Key risks of participating in crowd-funding activities
With the rapid development of the internet and social media, crowd-funding activities have emerged internationally and locally over the past few years. You may have heard about parties seeking to raise funds for a business start-up or borrow funds in the form of a loan through online platforms. Before investing or participating in such crowd-funding activities, you should be aware of the nature, risk profile and regulatory status of such activities. As always, don’t be lured by the high potential returns that crowd-funding activities may claim to offer, and be aware of the risks involved.
What is crowd-funding?
According to a paper published by the International Organization of Securities Commissions (IOSCO), “crowd-funding” typically refers to the use of small amounts of money, obtained from a large number of individuals or organisations, to fund a project, a business or personal loan, and other needs through an online web-based platform* .
There are generally four main types of crowd-funding (though such activities may come in other forms as well):
- Equity crowd-funding: Investors normally invest in a project or a business which is usually a start-up, through the online platform, in return for an interest in shares or debt issued by a company or sharing the profits or income of a collective investment scheme;
- Peer-to-peer lending (P2P lending): Investors participate in the crowd-funding activity as lenders, and the online platform matches lenders with borrowers (ie the issuers) to provide unsecured loans to individuals or projects;
- Donation crowd-funding: Funds are raised through the online platforms for charitable causes; and
- Reward/ pre-sale crowd-funding: Investors pay funds via the online platforms to the issuers, and receive returns in the form of physical goods or services (eg pre-paying for a product from a business).
The first two categories are collectively referred to as “financial return crowd-funding” for ease of reference in this article.
What are the key risks?
There are a number of risks associated with financial return crowd-funding that investors should be aware of when considering participating in such crowd-funding activities. These risks include (but not limited to) the following:
- Risk of default
For equity crowd-funding, if the business or investment projects fail, investors may not be able to get back their capitals and returns. In the case of P2P lending, the loans are commonly unsecured, meaning that the investor who provides the funds via the online platform as a lender will not have any collateral. If the borrower defaults on the loan, the investor may suffer loss. In the worst case, investors may lose all of their investments.
- Risk of illiquidity and dilution of stock value
In equity crowd-funding, there may be little or no secondary market for the investments involved. The equity itself may also be difficult to value. Investors may have difficulty in selling their investments once committed and even if they can do so, they may have to liquidate their position at a significant loss. The value of shares issued may also be subject to dilution by further issuance.
- Risk of platform failure or insolvency
The crowd-funding platforms may be temporarily or permanently shut down, become insolvent, or are hacked, investors may lose all their investments, in addition to loss of information.
- Information asymmetry and lack of transparency
The anonymous nature of certain crowd-funding platforms means that investors may have difficulty in obtaining full and accurate information on their investments or loans from the crowd-funding platforms. Investors may not know the project or company in which the investment is made or the borrower’s profile from the platforms, and the information available may not be fully verified either.
Transparency of certain crowd-funding platforms may be low, for example, as to the valuation of an investment as they may withhold certain information (for instance, about historic default rates or costs). In addition, risks may not be fully disclosed even after the investor has made an investment or become a member of the crowd-funding platform. Therefore, investors should be aware that they may not be able to get full knowledge about the business or the borrower before investing.
- Risk of fraud
Due to the anonymous nature of certain crowd-funding platforms and the lack of transparency, investors should be cautious about the risks of financial fraud, such as being lured into purchasing worthless financial products or investments, if they participate in crowd-funding activities. In such case, investors may lose their entire investments.
- Platform operating outside Hong Kong
If the crowd-funding platform is out of the jurisdiction, investors may not enjoy the same protection under applicable laws and regulations in Hong Kong.
- Cyber security
Crowd-funding is mainly operated online and investors engaging in such activities may expose themselves to the risks of cyber-attacks. Such cyber-attacks may come in varied forms, such as overloading a platform’s infrastructure, confusing accounts, identity theft and/or stealing personal data.
- Illegal activities
Crowd-funding platforms may be involved in certain illegal activities such as money laundering or other illegal commerce that could lead to regulatory actions including suspension by relevant law enforcement agencies. Depending on the specific arrangement of the particular crowd-funding activity, it may also be subject to other non-securities related laws and regulations.
Potential regulations applicable to crowd-funding
Depending on the specific structure and features of the relevant arrangement, some types of crowd-funding, in particular the financial return crowd-funding, may be subject to the provisions of the Securities and Futures Ordinance, the Companies (Winding Up and Miscellaneous Provisions) Ordinance, and/or relevant Securities and Futures Commission requirements, including regulations on offers of investments, intermediary licensing and conduct of business requirements, and requirements applicable to automated trading services and/or recognised exchange companies. Other Hong Kong laws and regulations may also apply depending on the features of the activities.
Exercise vigilance before investing
Bear in mind that making uninformed investment decisions based on unverified information is highly risky and may lead to a total loss of your investments. You should not invest in any financial products or activities that you do not know or understand.
Therefore before participating in crowd-funding activities, it is important that you know and understand the risks involved and your responsibilities, and to think carefully before you participate or invest. If you are in any doubt about the nature or risk profile of any financial products or activities, as well as their regulatory status, you are advised to seek independent professional advice.
For more information, please refer to the press release on SFC outlines risks of crowd-funding and potential regulatory issues and the Notice on Potential Regulations Applicable to, and Risks of, Crowd-funding Activities published by the SFC on 7 May 2014 available on the SFC’s website: www.sfc.hk .
*This definition is adopted in a staff working paper entitled “Crowd-funding: An Infant Industry Growing Fast” published by IOSCO on 5 February 2014.