Question 6 What provision, if any, should be made for each of the following matters as they concern CSEF intermediaries:
(i) permitted types of intermediary (also relevant to Question 5):
Something similar to the US proposal would be suitable, whereby the intermediary is registered with ASIC and has ongoing reporting obligations to ASIC. In addition, something similar to the Italian approach should be required. For example, one requirement could be that the directors and officers of an intermediary have not been convicted of an offence involving dishonesty, much like existing requirements in various professions in Australia. If security is to be provided for enforceability in the event of a breach (discussed elsewhere), there might be minimum requirements involving this, perhaps personal guarantees and minimum levels of financial performance. As with issuers (see response to question 4(i) above), there might be requirements that intermediaries are Constitutional corporations and their directors and officers have other links tying them to Australia. There might also be licensing and other requirements to adhere to (discussed below).
(a) should CSEF intermediaries be required to be registered/licensed in some manner
Yes. I can envisage a licensing regime similar to that for holders of an AFSL license, albeit with less stringent requirements. The process of obtaining a license would ensure that the holder understands the relevant laws and regulations governing the industry, only applicants with suitable qualifications could apply, that ongoing reporting obligations are complied with and so forth.
(b) what financial, human, technology and risk management capabilities should an intermediary have for carrying out its role
In order to be conducive to the establishment and growth of the industry whilst simultaneously maintaining harmony between it and the other conventional financial markets, the requirements should not be too stringent. However, the licensing process should require the holder to undertake a short course along the lines discussed in the preceding response, and it may be that two key officers of the intermediary hold sufficient qualifications, such as a bachelor’s degree, in two or more of several areas, including law, economics, finance, accounting and so forth. As with admission into a Masters program or specialist accreditation in a profession, there might be a subjective aspect for the regulator to consider, such as the length and breadth of experience of the applicant.
(c) what fair, orderly and transparent processes must the intermediary be required to have for its online platform
It should be borne in mind that intermediaries will have “duties of secrecy” in some instances, i.e. in protecting the privacy of personal information of investors. Between the ideas discussed in response to the other questions herein, and the usual disclosures required, for example, by privacy legislation, such as published policies regarding the collection, use and dissemination of personal information, not much else can or should be required. It may be that a further standardised cache of information must be disclosed through an intermediary’s website, that might cover, say, a general group of issues and provide disclosure on risks and the specific inherent risks of CSEF vis-à-vis conventional securities and markets. The only other aspect of information that springs to mind is the actual status of an investor’s investment. In that regard, a degree of flexibility should be given to intermediaries so as to ensure commerciality in their operations, but an investor should be able to obtain information as to the status of their funds and the performance or likely performance of their investment (bearing in mind that their securities may be near impossible to value in the early stages), provided reasonable notice is given. Any savvy intermediary might establish an online personal, confidential and secure portal enabling investors to log in and view this information as relates to all of their investments, much like what is offered at least by retail industry superannuation funds. It may be that this, or an alternative mechanism that achieves the same or substantially similar purposes, becomes a requirement of registration of the intermediary.
(d) should an intermediary be required to have an internal dispute resolution and be a member of an external dispute body, such as the Financial Services Ombudsman
Consideration must be given to the fact that this may add a great degree of transaction and regulatory costs, which may in turn hamper the establishment and growth of the industry. In addition, no other investment market appears to have blanket recourse to such avenues. It is also important to note that, typically, for the reasons discussed elsewhere herein, it is likely that the majority of investors will be less experienced and sophisticated, not only regarding investments, but possibly also in matters of finance and law. That being so, to enable such a system might be to encourage unnecessary refereeing of misguided disputes. It may be that a balance can be struck, for example whereby investors can refer matters concerning a failure to disclose to ASIC, or misrepresentations to Fair Trading NSW (or equivalent), even with minimum levels of investment in dispute required.
