As start-ups and small businesses continue to crowdfund through the Internet, governments and regulators have had to respond. The United States created a tailored regime for crowdfunding. The United Kingdom and Singapore publicly consulted and clarified their regulatory approaches. The Hong Kong regulator has been less proactive, thus inviting criticisms that Hong Kong has fallen behind in enabling financial innovation and entrepreneurship.
Are these criticisms fair and accurate? Not necessarily so. In my latest research paper, I ventured to show that gateways for crowdfunding already exist in Hong Kong. If these exemptions were fully utilised, Hong Kong would be broadly on a par with, or even ahead of, other international financial centres in allowing entrepreneurs to tap capital from professional (accredited) investors – the investor pool most coveted by entrepreneurs.
How Far Did the United States Go?
With a strong political will to create jobs and promote growth after the global financial crisis, the United States was the most ardent in enacting legislation to enable crowdfunding. The Jumpstart Our Business Startups Act (‘JOBS Act’) was passed in 2012 against this background.
What often hit the headlines was Title III of the JOBS Act, which crafted a new exemption for securities crowdfunding for retail investors. Securities offerings not exceeding US$1.07 million over a 12-month period are exempted from SEC registration. The exemption comes with restrictions designed for investor protection – issuers are subject to substantial disclosure requirements, the offering must be conducted via regulated intermediaries, and retail investors are subject to an annual cap on their investments. Under these restrictions, Title III might not be as helpful for a fund raising avenue as its founding architects first envisaged.
The unsung hero is in Title II of the JOBS Act, which liberalised the private placement exemption. Before Title II, private offerings to accredited investors under Rule 506 of Regulation D were exempt from SEC registration, but issuers could not advertise or promote their offerings. This created an information barrier, making it difficult for issuers to seek out and connect with latent angels and accredited investors. Given the reach of the Internet, the ban was particularly problematic. Title II and the new Rule 506(c) lifted the ban, allowing issuers to engage in general solicitation and advertising in respect of their private securities offerings. So long as an issuer takes reasonable steps to verify that all investors are accredited investors and they continue to be so at the time of sale, the offering comes within the exemption even if the advertisement reached non-accredited investors. There is no ceiling on the number of investors or the amount raised, and no requirement for disclosure (subject however to antifraud provisions in federal and state securities law).
Accredited investors account for only 7.4 percent of all households in the U.S., but they control over 70 percent of the available capital. A significant portion of capital-raising in the U.S. comes from the non-public capital market. Given the relaxations in Title II, some anticipated that Title III will be much less used than Title II. It has been suggested that only issuers who failed to raise funds among accredited investors will resort to crowdfunding with retail investors, making the latter a “market for lemons”.
What have the United Kingdom and Singapore Done?
The regulators in both markets consulted the public. In the end, neither regime introduced any new exemption for securities offerings through crowdfunding. These offerings must comply with applicable prospectus and registration requirements, unless one or more of the existing exemptions (eg private offerings to accredited investors and small-size offerings) are available. The traditional restrictions commonly applicable to private placements continue to apply with these offerings.
Where is Hong Kong?
(i) Offerings to Professional Investors
In Hong Kong, the exemption for offerings to professional investors is in s. 103(3)(k) of the Securities and Futures Ordinance (‘SFO’). While s. 103(1) SFO prohibits the issue to the public of any invitation, advertisement or document that offers or invites offers in respect of securities, structured products or interests in a collective investment scheme (‘CIS’), s. 103(3)(k) provides that the s. 103(1) prohibition does not apply if the relevant investments “… are or are intended to be disposed of only to professional investors.” A plain reading of s. 103(3)(k) suggests that a person may issue an invitation to the public or a sector of the public and still come within the s. 103(3)(k) exemption, provided that the investments in question are or are intended for professional investors only. Yet, not wanting to test the limits of the exemption lest they found themselves on the wrong side of the s. 103(1) prohibition, issuers and their advisers have followed the practice for private placements: no public advertising, small pool of recipients, existing or personal relationships with recipients, etc.
This practice should be revisited in light of the Hong Kong Court of Final Appeal (‘HKCFA’) decision in the case of SFC v Pacific Sun Advisors Ltd.  18 HKCFAR 138 (‘Pacific Sun case’).
