Summary and implications
On 6 March 2014, the Financial Conduct Authority (FCA) published Policy Statement 14/4 (Policy Statement) outlining the FCA’s final rules on the regulation of crowdfunding. We previously highlighted that this Policy Statement had been published and summarised the new rules on the Nabarro website. This article now provides further detail relating to the new rules in this area.
In October last year, the FCA published Consultation Paper 13/3 (Consultation Paper) which outlined the FCA’s proposals to regulate loan-based and investment-based crowdfunding. Having received 98 responses to the Consultation Paper, the FCA has published the recent Policy Statement confirming how it now proposes to regulate the crowdfunding industry.
The new rules apply predominantly to firms that operate, or plan to operate:
peer-to-peer lending platforms or peer-to-business lending platforms (on which consumers are able to lend money to individuals or businesses) (loan-based crowdfunding); or
- investment-based platforms (on which consumers purchase shares or debt securities in new or established business, generally structured as UK private limited companies) (investment-based crowdfunding).
Overall, the FCA’s proposals stated in the Consultation Paper related to protecting retail investors who, in the FCA’s view, lack the knowledge, experience and resources to cope with possible significant losses, whilst promoting effective competition in the interests of consumers. While one respondent to the Consultation Paper suggested the FCA should not develop a national approach to crowdfunding and should instead wait for Europe to legislate, the FCA has implemented the majority of the proposed rules as set out in the Consultation Paper. The new rules on crowdfunding have, for the most part, been welcomed and can be seen as a proactive step by the FCA to ensure a new and exciting industry is adequately regulated to protect consumer interests.
Currently, firms operating investment-based crowdfunding platforms are regulated by the FCA, if in doing so they carry on a regulated activity (without falling within an exemption). For example, such firms would need to be FCA-authorised if they are arranging deals in relation to shares or units in a collective investment scheme. In relation to loan-based crowdfunding, from April 2014 there will be a new regulated activity relating to the operation of a loan-based crowdfunding platform and the FCA Policy Statement outlines the regulation of firms that carry on this activity.
In the Consultation Paper, the FCA outlined its proposals to adopt a lighter-touch approach for loan-based crowdfunding platforms (compared with investment-based crowdfunding platforms). This is based on the FCA’s observation that, in general, loan-based crowdfunding activities appear to be of lower risk than investment-based activities. The FCA has confirmed in the Policy Statement that it continues to believe this is the correct approach and will implement the new rules on this basis.
One respondent to the Consultation Paper also suggested setting a threshold of, say, £250, and anyone investing below this threshold could do so without being subject to the new FCA rules. In this respect, the FCA responded by commenting that it does not “consider it appropriate to apply lower standards, or fewer consumer protections, if a consumer has less money to invest”.
The new rules that apply to loan-based crowdfunding regulation
The FCA has generally confirmed its approach to the regulation of loan-based crowdfunding platforms as set out in the Consultation Paper. These are summarised in the following table and we have explained some of those requirements in further detail below.
|Loan-based crowdfunding proposals|
Application of core FCA provisions including conduct of business rules (in particular, around disclosure and promotions).
Minimum capital requirements
Client money protection to minimise the risk of loss due to fraud, misuse, poor record-keeping and to provide for the return of client money in the event of the FCA‑authorised firm failing.
Requirement for firms to take reasonable steps to ensure continued administration of existing loans in the event of the firm failing
Dispute resolution rules
Reporting requirements for firms to send information to the FCA in relation to their financial position, client money holdings, complaints and loans they have arranged.
Restriction of the direct offer financial promotion of unlisted shares or debt securities by firms to certain types of retail client.
Appropriateness test, where no advice is provided to the investor, to ensure that only clients who understand the risks can invest.
Cancellation rights under the Distance Marketing Directive (DMD)
Our briefing relating to the crowdfunding Consultation Paper outlines how the DMD already applies to firms providing loan-based crowdfunding and the associated requirements (including the information that should be disclosed). However, in relation to the timing of cancellation rights, the FCA understands that it is not feasible to allow each investor the opportunity to withdraw from a particular loan agreement after agreeing to fund it. It therefore outlined two proposals in the Consultation Paper, but confirmed in the Policy Statement that the right to cancel will only attach to the investor’s decision to register with the platform, rather than when entering into a specific loan.
The FCA has confirmed that it will impose a minimum capital requirement based on the higher of a fixed capital requirement and a variable volume-based requirement. The volume-based requirement is calculated as a percentage of the total value of funds that have been provided to borrowers through the loan-based crowdfunding platform as at the firm’s accounting reference date.
However, the FCA confirmed in the Policy Statement that the calculation of the variable-based requirement will be different to the proposals set out in the Consultation Paper. In short, the FCA has reduced the percentage relating to loaned funds up to £50m (from three per cent to two per cent) and added another tier to the overall calculation (the £50m to £500m tier has been separated into a £50m to £200m tier and a £200m to £500m tier). Therefore, capital requirements for firms providing loan-based crowdfunding will now be the higher of £20,000 (rising to £50,000 from 1 April) and the volume-based requirement, which is calculated as follows:
|Volume-based financial resources calculation|
|0 to £50m||0.2%|
|>£50m to £250m||0.15%|
|>£250m to £500m||0.1%|
The relevant firm also has an obligation to notify the FCA if the total value of loaned funds outstanding increases by more than 25 per cent since its last volume based financial resources calculation (being the firm’s last accounting reference date).
