by Senator Ihenyen, Lead Partner
Download the PDF version here.
Crowdfunding today is no longer charity. It is serious business. And the ever-growing digital economy has been a big part of this. New business models as well as alternative financing models for Micro, Small and Medium Enterprises (MSMEs) have emerged with the digital economy. One of the most innovative alternative financing models used by many MSMEs today is crowdfunding. Globally, crowdfunding has not only democratized access to funding but also accelerated the transition from product development to market penetration.
But without intermediation between fundraisers and investors, risks necessarily arise. Investors lose their money sometimes to unsound projects or poorly managed projects. Sometimes this is due to poor investor education and sometimes due to outright fraud or scams, including Ponzi schemes and pyramid schemes. If not properly governed, crowdfunding could be crowded out.
This is why while we seek to maximize the opportunities crowdfunding brings to MSMEs, we must not fail to implement a regulatory framework that will help minimize the risks often associated with crowdfunding. Regulation is vital, especially in the capital market. The Securities and Exchange Commission (SEC) regulates Nigeria’s capital market. Tasked with the statutory duty of developing the capital market while also ensuring investor protection, the SEC regulates crowdfunding in Nigeria.
Having earlier issued the Rule on Crowdfunding (the ‘Crowdfunding Rules’),[efn_note]New Rules and Amendments to the Rules and Regulations of the Commission: Rule on Crowdfunding, https://sec.gov.ng/wp-content/uploads/2021/01/Jan-2021-Executed-Rules.pdf, accessed 28 May 2021[/efn_note] the SEC released a statement on 26 May 2021 reminding persons or entities operating investment crowdfunding portals or digital commodities investment platforms to register with the SEC before 30 June 2021 deadline.[efn_note]SEC, ‘Effective Date Of The Crowdfunding Rules’, 26 May 2021, accessed 28 May 2021 https://sec.gov.ng/effective-date-of-the-crowdfunding-rules/[/efn_note]
The Crowdfunding Rules is one of the rules contained in the SEC’s ‘New Rules and Amendments to the Rules and Regulations of the Commission’. It came into effect on 21 January 2021. From the effective date, a 90-day period for application for registration was given under the Crowdfunding Rules. This 90-day period elapsed 21 April 2021. The SEC has now given crowdfunding operators till 30 June 2021 to either comply with the Crowdfunding Rules or cease operations. According to the SEC, any crowdfunding operator that fails to comply but continues to operate will be categorized as illegal and face regulatory sanctions as stipulated in the Crowdfunding Rules.
Since the SEC’s statement was published, a number of stakeholders have been asking questions. Does the Crowdfunding Rules apply to all sorts of crowdfunding online? Are there any exemptions? What are the registration requirements for crowdfunding portals? Are digital asset-based crowdfunding models such as Initial Coin Offering (ICO), Securities Token Offering (STO), and Initial Exchange Offering (IEO) affected by the Crowdfunding Rules? These questions and more are what I will be treating in this piece.
Meaning of crowdfunding and the scope of the Crowdfunding Rules in Nigeria
What is crowdfunding?
Crowdfunding is simply the act of raising funds for a project by pooling funds from the crowd. It relies on the power of the crowd. According to Investopedia, crowdfunding is “the use of small amounts of capital from a large number of individuals to finance a new business venture.”[efn_note]https://www.investopedia.com/terms/c/crowdfunding.asp accessed 28 May 2021[/efn_note] Quite similar to the definition above, ‘crowdfunding’ is defined in the Crowdfunding Rules as “[t]he use of small amounts of money, obtained from a large number of individuals or organizations, to fund a project or a business through an online web-based platform”.[efn_note]Part 1, section 1 of the Crowdfunding Rules [/efn_note]
Noticeably, the SEC’s definition of crowdfunding above adds “through an online web-based platform“. By implication, the Crowdfunding Rules does not apply to offline crowdfunding platforms. In other words, the Crowdfunding Rules apply to crowdfunding portals.
What is a crowdfunding portal?
