The European Union (EU) never seems to get it right. Its answer to the rise of Silicon Valley was digital regulation. Its answer to artificial intelligence is, again, regulation. Yet the EU never managed to develop tech champions or similarly innovative technologies. This is a major political, economic and strategic failure. Regulation cannot replace innovation. Innovation is more than the basis for economic progress, social welfare and soft influence on other countries. It is also the key to maintaining power, sovereignty and strategic independence.
A good-faith attempt to close the innovation gap is the 28th regime, aka the EU Inc. This will add a new corporate form which may be used by innovative companies. Yet it will not remove the many regulatory obstacles that inhibit the investment in such companies by European savers. As the European Commission has underlined, these companies must cross two ‘valleys of death’—first to turn innovations into marketable products, second to scale up. In the US, ample finance is provided in both stages by angel investors and venture capitalists. In the EU, both are noticeably absent.
Besides the often-emphasised risk aversion of European investors, this is largely due to regulation. US securities law offers diverse safe harbors for start-ups that are soliciting venture capital from private individuals, most of them in Reg D. This has spurred the creation of a multi-billion-dollar private equity market, which readily finances innovative business models.
In the EU, the regulatory waters for would-be angel investors and venture capitalists are much murkier. The Prospectus Regulation and MiFID II pose serious obstacles to soliciting investments from individuals by setting rather high thresholds for investors’ eligibility to the marketing of private equity products. The first relates to their trading frequency (10 significant transactions per quarter in the last year); the second to their wealth (an investment portfolio of more than EUR 500,000); and the third to their professional experience (at least one year in the financial industry). Investors need to meet two out of three of these criteria to be considered as ‘professional’.
This two-out-of-three test can yield rather curious results. To illustrate, Elon Musk would not be considered a professional investor in the EU, despite his phenomenal wealth, if he had taken a break from investing in the stock market in the last quarter. In contrast, a hapless former employee in the financial sector who has gambled away his wealth through frequent stock trading during one year would qualify. Most importantly, an investor who has worked in a non-financial industry, like the biotech sector, would not meet the criteria even if she is spectacularly rich but does not frequently trade in securities.
The last profile describes the typical angel investor. These are individuals who have acquired wealth and experience in a certain industry, though not the financial industry. They are instrumental for the start-up market since they do not merely provide capital, but also advice and connections. Venture capitalists, who typically provide finance and business advice at a later stage, face similar obstacles. The people who are most able and likely to support start-ups in the EU can thus not easily be solicited by the latter.
To remedy this absurd situation, we suggest in our new article the following:
First, wealth should be an independent criterion for classifying an investor.
Second, annual income should be an alternative criterion, to allow the younger generation to enter the profitable private equity market.
Third, the investment amount should be limited to a certain percentage of the investor’s portfolio or income, say 20%. This percentage serves as a cushion against losses and may progressively increase with the value of the portfolio or the income of the investor, say to 30% or 40% for very wealthy individuals or super-high earners.
Fourth, we suggest obliging start- and scale-ups in the private equity market to provide minimum information to investors. This is a necessary safeguard to reduce the most blatant information asymmetries. To deter from providing false information, an EU-wide liability for securities fraud should be introduced.
Finally, and perhaps most controversially, we suggest introducing a ‘qualified investor examination’. This new way to become a professional investor will pave the way for smart and well-informed but not wealthy persons into the more lucrative segments of financial markets. It is also an essential tool to enhance financial literacy, to democratise finance and to avoid the paradoxical situation in which only the rich can become richer because the poor are protected from taking financial risk.
Critics will object that the suggested reform will not suffice to close the innovation gap. They are right. But it is an important piece in a larger puzzle that the EU must solve.
The authors’ article, published in the Capital Markets Law Journal, is available here.
Brian Carroll is a member of the staff of the US Securities and Exchange Commission. The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This article expresses the author’s view and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.
Matthias Lehmann is Full Professor of Private Law, Private International Law, and Comparative Law at the University of Vienna, and Professor of European and Comparative Business Law at Radboud University Nijmegen.
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