UK: FCA Imposes New Regulation On Crowdfunding

Last Updated: 27 May 2014
Article by Tristan Mutimer

INTRODUCTION

The Financial Conduct Authority ('FCA') published a Consultation Paper in October 2013 regarding its proposed regulatory approach to crowdfunding over the internet and the promotion of what the FCA calls "non-readily realisable securities" (i.e. an unlisted share or debt security with no, or a very limited, secondary market). The comments to the Consultation Paper have been received and, following the FCA's review of these comments, the FCA has now published the final rules on how it intends to regulate crowdfunding in Policy Paper PS14/4.

Crowdfunding generally falls within one of the following four main categories:

  • Donation or charitable crowdfunding; people donate money to charitable organisations. There is no expectation of financial return.
  • Loan-based crowdfunding; people lend money to organisations with the expectation that they will receive back the sums lent plus interest.
  • Pre-payment or rewards-based crowdfunding; people give money on the expectation that they will receive a reward, service or good in return. For instance, those who pre-purchase a book to help fund the publication of that book might be rewarded with a signed copy of the book. Those who donate money or purchase a quantity of books could, for instance, be rewarded by being given an evening with the author.
  • Investment-based crowdfunding; people invest in a business by buying shares, debt securities or units in an unregulated collective investment scheme.

The new rules affect loan-based and investment-based crowdfunding.

WHY THE NEW RULES?

Crowdfunding has brought investment opportunities and the related risks to the masses. Prior to the advent of crowdfunding, it was much more difficult to invest in or loan money to an unlisted company. The rise of crowdfunding is expected to continue and, as crowdfunding grows, the FCA is seeking to protect retail investors by redressing some of the risks involved.

The risks perceived by the FCA include:

  • The lack of understanding by the investor of the potential risks involved in investing. The FCA is concerned that investors do not realise how high the risk is when investing in early stage companies. The FCA is also concerned that investors may not, for instance, fully appreciate that there may be no secondary market in the investment and that their funds may be tied up for a long period.
  • The conflicts of interest. The FCA is concerned that the risks involved in investing might be understated by the investment or lending platform which wishes to encourage investment.
  • The potential abuse of the platform for fraud and money laundering.
  • The potential for platform failure and poor management.
  • Whether proper checks are being carried out on the borrowers and target companies.
  • The platform operators inadvertently giving unauthorised advice.

The FCA has sought to give consumers more protection by addressing some of the above risks whilst also ensuring that the new rules do not exclude investors or stunt the growth of crowdfunding.

WHAT TYPES OF CROWDFUNDING ARE NOW FCA REGULATED

The FCA does not regulate either charitable crowdfunding or rewards-based crowdfunding. As there is no financial return expected when investing in such schemes FCA regulation is considered unnecessary.

Investment-based crowdfunding was largely already regulated by the FCA as the investment activity generally amounts to a regulated activity, such as: arranging deals in a specified investment or agreeing to carry on a regulated activity. The new rules do not seek to amend these regulations and it is likely that companies operating such platforms will be required to be authorised by the FCA.

The main change in the FCA's regulatory powers is that the FCA's scope will now include "lending platforms".

THE CHANGES TO REGULATION

Loan-based crowdfunding

Previously, loan-based crowdfunding was unregulated by the FCA and came under the remit of the Office of Fair Trading ('OFT'), as the OFT regulated the provision of consumer credit. From 1 April 2014, the FCA assumed the OFT's responsibility for the consumer credit market.

The new rules have created a new regulated activity of "operating an electronic system in relation to lending". This means that where a firm uses an electronic system to operate a loan-based crowdfunding platform, in practice it is likely that it will need to be authorised by the FCA.

However, the FCA has been less stringent in its regulation of loan-based crowdfunding than it has been with investment-based crowdfunding. This is because the FCA feels that loan-based crowdfunding is less of a risk to lenders than investment-based crowdfunding. There is, therefore, an emphasis on providing lenders with the information they need to make informed decisions, rather than restricting promotion.

