Investor protection on crowdfunding platforms
The main principle to be observed is that investments are made only through the service providers that have obtained an authorisation to provide investment services in Latvia and are subject to supervision. If an unlicensed service provider is selected, the risk of losing invested funds rises many times; moreover, there are often cases where an investor loses not only all the invested money, but also borrowed funds, as a false advisor has persuaded the customer to borrow an additional amount for investment. As a result, not only savings are lost, but the debt to be repaid has incurred as well. Meanwhile, the false investment service provider has disappeared with all the as if invested money.
In any case it should be borne in mind that every investment involves risk! In most cases, the principle of return on investment also works – the higher return on investment, the higher risk of this investment. Besides, there is a risk of not only failing to make anticipated profits, but also losing entire investment. Therefore, one of the fundamental principles to be observed: invest only the amount of money you can afford to lose!
Currently, there are no shortages of various investment opportunities offered by authorised service providers. Although this does not exclude the possibility of failing investment and the risk of losing invested funds still exists, it is very important to reduce the possibility that the selected service provider is a fraudster and may simply disappear with all the money entrusted by customers.
Crowdfunding platforms – a new opportunity for investors
One of the newest types of investment service providers and regulated financial market operators are crowdfunding platforms. In this blog, investor protection mechanisms that have been put in place in the crowdfunding area will be described.
Although crowdfunding has been known in Europe and elsewhere already for some time, a single regulatory framework was introduced in Europe only in the autumn of last year, laying down the requirements for the authorisation of crowdfunding service providers, the operation of service providers and the provision of services. In particular, since 11 November 2021, Regulation (EU) 2020/1503 of the European Parliament and of the Council of 7 October 2020 on European crowdfunding service providers for business (hereinafter – the Regulation) has been applied in the European Economic Area.
Before the Regulation was applied in Europe, there was no single regulatory framework: in some countries, the provision of crowdfunding services was governed by national laws and regulations, while there were no regulations adopted elsewhere. There was no national regulation in this area in Latvia before; however, service providers whose activities were not in contradiction with other regulatory requirements for other areas could also operate in Latvia, and such service providers were not subject to supervision. Meanwhile, in several other member states of European Union, crowdfunding service providers were able to operate comparatively freely, unfortunately this had resulted in a series of crowdfunding platforms, which led to the loss of investment by investors.
One of the main reasons for adopting a single framework for crowdfunding was to avoid activities of fraudulent service providers and to introduce requirements to protect investor interests.
As investment opportunities are rather diverse and inexperienced investors find it difficult to focus on, and not all the investment details are simply understandable, the Regulation aims to protect investors from ill-considered or inappropriate investments. In order to ensure adequate protection, investors are categorised, i.e., the Regulation distinguishes between sophisticated and non-sophisticated investors. Initially, all investors are considered to be non-sophisticated: for an investor to be recognised as sophisticated, he/she should meet the criteria laid down in the Regulation, as well as submit a request to the service provider to be recognised as a sophisticated investor. Sophisticated investors understand investment products and the risks associated with their use; therefore, protection is aimed at respecting the interests of non-sophisticated investors. Moreover, it is expected that non-sophisticated investors on crowdfunding platforms would be much more than sophisticated investors. To protect non-sophisticated investors, the Regulation lays down a number of requirements.
Investors’ knowledge test
The nature of crowdfunding products differs from traditional and usual investment or savings products, thereby to ensure prospective investors’ awareness of crowdfunding service products and the associated risks, the service provider shall carry out testing of non-sophisticated investors’ experience and knowledge with a view to assessing their understanding of the investment services offered.
In order to assess the knowledge of prospective non-sophisticated investors, crowdfunding service providers should require investors to provide information on their experience and previous investments, investment objectives, financial situation, as well as to clarify their understanding of the risks associated with both investments in general and investments offered on the crowdfunding platform.
The knowledge test is necessary to enable the crowdfunding service provider, based on the results of the knowledge assessment, to alert prospective non-sophisticated investors that the investment services offered on the platform could be inappropriate for them and there is a risk of losing all the investment.
Although, in certain cases the prospective non-sophisticated investors are being warned that the investment product offered on the platform may not be appropriate for them and there is a risk of loss of investment, the provisions of the Regulation do not, however, prohibit from investing in the investment products offered on the platform.
