Crowdfunding, as an instrument for the non‑sophisticated investor (I)

Crowdfunding (hereinafter “PFC”) is justified because stock exchanges exist, as it seeks a different market, though with similar logics. It aims to bring together people who share certain characteristics—peers, rather than completely anonymous individuals as usually happens in financial markets; it seeks to exempt securities regulations, in Chile the Securities Market Law (LMV); it seeks channels different from what doctrine calls “formal” markets (regulated, self-regulated); it does not aim to scale, instead pursuing modest sums of capital at low cost; it focuses on financing emerging companies, which in simple terms have not yet been commercially validated (their risk is greater, at least theoretically, than companies listed on stock exchanges); and, most importantly, it seeks to create a space for non-institutional or non-qualified investors to participate, under the LMV, without prejudice to the fact that such investors may also participate (this requires some distinctions with so-called accredited investors regulated in the U.S., but that is not necessary for these Notes).

A good example is Chile’s Fintech Law, which already regulates this system, calling it collective financing platforms. Legal recognition was necessary because our financial regulations cover certain acts merely by being subsumable under the definition, without much jurisprudential or regulatory moderation (though this has been changing). For example, since the LMV recognizes “securities” and “public offering of securities” as objects of regulation, if the requirements were met or subsumable under the definition (even if somewhat debatable), there was a risk of falling within the perimeter of the LMV and, therefore, under the Financial Market Commission (CMF).

We can safely affirm that the Fintech Law creates an exemption or safe harbor for deploying PFC projects, without regulated parties having to consider LMV rules, though they still fall under the CMF. It should be noted, however, that there should not be overlap between LMV activities and those of the Fintech Law in this respect, at least in normative (not material) terms, since the latter defines what an investment project is (what is traded in PFC), though doubts remain about what “financing needs” are (the other item traded in PFC, which the law and regulatory norms vaguely suggest).

This last point matters, because in other jurisdictions the exemption is based on amounts or similar criteria, not on a definition of what is traded. That is, in other jurisdictions the law understands that securities and what is traded in PFC are the same (as in the U.S. with the Crowdfunding Act). The Chilean legislator, instead, was clear in excluding PFC from securities regulations.

Now something extremely important. This is not the place to describe the nature of PFC—whether they are intermediaries that create markets (like securities agents acting as market makers) or whether they are markets (like stock exchanges)—but the point is that it is a necessary and sufficient condition to operate these assets through PFC. We do not need another agent, whether an intermediary or an exchange, according to legal nature and by analogy with the securities market. PFC are enough.

Once again, the law relaxes the natural mechanisms of financial markets to achieve the purpose sought by PFC. It reduces several agents.

On the other hand, the rules suggest that the risk of these projects may be extraordinarily high. For example, in the general rule on the matter (NCG No. 502), the information that PFC must make available to the public includes degrees of risk exposure, whether they are natural obligations, advisable risk, among other elements aimed at disclosing the inherent risk of these instruments. And, in the same sense, the rule excludes the need to disclose some of these analyses when investors are qualified or institutional, recognizing that such agents are capable of weighing risks themselves.

Thus, the rule clearly differentiates between investors to whom risk must be disclosed and sophisticated investors, on the one hand; and, by this means, acknowledges that it wants non-sophisticated investors to participate in these types of investments, as this is in fact the general rule of regulation, on the other hand.

Therefore, PFC regulation considers the general public as the main investor agent. This distinction is framed through risk, in line with financial theory, which is no coincidence. Indeed, in finance, when analyzing risk, the investor’s profile is extremely important—from the confidence level used to model Value at Risk (VaR), to portfolio construction, to risk tolerance.

Therefore, the law recognizes that (i) these are risky products for (ii) non-sophisticated investors. Perhaps the law could have been more explicit, as in the U.S., where it expressly requires informing the non-sophisticated investor that they run the risk of losing the entire investment, with a higher probability than in other types of securities investments. Nevertheless, this does not prevent us from acknowledging that the law is designed for non-sophisticated investors.

But we must be careful about which risks we are referring to. Clearly, we are not referring to risks of issuer fraud (since PFCs are responsible for verifying that), but rather to market, credit, and liquidity risks. This matters because the first is sanctioned differently, while the second is left to market mechanisms.

Moreover, the rules on these matters suggest that PFCs lead the financing mechanisms, unlike the securities market where such agents (exchange or intermediary) usually only bring parties together, leaving the relationship between issuer and financiers to each of them or to third parties (e.g., bond representatives). In fact, it is these platforms (PFCs) that must provide mechanisms or tools for financiers to monitor and verify the development of the project.

Also, PFCs do not consider secondary markets as an essential part of their system. In fact, PFCs differ from alternative trading systems (also regulated under the Fintech Law), since in the latter investments originating in PFCs (primary market) could potentially be traded secondarily. This again raises the risk, compared to securities markets, because it reduces liquidity.

