Post-financial crisis, many small businesses, unable to get bank financing in the wake of the tightening of bank capital rules, turned to crowdfunding. At that time, crowdfunding was largely unregulated. In the last three years or so, several regulators implemented rules to regulate the rapidly expanding crowdfunding market.
In February 2014, IOSCO published a staff paper describing the phenomenon and experience across jurisdictions. In October 2013 the EU Commission (Commission) released a paper highlighting the fundamental characteristics and risks of crowdfunding and exploring the added value of potential EU action on this area. Following this, in December 2014 ESMA issued an opinion and advice to the Commission on the need for investment-based crowdfunding to be regulated at EU level. In the US, the Securities and Exchange Commission (SEC) is set to release its final rules on crowdfunding in the JOBS Act 2012 in October 2015. In the UK, the regulatory perimeter has already been widened beyond "investment-based crowdfunding" to loan-based crowdfunding. On 1 April 2014, FCA assumed responsibility for loan-based crowdfunding from the OFT.
In this article, Rosali Pretorius and Christina Pope look at the UK legislation and FCA's rules. They also discuss FCA's February 2015 Review of the regulatory regime for crowdfunding and the promotion of non-readily realisable securities by other media (the Review). They begin by outlining the various crowdfunding models and the risks they present and then turn to FCA's rules.
Crowdfunding commonly includes custom-built online platforms as well as more informal initiatives seeking support through social media. The business or individual seeking funding typically sets out its plans and the funds it needs to raise, and interested investors can usually invest anything from a very small to a very large amount. Often, investors will get their money back if the fund-seeker fails to reach its target, but in some models this is not guaranteed. Depending on the model, investors can receive shares or debt interests in the business or project they contribute to, or enter into formal loan agreements. Other models are not based on loans, shares or debt, but instead give investors rewards in the form of goods or services, such as advertising, or use of facilities. Each model has different risks, and regulation impacts on different models in different ways.
FCA distinguishes between regulated and unregulated crowdfunding models: it does not regulate crowdfunding that is donation-based or based on pre-payment or rewards. It does regulate loan-based and investment-based crowdfunding platforms. Under the Financial Services and Markets Act 2000 (FSMA), investment-based crowdfunding involves at least the regulated activity of arranging deals in specified investments. This is an activity that has required authorisation for many years.
Providing loan-based platforms is now also an FCA-regulated activity (operating an electronic system in relation to lending). Loan-based crowdfunding, expanded to include peer-to-business lending, has driven most of the recent fundamental changes to FCA rules and the scope of FSMA regulation. FCA assumed responsibility for this, coinciding with the transfer of consumer credit regulation from the OFT to FCA, in April 2014.
Existing platforms that facilitate peer-to-peer lending to individuals should already have been licensed under the OFT's debt administration licence category and should have applied for FCA authorisation from April 2014, meaning they would currently hold an interim permission.
FCA already regulated investment-based crowdfunding, but has changed its approach to make the market more accessible. However, this change, it seems, may have more wide-ranging consequences.
Revision of the approach to investment-based crowdfunding
Platforms that facilitate the subscription of units in unregulated collective investment schemes (UCIS) or in "non-readily realisable securities" (the term given by FCA for illiquid securities and debentures, which are not readily realisable securities, packaged products or non-mainstream pooled investments) were already subject to FCA authorisation. FCA already applied restrictions on the category of investor to whom firms could promote this type of investment but wanted to make this market more accessible to retail clients. From 1 October 2014, firms can make direct-offer financial promotions, by whatever media including the use of websites, of non-readily realisable securities to retail clients who:
- are certified as sophisticated or certified as high net worth investors, or are self-certified sophisticated investors; or
- are certified as restricted investors, declaring that they will not invest more than 10 per cent of their portfolio in unlisted securities; or
- will be receiving advice from the platform, or confirm they will receive advice from another authorised person; or
- are corporate finance or venture capital contacts.
The promotion of UCIS remains subject to the same restrictions that apply from 1 January 2014.
Where the retail client is not receiving advice, and is not a corporate finance or a venture capital contact, the appropriateness test applies. This requires the platform to gather information about a client's investment knowledge and warn the client when the investment is not appropriate to his or her profile. Shares not admitted to trading on a regulated market, including those unlisted, are already considered a complex financial instrument under COBS 10, in respect of which non-advised sale attracts appropriateness requirements. But debt securities, except where they embed a derivative, are considered a non-complex financial instrument whose execution-only sale has so far been exempted from the appropriateness test.
Investors may be attracted by platforms that highlight possible higher returns than investors might achieve on more traditional investments. The danger is that many start-up businesses fail, and investors may not appreciate that the risks of losing their money are often greater than the desired high returns. That said, FCA recognises that, for certain experienced and sophisticated investors, investment in crowdfunding initiatives could make up part of a diversified portfolio.