As defined in the Crowdfunding Rules, a ‘crowdfunding portal’ is “[a] website, platform, portal, intermediary portal, application, or other similar module that facilitates interaction between Fundraisers and the investing public.”[efn_note]Part 1, section 1 of the Crowdfunding Rules[/efn_note]
Unlike the common practice whereby a fundraiser may also serve as the crowdfunding portal or be able to use an unlicensed third-party crowdfunding portal through which crowdfunding is facilitated, it operates differently under the Crowdfunding Rules. The Crowdfunding Rules separates the fundraiser from the crowdfunding portal. It requires that a crowdfunding portal will only be owned and operated by a crowdfunding intermediary.
Who is a crowdfunding intermediary?
A ‘crowdfunding intermediary’ is the middleman who facilitates the investment transaction between a fundraiser and an investor. According to the Crowdfunding Rules, is “[a]n entity organized and registered as a corporation to facilitate transactions involving the offer or sale of securities or investment instruments through a Crowdfunding Portal.”
A crowdfunding intermediary is the operator who must be registered with the SEC. Once the crowdfunding portal to be used by a crowdfunding intermediary has been registered with the SEC, the crowdfunding intermediary is prohibited from using any other website, social media portals, or third-party portals other than the registered website of the crowdfunding portal.[efn_note]Part 7, section 37(d) of the Crowdfunding Rules [/efn_note]
So the participants in a crowdfunding transaction are the crowdfunding intermediary, the fundraiser, the investor, and not forgetting the custodian. The crowdfunding intermediary essentially intermediates between the fundraiser and the investor in order to solve the problem of trust.
A crowdfunding intermediary has a number of obligations under the Crowdfunding Rules. These obligations centre on disclosures, investor education, due diligence, monitoring and reporting, and data protection and privacy. Other obligations include operation of a trust account through a custodian, issuance and publication of warning statements, compliance, record keeping, transparency, and avoidance of conflicts of interest.[efn_note]Part 3, sections 11–20 of the Crowdfunding Rules [/efn_note]
What are commodities investment platforms, and how are they similar to or different from crowdfunding intermediaries?
While there is the crowdfunding intermediary through whose crowdfunding portal the money needed by a fundraiser is raised, the Crowdfunding Rules also recognize commodities investment platforms. A commodities investment platform is “[a]n electronic platform that connects investors to [sic] specific agricultural or commodities projects for the purpose of sponsoring such projects in exchange for a return.”[efn_note]Part 1, section 1 of the Crowdfunding Rules [/efn_note] They are digital platforms that crowdfund agricultural or commodities projects.
So commodities investment platforms may be said to also be crowdfunding intermediaries. But not all crowdfunding intermediaries are commodities investment platforms. This is why under the Crowdfunding Rules, a crowdfunding intermediary may operate a commodities investment platform under certain conditions. One of those conditions is that a crowdfunding intermediary registered to operate a commodities investment platform is prohibited from facilitating on its portal any other crowdfunding business other than sourcing funds for investments in agriculture or other commodities.[efn_note]Part 8, section 4 of the Crowdfunding Rules [/efn_note]
How is a crowdfunding portal determined under the Crowdfunding Rules?
To determine whether a person or entity is a crowdfunding portal under the Crowdfunding Rules, two things must be present:
- The person or entity must offer or run a portal that facilitates, operates, provides, or maintains interactions between fundraisers and the investing public (crowd) in Nigeria; and
- The purpose of the crowdfunding must be investment-based.
What is investment-based crowdfunding?
There are various types of crowdfunding. They include donation-based crowdfunding, interest-based crowdfunding, and reward-based crowdfunding. These three crowdfunding types have nothing to do with investments or any form of equity or security. Equity-based crowdfunding, asset-based crowdfunding, or investment-based crowdfunding does not include charities or donations, interests, or rewards with goods or services. Investment-based crowdfunding is based on investment instruments such as debt securities, shares, etc.
Under the definition section of the Crowdfunding Rules, ‘investment-based crowdfunding’ is defined to mean “[t]he process of raising funds from the public through an online portal in exchange for shares, debt securities or other investment instruments approved by the Commission”. These investment instruments include ordinary shares, plain vanilla bonds or debentures, and simple investment contracts. Before becoming issuable through any crowdfunding portal, these investment instruments must have been approved by the SEC.
