Research on the Reform on Capital Markets Act
and its Impact on Young Companies
A. How the Research is Started
Majoring in Economics in college, I had a chance to take the course named “Capital Market Imperfections and Entrepreneurial Finance.” In the course, the class not only went through the problems that the investors face due to the asymmetric information but also explored how startups, or young companies, struggle to fund, build the company, and exit through IPO or M&A. During the course, I was particularly intrigued by the idea of startups – how they turn intangible ideas into reality. After having the general interest on the startup ecosystem, I learned that startups are one of the most desirable job markets in the United States. Furthermore, the number of Korean startups stood at 29,561 as of November 2014, a dramatic increase from 7,702 in 2003. As Korea is known for its dynamic ideas, technology, culture, and nationality, I thought the Korean startup ecosystem has a great potential, and decided to investigate more about the current situation that the young Korean companies are facing.
B. Life of Startups and Korean Startup Ecosystem
As mentioned above, the number of Korean startups has been significantly increasing. Furthermore, the amount of angel investment and the number of angel investors have been increased, from 47 million KRW in 2012 to 54 million KRW in 2013. This increase is especially led by the governmental support. One of the slogans that the current government pursues is “creative economy,” supporting innovations from various mid-sized companies – including startups and young CEOs. The government expects this policy to bring more job openings for the 20s and 30s and to alleviate Korean jobseekers’ tendency to prefer conglomerates as their first job. The government created SMBA (Small and Medium Business Administration) and Korea’s Angel Investors Association to assure the guaranteed ways to fund small and mid-sized companies. The government also runs Angel Investment Matching Fund in 2013, up to KRW 87 billion.
However, legal, or systematical, support for young companies was not as strong as the policy support. As Korea did not have specific laws just to regulate startup funding, compared to U.S. having JOBS Act, some funding methods were conflicting with Capital Markets Act. The legal reform of Capital Markets Act, therefore, could be working as a way to speed up the initial funding of young companies. Knowing that the new reform just passed the assembly, I finally decided to analyze the reform and the result that the reform would bring. This paper would briefly introduce different types of crowdfunding, explain which type would be focused in the paper, analyze Capital Markets Act before and after the reform, and finally give perspective on the change that the reform would bring.
II. Four Types of Crowdfunding
A. Brief Introduction on Four Types of Crowdfunding
“Crowdfunding” is the process of raising money to fund what is typically a project or business venture through many donors using an online platform, such as Kickstarter, Indiegogo and Crowdfunder. There are four types of crowdfunding- Social Lending (Donation Crowdfunding), Reward Crowdfunding, Peer-to-Peer Lending, and Equity Crowdfunding. Each funding system shows differences in the form of contribution, the form of return, and the motivation of funder.
First, Donation Crowdfunding collects contribution through donation. It provides intangible benefits to the investors, such as self-satisfaction from being supportive. Therefore, motivation of funder is intrinsic and social. Second, the form of contribution of Reward Crowdfunding is donation or pre-purchase. The form of return would be not only rewards (non-monetary benefits) but also intangible benefits. For example, when one invests to the music industry, he might get a special edition music album as a reward. Thus, desire for reward further motivates the funder. Peer-to-Peer Lending works the same as loan system. The form of contribution is loan, and the form of return is repayment of loan with interest. Motivation of funder is primarily financial. Lastly, Equity Crowdfunding’s form of contribution is investment. The investor gets stock dividend in time if the business does well; sometimes, rewards and intangible benefits are also offered. In this case, motivation of funder is usually a combination of intrinsic, social and financial motivation.
B. Why Equity Crowdfunding is Essential to Startups
Among all four types, equity crowdfunding is the most effective to startups with bigger financial potentials and those in need of a greater amount of capital, such as IT and Finance startups. Fund inflow from the first three types of crowdfunding is usually small-sized and more risk-averse, and therefore not applicable to startups requesting a decent amount of funding based on high risk but high chance at the same time. Furthermore, for high risk based startups, banks are also barely supportive as well because banks are usually conservative in lending, and they prefer companies with guaranteed and stable interest payment. Individual investors might also worry about the same risk management issue; however, crowdfunding opens up and publicly discloses the funding information and the process. The disclosure can clarify the uncertain side of the investors by allowing mutual checkups, which is one of the main characteristics of crowdfunding, or social funding.
III. Capital Markets Act before the Reform
Before the reform, there was no regulation directly created based on equity crowdfunding, because it is fairly a new method of investment to the market. However, as equity crowdfunding has emerged as a new means of investment, legal entities have been trying to apply equity crowdfunding onto the existing legal regulations.
