Blog: Cyprus: Transitioning into a new crowdfunding hub – International Financial Law Review

Despite – or perhaps even because
of – the Covid-19 pandemic, the fintech sector in Cyprus exhibited strong
progress in 2020. During the year, and throughout the beginning of 2021, the regtech
and cryptocurrency clusters have also grown and the Cypriot government has
played an important role in enabling the evolution. It aims to secure Cyprus’s
place as a leading international financial centre and as a result, it has promoted
a properly regulated fintech sector, as well as research and innovation.

Cyprus has established the Deputy
Ministry of Research Innovation and Digital Policy to promote, guide and
develop the digital transformation of Cyprus and to facilitate the start-up of
innovative businesses. There is also a generous EU and state financial support package
in place to fund specific projects in the next few years. However, funding gaps
remain, and with a historic lack of a venture capital or business angel culture
in Cyprus (or Europe), it is far from surprising, given the rapid advance of
technology, that a number of ‘crowdfunding’ platforms have emerged to fill the
void.

While in many respects this is a
welcome development, it has raised legitimate concerns that some aspects of the
operations of such platforms fall outside existing investment and banking
regulations and may require specific regulation to ensure transparency and the
protection of investors.

Cyprus legislative initiatives

CySEC crowdfunding directive

As a clear example of the effort
to attract fintech companies whilst simultaneously promoting itself as a bona
fide, well-regulated destination for investors, Cyprus chose to take action to
regulate the crowdfunding sector in advance of any legislation on the part of
the EU. In January 2020, following stakeholder consultations, the Cyprus
Securities and Exchange Commission (CySEC) published the ’Directive DI87 – 10
on the provisions of crowdfunding services in respect of transferable
securities’ (the crowdfunding directive).

CySEC’s crowdfunding directive
relates solely to investment-based crowdfunding through transferable securities
and excludes loan-based, reward-based and donation-based crowdfunding. The crowdfunding
directive comprises a set of secondary rules for investment-based crowdfunding
under the law. It is complementary to MiFID II’s obligations, including but not
limited to: conduct of business rules; management of conflict of interests;
holding clients’ money and financial instruments and product governance. Under
the crowdfunding directive, if offering cross-border transferable securities
via investment-based crowdfunding, crowdfunding service providers and their
platforms are subject to prospectus thresholds governing the marketing, sale
and distribution of securities across the EU.

The crowdfunding directive also
imposes additional provisions aimed at ensuring investor protection on Cyprus investment
firms (CIFs) acting as crowdfunding service providers. Briefly, the most
significant of these include:

Measures to prevent conflicts of interest

CIFs are subject to neutral
intermediation through licensing and activities restrictions. CIFs are not
allowed to receive order routing benefits in respect of crowdfunding projects
in general. CIFs are not allowed to acquire (equity or debt as the case may be)
participation in crowdfunding projects on a platform or allow ’involved persons’
to act as project owners.

Measures to implement due diligence procedures

Additional customer and financial
due diligence in respect of both the crowdfunding project (including credit
risk) as well as the project owner, must be implemented before a project can be
listed on a platform. Identity verification and anti-money laundering checks
must be performed on both the end-investor and project owner.

Measures to ensure transparency

Project owners must produce a
standardised pre-contractual document (under the responsibility of the project
owner), including the natural persons effectively conducting the project
owner’s business. This must be detailed in a key investment information sheet
(KIIS). Certain procedures are in place to ensure that the content of KIIS is
up to date and for rectifying errors or omissions. CIFs acting as crowdfunding service
providers must ensure that the content of KIIS is clear, complete and accurate
before accepting a project on their platform. Marketing communications must be
clear, accurate and not misleading, and consistent with the content of
marketing communications and the KIIS.

Measures to safeguard clients’ funds and financial instruments

All monies raised via the
crowdfunding platform must be transferred by the CIF to the project owner only
after the successful closing of the relevant offer. Financial instruments (i.e.
transferable securities (TS)) are subject to safekeeping, and must be divided
into custodial and non-custodial transferable securities. CIFs acting as crowdfunding
service providers may only release the funds to the project owner where the TS
have been physically delivered or where sufficient evidence is provided by the project
owner to the CIF that the ownership of the TSs has been transferred to the
respective investors, in line with their contributions.

