Question 4 What provision, if any, should be made for each of the following matters as they concern CSEF issuers:
(i) types of issuer: should there be restrictions on the classes of issuers permitted to employ CSEF (for instance, investment companies are excluded from the CSEF provisions of the US JOBS Act. In Italy, CSEF is confined to designated ‘innovative start-ups’)
Yes. We already have in place a system that achieves well-founded goals and public policy objectives relating to traditional markets and the participants in them. There is no particular reason why that should change.
What we are talking about here, however, is a new realm: a new type or class of business, that requires new models to achieve its objectives. These businesses typically face issues in their ability to overcome particular obstacles, and so a new targeted regulatory regime must evolve to assist in bridging gaps.
For example, we may have a modular renewable energy project struggling to raise capital for expansion and to achieve economies of scale because of generally low profitability. People may not be convinced to simply donate to such a project, for whatever reason, or they may be just shy of investing on a large scale due to a lack of returns. Many investors may, however, be willing to invest small amounts for both commercial and altruistic reasons. Alternatively, take an innovative technological start-up: they may not have the funds to articulate their ideas and commercial projections in a manner easy for sophisticated investors to digest. In such a case, they would require “seed funding” before they are at a stage where they can afford to do so by traditional means. In addition, both of these types will be competing in a new market, with different investors and a limited pool of funds. If they are to survive, competition in this market must be regulated to an extent.
On the other hand, existing public companies or proprietary companies who are already operating in markets are already at this level, have the experience and typically the funds to achieve this. As such, the regulations must be lifted to enable the early growth of a limited class of business only.
That being said, the US approach in excluding investment companies is suitable and justified, subject of course an intermediary being the investment vehicle for the market, which in turn would invest in the issuer. Similarly, the Italian approach seems sensible and well targeted, albeit a little too restrictive. Any approach in Australia should be expanded to include projects that may not necessarily be innovative in the traditional sense, but also to include those projects that achieve certain public policy objectives but require artificial economic incentives in order to do so, such as those with aims of climate change mitigation or adaptation, and so forth. In addition, there should be a criterion established whereby it is determined that the entities that will benefit from CSEF are actually in need and deserving, i.e. the Italian “start-up” definition, plus perhaps a limited amount of current working capital and / or turnover, balanced by a minimum projected break-even point, for example. The Canadian example would also be useful in combatting fraud and anti-avoidance, and it may be that Australian entities must be Constitutional corporations, with their directors and officers all required to maintain at least permanent residency status and have some other form of ties to Australia, be it local assets or otherwise.
(ii) types of permitted securities: what classes of securities of the issuer should be able to be offered through CSEF
In light of the comments above and the implicit traits of investor participants, the Canadian model seems appropriate, i.e. in restricting the types of securities to traditional modes with low levels of complexity.
In fact, I would even go so far as to say that less is more in this context. Specifically, it may be an idea to only allow securities with little to no voting rights to be issued. This would enable these entities to carry on with their business with minimal transaction and other costs in the early stages, in addition to maintaining the creative, operational and other controls required to give fruition to their ideas. Provided the issuer meets other criteria to be decided, such as those discussed above, and adequate levels of disclosure, such that any investor was in a position to make a conscious decision to effectively treat such an investment almost analogously to a term deposit prior to entering the transaction, a fair balance between issuers and investors could be achieved, while minimising complexity, red tape, public and private costs simultaneously.
(iii) maximum funds that an issuer may raise: should there be a ceiling, and if so what, on the funds that can be raised by each issuer in a particular period through CSEF. Should that ceiling include any funds raised under the small scale personal offers exemption
Again, in light of the comments above, there should be a ceiling. After all, once these entities have raised sufficient capital to grow to the next stage, there is no longer a desperate need to bridge a gap or continue to provide false economic indicators to the market. In addition, by that stage, they should have a proven track record / passed “proof of concept”, which would bring them to the level where angel investors or other conventional sources are likely to assist in taking them to the next level.
On one view, there is no real reason why the ceiling should be any different to that contained in s 708 of the Corporations Act 2001 (Cth) (“the Act”), given that this would be sufficient for the majority of start-ups to prove their concept on a small scale and retain sufficient capital to attract further capital. However, on the other hand, we will surely see completely new innovations and business models, particularly in the areas of technology and “clean-tech”, and after all, the entities to participate in this market will already be in a position where they find it more difficult, and therefore more costly, to progress by conventional means. As such, it may be that a tiered system is put in place, whereby the ceiling is different for certain types of projects according to varying criteria to be assessed with reference to costs associated with proving the concept and perhaps the time and cost likely to be involved in breaking even and generating a profit.
(iv) disclosure by the issuer to investors: what disclosures should issuers have to provide to investors
Given the matters raised particularly per (i) above, something in between the US and Canadian approaches seems appropriate, provided this is general (yet balanced) enough so as not to be even half as prohibitive in terms of cost and actual abilities as compliance with even the lesser options in the Act. If anything, this should be more general and conducive to the industry, for example something alike a short form product disclosure statement as required to be issued by the holder of an Australian Financial Services License. This would enable an issuer (or intermediary) to comply at low cost, and provided a number of mandatory items are required for disclosure, it will necessitate some serious thought and investigation on the part of the disclosing entity.