(ii) intermediary matters related to issuers: these matters include:
(a) what, if any, projects and/or issuers should intermediaries not permit to raise funds through CSEF
Generally speaking, there should not be any restrictions on the types of projects able to raise funds through CSEF. It should be borne in mind that, as per the above, there may already be tests and definitions which a proposed issuer may be required to meet. It may be that issuers are also required to obtain registration for participation in the market, as with intermediaries, and if that is the case, mandatory disclosure of entity and personal information could filter out those not suitable (i.e. those convicted of dishonest offences). In addition to these two filters, it may be that the regulator seeks to use the process to encourage particular projects of a certain type, and to discourage others, for example that are against public interest. This would be a matter for the regulator.
(b) what preliminary/ongoing due diligence checks should intermediaries be required to conduct on issuers and their management
The regulator could reduce uncertainty and risk by requiring issuers and their management to be subject to registration approval by the regulatory, as discussed elsewhere herein. This would further reduce the risk of fraud, human error and so on. It could be achieved, for example, by way of statutory declarations and criminal record cheques to accompany a complete application form.
(c) what preliminary/ongoing due diligence checks should intermediaries be required to conduct on the business conducted by issuers
Similarly, control could stay with the regulator through a periodical re-issuing of licenses. The onus could be put back onto the issuer by also requiring them to disclose any material changes to the facts stated in their application forms as and when they occur.
(d) to what extent should intermediaries be held liable for investor losses resulting from misleading statements from issuers made on their websites
Joint and several (but perhaps not personal) liability, with the issuer as discussed herein, might be suitable where the intermediary is negligent, has breached a fiduciary duty or has fallen short of satisfying themselves, through independent means prior to accepting the issuer’s project for the purpose of their own offerings, of material facts required to be disclosed to investors and / or the matters which must be disclosed to the regulatory as part of the application for registration process (discussed elsewhere herein). However, falling short of such an event, an intermediary cannot and should not be held responsible for the actions of another entity, particular where the intermediary itself may be the victim of a fraud.
(e) to what extent should intermediaries be held liable for investor losses resulting from their websites being used to defraud investors
See answer to the preceding question.
(f) what possible conflict of interest/self-dealing situations may arise between issuers and intermediaries (including intermediaries having a financial interest in an issuer or being remunerated according to the amount of funds raised for issuers through their funding portal), and how these situations might best be dealt with
In response to the other questions, we have discussed various ideas, including the introduction of joint and several liability for issuers and intermediaries in relation to a failure to disclose or misrepresentation, personal liability of directors and officers, specific duties on directors and officers, personal guarantees and enforceable security, mandatory matters to be disclosed and reported on an ongoing basis (including the steps taken by an intermediary to satisfy itself independently of an issuer’s claims) and so forth. It would not be difficult also to implement a public warning statement, much like that used by Fair Trading NSW (or equivalent), to impose civil penalties and other consequences, such as a ban on registration and / or holding the office of director of a company. Although these measures appear to be less targeted to the specific issue of a conflict of interest, the motivation and result will be the same in most cases: a failure to disclose or a misrepresentation motivated by commercial interests. As such, there is no reason why such penalties could not be used in a targeted manner to also eradicate conflicts of interest. Considering that, in most cases, the intermediary’s consideration will be linked to the amount of capital raised and / or the performance of an issuer, as opposed to a simple fee for time, if only due to the financial nature of issuers participating in the market, to ban commissions or other performance-based incentives would probably be to doom the industry from the outset.
(g) what controls should be placed on issuers having access to funds raised through a CSEF portal
See response to question (iii)(f) below.
(iii) intermediary matters related to investors: these matters include:
(a) what, if any, screening or vetting should intermediaries conduct on investors
None. To qualify, we have already discussed the idea herein that investors are required to run through a short internet-based module outlining the terms and conditions of the investment, the matters required to be disclosed, the risks and so forth. There will also be personal information collected by the intermediary as a matter of necessity, from which the intermediary can determine whether the investment would be permissible. Apart from this, and particularly given we will be concerned with relatively minor investments, anything else might be excessive.
