Summary
Crowdfunding, the term used to describe the increasingly popular method of financing, or re-financing individuals, firms, charities or activities by bringing together a number of contributors, is to be more closely regulated by the UK Financial Conduct Authority (the FCA), pursuant to a suite of new rules expected in Q1 2014.
What is crowdfunding?
Crowdfunding, and the electronic platforms which facilitate it, have attracted a lot of media attention in the wake of the financial crisis, and are now taking their turn under the regulatory spotlight. Crowdfunding is appealing both to small and medium sized enterprises (SME) struggling to secure funding on favourable terms, and investors seeking to maximise return in a prolonged period of low interest rates. Many investments in SMEs have tax advantages by virtue of the Enterprise Investment Scheme and the Seed Enterprise Investment Scheme, as well as offering the possibility of high returns.
Crowdfunding is used for a variety of purposes, from gathering funding for an arts project to a viable alternative to traditional venture capital. Crowdfunding platforms are an electronic environment, facilitated by a website, through which individuals or firms can contribute varying amounts of capital alongside numerous other investors into a particular business or activity. Different platforms offer different opportunities for investors; some offer a range of charitable projects for which donations are sought through a crowdfund, whilst others might offer equity or debt securities issued by small micro-enterprises, in return for funding.
It is this latter platform activity which is attracting increasing attention from financial regulators, in the UK and overseas. Financial investment through crowdfunding platforms is considered to carry a number of risks for investors. As a new and interesting medium for investment, which can carry particular tax benefits, regulators are concerned to ensure that the increasing number of investors and recipients of finance, are afforded proper protection.
The FCA recently consulted on amendments to its Handbook which more closely target the activities of crowdfunding platforms. The new rules for crowdfunding platforms regulate financial promotions by such firms, ensure failure-planning for the platform, and give specific guidance in relation to resourcing, so as to ensure that both investors and borrowers are adequately protected. These new rules complement the transfer of responsibility for consumer credit regulation from the OFT to the FCA on 1 April 2014, which will introduce a new regulated activity of ‘operating an electronic system in relation to lending’, designed to cover certain crowdfunding platforms.
As alluded to above, ‘crowdfunding’ can mean a number of activities. Commentators have tended to discuss the different forms of crowdfunding, by reference to the outcome for investors. These categories include:
- ‘Charitable crowdfunding’, where individuals or firms donate a sum to a project, for instance, but do not expect or anticipate any return;
- ‘Reward crowdfunding’, where the funded individual, firm or project supplies a defined benefit in return for the contributed funds, which is worth less than the funds themselves;
- ‘Loan-based crowdfunding’, where borrowers seeking funds are matched with lenders who provide funding by way of a loan or loans. Loan-based crowdfunding platforms are more commonly known as ‘peer-to-peer lending platforms’, since the function of these electronic platforms is to match potential borrowers with potential lenders; and
- ‘Investment-based crowdfunding’, where investors provide funds in return for unlisted equity or debt securities.
Loan-based crowdfunding and investment-based crowdfunding have emerged as potent sources of funding for start-up and early-stage businesses. In this capacity, crowdfunding is increasingly seen by policy-makers and economists as a beneficial economic driver, delivering much-needed funding to SMEs during the UK recession, which can help to stimulate economic growth. Hence, as the popularity of crowdfunding increases, fuelled by governmental encouragement, the FCA is keen to ensure that those who take part in such activities, as investors, lenders or borrowers are properly protected.
Both loan-based crowdfunding and investment-based crowdfunding are likely to involve an individual, either as investor pursuant to a loan-based crowdfunding solution or an investment-based crowdfunding solution or as borrower.
OFT and FCA Regulation
Not all crowdfunding platforms will be subject to financial services regulation. Platforms which arrange crowdfunding for a social, non-financial benefit, such as charitable donations-based crowdfunding or rewards crowdfunding (where the investor receives an item in return for investment, usually related to the crowdfunded enterprise) will be unregulated. There are no ‘specified investments’ offered in return for the ‘investment’ on such platforms, and the ‘investment’ cannot be considered a loan, since there are no repayment obligations.