PFCs aim to reduce costs for investors, but also for those offering their projects and ideas through them. And to a large extent, this is primarily sought in economic terms, since securities markets, due to regulatory burdens, are increasingly onerous.

Innovative, new, and risky companies are desirable, but traditional financing mechanisms strangely do not work well for them. PFCs bridge this gap, especially by requiring a minimum level of preparation when issuers enroll with the regulator or PFC, and by demanding a minimum flow of information to comply with regulations.

On the other hand, one might ask why not promote private offerings and the LMV exemptions for certain public offerings—both recognized in Chile by the LMV—instead of creating PFCs. The problem is that doctrine understands that these two forms of operation, private securities and LMV-exempt securities, are not directed at the general public. These mechanisms target qualified or institutional investors, or very limited markets of non-sophisticated investors (e.g., employee stock options). That is why they were discarded.

For all these reasons, one could reject the claim that we are dealing with a traditional financing system. On the contrary, this regulation seeks to escape that traditional conception. Instead, it aims to be a low-cost alternative, especially in a context of credit restrictions.

PFCs indeed create markets that entail significant risks, compared to traditional financing paths. And this applies to both sides—that is, for the investor and for the issuer. But this is not a defect; on the contrary, it is precisely their virtue. PFCs are the way to invest in these types of assets, which are so desirable in civilized societies.

This mechanism targets a specific investor profile considered in the ratio legis, namely, the non-professional investor, who lacks sophisticated tools. The idea is precisely to encourage non-sophisticated investors to have access to this type of investment.

Is a PFC investor a consumer? This is not the place to answer such a difficult question, but if affirmative, we would be imposing obligations on financial agents in this market that run contrary to the very purpose of this regulation. Again, this regulation seeks a low-cost alternative. Consumer law increases costs and generates frictions in financial markets. We may be dealing with an investor profile that coincides with that of a consumer, but that does not mean that a person carries that status in every aspect of their life. Even Warren Buffett is a consumer when he goes to eat a hamburger in Omaha. One status does not communicate with the other.

Recognizing that we are in a market where agents have little knowledge; there is high information asymmetry; weak contractual positions; and low liquidity, is precisely to make explicit the way these markets operate. This makes sense if we consider that the law safeguards and acknowledges this uncertainty. That is why, for example, requirements usually fall on the platforms, not on the investors, when determining the tools that will track the asset.

The lack of flexibility of the investor here is the virtue, because it maximizes costs over the maximization of investment flow security.

Now, neither in this market nor in securities markets is there the possibility of correcting investment mistakes. Investment always carries inherent risk; counterparty and credit risk are the most relevant. But this is shared with any other obligation, e.g., loans or even time deposits. And these types of risks cannot be classified as a defect of consent or any other flaw. Nor as the absence of a contractual element. They may give rise to non-compliance, but that is true of any contract.

With this in mind, it should be noted that in these types of markets projections are extremely relevant, but subject to a low probability of being fulfilled. And these projections often consider abnormal growth compared to the market. But this is not an exaggeration (“good faith misrepresentation”), fraud, or error, nor even a projection error, but rather an uncertain projection (condition). What matters is to disclose the fragility of fulfilling that promise.

Once again, the law is absolutely clear that this is how these markets operate—with fragile promises. Seed capital industries, venture capital, venture corporations, PFCs, etc., have as their essential element the trading of issuances from companies that may even be difficult to classify as going concerns.

Does this last point—promises of high returns—distort risk? Risk, understood here as the possibility of suffering a loss, is in no way damaged. The reason is that we are not in a scenario of large investments; these are contracts where the promise of high returns is exchanged for amounts that are not significant. Risk—that variability of actual results compared to expected results—in financial terms (not legal terms) is a way of quantifying, but not of comparing as the law does, e.g., injury when weighing the sacrifice made against the benefit obtained. Whatever the entrepreneurs’ promise, we could never distort risk.

We can, however, acknowledge the validity of an important criticism, which may leave investors unprotected in the jurisdiction used in our examples (Chile). Namely, there is no regulation for cases where projects are advertised outside of PFCs. This criticism is valid. These types of companies often use aggressive communication models, prompting decisions without much reflection, without tools to model investor risk profiles, among other strategies.

A remedy for this could be to resort—subject, of course, to broad discussion—to advertising rules applicable to private securities offerings or offerings excluded by the CMF from LMV rules. In both frameworks, the CMF provides more detailed guidelines on how to act so as not to be ultimately classified as a public offering. This could guide offerings outside of PFCs, if the issuance is enrolled in a PFC.

In a second part we will continue addressing Crowdfunding. But just to conclude: the foundation of PFCs is important because it brings to light two concepts that must be distinguished, namely, the cost of capital and the cost of obtaining capital. Each day this distinction becomes clearer, due to regulatory burdens, especially in Latin American and European jurisdictions.

Disclosure: the analysts of this report hold asset positions in Crowdfunding.