A. Act on the Regulation of Conducting Fundraising Business without Permission
Even if it is mainly regulated with Financial Investment Services and Capital Markets Act, equity crowdfunding has also gone against Act on the Regulation of Conducting Fundraising Business without Permission. Article 2 of the act defines “Fundraising Business without Permission” as “collecting business from unspecified individuals as a profession without registration based on the law.” Article 3 and 4 prohibit those activities and also the act of promoting those activities. Even if this regulation is not much used regarding equity crowdfunding, equity crowdfunding could not lie onto the legal side even with this act.
B. Fiancial Investment Services and Captial Markets Act
As there was no law specifically applied to crowdfunding, it was categorized to be regulated by Fiancial Investment Services and Capital Markets Act. Especially, equity crowdfunding is categorized within “public offering,” defined in Article 9 of Capital Markets Act. Based on Article 9, Clause 7, the term “public offering” means “the invitation of 50 or more investors, as computed by a formula prescribed by Presidential Decree, to make offers to acquire securities newly issued.”
The law further regulates and specifies “public offering” in Article 119, or Registration of Public Offering or Sale. Before the reform, as all kinds of equity crowdfunding should be categorized into public offering, it cannot be “publicly offered or sold, unless and until a registration statement filed by the issuer in connection with the public offering or sale of the securities with the Financial Services Commission is accepted by the Commission.”
|Article 119 (Registration of Public Offering or Sale)
Otherwise, public offering can also be issued when “universal shelf registration statement is submitted and accepted by Financial Services Commission,” which is regulated by Article 119, Clause 2.
|Article 119 (Continued)
(2) When a registration statement for a total amount of securities to be publicly offered en bloc over a certain period of time (hereinafter referred to as “universal shelf registration statement”) in accordance with the guidelines and methods prescribed by Presidential Decree, considering the type of securities, scheduled issue period, frequency of issuance, requirements for the issuer, etc., is submitted to and accepted accordingly by the Financial Services Commission, such securities may be publicly offered or sold without necessarily submitting a registration statement each time such securities are publicly offered or sold during the period of time stated therein, notwithstanding paragraph (1). In such cases, the documents related to the universal shelf registration statement (hereinafter referred to as “supplements to universal shelf registration statement”), as prescribed by Presidential Decree, shall be submitted each time such securities (excluding collective investment securities, specified by Presidential Decree) are publicly offered or sold.
Details about the documents needed for public offering are explained in Subsection 1 to 4 of Clause 3 of Article 119. As shown below, it mostly requires specific prospects about the upcoming business outcomes, such as “forecast and prospects for the issuer’s sales performance.” To provide these documents was the biggest obstacle to the startups. Startups usually undergo the risks; young companies challenge the ways that the society always had, twist those to new ideas, and gain a huge amount of leveraged profits. In this manner, they usually set up the goals with high profits, but the expectation or possibility to actually reach onto that stage is very low. They usually wait for “the one moment” when their profits skyrocket.
As startups are unable to provide tangible results or specific prospects for their upcoming output, this Act has been basically blocking startups from using equity crowdfunding, making it practically illegal. In this manner, the foreign laws and the reform have mainly focused on either alleviating the registration requirement, or making the special law that specifically regulates startups and their funding.
|Article 119 (Continued)
(3) An issuer may make a statement or representation of the following matters (hereinafter referred to as “forecast information”) concerning the forecast or prospects for the financial status of the issuer (referring to an investment trust or an undisclosed investment association, in cases where the beneficiary certificates of an investment trust or the equity securities of an undisclosed investment association are involved; hereafter the same shall apply in this paragraph), its business performance in the future, etc. in the registration statement under paragraph (1) and the universal shelf registration statement under paragraph (2) (hereinafter referred to as “registration statement”). In such cases, such forecast information shall be stated or indicated in accordance with the method set forth in Article 125 (2) 1, 2, and 4:
1. Matters concerning forecast and prospects for the issuer’s sales performance, including sales volume, size of income, and other business performance;
2. Matters concerning forecast and prospects for the issuer’s financial status, including size of capital and cash flow;
3. Matters concerning the issuer’s business performance in connection with the occurrence of a specific event or the establishment of a specific plan, or the targeted level at a certain point in time;
4. Other matters prescribed by Presidential Decree as those concerning forecast and prospects for the issuer’s future.
The rest of the sections regulates the issuer’s honesty responsibilities.
