijo Hans, Rich Hynes, Louis Kaplow, Howell Jackson, Lin Lin, Geoff Miller, Holger Spamann;
Kathy Spier; and two anonymous MLR referees for helpful comments. Martin Bengtzen provided
excellent research assistance. The usual disclaimers apply. All URLs were last accessed 29 May 2017.
1 See BIS, ‘SME Access to External Finance’ BIS Economics Paper No 16 (January 2012); A.
Freeman, Challenging Myths About the Funding of Small Businesses: Finance for Growth (London:
Demos, 2013); National Audit Office, BIS and HM Treasury,Report by the Comptroller and Auditor
General: Improving Access to Finance for Small and Medium-Sized Enterprises HC 734 (November
2013) 13-15; British Business Bank, ‘Analysis of the UK Smaller Business Growth Loans Market’
Research Report (March 2015); cf R. Brown and S.Lee, Funding Issues Confronting High Growth
SMEs in the UK (Edinburgh: ICAS, 2014).
2 See, for example, I. McCafferty, ‘UK Business Finance Since the Crisis – Moving to a New
Normal?’ speech given at Bloomberg, London, 20 October 2015.
3 See, for example, B. H. Hall, ‘Innovation and Productivity’ NBER Working Paper No 17178
(2011); L. Kogan et al, ‘Technological Innovation, Resource Allocation, and Growth’ NBER
C2018 The Author. The Modern Law Review C2018 The Modern Law Review Limited. (2018) 81(1) MLR 51–84
Published by John Wiley& Sons Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA
The Promise and Perils of Crowdfunding
possibility of a ‘funding gap’ for start-up firms is a significant concern for
policymakers.4
In the last few years, a new source of finance for start-ups, known as ‘crowd-
funding’ (CF), has become widely available. As the name implies, this involves
raising capital from a large number of individuals, each of whom typically con-
tributes a small sum. The internet has lowered the costs of raising funds in this
way, by facilitating the dissemination of information about small projects. Use
of CF has grown exponentially. Industry statistics estimate a total of $34 billion
was raised worldwide using crowdfunding in 2015, having grown thirteen-fold
over just three years.5This is just over a sixth of the amount raised worldwide
through initial public offerings (IPOs) on equity markets in the same year.6
While the availability of CF is clearly good news for entrepreneurs, its mer-
its for those providing the funding are less certain. Because funders typically
invest only small sums in projects, CF may appeal to consumers, that is, un-
sophisticated individuals. However, consumers have limited capacity to assess
the prospects of a business, and are prone to making investment decisions sub-
ject to biases and herd behaviour. In addition to losses to funders, this can
cause finance to be misallocated to inferior business projects. These risks raise
important questions for regulators.
In this article, we sketch out a normative roadmap for the regulation of CF
in relation to business start-ups. This is a highly salient enquiry. In the UK, the
Financial Conduct Authority (FCA) has recently conducted its third review
of CF regulation in as many years.7In the US, the Securities and Exchange
Commission (SEC) regulations for retail CF came into force in May 2016
pursuant to the JOBS Act of 2012;8their operation is being carefully studied.
Meanwhile, the European Commission is actively seeking to promote CF as
part of the Capital Markets Union action plan.9
We begin by considering the use of CF and the characteristics of typical CF
contracts. One type of CF contract – the ‘reward’ model, in which funders are
rewarded with units of product – offers both firms and funders the promise of
reducing uncertainty by generating new information about consumer demand.
Working Paper No 17769 (2012); National Audit Office, BIS and HM Treasury, Report by the
Comptroller and Auditor General: Improving Access to Finance for Small and Medium-Sized Enterprises
HC 734 (November 2013) 13; BIS, ‘SMEs: The Key Enablers of Business Success and the
Economic Rationale for Government Intervention’ BIS Analysis Paper No 2 (December 2013);
J. Edler and J. Fagerberg, ‘Innovation policy: what, why, and how’ (2017) 33 Ox Rev Econ Pol
2, 9-10.