Peer-to-peer platforms are not currently subject to FCA-regulation, though they are subject to OFT licensing where their activities encompass certain debt administration activities. However, since peer-to-peer lending platforms do not offer credit themselves, they are not subject to substantive regulation by the OFT for their primary functions.
The new regulated activity of ‘operating an electronic system in relation to lending’ (A.36H, Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (as amended) (RAO)) is intended to cover the actual function of peer-to-peer lending platforms and will encompass the platform’s arrangements with both consumer lenders and borrowers. This new activity is effective from 1 April 2014, and will bring peer-to-peer platforms, or ‘loan-based crowdfunding platforms’ under the umbrella of FCA regulation.
Those firms who operate peer-to-peer platforms, and who were previously either entirely unregulated or regulated by the OFT for an ancillary function, should ensure that they are fully prepared for FCA regulation from 1 April 2014. Although FCA regulation of peer-to-peer platforms will be lighter than for investment-based platforms (see below), there remain a number of important obligations which may require significant adjustments to the firm’s business model.
The financial activities of investment-based crowdfunding platforms are already covered by FSMA, and subject to FCA regulation. Crowdfunding platforms are likely to be considered as carrying on several regulated activities including arranging deals in investments (A.25(1), RAO) as well as the ‘placing’ activities more usually associated with stockbroking firms, e.g. making arrangements with a view to transactions in investments (A.25(2), RAO). Depending on the function of the platform, it may be that it is also considered by the FCA to be a multilateral trading facility, which carries additional regulatory obligations.
However, there are currently no specific rules within the FCA Handbook which are aimed at regulating the activity of investment-based crowdfunding platforms. The FCA therefore consulted on new proposals for the regulation of loan-based and investment-based crowdfunding platforms during December 2013, in CP 13/13. The consultation closed on 19 December 2013. The FCA is now considering the responses to the proposed new rules before publishing a policy statement which is expected in February or March 2014.
Risks involved with crowdfunding for financial gain
Investing in unlisted securities carries specific risks, which relate to the nature of these investments, e.g. illiquidity. Where the return for the investment is an issue of equity securities, additional issues such as subsequent dilution of holding and lack of dividends may exist. Further, unlike deposits, investments made on a crowdfunding platform are not protected by the Financial Services Compensation Scheme.
Crowdfunding platforms which are used to generate investment in start-up or early-stage businesses, necessarily present additional risks. Start-up businesses do not have a proven track record, a trading history or a revenue pattern with which to assess the value of the investment offered in return for funding. Additional risks such as fraud and money-laundering have also been identified as relevant concerns.
The FCA has taken the approach of dividing ‘loan-based crowdfunding platforms’ from ‘investment-based crowdfunding platforms’, to generate its conduct rules and guidance. Loan-based crowdfunding is seen to be of lower risk than investment-based crowdfunding. Loan-based crowdfunding will be subject to lighter-touch regulation based around adequate disclosures to consumers. In assessing the risks of crowdfunding platforms, the FCA has highlighted that the accessibility and novelty of investment-based platforms may particularly appeal to younger consumers, who might not possess the necessary financial expertise to fully assess the risks involved.
The FCA anticipates that most investors on crowdfunding platforms will transact without taking advice and that information provided by the platform is the main way that investors assess the investment.
New FCA Rules for ‘loan-based crowdfunding platforms’
The FCA has consulted on a number of specific rules for loan-based crowdfunding platforms which will complement existing rules in the FCA Handbook. For example, loan-based platforms will be subject to prudential requirements. The prudential resources which the platform will be required to hold will be the higher of £20,000 or an amount calculated by reference to the volume of funds loaned on the platform. From 1 April 2017, the fixed minimum amount which firms will be required to hold in prudential resources will rise to £50,000 as the FCA’s transitional provisions for peer-to-peer platforms expire.
