Governments worldwide are increasingly recognizing that assisting the development of start-ups and small to medium enterprises (SMEs) is critical to fostering job creation and economic growth. As such, many governments have reworked their securities regulations to encourage the funding of these businesses through new approaches such as equity crowdfunding. However, one major problem with investing in securities issued as a result of crowdfunding is that investors typically have limited, and in some cases no, ability to on sell the securities. Without secondary markets to sell such securities there is a risk that equity crowdfunding will become a niche industry as investors increasingly learn to avoid such issues because of the lack of a sufficiently liquid exit strategy.
There are already a number of secondary markets which allow the trading of securities issued by smaller companies as well as proposals in some countries to establish new markets specifically designed for the trading of these kinds of securities. However, historically, these types of markets have had problems which has impacted upon their success and, in some instances, have resulted in the closing of the market. In particular there is often a lack of liquidity for buyers and sellers and this has contributed to such markets becoming plagued with fraud such as ‘pump and dump’ manipulation schemes. Furthermore, the perpetrators of such fraudulent schemes are often situated outside of the jurisdiction making it quite difficult to take effective enforcement action.
In my article recently published in the Harvard Business Law Review Online ‘How do I sell my Crowdfunded Shares? Developing Exchanges and Markets to Trade Securities Issued by Start-ups and Small Companies’, I argue that it is critical to the success of equity crowdfunding that secondary markets for these types of securities be developed and for regulators and the markets themselves to find ways to enhance the integrity of these markets in order to attract investors and issuers alike. I suggest some solutions to the problems that have existed in these markets, such as ensuring the proper vetting of companies prior to listing and improving liquidity through both concentrating trading in one market and having trading take place in batch auctions rather than allowing continuous trading throughout the day. Concentrating trading within one venue should also work to improve detection of manipulation and other fraudulent practices because surveillance systems that are designed to detect abnormal trading on a single market are significantly cheaper, and arguably more effective, than surveillance of trading fragmented over multiple markets. To deter those contemplating engaging in market offences there also needs to be a high probability of detection and subsequent prosecution. Since the perpetrators of such schemes often appear to be situated outside the jurisdiction of the market, it could perhaps be argued that persons who reside in countries where there is no extradition treaty or where it is clear that the authorities of that country will not bring their own proceedings against the perpetrators should not be allowed access to the market.
Ultimately, it should be feasible to ensure the integrity of secondary markets designed to trade securities issued by smaller companies although in order to do so effectively regulators may need to look to a different array of techniques than have traditionally been used in relation to the large exchanges.
Dr Janet Austin is an Associate Professor at the Faculty of Law, University of New Brunswick.