How about simple investment contracts? What do they really mean?
It’s really simple. A simple investment contract is any agreement, scheme, or transaction whereby a person:
- invests money;
- the money is invested in a common enterprise;
- the person is led to expect profits; and
- the expected profits are solely from the efforts of the promoter or a third party.[efn_note]Denise L. Evans, JD and O. William Evans, JD., The Complete Real Estate Encyclopedia, The McGraw-Hill Companies, Inc., 2007; the judicial test in SEC v. W.J. Howey Co., 328 U.S. 293 (1946) (“Howey”) [/efn_note]
Similar to the meaning of simple investment contracts provided above, a simple investment contract is defined under the Crowdfunding Rules as “[a]contract or scheme for the placing of capital in a way intended to secure income or profit from its employment and includes participation in any profit-sharing agreement by virtue of which: [i] The investors provide the capital; [ii] The promoters manage, control and/or operate the enterprise; and [iii] The investors share in the earnings and profits.”
Crowdfunding portals in Nigeria and the Crowdfunding Rules
What will make a person or entity be considered to be providing a crowdfunding portal in Nigeria?
An entity will be considered to be facilitating, operating, providing, or maintaining a crowdfunding portal in Nigeria if the crowdfunding portal:
(i) is operated, provided, or maintained in Nigeria; or
(ii) is located outside Nigeria but targets investors in Nigeria; or
(iii) has the component parts of the portal when taken together physically located in Nigeria even if any of its component parts, in isolation, is located outside Nigeria.
Even if a crowdfunding portal is located outside Nigeria, the SEC will consider the portal eligible for registration if the portal is “actively targeting investors in Nigeria if the operator, or the operator’s representative, promotes directly or indirectly the Crowdfunding Portal in Nigeria”.
Therefore, regardless of location, the investors targeted by the crowdfunding portal is a vital consideration.
Any exceptions to persons or entities who are not crowdfunding portals but facilitate crowdfunding portals by other means?
Being an online or web-based business operation or activity, there are understandably certain aspects of providing a crowdfunding portal that do not involve the act of facilitating, operating, providing and maintaining a crowdfunding portal as such. This is probably why certain exceptions have been provided under the Crowdfunding Rules. The three exceptions are as follows:
(i) A technology service provider who merely provides the infrastructure, software or the system to an operator;
(ii) an operator of a communication infrastructure that merely enables orders to be routed to an approved stock market;
(iii) an operator of a financial portal that aggregates content and provides links to financial sites of service and information providers.[efn_note]Part 2, section 5(e) of the Crowdfunding Rules [/efn_note]
Which persons or entities are eligible to raise funds through a crowdfunding portal?
You need to have some track record, have a technical partner who does, or you have a core investor who has your back. One of these three must tick the boxes for you as a fundraiser. Specifically, the Crowdfunding Rules require the fundraiser to be an MSME:
- incorporated as a company in Nigeria with a minimum of two-years operating track record;
- incorporated as a company in Nigeria with less than 2 years operating track record but which has a strong technical partner that possesses a minimum of 2 years operating track record or has a core investor.[efn_note]Part 1, section 3 of the Crowdfunding Rules [/efn_note]
Fundraisers in Nigeria, investment thresholds, and restrictions
Are there any exemptions for fundraisers from the registration requirement under the Crowdfunding Rules?
A fundraiser who meets the two conditions below is not required to register with the SEC to offer or sell investment instruments:
(a) The fundraiser is an entity incorporated in Nigeria, and accredited and/or accepted by a crowdfunding intermediary to utilize its portal;
(b) The fundraiser must not exceed the acceptable investment threshold for each type of enterprise.
According to the Crowdfunding Rules, the aggregate amount of investment instruments that can be offered and sold by a fundraiser within a 12-month period shall comply with the following limits:
(i) The maximum amount which may be raised by a Medium enterprise shall not exceed N100 Million;
(ii) The maximum amount which may be raised by a Small enterprise shall not exceed N70 Million;
(iii) The maximum amount which may be raised by a Micro enterprise shall not exceed N50 Million.
