A complex regulatory framework applies to the various different crowdfunding models but this doesn't have to be a problem provided you get it right from the start.
In recent years we have seen an exponential growth in the number of online crowdfunding platforms in the UK as businesses and individuals seek alternative ways of raising funds. There are, however, a number of regulatory and other legal issues to consider when setting up a crowdfunding platform (CFP).
What is crowdfunding?
'Crowdfunding' is a means of raising investment from a large number of investors, particularly small-time or 'lay' investors, via the internet, and often (but by no means always) in return for various incentives. In order to fund a project in this way, a suitable online platform is needed to connect the fundraiser with multiple investors.
What are the main types of CFPs?
There are currently four main types of crowdfunding structures in the market:
Donation-based crowdfunding e.g. You Caring
This structure is best for social benevolent enterprises with investors pledging money without expecting anything in return.
Reward-based CFPs tend to be used for social enterprises. Usually, an investor pledges an investment in return for an (often nominal) reward, such as a copy of a book which is published using the funds raised.
Loan-based or Peer-to-Peer (P2P) lending e.g. Buzzbnk
The precise structure of P2P platforms depends on how finances are repaid. Two of the most common models are based on revenue participation and revenue interest. In the former, the investor receives a percentage of sales for a given time period from the fundraiser but does not expect the loan's repayment. In the latter, the investor receives a fixed interest payment for a given period from the fundraiser and at the end of the loan term the loan is repaid in full.
This structure is thought to present one of the biggest crowdfunding opportunities. For example, in 2012, according to a blog published on Nesta, while less than £10m was raised in the UK from reward-based crowdfunding, £180m was raised from P2P lending.
Equity-based crowdfunding e.g. Crowdcube
This is most commonly used for start-ups looking for significant investment to support a growth strategy, with investors being offered a share in the fundraising entity in return for capital investment.
In addition to the legal and regulatory considerations, each of these crowdfunding models has different accounting and tax implications which need to be considered carefully (but which are not dealt with in this article).
Tip 1: Consider whether the financial regulations apply
All CFPs should be aware of the Crowdfunding Association (UKCFA), which is the self- regulatory body made up of leading crowdfunding businesses whose aim is to provide greater clarity and consumer protection for the whole industry. It has released a Code of Conduct which is aimed at protecting the growing number of investors and fundraisers using CFPs.
The key external regulatory body for CFPs is the Financial Conduct Authority (FCA). While most CFPs (whether donation or reward-based) do not need to be FCA regulated, loan and investment-based CFPs generally do. The collapse of Bubble & Balm in July 2013, one of the first companies to raise money via Crowdcube, supports the basis for the FCA's concern: namely the potential for CFPs to offer high risk asset classes to a far reaching 'crowd' of would-be investors and, thereby, undermining the FCA's objective of protecting consumers of financial services.
The two key issues for any CFP to determine in respect of financial services regulations are:
- whether the CFP requires authorisation; and
- whether the financial promotion regime applies.
1. Does the CFP require authorisation?
Any person or entity carrying on regulated activities within the UK needs authorisation from the FCA (and in some cases, the Prudential Regulation Authority). Making arrangements for another person to buy or sell shares (i.e. equity-based crowdfunding) or operating an electronic system in relation to lending (i.e. P2P crowdfunding) are both regulated. Donation and reward-based platforms are usually outside the scope of authorisation, although issues can arise depending on how payments are processed (see Payment Processing section below) or if any reward offered starts to look like a return on investment (for example, a profit share from a successful creative enterprise).
Importantly, it is a criminal offence for a CFP to act without the required authorisation, punishable by a prison term of up to two years, unlimited fines and potentially a liability to compensate for investor losses. Key individuals involved in running the CFP may also be held personally accountable. Even if it comes to nothing, dealing with a regulatory investigation is hugely draining on time, which can have a material impact on a small business and, of course, this is in addition to the reputational damage to the CFP.
Unless an exemption is available, an FCA licence is usually a pre-requisite for equity-based CFPs. The process for obtaining authorisation can be time consuming and costly. The FCA has a six month statutory period to review a 'completed' application but firms should not underestimate the resources necessary to prepare an application and business model that would stand up to FCA scrutiny.
Once regulated, firms are subject to the FCA's rules (e.g. maintaining regulatory capital, registering key individuals as 'approved persons', safeguarding client assets and conduct of business (relevant to areas such as marketing, complaint handling and general operations).
Critically for CFPs, there are particular rules that reign in the 'crowd' of investors that platforms reach out to. New rules, introduced earlier in 2014, are permissive and allow CFPs to deal with retail investors that have certified that in the previous twelve months they have not, and in the following twelve months will not, invest more than 10% of their net assets in unlisted securities. Crucially, the new rules require equity-based CFPs to assess whether the retail investor has the necessary experience and knowledge in order to understand the risks for making an investment of that nature.
Loan-based / P2P CFPs
An FCA licence is required for operating a platform that connects individuals or small partnerships to lend to other individuals or small partnerships, as well as carrying on related activities. Depending on the perspective, the platform provider, therefore, sits between aninvestment (by the lender) on the one hand, and a credit loan (to the borrower) on the other. To reflect this duality, the FCA imposes both investment and consumer credit related responsibilities on loan-based CFPs.
On the 'investment' side, the FCA generally considers loan-based funding less risky for investors than equity investments in start-ups so the regulatory requirements are not quite so onerous (for example, the crowd of investors is not limited and there are no obligations to assess appropriateness). However, requirements do include: (i) maintaining a certain amount of regulatory capital (at least 0.2% of the first £50m of loaned funds, with decreasing percentages thereafter); (ii) providing clear and comprehensive risk warnings to potential investors; (iii) safeguarding investor funds in accordance with FCA client money rules; and (iv) having a resolution plan in place in case the platform fails (often, the requirement for a third party to take over).