In the Pacific Sun case, an investment adviser sent emails to contacts on its database about a new fund. It also posted relevant documents on the firm’s website. It was accepted in the courts (the Magistrate’s Court, Court of First Instance and the HKCFA) that the advertisements were issued to the public or a sector of the public. The question was whether the s. 103(3)(k) exemption was available. On the face of the documents, there was no mention that the fund was exclusive for professional investors. Is a statement to that effect necessary for the issue of an advertisement to come within the s. 103(3)(k) exemption?
The HKCFA answered in the negative. As a matter of statutory construction, s. 103(3)(k) only requires a person to prove a genuine intention to limit the offer to professional investors exclusively. There is no further requirement of a statement to that effect in the advertisements or documents. Hence, the case turned on a question of fact: did the investment adviser genuinely intend to limit the offer to professional investors only? The Magistrate’s finding, which was binding in the appeal hearings, was that the fund was intended to be available to professional investors only, as the firm had adopted procedures to screen out non-professional investors. As a result, the exemption under s. 103(3)(k) was available.
It follows logically that issuing an invitation to the public or a sector of the public is permissible so long as there is a genuine intention (the burden of proof being on the issuer) to limit the offer to professional investors, and no investments have been sold to non-professional investors. What took the U.S. many years of debate and a long legislative process to accomplish (through JOBS Act Title II), Hong Kong effectively landed in a somewhat similar place.
There should be a word of caution here. The s. 103(3)(k) exemption turns on a proof of “intention”. If an issuer in Hong Kong advertised its offering on a mass-scale, such as in all local supermarkets or on open-to-all social media, it might be difficult to convince the court that there was a genuine intention to limit the offer to professional investors exclusively.
The HKCFA’s clarification of the application of s. 103(3)(k) has potentially far-reaching implications. There are 200,000 high net worth individuals in Hong Kong holding US$1.1 trillion in wealth. Start-ups will likely prefer a smaller number of keen professional investors to a large number of random retail investors. It has been reported that angel investors tend to stay away from companies that have crowdfunded from retail – a company with too many investors is difficult to manage. The HKCFA decision will make it easier for issuers to locate and connect with these business angels. There is speculation that the authorities may consider legislating to reverse the HKCFA decision. That would be regrettable. As Fok PJ succinctly explained in his judgement in the Pacific Sun case, “…if the investment products are not in fact sold or intended to be sold to the general public and instead are sold or intended to be sold only to professional investors, there is no necessity for protection to be afforded to the general public since they are not exposed to any material risk.”
(ii) Offerings to Retail Investors
Small-scale retail crowdfunding has always been an option. Under Part 1 of Schedule 17 of Companies (Winding Up and Miscellaneous Provisions) Ordinance (‘CWUMPO’), offers of securities not exceeding HK$5 million over a 12-month period are exempted from the prospectus requirement under CWUMPO. Issuers need only state on the document that it has not been reviewed by any Hong Kong regulatory authority. Under s. 103(2)(ga) SFO, these exempt offers are also exempted from the s. 103(1) prohibition. The combined effect of these provisions is that small-scale offers can be made to the public without the disclosures in a compliant prospectus.
The HK$5 million small-scale offer exemption is slightly lower than the US$1.07 million small-scale offering exemption in the United States. The Hong Kong regime however comes with a lighter touch. There is effectively no particular disclosure requirement (subject however to provisions in the SFO governing false or misleading statements). One should not underestimate the potential of this exemption for small or initial capital-raising, such as seed funding. Note however that the exemption is available to companies only. This exemption is not available to projects that are structured in the form of a non corporate CIS or a structured product.
As demonstrated, Hong Kong is not falling behind in the gateways that are available for securities crowdfunding. Yet, because the prohibitions and exemptions in the securities offering regime are fraught with difficulties, and the penalties for contravention severe, market players have been hesitant in making full use of the exemptions.
We have heard endless debates on why and how the Hong Kong regulatory rules should facilitate crowdfunding. Rather than wait for a tailored regime to come, issuers should kick-start their projects by making purposeful use of existing exemptions. As the market starts to mature, regulators will have a fuller sense of how best to facilitate and regulate the crowdfunding space. In the meanwhile, there is sufficient room for going forward.