Loan-based crowdfunding platforms will be subject to the client money rules contained in the Client Assets Sourcebook as they generally hold client money before it is lent to borrowers. The client money rules will apply from the earlier of:
(a) the firm’s full FCA authorisation; or
(b) 30 September 2014 should the firm continue at this date to hold an “interim permission” following the transfer of the consumer credit regime from the Office of Fair Trading to the FCA.
The FCA received a number of responses relating to the position of client money upon the insolvency of a firm operating a loan-based platform. In this respect, the FCA confirmed that any client money will be pooled and returned pro rata to the relevant investors and that this will include any loan funds provided by investors but which have not yet been drawn down by the borrower.
Platform or firm failure
If the platform fails then there must be arrangements in place for existing loans to continue to be managed and administered in accordance with the contract terms. The FCA has avoided setting any prescriptive requirements for such arrangements but expects firms to adopt appropriate measures.
In the Consultation Paper, the FCA highlighted that all communications from firms to retail clients must be fair, clear and not misleading. In particular, the FCA highlighted that it seeks to combat insufficient information being provided and a lack of balance, where disclosures emphasise benefits without a prominent indication of risks.
In the Policy Statement, the FCA confirmed that it proposed to implement these disclosure requirements but has not provided any specific disclosures that will need to be made as it appreciates that business models vary across the market. The new rules require firms to consider the nature and risks of the investment, and the information needs of their customers, and then to disclose relevant, accurate information to them.
The platform websites and details of any proposed investment in loans will be considered financial promotions and will therefore need to comply with the financial promotion rules.
Complaints and compensation
Investors have the right to complain first to the firm and then to the Financial Ombudsman Service. However, the FCA has confirmed that loan-based crowdfunding platforms will not fall within the remit of the Financial Services Compensation Scheme. The FCA believes that other protections introduced by the new rules should provide adequate protection at this time.
Loan-based crowdfunding platforms will be subject to regularly reporting information to the FCA. This will include prudential data, the firm’s accounts, client money position, investor complaints experience and information on loans arranged over the previous quarter.
The requirements will generally apply to all firms from 1 October 2014, although prudential and financial reporting will apply once a firm is fully FCA authorised (if earlier than this date).
Definition of “non-readily realisable security”
The FCA originally envisaged the new investment-based crowdfunding rules to apply to firms that promoted “unlisted shares” or “unlisted debt securities”. Following responses received by the FCA to the Consultation Paper, the FCA accepted that such a definition did not adequately describe the “hard to price, illiquid securities” that they meant to describe. The FCA has therefore adopted a new definition of “non-readily realisable security” with the aim of ensuring that equity or debt securities of small and medium enterprises which are difficult to price and for which there is a limited secondary market fall within the scope of the new FCA rules.
In relation to shares of companies that are traded on a platform, the FCA has clarified its position by stating that only securities admitted (or about to be admitted) to an official listing, recognised investment exchange or designated investment exchange are considered to fall outside the scope of a “non-readily realisable security”. Therefore, in the short to medium term, securities traded on the secondary exchange of a platform will still fall within the definition of a non-readily realisable security regardless of the liquidity of those securities on the relevant platform.
Direct-offer financial promotions
The FCA has confirmed the approach to direct-offer financial promotions previously set out in the Consultation Paper. In summary, a firm must not communicate or approve a direct-offer financial promotion relating to a non-readily realisable security to a retail client unless, in summary, that retail client falls within one of the following categories:
Certified as a “high net worth investor” – with an annual income in excess of £100,000 or net assets of £250,000 (excluding primary residence, any benefits in the form of pensions or otherwise and any rights under certain contracts of insurance).
Certified or self-certified as a “sophisticated investor” – assessed by an FCA-authorised firm as sufficiently knowledgeable to understand the risks associated with engaging in investment activity or self-certifying where the individual falls within one of the categories set out in the FCA rules.
Certified as a “restricted investor” – an individual who has not invested more than 10 per cent of their net assets in non-readily realisable security (net assets for these purposes does not include any primary residence, any benefits in the form of pensions or otherwise and any rights under certain contracts of insurance).
Where the FCA-authorised firm concerned will comply with the “suitability” requirements in the FCA rules or, alternatively, the customer has confirmed before the communication is made that another FCA-authorised firm will comply with the suitability requirements.
The customer is classified as “corporate finance contact” or a “venture capital contact” under the FCA rules.
The investment-based crowdfunding industry has generally reacted unfavourably to the restriction on marketing to retail investors. However, it is worth noting that it is possible for a retail client to initially be classified as a “restricted investor” and, once they have made more than one investment in an unlisted company (including through the platform) they could self-certify themselves as a “sophisticated investor” and fall within this category relating to any future direct-offer financial promotions.
Where the suitability rules do not apply (and the recipient is not classified as a corporate finance contact or a venture capital contact), the FCA has confirmed that firms will be required to comply with the rules on appropriateness before they arrange, or deal in, the investment concerned.
The new rules come in to force on 1 April 2014, with transitional arrangements for certain requirements (such as in relation to capital). In relation to loan-based crowdfunding, firms with interim permission following the transfer of the consumer credit regime from the Office of Fair Trading to the FCA also have a transitional period and must comply with the new rules from 30 September 2014 or the date they become fully FCA-authorised.
Firms that currently operate either loan-based or equity-based crowdfunding platforms will need to review their business models to ensure they are able to comply with the new rules. For example, firms will need to ensure that the marketing and disclosure requirements are complied with when an investment is listed on the relevant crowdfunding platform.