Furthermore, there is a disclosure requirement for the issuers. As shown in the attachment below, this disclosure requires “investment prospectus,” and it is for the public. Specifics are listed in Article 123, and the context is mostly similar to what is required in Article 119, except for the fact that it is allowed to exclude facts that are crucially important and confidential to the business management. That is to say, disclosure requirement also gives pressure to young companies together with Article 119 in blocking startups from using the law to utilize equity crowdfunding.
|Article 123 (Preparation and Public Disclosure of Investment Prospectus)
(1) When an issuer publicly offers or sells securities in accordance with Article 119, the issuer shall file an investment prospectus (hereinafter referred to as “investment prospectus”), prepared in accordance with the manner prescribed by Presidential Decree, with the Financial Services Commission on the day on which the relevant registration statement becomes effective (or the day on which the supplements to a universal shelf registration statement are filed, in cases where the supplements to the universal shelf registration statement shall be filed in accordance with Article 119 (2)) and keep it at a place specified by Ordinance of the Prime Minister to make it available to the public for inspection.
(2) No investment prospectus shall contain any description different from the one described in the relevant registration statement (including any supplements to a universal shelf registration statement under Article 119 (2); hereafter the same shall apply in this Chapter) or omit any description stated therein: Provided, That a description may be omitted, if it is necessary to omit the description in consideration of the balance between confidentiality in corporate management, etc. and protection of investors, etc., as prescribed further by Presidential Decree.
(3) An issuer of the collective investment securities specified by Presidential Decree shall file an additional investment prospectus separately from the one under paragraph (1) in accordance with the following subparagraphs, with the Financial Services Commission, and shall keep it at a place specified by Ordinance of the Prime Minister to make it available to the public for inspection: Provided, That such filing, keeping, and disclosure may be omitted, if offering or selling such collective investment securities is discontinued:
1. A revised investment prospectus shall be filed at least once after the investment prospectus under paragraph (1) is filed within an interval prescribed by Ordinance of the Prime Minister;
2. In cases where an amendment to registration is filed in accordance with Article 182 (8), an investment prospectus in which such amendment is reflected shall be filed within five days after a notice of amended registration is delivered.
To sum up, as it has never meticulously defined in the law, equity crowdfunding had to be broadly categorized and therefore generally regulated with other financial equity issuing services. However, as mentioned, young companies are different from the already-grown companies in that they rely on risks. As the regulation barely counted on these special aspects of young companies, crowdfunding was basically forbidden by the law, as it had to be categorized merely as “public offering.” This issue became the initial motivation to reform the law.
IV. Capital Markets Act after the Reform
A. History of the Reform
As Capital Markets Act before the reform technically prevents startups from using equity crowdfunding, there has been the movement to reform Financial Investment Services and Capital Markets Act. On May 01, 2012, the Ministry of Strategy and Finance announced that they would work on finding the ways to introduce equity crowdfunding into Korean legal system. On December 24, 2012, Ministry of Employment and Labor suggested “Social Enterprise Promotion Basic Plan,” supporting the former plan of Ministry of Strategy and Finance. From February 2013, unofficial governmental task force (TF) team for Research and Development of equity crowdfunding has kicked off. From June 2013, “Partial Reform Proposal on Capital Markets Act” has been proposed to the National Assembly. Finally, on July 6, 2015, the proposal was passed in the plenary session of the National Assembly. This proposal has been enforced since January 2016.
B. Specifics of the Reform
On July 6th, 2015, the reform of Capital Markets Act passed in the National Assembly, expected to be enforced from January 2016. Major changes focused on defining equity crowdfunding and therefore sorting it out as the separate category, preventing equity crowdfunding from being categorized simply as “public offerings.” Before analyzing what has been changed, I hereby mention that as the new version of the law has not been translated by the official institution, this writing is unofficially translated based on the reformed law in Korean.
- Defining Equity Crowdfunding: Article 9
First, as mentioned, the reform defines and therefore introduces crowdfunding to the legal system as a specific category, by creating the concept of “Online Small Investment Broker” in Article 9, Clause 27. In this law, “Online Small Sum Investment Broker” means online investment broker who mainly acts as a broker to invite subscriptions about private equity of debt security, equity security, or investment contract securities. ‘In whose name’ does not matter but it should not be owner’s equity. Those brokers have to satisfy any of the following subparagraphs: First, business founders who are in the category defined by Article 2, Clause 2 of Support for Small and Medium Enterprise Establishment Act and prescribed by Presidential Decree, and second, those who meet the requirements prescribed by Presidential Decree. As shown, by introducing potential categories that include equity crowdfunding, Article 9 opened up the possibility to separately regulate equity crowdfunding.
