“Take care of the crowd!” – Legal protection of retail investors in crowdfunding is long overdue
As crowdfunding takes off, retail investors face a host of new risks and opportunities. In this guest blog, Rainer Lenz, identifies some of the dangers of crowdfunding and some of the ways in which retail investors could be better protected in the future.
Dr. Rainer Lenz is Professor of Finance at the University of Applied Sciences in Bielefeld, Germany. He is a board member of Finance Watch. He writes in his personal capacity.
When looking for a little more yield in times of low interest rates, retail investors as well as institutional investors turn increasingly towards crowdfunding. But the crowdfunding business offers “no free lunch”, meaning investors don’t get higher yields for free. In return for a yield pick-up they have to accept higher risks and some of those risks are different and new because they are specific to crowdfunding. Investors might not be aware of those risks.
Crowdfunding connects the investor directly with the investee without having a middleman standing in-between. Thus, crowd funders are immediately confronted by the prevalent information asymmetry between both parties. The investee holds all the information while the investor has only limited chances to verify the truth and relevance of the given platform information. Investors need a good portion of trust to believe that investees don’t make an unfair use of their information advantage. But how could investors build up interpersonal trust on a web-based capital mediation platform without knowing each other? This seems to be difficult. Maybe the platform can play the role of a trust broker? No, the platform’s own business model depends on transaction fees, which makes the situation for crowd investors even worse. Are there any minimum information standards for crowdfunding platforms set by European or national law? Only a few European countries have so far defined minimum information standards for crowdinvesting by law. A unified European regulation doesn’t exist. Are platforms accountable for publishing incorrect or false information about investment opportunities? No, platforms deny taking any accountability for the information published. Are there central public authorities as in the banking sector, which control and monitor the crowdfunding industry and its platforms? No!
Retail investors are the weakest part of the crowdfunding business. Small investors and institutional ones not only differ by the depth of their pockets. Institutional investors also have more financial expertise and experience. Hence retail investors need a much higher degree of legal protection against crowdfunding risks, because one cannot presuppose the same professionalism as with institutional investors.
The aim of this article is to create awareness among European law makers about the substantial risks that face retail investors when investing in crowdfunding. The rest of the article documents the main risks and highlights where legal protection and regulation are urgently needed.
Insolvency risk of the platform operator
Basically, it must be ensured that the platform only mediates capital and takes no own risk positions – not even for a short period in time. The platform itself acts as a pure intermediary and not as a middleman or counterparty who collects crowd investor’s money in advance and forwards it later to the borrower, or vice versa. The transfer of cash against a credit claim must be completely done (after deduction of platform fees) as one against-trade at the same time. This restriction reduces the insolvency risk of the platform operator. This allocation of risk is a major difference between commercial banks and web-based mediation platforms: banks centralize and accumulate risks while internet platforms decentralize and spread risks to the crowd.
Nevertheless, the platform might disappear overnight if the platform operator goes bankrupt. What happens in this case to the investment and the purchased loan receivables? The retail client should not bear a loss by the sinking of the platform. In the event of insolvency of the platform-operator the continued existence of the incurred claims and their servicing (interest payments, dividends, redemption and information) must be guaranteed to the end of maturity. As the retail investor is unable to cope with the assessment of the insolvency risk of platform operators, he needs legal protection against this risk. The case of insolvency has to be regulated by setting standards for the platform resolution to ensure that it does not harm the crowd.
The issue of data security can be considered as a platform-specific risk. The anonymity of personal data must be ensured, and a guarantee given that no further use, transfer or cross-selling of personal data for other purposes will take place unless the user expressly consents to the disclosure of personal information. This is a major difference to the current practice of most platforms, in which the investor must declare his express opposition to the use of data for other purposes.  The prohibition of disclosure of personal data is especially critical for such platform providers which operate several trading platforms and not only financial ones. The aspect of data protection includes the security of the data, the protection against hacker attacks as well as access to the data in the event of insolvency.
Information standards, conflicts of interest and liability for misinformation
In the general terms and conditions of crowdfunding platforms, users could read that no information published on the platform constitutes investment advice or a solicitation to engage in any business. Furthermore, the platform operator takes no responsibility and no accountability for the correctness of published information given by companies capital seeking or other borrowers. But how could the retail investor make his own assessment about risk and return if he can’t trust the correctness of the given information?