4 For details of recent policy initiatives, see BIS and HM Treasury, ‘2010 to 2015 Gov-
ernment Policy: Business Enterprise’ Policy Paper, May 2015 at https://www.gov.uk/
government/publications/2010-to-2015-government-policy-business-enterprise.
5 Massolution, Crowdfunding Industry 2015 Report (2016).
6EY,EY Global IPO Trends 2015 4Q, 4 (2016).
7FCA,Interim Feedback to the Call for Input to the Post-Implementation Review of the FCA’s Crowd-
funding Rules FS16/13 (2016). See also FCA, The FCA’sRegulatory Approac h to Crowdfunding over
the Internet, and the Promotion of Non-Readily Realisable Securities by Other Media PS14/4 (2014).
8 SEC, ‘Crowdfunding: Final Rule’ (2015) 80 Federal Register 71388 (17 CFR Parts 200, 226,
232, 239, 240, 249, 269 and 274).
9 See European Commission, Action Plan on Building a Capital Markets Union COM(2015) 468
final, 30 September 2015, 7; European Commission, Crowdfunding in the EU Capital Markets
Union SWD(2016) 154 final, 3 May 2016.
52 C2018 The Author. The Modern Law Review C2018 The Modern Law Review Limited.
(2018) 81(1) MLR 51–84
John Armour and Luca Enriques
By using reward CF, founders capture synergies between their product and
capital markets. Rather than raise capital and aggregate information about
likely success as a by-product (through the price mechanism), they tap the
product market, thus directly testing demand, and raise capital as a by-product.
In contrast, with ‘equity’ CF, where funders buy shares, their valuations
are based on estimates of others’ future consumption of the product and the
venture’s profitability, about which they have no special expertise. There is
consequently a real peril that consumers (whom we will refer to as ‘retail
investors’ when they invest in equity CF) will simply ‘herd’ into backing
projects that early adopters have previously found attractive, which can lead to
misallocation of capital.
We then review the regulation of CF in the UK (which largely reflects
the implementation of EU law) and the US. Because CF is a novel practice,
regulatory policy has tended, to some degree, to take the form of the application
of existing frameworks designed with other contexts in mind. This has led to
inconsistent, and in places misconceived, regulatory treatment.
Reward CF binds together a start-up firm’s financial and product markets.
The involvement of the product market means that the practice appears to be
subject, in the UK, to the regime established by EU consumer protection rules,
mandating amongst other things that consumers have an option to cancel the
transaction and reclaim their money. This, we argue, fails to take account of
funders’ dual function as product consumers and financiers, in the latter aspect
of which they bear risk associated with the product’s completion. In contrast,
few mandatory terms are imposed on consumer contracts in the US. This gives
parties greater freedom to design reward CF arrangements. While reward CF
is virtually non-existent in the UK, it has flourished in the US.
Equity CF involves issuing securities to investors, and for that reason is
formally within the domain of ‘securities law’. A central plank of securities law
is mandatory disclosure, the compliance costs of which are often prohibitive
for small firms. Despite the reduction of these costs in the US through a special
regime for equity CF, with effect from May 2016, they still seem too high to
foster the development of equity CF in that country. In contrast, equity CF has
flourished in the UK, where there is an exemption from disclosure obligations
under the Prospectus Directive for small offerings. In our analysis, the way
equity CF markets operate is sufficiently different from traditional securities
market contexts that the justifications for mandating disclosure in those other
market contexts do not carry across.
The structure of the problems of CF are common to many consumer fi-
nance transactions. However, evidence-based regulatory solutions in consumer
finance tend to be context-specific, and poorly-crafted intervention can easily
make things worse rather than better. At this early stage of the market’s devel-
opment, we consequently advocate a permissive regulatory regime. This allows
the promise of reward CF to be fulfilled, and offers the opportunity for the
development of market solutions in respect of equity CF. In the penultimate
section, we review the range of market mechanisms that have been deployed in
the UK and other jurisdictions to overcome the contracting problems inherent
in equity CF. We suggest that these hold out promise, and that an initially
C2018 The Author. The Modern Law Review C2018 The Modern Law Review Limited.
(2018) 81(1) MLR 51–84 53
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