Measures to promote investor exit opportunities

CIFs which are crowdfunding service
providers may operate a bulletin board through which crowdfunding clients of
the CIF may advertise their interest to buy or sell (as the case may be)
transferable securities that had been made available through the CIF’s platform.
Such bulletin boards are to operate as information exchanges only, they are not
to be used as a trading venue.

CySEC’s crowdfunding directive
was introduced whilst the European Commission’s proposal for an EU Bespoke
Crowdfunding Framework (the framework) was still subject to an ongoing legislative
process. It was viewed as a bridging step necessary for the protection of
potential investors. Its contents took into consideration the content of the
proposed framework, without prejudice to the overall investor protection
offered by the MiFID II regime. The intention was to provide interim protection
in a manner designed to facilitate a smooth legislative transition at the
appropriate time.

EU legislative initiatives: Regulation 2020/1503

On October 5 2020, with a view to
facilitating cross-border corporate financing, the European Parliament approved
Regulation 2020/1503 ‘on European
collective financing providers for business’
(Regulation2020/1503).
Regulation 2020/1503 incorporates the framework. It enters into force on
November 10 2021.

The new EU framework is a key
element in the EU’s strategy for a capital markets union. It aims to eliminate
the fragmentation of the legal framework for crowdfunding and to promote
cross-border corporate financing, while improving investors’ protection and the
efficiency of the single capital market. In future, crowdfunding platforms
operating in more than one member state will be able to organise their
activities according to uniform rules – they will no longer have to comply with
national rules separately in each EU member state.

In contrast to the crowdfunding directive,
the scope of Regulation 2020/1503 captures both lending-based crowdfunding (facilitation
of lending not the provision of loans) and investment-based crowdfunding, with
a ceiling of €5 million (approximately $6.1 million). As with the CySEC crowdfunding
directive, reward and donation-based crowdfunding is excluded.

Key provisions of Regulation 2020/1503

Crowdfunding loans

The regulation introduces the
concept of authorised crowdfunding platforms and makes it clear that such platforms
are only permitted to facilitate the conclusion of loan agreements between
investors and project owners. At no time may the platform act as a creditor to
the project owner.

Accordingly, as is currently a
common occurrence in Europe, if the platform wishes to issue a loan to the
project owner and, after issuing it, offers the claims related to such a loan
to investors it cannot be authorised as a crowdfunding platform under
Regulation 2020/1503. If offering such a service a platform might meet the
characteristics of a credit institution or investment brokerage company, in which
case it would require a separate authorisation before it could operate. The
same would apply if, through the platform, third parties offered investors to
purchase the loans they had originally granted by transferring them.

Crowdfunding as a payment service

The framework clarifies one of
the key issues that has so far been regulated and interpreted differently
across the member states. Namely, whether the acceptance of funds from
investors and the creation of virtual accounts are subject to the regulation of payment services. Regulation
2020/1503 states that the authorisation to provide collective financing
services is not comparable to the authorisation to provide payment services.

In the event that a platform
provides payment services, such as offering to set up a virtual account, then
the platform must be licensed as a payment institution or cooperate with a third-party
platform provider who holds such a license already. If the platform provider
decides to cooperate with a third-party payment institution, then the platform
is likely to be registered as an agent of the payment institution.

Reducing risks for investors

Regulation 2020/1503 stipulates
that crowdfunding platforms must carry out a due diligence check on project
owners and provide investors with a key project information sheet. Unlike a
prospectus, the information sheet does not necessarily have to be approved by
the competent authority (i.e. CySEC in Cyprus).

Crowdfunding platforms planning
to operate cross-border under the regulation will need to develop a business
continuity plan to ensure that, in the event of the platform ceasing to
operate, critical services related to existing investments are not interrupted
and contracts between the platform and its customers are properly managed.

