UK: Crowded House

Last Updated: 16 February 2015
Article by Rosali Pretorius

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.

IOSCO published a staff paper describing the phenomenon and experience across jurisdictions in February 2014. 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 models

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.

Loan-based platforms

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.

Investment-based crowdfunding

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.

Investor risks

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:

i.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

ii.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.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions