Crowdfunding platforms—the FCA's approach and intentions

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:

 

  • those that allow businesses to raise money by arranging the sale of unlisted equity or debt securities, or units in an unregulated collective investment scheme, and
  • those that arrange loans from the pool of investors to other individuals or businesses

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:

 

  • one that relates to the investor making their funds available on the platform
  • one that arranges the eventual investment (in whatever form it takes) in the funded entity

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?

 

Investment-based

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.

 

Loan-based

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?

 

Investment-based

The key features of the FCA's approach in this area are:

 

  • emphasising to platform operators that the (new) rules on unregulated collective investment schemes apply to their operations and therefore there are restrictions on who they may be promoted to
  • imposing marketing restrictions upon offers for unlisted debt securities or shares--this is to prevent them being offered to 'pure' retail clients without advice, as the FCA believes it is these individuals who are most at risk (note they will not be prohibited from accepting such investments)
  • where no advice is to be given to retail clients, the FCA will require the operators to communicate only direct offers after ensuring the rules on appropriateness have been complied with--they will need to ensure the client has the requisite level of knowledge and/or experience to understand the risks of the investment

 

Loan-based

The key features of the FCA approach in this area are:

 

  • the creation of a new regulated activity specifically related to loan-based crowdfunding platforms--firms will therefore require the appropriate permissions and, where controlled functions are being performed, individuals will need to be authorised (this will therefore bring these operations within the scope of the Financial Services and Markets Act 2000 and therefore require operators to comply with the FCA rules)
  • that the FCA will treat investments through such platforms as they would any other designated investment, therefore requiring operators to look at two sourcebooks, one for investors and the other for lenders--this widens protection for both sides of the operations
  • excluding the platform operations from the Financial Services Compensation Scheme (FSCS)--this is on the basis that an investor is unlikely to have a relevant claim against the operator and ultimately there are likely to be greater protections available under other sources
  • setting resource requirements on operators (likely to be at a minimum to begin with and a long lead in time)--the requirement will either be a fixed minimum or a percentage of volume measure so the requirements have a floor but also grow with the increase in business
  • that money placed on the platform but not yet lent, and repayments not yet distributed, will be considered client money and therefore will be subject to the appropriate rules
  • considering cancellation rights on both sides (where no secondary market functionality exists within the platform, investors should have 14 days to withdraw from the platform)--this presents issues where the investor has already committed to a loan, therefore operators are entitled to put in place systems to prevent this
  • increased disclosure rules:

               

◦            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

  • imposing disputes resolution procedural requirements and ensuring access to the Financial Ombudsman Service
  • imposing reporting requirements

 

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.

 

Flexibility

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?

 

For lenders

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.

 

For borrowers

 

  • consider the borrower risks--the CCA may not give borrowers much protection should the lending relationship deteriorate
  • consider the commercial aspects--while the platforms may provide a borrower with greater flexibility, and possibly availability of funds, this is at a cost of increased interest rates, meaning it is not the cheapest source of funding
  • consider the investor base--investors are likely to be less restrictive but they are also less likely to offer guidance and/or be involved in the business
  • appreciate that marketing the investment opportunity will require internal due diligence

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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