Simulation of the ability to bear loss
In addition to the knowledge test, to assess the appropriateness of investment services offered on the platform for the particular investor, the provisions of the Regulation require the investor to carry out a simulation of his/her ability to bear loss. According to the provisions of the Regulation, it is calculated as 10% of net worth. The calculation takes into account both the investor’s income and assets, including financial investments and cash deposits, but excluding personal property and investment in property and also in pension funds. Investor’s existing and future commitments are deducted from assets and income.
Such simulation of investor’s ability to bear loss is necessary because of the risks inherent in crowdfunding services, which may result in losing a substantial part of the invested amount or even entirety of investment by an investor. Therefore, non-sophisticated investors should avoid overexposure to them, and it is appropriate to set the amount of investment that would not be exceeded.
In order to make non-sophisticated investors aware of the risks inherent in investment services, in particular the risk of losing the entirety of invested money, the Regulation provides that every time the investment exceeds EUR 1000 or 5% of net worth of investor’s assets, a risk warning is issued. The crowdfunding service provider should receive an explicit consent from an investor to undertake this risk, and the investor should provide proof that he/she understands the investment and its risks – if the investor cannot prove his/her awareness of risks, the crowdfunding service provider may not accept the particular investment.
Investment risk warnings
The Regulation provides for a mechanism that only those investors who have expressly acknowledged that they understand the risks may invest in a crowdfunding platform. In particular, the crowdfunding platform displays warnings to the investor about the probable inappropriateness of services, as well as investment risks and risk of partial or entire loss of the money invested. The Regulation lays down the content of specific warnings, so that investors receive the same information with all crowdfunding service providers on investment risks and probable inappropriateness of investment services to the particular investor.
When receiving these risk warnings, investors should expressly acknowledge to the crowdfunding service providers that they have received and understood them. It is necessary for the service provider to make certain that investors have sufficient understanding of risks.
Pre-contractual reflection period
In view of the risk of undervalued investments by non-sophisticated investors, the Regulation determines an additional investor protection mechanism, namely a pre-contractual reflection period, during which a non-sophisticated investor may revoke his/her offer to invest or expression of interest in the crowdfunding offer without any restrictions.
According to the provisions of the Regulation, four calendar days are given to non-sophisticated investor during which they may reflect on their previously expressed intention to make investment and to revoke it.
As regards the application of pre-contractual reflection period the Regulation also lays down an obligation to provide information by a crowdfunding service provider. In particular, before notifying of an offer to invest or expressing interest in the crowdfunding offer, an investor should be timely provided with at least the following accurate and clear information:
- that the offer is subject to a reflection period;
- the duration of reflection period;
- the modalities to revoke the offer to invest during a reflection period.
Once a non-sophisticated investor has made an offer to invest, the crowdfunding service provider should inform the investor through its platform that the reflection period has started. The Regulation also determines that the modalities to revoke the offer to invest should include at least the same modalities by which the investor is able to make an offer to invest.
Key investment information sheet
Investors decide on investment in particular crowdfunding offer on the basis of information available to them, thereby it is essential to receive clear and comprehensible information on the project for which funding is sought. Therefore, another mechanism focused on investor protection is a standardised key investment information sheet for a project. In particular, the Regulation lays down a specific form and content for information on the project to be disclosed, specific indicators and risks inherent in the project. The key investment information sheet should also include warnings about investment risks, including a possible failure to receive any return on investment and the risk of partial or entire loss of the money invested.
To ensure that information is easy to understand, the maximum size of the key investment information sheet is set, i.e., no more than six A4-sized pages. The person who seeks funding for his/her project through a crowdfunding platform shall be responsible for preparing investment information. However, to ensure stronger protection of investor interests, crowdfunding service providers should introduce appropriate procedures for verifying whether the information contained in the key investment information sheet is complete, accurate and clear.
This article deals with the fundamental mechanisms for investor protection provided for in the Regulation, but it should be borne in mind in any case that every crowdfunding offer entails the risk of a possible failure to receive any return on investment and the risk of partial or entire loss of the money invested. We therefore call for careful consideration of any investment and consulting the information available, as well as giving attention to risk warnings!