In respect of the borrower, platforms are subject to many of the same or equivalent FCA rules that apply to consumer credit lenders or brokers. These obligations include the provision of pre-contract explanations to borrowers, assessing borrower creditworthiness and dealing fairly with borrowers in arrears (including an obligation to notify borrowers of arrears or default sums due).
2. Does the financial promotion regime apply?
Companies seeking investment via CFPs often upload pitches online, giving the background to their business and/or project, and this this may be classed as a financial promotion (that is, an invitation or inducement to engage in investment activity, such as subscribing for shares). If caught by this definition, the company must either fall within an exemption (including communication to certain sophisticated investors or high net worth individuals), or have the content of its promotion approved by an authorised person. Often it will be the authorised CFP signing off on the promotion.
If the CFP is authorised, it will be able to communicate or approve financial promotions on its platform and via other media. However, strict FCA rules govern the content of these promotions to ensure they are clear, fair and not misleading (indeed, the FCA has recently targeted CFPs to ensure compliance). This means that the benefits of investing must be fairly represented along with the risks, and the content should be appropriate for the expected recipient of the promotion. This can be particularly challenging for social media channels that are typically limited by available characters (such as Twitter), but recent FCA guidance reaffirms that the regulatory requirements are media neutral. CFPs should also be careful that any promotion does not stray into investment advice (see FCA GC 14/6 for examples of good practice).
CFPs should be aware of other issues regarding a public offer of shares. Firstly, Part VI of Financial Services Market Act 2000, makes it unlawful to offer shares to the public unless an FCA approved prospectus is available. Exemptions may apply, notably if the total consideration for the shares offered is less than €5 million.
Secondly, UK private companies are prohibited, under section 755 of the Companies Act 2006, from offering shares to the public. It is likely that most start-ups will be private companies rather than plcs and so investment-based CFPs will need to consider whether there are suitable structures for mitigating the risk (for example, so that offers can be considered to be made to specific investors rather than the public). This remains an uncomfortable and complex issue for crowdfunders.
Tip 2: Think carefully about how payments will be processed
Another key consideration for a CFP is how to process payments made by the investors / donors. The Payment Services Regulations 2009 (PSR), set out a number of 'payment services' that require a firm to be FCA authorised. A common issue is where investments / donations come through a CFP's own bank accounts as this could be deemed to be a money remittance service under the PSR. There are exemptions, including where a platform acts as a commercial agent for either payer or payee to conclude or negotiate the sale or purchase of goods or services. However, this is not a comfortable fit given that CFPs are rarely involved in the sale or purchase of actual 'goods or services'.
This is a complex area and due to the effect of the PSR, CFP operators often opt to use third party online processing providers (like WePay, PayPal and Stripe) to process payments on their behalf.
Tip 3: Mitigate risk through CFP terms and conditions
All CFPs will need terms and conditions (T&C) governing the use of their platform. Depending on the CFP model adopted, the T&C should clarify what the CFP is and is not liable for. The CFP operator's position on liability (for example for problems with particular transactions on the site) will depend on the CFP's model and the operator's appetite for risk.
If the CFP is consumer-facing, the operator will need to comply with consumer protection legislation. CFPs authorised by the FCA should also be aware of the standards expected under its Treating Customers Fairly requirements. The FCA's website contains a lot of useful information on this area.
Particularly important T&C to consider include: disclaiming responsibility for the availability and financial suitability of the fundraiser to ensure the CFP is not significantly financially exposed to any ensuing claims; terms specifying the laws and jurisdiction which govern the agreement and where users of the platform must be resident / operate; and any prohibited locations from which users may not use the platform.
To enhance the CFP's ability to rely on the T&C and help ensure they are enforceable, rather than merely providing a link to the T&C on its website, CFP operators should ensure that users accept the terms and conditions by taking an active step (for example, by clicking "I accept").
Tip 4: Consider the data protection law requirements
CFPs processing personal data have statutory obligations relating to the collection, use, storage and sharing of that data. In order to comply with the Data Protection Act 1998 (DPA) and other legislation, CFPs will need to (among other things):
- register with the Information Commissioner's Office (ICO). A CFP processing personal data will almost certainly be a "data controller" under the DPA, in which case it will need to register with ICO. Failure to do so is a criminal offence;
- establish and maintain a robust privacy and cookies policy, and make sure that the policy is easily accessible via the CFP;
- if any third party processes data on the CFP's behalf (as the "data processor"), enter into an agreement to ensure that the third party is contractually obliged to process the data in accordance with the statutory requirements;
- ensure that no personal data is transferred outside the EEA unless certain pre-conditions are satisfied. This rule applies to personal data held on servers outside the EEA, so care must be taken when selecting any cloud providers or other data processors;
- put in place adequate security measures to mitigate the risk of users' data being accidentally or deliberately compromised; and
Tip 5: Think about getting local advice
If the CFP is specifically targeting another jurisdiction (or if use of the platform is permitted in specific locations), it may be advisable to take specific local regulatory advice. Whether local advice is needed, however, will depend on a number of factors such as the type of crowdfunding model; the relevant jurisdiction(s) in which the CFP is permitted to be used; whether the CFP will be carrying out any marketing / promotions in the jurisdiction(s); and whether the CFP operator has an active presence in the jurisdiction(s).
While the various regulatory regimes which may apply to CFPs can seem overwhelming, particularly for start-ups on tight budgets, potential pitfalls can be avoided by taking advice during the early stages of set-up. The increasing prevalence of CFPs shows that the challenges are far from insurmountable.