The main risk when investing in crowdfunding is clearly that there is no guarantee investors will receive any return on their fund and they may lose all of their money. Even where a start-up business succeeds, it will take significant time to become sufficiently profitable for its funders to benefit. Crowdfunding, therefore, is not a suitable short-term investment, and investors should not expect to be able to trade or otherwise get back their investment before term.
In its consultation paper preceding implementation of the new rules, FCA identified three sources of failure and investor harm in the crowdfunding market that regulation is designed to address:
- Mispricing: The first and most crucial is the mispricing of credit and investment risk. This mispricing, or underestimation, of risk is driven by information asymmetries, behavioural biases or lack of an effective secondary market. Shortage of information and due diligence on the borrower can also lead to opportunities for fraud.
- Platform default: FCA flagged the possibility of crowdfunding platform default, a risk compounded by a platform's need to expand quickly to cover operating costs.
- Misleading promotions: FCA also carried out a review of 21 loan-based crowdfunding platforms, and found their website promotions did not present information in a clear, balanced and straightforward manner. In particular, it found instances of downplaying of important information and misleading comparisons of crowdfunding with deposits and saving. Promotion was a key focus in the Review, and it is clear that FCA is still not satisfied with the way in which crowdfunding is promoted, especially given that it is mainly aimed at retail investors.
Not just crowdfunding
The new rules regulate crowdfunding and the promotion of non-readily realisable securities by other media. There is now a restriction on the promotion of non-readily realisable securities and an expansion of the appropriateness test to the arranging of investments in unlisted debt securities. This affects execution-only channels offered by retail banks or investment services firms, as well as the largely frowned upon and often already illegal activity of penny share promoters and boiler rooms.
In its introduction to its policy statement, FCA specifically notes it will also be relevant to:
- any firm that uses offline media to communicate direct offer financial promotions for non-readily realisable securities to retail clients, where those clients do not receive regulated advice or investment management services for those investments, and are not corporate finance or venture capital contacts; and
- firms that approve these promotions.
FCA's initial review
Less than a year on from the implementation of these rules, FCA has published the Review. The Review focuses on how the rules are working in practice. It found that, in 2014, business loan-based crowdfunding overtook loan-based crowdfunding for consumers for the first time. Investment-based crowdfunding in 2014 is likely to be three times the amount raised in 2013, with equity-based crowdfunding increasing by over 200 per cent.
It reported that 50 loan-based crowdfunding platforms applied for interim permission. FCA has fully authorised one to date and is reviewing a further eight applications. Three firms with interim permission have left the market meaning, as at the end of 2014, there were 56 active firms in this market. There has also been an increase in firms carrying on investment-based crowdfunding. 14 are fully authorised, with 10 applications under way, and FCA has identified 11 appointed representatives that conduct regulated activities in relation to investment-based crowdfunding.
FCA has engaged with the markets, looking at governance, management information and controls and the websites of the firms. It has intervened in several financial promotions of investment-based crowdfunding firms, but has found good levels of compliance in loan-based crowdfunding firms, especially on anti-money laundering and know your customer checks. FCA's website review showed some websites lacked balance between prominence of benefits and risks, and cherry-picked information or downplayed important information. FCA looked particularly at "mini-bonds", which are becoming increasingly popular, and found a number of misleading promotions for these products. It also looked at use of social media and plans to publish guidance on how the financial promotion rules interplay with use of these media. Finally, FCA gives guidance to co-operative and community benefit societies in how they should promote their withdrawable shares on crowdfunding platforms.
FCA concludes that there is no need to revise the regulatory approach at this stage and is planning to carry out a full post-implementation review in 2016. Firms would be well advised to study the Review carefully, as, it provides firms with a much better idea of exactly what standard FCA expects.
Where next for crowdfunding?
FCA clearly has its priorities now in relation to crowdfunding. We may, however, see further movement following ESMA's recently published opinion and advice to EU authorities and national supervisors. The documents demonstrate that different regulators treat elements of crowdfunding in different manners. They set out those pieces of EU legislation that may apply (and highlight how Member States may use exemptions from that legislation) and suggest a framework for EU-wide consistency in regulatory approach.
It is clear that crowdfunding is continuing to gain popularity in previously untapped jurisdictions and consumer awareness of its existence is increasing fast. Regulators are aware of this and are trying to take a proactive approach to dealing with the risks it presents in a proportionate way. FCA has stated that it believes most crowdfunding should be targeted at sophisticated investors who know how to value start-up businesses, and who understand the risks involved and that they could lose all of their money. It wants to apply two-pronged protection within the platforms and players it can regulate so investors are clear they have little or no protection if the crowdfund fails, and stand to lose their whole contribution. It also wants to be sure those who carry on regulated activities have the right permissions – in particular it wants firms to check that if they are handling client money they have the right permissions to do so. Whether this will make crowdfunding in regulated forms more popular or less remains to be seen, but what is clear is the increase in global regulatory interest.