In addition, platforms will need
to integrate the compliance measures to prevent conflicts of interest, ensuring
that they do not participate in any project on their own platform, nor do they
accept projects from related parties. At the same time, related parties are not
prevented from investing through platforms, provided that it is ensured that
they are subject to the same rules as any other investor. In this case, the
platform must disclose information about the acceptance of investments from
related parties. For their part, loan facilitation platforms will be required
to publish project default rates for at least the previous 36 months on an
annual basis, as well as quarterly expected and actual default rates for all
loans.

As with other regulated market
participants, crowdfunding platforms will need to provide prudential safeguards
in the form of equity, insurance policies or a combination of both. The
platforms must have a reserve of at least €25,000 of own funds or an amount which
is equivalent to 25% of the platform’s fixed expenses for the previous year. If
the platform executes payment transactions related to transferable securities,
it must use the services of a custodian bank.

ESMA register

Regulation 2020/1503 stipulates
that the authorisation and supervision of platforms is entrusted to the
competent authority of each member state (in Cyprus, this is CySEC). These
competent authorities are required to maintain close cooperation with the
European Securities and Markets Authority (ESMA). In turn, ESMA is tasked with
setting up a dedicated register where the general populace will have access to
a wide range of information on all authorised crowdfunding platforms in the EU.

Regulation 2020/1503 facilitates
the provision of cross-border services. It requires an authorised platforms to provide
its home competent authority with a list of member states, where it intends to
provide crowdfunding services. Following this, the home competent authority
will inform the competent authorities of those member states of the intention
of the platform to passport its services into that member state and the
information will be included in ESMA’s register. Significantly, Regulation
2020/1503 prohibits member states, other than the member state where the platform
is authorised, from requiring the physical presence (office) of platforms in
their territory.

Sophisticated and non-sophisticated investors.

As with investment funds and
alternative investment funds, Regulation 2020/1503 distinguishes between
sophisticated and non-sophisticated investors. It introduces different levels
of investor protection measures that are appropriate for each of these
categories. In the case of non-sophisticated investors, Regulation 2020/1503
requires that the platform must perform an investor engagement test. This
requires the investor to provide various types of information and to ensure
that the investor simulates their ability to bear losses calculated as 10% of
its net asset value.

In case the investor refuses to
provide such information or, the platform considers that the investor’s
knowledge, skills and experience are insufficiently sophisticated to assess
risk, then Regulation 2020/1503 requires the platform to inform the investor
that its services may not be suitable, issue a risk warning and receive
confirmation from the investor that he/she understands this risk. Such risk
warning procedure, including explicit confirmation from the investor must be
followed each time a non – sophisticated investor makes a new investment in
excess of €1,000 or 5% of the net asset value of the investor calculated in the
above simulation.

Crowdfunding in Cyprus: The way ahead

It is clear that the current crowdfunding
regime in Cyprus, whilst narrower in scope than Regulation 2020/1503, overlaps
closely with the majority of its provisions. This is a significant boost for
the crowdfunding sector in Cyprus. It confers a high degree of legitimacy on the
current regime and offers comfort to existing and potential crowdfunding investors.

Regulation 2020/1503 provides for
transitional arrangements so that persons providing crowdfunding services in
accordance with their national law, and which now fall within the scope of the
Regulation can adapt their business activities over time to ensure compliance. Such
persons may continue to provide crowdfunding services that are included within
the scope of the regulation in accordance with the applicable national
law until November 10 2022.

In the case of crowdfunding
platforms already authorised in Cyprus the transitional requirements should be
minimal and low cost. Additionally, despite the fact that fintech is a rapidly
changing sector, both crowdfunding platforms and potential investors can take comfort
in the fact that they are unlikely to be caught off-guard by sudden legislative
change.

In Cyprus, the CySEC established ‘Innovation
Hub’ is mandated with determining the future requirements for new legislative
and supervisory priorities. It regards consultation with the relevant
stakeholders as a crucial part of this process and recognises that both
businesses and investors value stability and that can only be good news for
Cyprus’s prospects as a crowdfunding hub.

Linda Stokes

Publications editor


Michael Pelosi

Senior legal consultant


Diana Golube

Associate

© 2021 Euromoney Institutional Investor PLC. For help please see our FAQs.

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