Peer-to-peer platforms will hold client money when a lender submits capital via the platform to be invested into a crowdfunded business. These platforms will therefore be required to comply with client money rules, when acting in such a capacity. One aim of the client money rules is to ensure that administration of loans continues in the event of a platform failure. Since crowdfunding investors often contribute small amounts to a business whose identity is unknown to them, there is some evidence that borrowers deliberately default on loans, in the event of platform failure, since it is uneconomic for investors to chase repayment.
Firms who carry on the new regulated activity of ‘operating an electronic system in relation to lending’, from 1 April 2014, will be required to comply with several elements of the FCA Handbook, including (where relevant) the new Consumer Credit sourcebook (CONC). The FCA has already surveyed the peer-to-peer lending market, and found that several platforms may be in breach of the disclosure requirements for communications. Principle 7 of the Principles for Businesses requires that communications with clients be ‘clear, fair and not misleading’. The FCA has already drawn attention to issues such as comparisons of loan-based investments, with deposits. The FCA’s conduct of business rules will also be applicable, since such comparisons are unlikely to be considered ‘like-for-like’ and ‘may be problematic’.
The thrust of the FCA’s regulation of loan-based crowdfunding platforms is to ensure adequate disclosure to consumers, which, in particular, highlights the risks of investment on the platform. However, since the business model of loan-based crowdfunding platforms can vary significantly, the FCA does not intend to be prescriptive about the precise information to be provided; preferring to leave this to the firm’s judgment as to compliance with the high-level rules regarding communications with clients.
Firms who operate a peer-to-peer lending platform from 1 April 2014, will also be required to comply with several other FCA conduct of business rules, including customer reporting requirements.
New FCA Rules for ‘investment-based crowdfunding platforms’
The FCA is in the process of revising its approach to the regulation of investment-based crowdfunding platforms. This revision ‘aims to make investment-based crowdfunding more accessible to a wider, but restricted, audience of consumers’. Crowdfunding already falls within the scope of FCA regulation where it involves a person carrying on a regulated activity, such as arranging deals in investments, in the UK. The FCA’s current approach is to place specific restrictions on firms at the authorisation stage. this ‘case-by-case’ approach is no longer considered viable.
The FCA’s recent consultation therefore included proposed rules for firms operating investment-based crowdfunding platforms.
Importantly, the proposed rules will apply to any firm which promotes and sells unlisted securities, not just to electronic crowdfunding platforms.
The FCA is concerned to ensure that, at a high-level, only suitable retail consumers, who understand the risk involved, invest in unlisted securities through an investment-based crowdfunding platform.
Currently, most investment-based crowdfunding platforms are subject to restrictions in respect of clients to whom it may promote investments on the platform. Going forward, the FCA has proposed that all investment-based crowdfunding platforms which target retail consumers, will be subject to investor restrictions. The FCA proposes that such platforms should only communicate to self-certified sophisticated investors, certified high net worth individuals and those clients who confirm, before a financial promotion is made, that they will either: receive regulated investment advice or investment management services from an authorised person; or certify that they will not invest more than 10% of their net investible portfolio in unlisted securities.
The FCA does not, however, intend to extend these proposals to corporate finance business or to venture capital business when the platform communicates with corporate finance contacts or venture capital contacts; on the condition that in providing the platform to such contacts, the firm does not provide another regulated activity such as arranging deals in specific investments.
Where the platform does not offer advice to clients, the FCA proposes that the platform must ensure that the rules on appropriateness are complied with, for any direct offer financial promotion.
The international context
The European Commission has recently conducted a public consultation which aims to determine the best approach to encourage increased access to, and encourage the growth of, crowdfunding as a viable means of alternative finance across Europe. The consultation was open until 20 December 2013, and the Commission is now considering responses.
Meanwhile, in the United States, the Securities and Exchange Commission has indicated that it will review the current regulatory exemptions for certain crowdfunding platforms, as their popularity increases.