As a result of the FCA's Policy Paper the core FCA provisions, including the conduct of business rules, will now apply to the firms which run loan-based crowdfunding platforms. Some of the key changes are as follows:

- Capital requirements & prudential standards

The FCA has imposed a minimum capital requirement on loan-based crowdfunding platforms. The minimum capital amount will be the higher of a fixed minimum requirement and a variable volume-based requirement. The fixed capital requirement minimum is currently £20,000, rising to £50,000 from 1 April 2017.

In terms of the volume-based capital requirement, the minimum required is:

  •  £0 – £50m*: 0.2%
  •  £50m – £250m*: 0.15%
  •  £250m – £500m*: 0.1%
  • £500m+*: 0.05%

* Figures relate to the total outstanding value of funds loaned through the platform.

- Investor finance protection

The FCA has stated that loan-based crowdfunding platforms will now have to comply with certain aspects of the client money rules in relation to monies received from lenders and in respect of receipt of borrowers' repayments and the distribution of these funds to lenders.

- Administration of loans following failure

The loan-based crowdfunding platform must have appropriate arrangements in place for existing loans to continue to be administered following any failure of the platform or firm. The FCA has not, however, specified any exact requirements.

- Dispute resolution

Lenders using loan-based crowdfunding platforms will not fall within the remit of the Financial Services Compensation Scheme. The FCA feels that the mechanisms introduced by the new rules give lenders enough protection. However, loan-based platforms should have adequate complaints procedures in place to allow users first to complain to the firm before complaining to the Financial Ombudsman Service.

- Reporting/Disclosure

There is no set list of information which has to be provided by the loan-based crowdfunding platform to the client. There is a general obligation on the firm to provide information which is fair, clear and not misleading.

The FCA has, in particular, sought to ensure that there is not a general lack of information and to make sure that the information being given to investors is balanced and shows both the potential negative and positive outcomes in making a loan.

  • The types of information which is likely to be required include:
  • Expected and actual default rates.
  • Fair description of likely return.
  • Details of loan risk assessment.
  •  Details of lender protection.
  • Lender exit options.

Loan-based platforms will also be subject to reporting obligations. The firm will have to report information to the FCA including the capital requirements, accounts, client money position, complaints and information on the loans conducted over the previous quarter and any change in the total value of loans outstanding of 25% or more.

Investment-based crowdfunding

The major changes to the rules relating to investment-based crowdfunding are as follows:

- Direct-Offer Financial Promotions

The FCA has confirmed that a firm must not communicate or approve a direct-offer financial promotion relating to a non-readily realisable security unless the retail customer falls within one of the following categories:

  • Certified high-net-worth individual: annual income in excess of £100,000 or net assets (excluding primary place of residence, pensions and rights existing under certain contracts of insurance) in excess of £250,000.
  • Certified/Self-certified sophisticated investor: assessed by an authorised firm as being sufficiently knowledgeable to make accurate and reasoned investment decisions. Certain individuals can self-certify if they fall into one of the prescribed categories; such categories include those who have worked in private equity for the two years leading up to self-certification.
  • Restricted investor: An investor who will not invest more than 10% of their net assets in a non-readily realisable security.
  • Where the FCA-authorised firm will itself comply with the suitability requirements.
  • The investor has confirmed before the promotion that they are a retail client of another firm that will comply with the suitability rules in relation to the investment promoted.
  • The investor is a corporate finance contact or a venture capital contact under the FCA rules.

A useful category under which investors can self certify as sophisticated investors is the category applicable if an investor, in the two years prior to their self certification, has made more than one investment into an unlisted company.

Appropriateness

In addition, where no professional advice has been provided, an investment-based crowdfunding firm will have to consider the appropriateness of the investor and the firm must check that the investor has the knowledge and experience needed to understand the risks involved with investing. The FCA expects that firms will be able to assess the investor as part of an online registration process.

CONCLUSION

The news rules came into force on 1 April 2014 with interim provisions for certain requirements such as those in relation to capital. Those consumers and consumer organisations with an interest in investments which are offered on crowdfunding platforms, and other similar investment schemes, are urged to read the full FCA Policy Statement PS14/4  and to seek advice if they are unsure of any of its provisions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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