Regulation of the Chinese Equity Crowdfunding Market

In 1998, Stanford University professor David Cheriton invested $100,000 in a startup founded by two former Stanford graduate students. That nascent company was Google. The investment contributed significantly to Cheriton’s current several billion-dollar fortune. Until recently, the ability to invest in exciting new companies had largely been limited to those with access to startup hubs like Silicon Valley and with the means to make significant contributions. Today, equity crowdfunding—a tool that allows large numbers of investors to fund startups in exchange for equity—aims to expand this market. Still, such crowdfunding may not realize its full potential without careful regulation. Perhaps no country faces more consequential choices about how to regulate crowdfunding than China. China boasts the world’s largest equity crowdfunding market at $948.26 million—close to the combined size of the equity crowdfunding markets in the United States and the United Kingdom. A recent scholarly paper points to serious problems in China’s crowdfunding market that demand improvements in regulatory oversight. Professor Lin Lin at the National University of Singapore argues that equity funding poses greater risk to investors than does the more traditional investment setting, such as venture capital. Equity crowdfunding does not allow investors to meet face-to-face with companies that are looking to raise money and collect a wealth of information on the company. As a result, investors face unequal access to information and are forced to rely on the online information provided by the equity crowdfunding platform they may use. Adding to this problem, Lin argues, is the fact that equity platforms generally earn most of their profits from the companies, not the investors. The typical model is one where equity crowdfunding platforms charge a commission on successful projects—those that meet their fundraising goal. Lin argues that companies serving as platforms’ main profit source creates an incentive for platforms to take on as many projects as they can without properly vetting them. In turn, this incentive has led to “uncertainty with regard to the legitimacy of platforms.” Lin argues that contracts and market mechanisms present part of the solution to the Chinese equity crowdfunding problems. For example, she points to the power of reputation in the marketplace as a tool for keeping platforms in line. Still, Lin views these as incomplete solutions. To fill the gaps, she suggests several tools that China could use to regulate equity crowdfunding platforms. Lin argues that China should adopt a licensing scheme—a tool that is used in both the United States and the United Kingdom—that forbids unlicensed platforms from hosting equity crowdfunding campaigns. Further, she suggests that the licensing scheme could involve requiring firms to pay a security deposit to protect investors in the event of wrongdoing, such as embezzlement, by the platform. Although there is a provisional licensing system in existence, Lin argues that it does not adequately define the criteria for granting approval to a platform. Lin points to practices in the United States to argue that China should also implement mandatory disclosure and due diligence requirements. Under the Jumpstart Our Business Startups Act, the United States imposes what Lin describes as stringent disclosure requirements. Platforms are required to disclose their compensation structure to inventors and provide information on companies that are raising funds 21 days prior to the beginning of investing. Lin argues that China, which currently has no mandatory disclosure or due diligence laws for equity crowdfunding, should follow the United States’ lead. Imposing similar laws would promote the integrity of platforms’ “neutral role in information distribution and verification,” she says. Lin advocates for disclosures on businesses that raised money on a platform, but later failed, and on how much capital has been raised by investors who have no relation to the company raising funds. If China implements a due diligence requirement, Lin argues, then that requirement would force platforms to inform investors about the extent to which a company that is raising funds has been analyzed. This information would allow investors to determine how much research they need to do before investing. Lin identifies the generally poor financial literacy of Chinese investors as a factor that could diminish the value of mandatory disclosures and due diligence. To account for poor financial literacy, she suggests “clear and widely accessible” disclosures and an investor education system. Lin also advocates for placing restrictions on the kinds of activities in which equity crowdfunding platforms engage. For example, the Securities Association of China issued a draft set of regulations that would impose restrictions on the activities of platforms, including barring them from raising funds on behalf of companies and from serving as investment advisors. Although Lin agrees with these restrictions, she points out that the Securities Association’s proposed regulations remain nothing more than a draft. To supplement these tools, Lin suggests requiring monitoring of the advertising of equity crowdfunding campaigns, and requiring that platforms take steps to address conflicts of interest and notify investors when they cannot eliminate them. Lin’s paper is published in the Journal of Corporate Law Studies