2. Special Provisions on Equity Crowdfunding: Article 117, Clause 3 to 16
New regulations on equity crowdfunding are further defined in the following articles. Article 117 elaborates special provisions on equity crowdfunding. First of all, as a background assumption, Clause 3 restricts those who did not register based on the law from doing business on online small sum investment brokerage. If they are not registered, Clause 5 also restricts them from using the term “online small sum investment brokerage.”
Second, Article 117 exempts equity crowdfunding from registration requirements; this mainly alleviates entry level regulations on startup investors. Specifically speaking, Clause 7 provides deregulation for those who plan to build equity crowdfunding brokerage system, on selecting the investors. Based on Clause 7 of Article 117, “Clause 40, 46, 46②, 47 to 53, 59, 61, 66 to 70, 72 to 77, 77②, 77③, and 78” is not applied to online small sum investment broker. The exempted clauses require the brokers to distinguish if the investor is applicable to investment, by deciding if they are a general investor or a professional investor. Furthermore, online small sum investment brokers are exempted from the responsibilities to check past experiences, size of the capital, reasons for investment of the non-professional investors, to keep investors’ signature and recorded statements about the facts above, and exempted from the duty not to persuade non-professional investors to invest if they are not regarded as desirable and stable investors. Online small sum brokers also do not have responsibilities to clearly explain possible damages to non-professional investors, and to compensate for damages. Rather, Clause 7 separately defines the duties of online small sum investment brokers.
Before the reform, the only way to conduct financial investment business was to be ‘authorized’ by the Financial Committee. In order to get the authorization, brokers had to submit Stock Placement and Sales Declaration, or Batch Report and receive approval. This report includes sales and profit report, management prospect, size and flow of the capital, financial position, possible changes of the objectives, and other provisions by the Presidential Decree. As mentioned, this clause works as the obstacle to the startups. However, Clause 10 of Article 117 clearly mentions that “In the case of Online Small Sum Investment Broker, application of Article 119 is exempted.” That is to say, Online Small Sum Investment Brokers only have to be ‘registered,’ instead of ‘authorized.’ The required document, mentioned in Article 4, is far more lenient than the documents required before. Financial Committee, after Online Brokers submit the required documents, has to decide whether or not to register them within 2 months, and immediately report back to the applicants. In case of mistakes regarding submitting documents, Financial Committee might require the applicants to supplement the missing parts and re-decide.
This deregulation has a certain size of capital limitation. In fact, to use online broker investment, one who meets the requirement by Presidential Decree, such as income limitation, has to have accumulated investment size less than what is defined by Presidential Decree, less than 20 million KRW or 10 million KRW. For those who could not meet the requirement by Presidential Decree, the amount is limited to 5 million KRW and 2 million KRW.
If dealing with securities is below a certain amount, disclosure regulations are not applied. Therefore, startups could freely accept investment up to that amount without strict disclosure responsibilities. As mentioned above, the usual life cycle of startups requires huge amount of endurance at first. Since the size of the company is small, they might earn immense profits if they are successful; but until they reach the point, they obviously need not-too-picky initial investment. This clause 117 just works as the tool for the situation.
3. Dealing with Asymmetric Information Problems
However, it is obvious that if the regulation goes too lenient, it might bring a safety problem. That is to say, even if lenient regulation obviously frees business founders to try whatever they want to try in an easier way, alleviated disclosure regulation might lead an asymmetric information problem between the business founder and the investor. In this manner, the reform still tries to provide safety nets on the perspective of every involved entity to protect investors.
A. Protection for Investors: Regulations on Stock Issuers
First of all, the law is protecting the investors through the regulation on stock issuer, or the young companies. Article 117, Clause 10 only allows offering stocks for subscription up to the amount of 700 million KRW. This clause basically defines the investors’ maximum amount of the loss, making them expect the loss and decide whether to invest. Furthermore, even if disclosure regulation and the requirement for documents are alleviated, they are not fully exempted. Disclosure regulation is divided into initial disclosure regulation and continuing disclosure regulation. Article 117, Clause 10 requires young companies who are initially starting crowdfunding to post their stock opening conditions, financial situations, and business prospect on the website of online small sum investment brokers. Furthermore, a larger amount of subscription invitation requires stricter document on financial situation. Continuing disclosure regulation means that young companies’ continuing provision of information to the investors based on their request or company’s own decision. This system is established because non-public companies are using crowdfunding. As not much information is naturally provided, crowdfunding is trying to use collective intelligence, or stable information interaction between the investors and the owners of the young companies, to minimize the asymmetric information problems that might arise in this situation. Moreover, issuers of the companies and major stockholders are not allowed to sell their stocks within one year. For the young and non-public companies, as it is a small company, the skills and responsibilities of the business founder are one of the most important factors that decide the life span of the company. The impact of one mistake of the issuer is far bigger than the companies already big and stable. Young and small companies are risky in that the founder might just take the profit by selling his stock and quit from the business. In this manner, to guarantee the minimum amount of the responsibilities, as mentioned in article 117, Clause 10, issuer and major stockholders cannot sell their securities after 1 year of issuing. They might be charged when acting against this obligation. Furthermore, Article 117, Clause 10 also requires young companies to entrust investor log management to KSD.