The focus, really, should be more on whom the most appropriate disclosing entity is, and where and how the above disclosure is made.
Personally, I think any disclosure obligations should rest with intermediaries. It is this very activity of itself that, in many cases, proves to be prohibitive to the entities we will see in this space. It is obvious though that this new market will spawn a new industry of itself in the form of intermediaries. These entities will no doubt be regulated to some extent also. It may be that issuers are ultimately forced to offer and / or issue securities only through intermediaries (which may not prove such a bad idea). Intermediaries will presumably be paid on release of capital to issuers, take some form of commission along the way or whatever. Their consideration will be two-fold: the price of attracting and providing capital to issuers, and the price of interacting with investors. Any organisation who plans to enjoy any success in the industry will need to have a background, qualifications and so forth in financial markets and products and general or specific business concepts, and this may be mandatory to varying degrees in any event. As such, intermediaries are arguably in a much better position to fulfil disclosure obligations and provide better disclosure to the public at large. This is especially so given that their online portals will be the main port of call, and they could require investors to read, agree and confirm their agreement again to the level and their understanding of disclosure online prior to proceeding with the investment, much like the terms and conditions of software products are currently disclosed. It would then be incumbent on the investor to look further: if they did not, they were obviously not too much at risk of financial loss; if they did, they had the option not to proceed. There is no reason why issuers and intermediaries should not be free to bargain freely as to the price paid for this service, and perhaps if it was actually mandatory, there may be a better balance struck between all three classes of market participants.
Of course, if that were to be the case, the issuers would then need to be subjected to certain levels of disclosure and diligence to the intermediaries, and the intermediaries would need to reach certain thresholds in conducting their own due diligence. Both of these entities, and perhaps their directors and officers if companies, could, for example, share joint and several liability to investors with respect to misrepresentations, breaches of fiduciary duties and so on, and each could be liable to the other in turn. It may be that a new class of duties is created, as with those of directors already set out in the Act.
(v) controls on issuing by the issuer: what controls, if any, should there be on advertising by an issuer
I suspect that the current prohibition found in s 734 of the Act, for example, is one of the primary reasons CSEF has gained interest in the first place. Considering the types of issuers that can be expected to be playing in this market, in light of comments above, one would presume that general solicitation would be highly desirable, if not essential, at least for some types of projects.
It must be borne in mind that, provided the types of issuer are restricted as set out above, the investors that will be attracted to this market will be small-scale retail investors, typically looking to commit anywhere between a few dollars to a few hundred dollars only. In addition, those that are attracted to such an investment are typically not the sophisticated investors that will place them to come across personal offers within the meaning of the Act.
Further, the online portals of intermediaries will not simply attract attention sitting idle. They should be entitled to advertise themselves also. However, advertising their own activities, without any specific mention of the projects with which they are involved and the particular investment opportunities they currently have, could prove useless and counterproductive to the industry, especially if generic advertising comes to be seen as spam.
There is nothing wrong with advertising at all. It is advertising and subsequent enticement without a fair balance between disclosure to investors and practicality for issuers that creates a problem. As such, if anything, the nature and extent of advertising could be regulated and perhaps scaled according to the level of investment an investor can commit to for any given project, but not the ability to advertise generally.
(vi) liability of issuers: in what circumstances should the directors or controllers of the issuer have liability in relation to CSEF. What defences to liability should apply
See comments per (iv) above. The idea that a sufficient breach attracts liability to repay the investment plus interest makes sense. For more serious offences, there should be larger civil penalty provisions, personal liability of directors and other officers (perhaps enforceable by personal guarantees provided to the regulatory on formation), and for the most egregious, maybe even as much as custodial sentences.
As to defences, considering the level the issuers will be at, and the typical low-scale and low-risk nature of this market (considering that economic forces will see small investments only), the defences should be a little more lenient toward issuers (and intermediaries) for some of the more innocent offences (i.e. non-intentional and less serious breaches of fiduciary duties or disclosure rules). For example, something similar to a tailored mixture of the honest opinion and fair reporting defences to defamation might be appropriate, dependant obviously on the scale of loss done and set thresholds for scales of acceptable conduct, unsatisfactory conduct and professional misconduct, as most of the professions have. Of course much more limited for malicious offences such as misappropriation, fraud, misrepresentation (as opposed to negligence misrepresentation) and so on.
(vii) ban on a secondary market: should CSEF be limited to new issues, excluding on-selling of existing securities
Again, in order to prevent harm to the public, investors need sufficient disclosure to place them in a position where they understand the speculative nature of the investment and for them to treat it analogously to a term deposit, albeit with a risk of loss. Again, transaction and other costs are what are currently prohibitive to issuers, so these must be minimised. Further, subject to the issue of voting rights, these entities will need a great degree of stability from investors as they grow to the next level and “get off their training wheels”. As such, there should probably be a ban, and in any event, considering the likely size of investments, there is probably no great reason to allow on-sales. It may be that the issuer or the intermediary is permitted to buy back from investors, subject to certain rules as to price and an intermediary’s additional disclosure obligations and / or ban from such purchases.
(viii) any other matter?
I will leave this open for further comment as discussions progress…
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