Both the platforms and the borrower have some incentive not to be too critical concerning the risks. The platform generates its income through a fee which usually corresponds to a certain percentage of the transaction volume. This payment model provides a steady incentive to stimulate the platform’s transaction volume by exaggerating the investment opportunities and profit chances while the risks of investment projects are rather played down or concealed. Obviously if the crowdfunding platform publishes an investment offer from a capital-seeking company without prior audit, then all too often the risks of this investment are concealed. Also, it might seem strange that the assessment of a debtor’s creditworthiness by a peer-to-peer lending platform cannot be considered an investment recommendation, albeit one with a positive bias. No, platforms must not be taken out of the liability for misinformation; otherwise they will lose their role as a fair trust broker between savers and borrowers.
In addition, binding information standards for equity and debt must be valid, which allows the investor a realistic assessment of revenue opportunities and risks. The P2P-platform’s own assessment of credit risk must be complemented by the publication of non-performing loans based on the rating categories. The non-performing loan statistics enable the investor to prove the quality of the risk assessment. The same applies to crowdinvesting. Here statistics on the number of bankruptcies and the average internal rate of return of brokered platform investments would be helpful. In addition, information disclosure for retail investors should integrate the findings of behavioural economics and take inspiration from the Key Information Documents in UCITS and PRIIPs.
Given retail investors' occasional excessive enthusiasm and greed, combined with an environment of very low interest rates, investors might develop unrealistic return expectations and a blissful ignorance of the true risks. Any information should try to counterbalance these elements to foster sound investment decisions.
Information and control rights of equity investors
Equity capital investors bear full business risks and should therefore receive full corporate information and control rights in regard to corporate governance. At present, platforms mostly offer mezzanine solutions such as subordinated loans or silent partnerships where the return depends on the corporate profits. Such instruments exclude voting or control rights. This cannot be fair: taking full risk but having no say! Even if national company law does not explicitly offer such solutions, the crowdfunding industry should commit to creating facilities for investors to exercise equity shareholder rights. Governments must ensure under national company law that instruments such as unsecured shares for public offering come with shareholder rights.
Institutional investors versus retail investors
Crowdfunding is becoming more and more a playing field for institutional investors instead of a mass market for retail investors. This development has substantial disadvantages and should be terminated via legal regulation. First of all, the essential idea of peer-to-peer finance of establishing a direct link between investor and borrower is lost when institutional players get involved. A degree of personal ownership and accountability is important: if an investor’s return depends directly on the good governance of a company and there is limited opportunity to exit the investment in a secondary market, then retail investors will be forced to take ownership and to make use of their shareholder rights. This overall principle of crowdfunding - to establish a direct link between private investor and investee - should also apply to the capital demand side. Investment companies and other financial intermediaries should also be banned from raising capital via crowdfunding for further mediation. The crowd capital is not to be forwarded from one intermediary to another broker, so the investor in the end does not know what he has funded.
The crowdfunding industry still advertises that individuals have a unique opportunity to invest in start-ups and young companies, even if they have no personal relationship with the founders. To ensure this, each investor must be granted the same rights and opportunities, irrespective of their investment volume. In this respect, the volume per single investment has to be capped and for each investor (individuals and institutions) the same limit should apply. Otherwise institutional investors with high investment volume will buy up the entire issue and the mass of retail investors will not come into play. Furthermore, a general cap for each single investment increases transaction costs for institutional investors so for them the crowdfunding market would lose its attractiveness.
One other question is worth asking when observing the recent massive inflow of institutional money to the crowdfunding market. Are institutional funds really interested in the yield-pick up or is it rather an opportunity to use crowdfunding to evade much stricter financial regulation in organised capital markets and exchanges? Are they doing regulatory arbitrage via crowdfunding investments?
Warning on illiquidity of investments and the lack of exit options
Crowdfunding investments are unsecured and not fungible or liquid. That is, the investor must consider first whether he can deploy capital for several years. For loans (i.e. debt capital given as an unsecured loan), maturities of 3 to 5 years are normal, while investments done as equity capital or mezzanine capital typically have a minimum term of 5 to 8 years (equity investments can have a minimum term but, unlike loans, no maturity). An exit from the investment after the minimum term therefore requires a timely intervention by the investor. For retail investors, it is essential to have a clear warning on the illiquidity of the investments and on the periods of notice before closing the investment. In addition, the platform should commit to raising awareness of notice periods among investors during the term of the investment.
Transparency of valuations for equity financing
With equity financing the sticking point is often the valuation of start-up companies. A net asset value is not suitable for most start-ups, which typically lack corporate assets and whose main value is their underlying growth potential. The main way to estimate corporate value in these cases seems to be the discounted cash flow method (DCF), which makes many subjective assumptions about future profits, earnings growth and the risk-adjusted discount rate. At present, the corporate valuation in crowdfunding is done by the start-up company itself, so the earnings estimates are likely to turn out over optimistic. Platform operators are not doing due diligence or plausibility checks or providing transparency about the underlying assumptions of the valuation. However, here again the platform’s remuneration model provides an incentive for “money chasing deals”, instead of searching for a fair value for both sides. Investor protection starts with transparency in corporate valuation and its underlying income expectations. If those earning estimates prove to be wrong, the investor must be promptly informed by the start-up company and the platform. Start-ups and platform must both be held accountable for deliberate overvaluation and price rigging.