Whether a fundraiser is an MSME will be determined based on the total asset turnover or number of employees of the fundraiser. This is as prescribed by the Small and Medium Enterprises Development Agency of Nigeria (SMEDAN).[efn_note]Part 1, section 1 of the Crowdfunding Rules [/efn_note]
Can a crowdfunding portal be utilized by every fundraiser?
A crowdfunding portal is not for every fundraiser. Understandably, under the Crowdfunding Rules, the following are prohibited from raising funds through a crowdfunding portal:
(a) complex structures;
(b) public listed companies and their subsidiaries;
(c) companies with no specific business plan or a blind pool;
(d) companies that propose to use the funds raised to provide loans or invest in other entities;
(e) such other entities as may be specified by the Commission.[efn_note]Part 7, section 39 of the Crowdfunding Rules [/efn_note]
Just by the way, in a ‘blind pool’, money is raised from investors without any stated investment goal. Blind pools are usually based on a recognition of or reliance on the name of a particular individual or firm who is associated or identified with the investment.
The SEC’s position on the operations of crowdfunding portals and the need for compliance with the new crowdfunding regime in Nigeria
What does the SEC now want exactly?
Before the Crowdfunding Rules was issued by the SEC in March 2020, there were persons or entities who had been operating investment-based crowdfunding portals or digital commodities investment platforms. A number of these portals and platforms continue to operate till date.
To continue to operate, the SEC requires these platforms and portals to be registered with the SEC. In order to give the unregistered operators of these portals and platforms reasonable time to become compliant, the Crowdfunding Rules makes room for a transitional phase. In this transitional phase, the operators of these portals and platforms are required to restructure their operations in compliance with the Crowdfunding Rules. After restructuring, application for registration may then be made to the SEC. Effective from 21 January 2021, this transitional phase was a 90-day window. The window closed 21 April 2021. By its latest statement, the SEC has opened the window till 30 June 2021 in order to accommodate operators who wish to become compliant and desire to avoid being on the wrong side of the law with its attendant consequences.
Does the Crowdfunding Rules apply to digital asset-based crowdfunding?
First, though the SEC issued a statement in September 2020 where it classified digital assets as (i) crypto assets, (ii) utility tokens, (iii) security tokens, and (iv) derivatives and collective investment schemes,[efn_note]SEC, ‘Statement On Digital Assets And Their Classification And Treatment’, 14 September 2020, https://sec.gov.ng/statement-on-digital-assets-and-their-classification-and-treatment/ accessed 28 May 2021 [/efn_note] there is no specific regulation of ICOs, STOs, and other digital-assets based crowdfunding models.
Second, one may conclude that since the Crowdfunding Rules do not have any special provisions for digital assets-based crowdfunding, it is subsumed under the general provisions. Investment-based crowdfunding is what it is regardless of the disruptive technology being applied to get investments. So as long as the returns involve ordinary shares, plain vanilla bonds (with no frills or extras) or debentures, and simple investment contracts, it is investment-based crowdfunding. Technology neutral? Maybe.
I recall some of the recommendations in ‘The Future of Fintech in Nigeria’ report by the Fintech Roadmap Committee of the Nigerian Capital Market in August 2019. Of the number of recommendations submitted to the SEC, three are very relevant to crowdfunding regulation in Nigeria. The three recommendations are that:
(i) the SEC should regulate Initial Coin Offerings (ICOs) and Security Token Offerings (STOs);
(ii) the SEC should issue guidelines and standards for whitepapers and ICOs; and
(iii) the SEC should create appropriate licensing regimes for new entrants into the crowdfunding ecosystem.[efn_note]’The Future of Fintech in Nigeria’, the report by the Fintech Roadmap Committee of the Nigerian Capital Market, August 2019, https://sec.gov.ng/report-of-the-fintech-roadmap-committee-of-the-nigerian-capital-market/ accessed 28 May 2021 [/efn_note]