B. Protection for Investors: Regulations on Investors
Second, even if there is not much regulation on the investors, the amount of investment allowed varies depending on the investors’ income and assets, based on Article 117, Clause 10. Thanks to this regulation, the investors would not try to invest just based on their expectation on the luck. The specifics are mentioned while analyzing the specifics of the reform. This regulation is not applied when the investor is a professional investor. The limitation on the amount of investment is automatically regulated by Central Record Management Institution; this kind of investment amount regulation has already been successful in the United States, United Kingdom, Japan, and Italy. This regulation on investors not only lessens their risk but also increases the amount of investors by preventing one investors to fulfill the needed amount of subscription. Keeping a certain number of investors also fastens the exchange of information, helping collective intelligence mentioned above. Besides, investors have to check the investment information based on Article 117, Clause 7; otherwise, they are not allowed to invest. Investors also cannot sell securities within 1 year, because asymmetric information problem also exists between the initial investors and the investor who buys stock from him. This regulation is basically protecting investors who rebuy it.
C. Protection for Investors: Regulations on Other Entities
Third, there also exist regulations on online small sum investment brokers. If online small sum investment brokers apply to the securities subscription of the companies they are working with, to achieve the subscription goal they have set, it might spread wrong market information to the investors as well as to the market. In this manner, Article 117, Clause 7 prohibits the broker institutions to invest within their own capital. As mentioned above, the brokers are also not allowed to manage or receive deposit directly from the investors. (Article 117, Clause 8). Furthermore, the brokers also have due diligence responsibilities. As analyzed, the level of safety of the information regarding equity crowdfunding is lower than that of other investment methods. Clause 11 of Article 117 mentions a certain level of due diligence responsibilities to the brokers. Clause 12 of Article 117 defines those who have compensation responsibilities. They are online small sum securities issuer, the issuer’s representatives or board of directors, those who directed the establishment of business plan, the accountant or appraiser who signed to guarantee the needed document, those who gave the opinion on the document and who agreed to include his opinion on the analysis document. Entities that are just mentioned are allied with liabilities, (Bu Jin Jeong Yeon Dae Chae Moo in Korean legal term) making the investment safer.
As shown, even if the reform strongly aims to free the online small sum investment brokers and thus to help young companies, it strictly has built up the protection plans for the investors, by regulating not only the brokers and issuers but also the investors. It is sincerely desirable in that one of the facts that make investment strategies appealing is the minimum safety guaranteed to the investors so that they would not go broke even if the issuing company is not as successful as expected.
V. Changes that the Reform will Bring
Most of all, through the reform, one more way of funding is provided to young companies. Investors can have voting right as stockholders; they can share the profits through dividend and interest income, and stock sales. Second, this movement can reflect general governmental stance on startup regulations. That is to say, the government obviously showed the positive sign on supporting young companies by deregulation; as expected, the government successfully finished mock crowdfunding contest. Furthermore, this positive stance on innovation should help FinTech industry grow as well, and based on the report on 8th Trade and Investment Conference, the government is also planning to exempt dividend income tax for startup accelerators.
This research has started from the general interest in the virtuous cycle of the startups. When the government provides enough funds through the supportive policies, the young companies, with those increased capital, might grow as a high-potential startups, become more desirable companies, have better connections, and eventually exit successfully to start new innovation, and so on. The reforms of course signify the government’s positive perspectives on the young companies and therefore brighten the way to fasten up the virtuous cycle. However, as a new law that just has launched, it should not forget that the law always goes through the difficulties between deregulation and the safety. One of the most important aspects is to guarantee the safety for the investors; as equity crowdfunding is more on the public friendlier side, the public should not also forget the duty to keep an eye on how the law builds up the protection side along with the innovation strategies.
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