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Financial Services analysis: how does the Financial Conduct Authority (FCA) plan to regulate increasingly popular crowdfunding platforms? Bill McCaffrey, partner and head of consumer finance at CMS Cameron McKenna, discusses the FCA's attempts to catch-up with this new funding model.
Press Release: Financial Conduct Authority outlines how it will regulate crowdfunding
A proposal on new rules providing clearer information to consumers who want to invest in businesses via crowdfunding has been published by the FCA. Crowdfunding is a solution for individuals, organisations and businesses to raise money. It involves a number of people pooling money through a website, often called a platform. Peer-to-peer lending and equity investment based crowdfunding are the two investment forms requiring regulatory oversight. The FCA is issuing this consultation paper as it is taking over the regulation of the consumer credit market from the Office of Fair Trading (OFT) in April 2014.
What are the key features to consider when discussing crowdfunding?
There are two distinct forms of crowdfunding platforms:
For ease of reference we shall refer to the entity in search of funding under both structures as the 'borrower'.
The former is known as 'investment-based crowdfunding' and firms operating the platforms are likely to require the FCA permission of 'arranging deals in investments'--they are therefore already within the scope of regulation. However, the FCA recognises that the rulebook was not designed for such activities and therefore certain revisions will be required.
The latter is 'loan-based crowdfunding'. Operating such platforms does not currently require any FCA permissions, and while the OFT does operate a licensing regime for debt administration activities, a number of the Consumer Credit Act 1974 (CCA 1974) provisions do not apply to such agreements and investor protections.
The FCA has therefore sought to increase its regulation of such operations.
There is a further distinction to be made between the services provided by a platform. There can be seen to be two parallel services:
The former raises issues regarding the manner in which the platform is marketed to investors, the retaining and subsequent distribution of their funds and eventual repayment. The latter focuses more on the protections offered to borrowers in respects of the contracts made (which is of particular importance in respect of loan-based crowdfunding).
What level of regulation currently exists for crowdfunding?
Operators of investment-based crowdfunding platforms are currently required to have FCA permission to, as a minimum, arrange deals in investments. By providing a platform through which potential borrowers can solicit investment, the operator is effectively running a service that matches up investors with investments and therefore arranging deals.
Further, the FCA has stated that its current approach is to place tailored restrictions on firms operating investment-based crowdfunding platforms at the point of authorisation, so that the risks applying to their business models are mitigated.
By requiring operators to be authorised they are subject to the usual FCA core standards applying to all authorised firms. The use of additional restrictions enables the FCA to control the customers the operator transacts with, primarily limiting it to transactions with those who are high net worth/sophisticated investors given the risks involved in investing in unlisted securities and/or unregulated funds.
The FCA admits that its 'present conduct of business rules were not designed with crowdfunding business models in mind'. It is recognised that a level of regulation does exist but it is not of a sufficient suitability for this type of model.
The FCA does not currently regulate loan-based crowdfunding. Loans are outside the scope of the FCA's regulated investments and therefore, at present, the operator of such platforms does not require authorisation to conduct its services.
This therefore exempts operators from the FCA's conduct of business rules and a number of further restrictions on the manner in which they operate their businesses--the way in which they approach and deal with investors is therefore unregulated that presents potential risk exposures for investors.
Operations geared towards private individuals and small businesses are regulated to an extent. Given that they are arranging and often administering credit arrangements with individuals, these services may be regulated consumer credit activities and therefore require a licence from the OFT.
However the protections for individuals available under CCA 1974 may not apply to arrangements made through a platform on the basis that the investors are not providing such loans by way of business and therefore the loan is 'non-commercial'. Additionally, were a business to seek to use a platform it would also find CCA 1974 excluded for the purposes of its agreement.
What approach is the FCA taking to this new form of investment?
The FCA believes there are inherent risks in both forms of crowdfunding. It has stated that, on the whole, it believes investing through such platforms tends to involve more risks that traditional investments and deposits. To this extent they have particular concerns regarding consumer protection, particularly in relation to retail investors.
The FCA's focus is on ensuring relevant investors receive suitable information about the platform and the risks involved in its encouraged activities. A secondary limb of its approach is to ensure that funds deposited are adequately protected under the client money rules.
However, the FCA is generally open to this new form of investment and is not seeking to restrict its ultimate operations. To this end it is seeking to create specific regimes which are appropriate to it, rather than requiring them to adhere to the inappropriate current rules.
What is the FCA proposing in terms of expanding future regulation?
The key features of the FCA's approach in this area are:
The key features of the FCA approach in this area are:
◦ emphasising the information that operators must provide to investors about the operator itself and the risks involved--the FCA also expects firms to use more balanced and accurate comparisons, noting that comparisons to deposits may not be fair
◦ in certain instances the FCA expect firms to provide information about the specific risks of a particular type of loan
Are the regulators keeping pace with the technology?
The regulators have been slow to respond to the development of these platforms. The FCA openly admits its current regulatory systems do not sit well with these platforms, hence the required change. That the regulation of the activities is split across a number of bodies suggests they did not envisage there being a crossover between their areas of operations in this manner.
This being said, the proposals appear to be geared towards future-proofing the regulation. The regulations repeatedly refer to not only internet-based platforms but also those on any form of 'media'--covering a moving of these platforms onto mobile devices and physical locales.
There is however a slight issue of oversimplification. It does appear as though the FCA is only considering the existing models of crowdfunding--ie bilateral agreements for a specific range of products. It will be interesting to see how they build in flexibility to the rules to allow other sources of financing.
What opportunities does crowdfunding offer when expanding a business?
New, wider pool of investors
Platforms offer a greater number of investors when compared to traditional financing sources. This means greater availability of financing and potentially, in the future, a larger pool.
A greater number of investors means the borrower may have a better opportunity to negotiate more favourable terms.
Less restrictive/formal than most offers to the public
Access to a wider market with fewer requirements for prospectuses etc.
Agreements will be less restrictive
Given the potential diversity of investors it may be the case that there are fewer monitoring requirements/repeating representations
How can lawyers best advise clients looking to utilise such funding?
Lenders need to consider if the interest rates are 'too good to be true'. This investment has higher risks than placing money into a bank account. Therefore, lenders need to recognise that they may lose capital should the borrower and/or platform operator fail. This issue is compounded by the fact that the investor will be outside the scope of the FSCS.
Linked to the above, lenders need to be made aware of the risks in lending to the particular borrowers who are currently using such platforms. In a large number of cases these are borrowers upon whom very limited due diligence, both legal and commercial, will have been conducted. It is also possible they are parties who have been turned down by regular lending sources because of concerns about their business model and the ability to repay.
Interviewed by Lucy Karsten.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor. This piece first appeared on LexisNexis PSL Financial Services http://www.lexisnexis.com/uk/lexispsl/financialservices/home
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