Though the SEC has obviously not introduced a special regulation for ICOs, STOs, and other digital asset-based crowdfunding models (yet), it may be correct to deduce that the Crowdfunding Rules are meant to be technology neutral. Of course, such technology-neutrality stance may have come in conflict with the recent Central Bank of Nigeria (CBN) directive banning cryptocurrencies in Nigeria’s banking and financial system.[efn_note]CBN, ‘Letter to all Deposit Money Banks, Non Bank Financial Institutions and Other Financial Institutions’, https://www.cbn.gov.ng/Out/2021/CCD/Letter%20on%20Crypto.pdf accessed 28 May 2021 [/efn_note] The same CBN directive gravely affected the SEC Regulatory Incubation Framework and the planned implementation of the SEC Regulatory Incubation Guidelines for FinTech in Nigeria. According to the SEC, it had to suspend its plans because the target fintech platforms must be eligible to operate bank accounts within the Nigerian banking system. It remains debatable whether a regulator such as the CBN has the statutory power to deny access to banking and financial services to an entire market which neither the CBN nor the National Assembly has declared illegal. Adopting a risk-based approach—just as the Reserve Bank of India eventually did following the Supreme Court of India’s well-reasoned intervention in a similar matter involving denial of banking services to virtual assets service providers (VASPs) in that country[efn_note]Reserve Bank of India, ‘Customer Due Diligence for transactions in Virtual Currencies (VC)’, 31 May 2021 https://m.rbi.org.in//Scripts/NotificationUser.aspx?Id=12103&Mode=0, accessed 30 May 2021. The Supreme Court decision was made on 4 March 2020 in Internet and Mobile Association of India v. Reserve Bank of India (Civil) No.528 of 2018. [/efn_note]—would have been a better approach.
What are the requirements for registering as a crowdfunding intermediary?
Apart from submitting the relevant forms, registration fees apply. As stipulated in the Crowdfunding Rules, the registration fees are as follows:
- Evidence of payment of filing/application fee – N50,000 (Fifty Thousand Naira);
- Evidence of payment of processing fee – N200,000 (Two Hundred Thousand Naira);
- Evidence of payment of registration fee – N500,000 (Five Hundred Thousand Naira);
- Evidence of Payment of Sponsored Individual Fee – N50,000 (Fifty Thousand Naira) for each sponsored individual.[efn_note]Part 2, section 5(d) refers to Schedule 1 of the Crowdfunding Rules [/efn_note]
What are the regulatory sanctions for failing to comply with the Crowdfunding Rules?
Sanctions come in two folds. First, there are stipulated penalties. And second, there is liability in the event of loss of investor funds.
According to the Crowdfunding Rules, any crowdfunding intermediary that fails to comply with the rules shall be liable to a fine of not less than N100,000.00 (One Hundred Thousand Naira Only) and the sum of N5,000.00 (Five Thousand Naira Only) for every day the violation continues. Also, the crowdfunding intermediary will be liable for any loss of investor funds that may arise due to the crowdfunding intermediary’s failure to comply with its obligations under the rules.[efn_note]Part 10, section 42 of the Crowdfunding Rules [/efn_note]
MSMEs are the engine of any nation. According to the World Bank, MSMEs represent about 90% of businesses and more than 50% of employment globally. In Nigeria, MSMEs contribute nearly 50% of the country’s GDP and account for over 80% of employment in the country.[efn_note]PwC’s MSME Survey 2020: Building to Last (Nigeria report), https://www.pwc.com/ng/en/assets/pdf/pwc-msme-survey-2020-final.pdf&ved=2ahUKEwjqttzH4_bwAhXSQUEAHUnvBuYQFjAAegQIAxAC&usg=AOvVaw15QNincBSuT91ENYoi9V-d, accessed 29 May 2021 [/efn_note] This is why financing MSMEs is critical. In MSME financing, crowdfunding has become an alternative to traditional financing. Through crowdfunding, entrepreneurs are able to take their products and services to the market by leveraging the power of the crowd in a digital economy. Today investment-based crowdfunding is a big part of the success story of crowdfunding. It comes with its pros and cons. And this is why ensuring a regulatory framework that boosts investor protection is key. The Crowdfunding Rules seek to do exactly that.
This is where the SEC and all the participants in the crowdfunding business come in: the crowdfunding intermediary, the fundraisers, the investors, and the custodians. To keep open the funding of MSMEs through crowdfunding a sustainable alternative financing model, safeguarding the ecosystem is vital. Before crowdfunding is crowded out, the SEC and participants must get it right.