For the fixing of exit prices, again the DCF valuation model should be used. In the case of dissent, retail investors should have the right to entrust an independent third party to carry out due diligence on the valuation. Currently most crowdfunding platforms are using multiples for exit pricing, i.e. the value of the company is a multiple of sales or EBIT for the last year. This type of valuation is simple, but is not serious. Fairness demands the same pricing method for the entry as for the exit of investments.
Disclosure of effective interest rates
Just as in banking, the use of the Internal Rate of Return (IRR) which takes into account the platform fees, should become a standard for measuring the success of an investment. Simple profitability calculations without compounding effect, excluding the time value of money and without deduction of platform fees create unrealistic expectations of high earnings and can fool retail investors in decision making. This is especially dishonest for long maturing equity investments. By contrast, the effective yield (IRR) provides a much more realistic picture of the revenue in relation to invested capital per annum.
Risk diversification is inevitable
Taking out the middlemen as a risk buffer ultimately leads to a higher degree of individual (unsystematic) risk. Hence the principle of risk diversification by placing only small bets on a variety of different investment types becomes more important. Accordingly, the retail investor has to be explicitly reminded at each investment on the recommended diversification of risks. Particularly in equity funding, the platform should be committed to informing investors of the average risks versus returns of start-up funding. On average, more than five out of ten start-up companies become insolvent in the first five years, one or two do not provide the desired result and only one or two start-ups deliver a noteworthy return. 
European cross border investments are risky
In regard to an optimal capital allocation and to portfolio diversification it is excellent that Spanish start-up companies nowadays could be financed by German crowd investors. More and more platform operators, especially the British ones, are now expanding their business field across borders by taking over foreign platforms or by founding their own foreign subsidiaries. But the real economic world and its national laws within Europe are much less harmonized than the European banking and finance world. For instance, national company, tax and insolvency laws differ a lot from country to country. Even a central European business register for all EU countries doesn’t exist so far, which makes it difficult for investors to prove the existence of a foreign company, its location, the names of people representing the company and its subscribed capital. For sure this will change over time. The current EU Commission Action Plan on Building a Capital Markets Union contains several approaches to harmonize and unify these laws and to build up a central business register. However, in the meantime the crowd investor cannot be burdened with the legal and economic risks of a disharmonized Europe. If national crowdfunding platforms offer cross-border investments they must be legally forced to provide a higher degree of security for the crowd.
Crowdfunding offers a different proposal than traditional banking. On the positive side, web-based financial intermediation is more cost effective than that of banks. Crowdfunding finances the real economy and as a simple mediator of capital it cannot create its own deposit money. Unlike banks, crowdfunding decentralizes risks so that the platform does not become a risk itself. The spreading of risks to the crowd creates more opportunity for SMEs and start-ups to receive finance.
The flipside of these benefits is that there is no personal relationship between the lender and the borrower, which is a crucial element in assessing the credit risk of a start-up. In order to make a sound credit decision you cannot just rely on audited accounts and cash flow projections, you also need to meet the management. The lower fees and extra return might compensate for this additional risk, but there is no guarantee. So while investors can diversify their crowdfunding investments, they cannot mutualise risks at the same scale as a bank. Lastly the decentralisation of risks goes hand in hand with a bigger risk for the investor. Therefore, while crowdfunding offers a cheaper alternative, you get what you pay for.
In addition, what is crucially missing so far is consumer protection. Retail investors need a much higher degree of legal protection against crowdfunding risks as they are the weakest part in the chain and one cannot presuppose the same professionalism as with institutional investors. Unlike banking legislation, consumer and data protection laws have to have the highest priority in web-based financial intermediation. If crowdfunding can start to take care of the investor crowd, then it could become a socially valuable complement to bank financing.
 See ongoing discussion on EU standards for data protection in regard to the planned amendment of the EU Data Protection Directive
 Failure rate of start-ups are taken from OECD 2015: Entrepreneurship at a Glance 2015, p. 7.
The original and full article entitled "Konsumentenschutz im Corwdfunding (Investor Protection in Crowdfunding)" was published in the "Jahrbuch Crowdfunding 2015", edited by Gajda, o., F. Schwarz and K. Serrar, Wiesbaden 2015, p. 50 - 54 (online available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2622987).