As the Financial Conduct Authority (FCA) continues to place crowdfunding under the microscope, directors and officers need to be aware of the risks that they, and their insurers, may face in this developing field.
What is crowdfunding?
Crowdfunding, otherwise known as peer-to-peer lending, is the way in which individuals and businesses can raise capital from the public. This is an evolving marketplace but generally the borrower explains their project and seeks funding from as many retail investors as possible. Crowdfunding can provide lucrative returns. It is also consistent with the government's aim to achieve more diverse and accessible financing for individuals and small and medium sized enterprises (SMEs), as well as more rigorous competition in retail banking services.
The FCA estimates that the amount of money invested on crowdfunding platforms rose to £2.7bn last year, up from £500m in 2013.
Earlier this year, the FCA stated that it would be reviewing this sector as it regarded investment-based crowdfunding as a high-risk investment activity. The FCA published that it is "very likely" that an investor will lose all their money when investing in a start-up business due to the high failure rate.
The Treasury Select Committee (TSC) has written to the FCA expressing concerns about accurate information being given to investors when crowdfunding capital is being raised. The TSC emphasised the need to strike a balance between protecting consumers, who may have a false sense of security about the risks and rewards of investing in peer-to-peer lending, while not stifling the development of competition in the area. The FCA has confirmed that investors who lose money will not have access to the Financial Services Compensation Scheme.
The FCA is also seeking to monitor changes in the market following borrower protection rules which came into force in October 2014.
New exposures for directors and their insurers?
Directors and officers involved in crowdfunding need to be aware of the need for adequate disclosures to investors prior to seeking external investment. This activity is clearly under the spotlight of the various regulators. The risk is that inexperienced investors may seek to pursue claims against directors and officers if they sustain losses or achieve poor investment performance. These claims could become widespread in circumstances where the FCA has signalled that crowdfunding is a high risk investment activity.
Many D&O insurance policies have exclusions for investment losses as a result of any guarantee or warranty provided by the insured. However, the scope of cover and nature of losses will vary and these types of exclusions will need to be considered over the coming months as the crowdfunding market continues to grow. Directors and officers will need to be vigilant to ensure that adequate due diligence is undertaken and that investors are fully apprised of the risk factors and have been given appropriate advice.
Equally, in a competitive marketplace, insurers may see the growth in crowdfunding as an opportunity to target firms that participate in such activities.
We anticipate that the complexities and risk exposures in this market will continue to increase and we shall be monitoring developments closely as this market develops.