(b) what risk and other disclosures should intermediaries be required to make to investors
See answers to questions 4(iv) and 6(i)(c). Intermediaries might also be required to disclose any matters arising by way of the processes suggested at 6(ii)(b) and 6(ii)(c) in the event that any such changes are likely to bear upon investment decisions, in addition to an explanation of the steps taken as suggested in response to 6(iii)(a) above, the matters discussed at 6(iii)(h) and (i) below, and finally those matters at 8(viii) below.
(c) what measures should intermediaries be required to make to ensure that any investment limits are not breached
This issue could be dealt with quite simply. For example, the investor might be required to submit to an issuer along with an application a copy of at least 100 points of identification certified by a Justice of the Peace or solicitor. This would enable cross-referencing against all other investments the particular investor holds.
(d) what controls should be placed on intermediaries offering investment advice to investors
To ensure independence and market integrity, intermediaries should generally not be allowed to offer or provide investment advice to investors at all. If they are to be subject to a licensing regime, this would be an ongoing condition of their license. However, a balance must be struck whereby intermediaries are allowed to provide additional information and explain existing disclosure documents, but they should always provide disclaimers and qualifications, with a recommendation that the investor should seek the opinion of a financial or tax advisor, much like the common practice in other professions.
(e) should controls be placed on intermediaries soliciting transactions on their websites
See response to question 4(v) above.
(f) what controls should there be on intermediaries holding or managing investor funds
For the protection of investors, a relationship of trust or fiduciary should be established and maintained. No matter what the precise nature of the securities in question, investor funds should be held on trust unless and until released to the issuer. A regime should be put in place for the operation of trust accounts, much like those currently used in the legal profession, for example. Investor funds should then only be released to issuers at such point in time when all requirements have been met. For example, as discussed elsewhere herein, if a minimum amount of investment is required to be received or pledged, whether or not making provision for cooling off periods or otherwise, it might be a breach of trust to release funds to investors until that amount has been reached, time limits for the exercise of investor rights have closed and investors have been notified. Funds should only be able to be returned to investors in the event that the investment will not proceed, and intermediaries would only ever receive consideration from issuers once all requirements have been met.
(g) what facilities should intermediaries be required to provide to allow investors to communicate with issuers and with each other
Please see response to (j) below.
(h) what disclosure should be made to investors about being able to make complaints against the intermediary, and the intermediary’s liability insurance in respect of the role as an intermediary
The extent of this disclosure should be no greater than with any other industry or profession. Investors should be informed of the fact that they can make a complaint and to whom, for example if intermediaries are subject to the FOS, Fair Trading NSW (and equivalents), ASIC / the ACCC and so on, whether or not they have adequate insurance (which might be a requirement to their registration and operation) and whether their liability is limited by any professional standards legislation scheme.
(i) what disclosure should be made about the commission and other fees that intermediaries may collect from funds raised
This would depend on whether or not the intermediary is permitted to invest in the issuers themselves. If so, it might be that the intermediary is required to make disclosure in a manner analogous to the product disclosure statement of an AFSL license, as discussed, but if not, some form of lesser disclosure should apply, for example stating the fact that the intermediary will be remunerated based on the number of securities it sells, or whatever the case may be, but not going so far as to reveal the full extent of remuneration or other commercially sensitive information.
(j) what, if any, additional services should intermediaries provide to enhance investor protection
Adding too much to the work required of intermediaries will change the economic dynamics of their relationship with issuers. The more work required, the more consideration they will expect, and be entitled to receive. The more consideration they are entitled to receive, the less affordable their services are to issuers and / or the more investor funds required that go towards this end, rather than the ultimate purpose of the issuing entity. This is likely to dampen to establishment and progress of the industry. Provided the intermediary complies with disclosure requirements and ongoing reporting obligations (discussed below), and has some form of mechanism in place to respond to investor questions without going so far as to provide financial advice (discussed elsewhere), there should be no further obligations imposed on intermediaries.
(iv) any other matter?
I will leave this open for further comment as discussions progress…
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