This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.
Summary and Implications
On 3 February 2015, the Financial Conduct Authority (FCA) published a report on its review of the implementation of the regulatory regime for crowdfunding and the promotion of non-readily realisable securities by other media (the Report). This article highlights the information set out in the Report, which includes recent developments in the UK crowdfunding industry, the FCA’s supervisory approach, website/financial promotion reviews, and social media.
Background
In October 2013, the FCA published Consultation Paper 13/3 (the 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 published Policy Statement 14/4 confirming how it proposed to regulate the crowdfunding industry, with the relevant rules entering into force on 1 April 2014. The 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).
We previously analysed the scope and application of the FCA’s rules relating to crowdfunding in a briefing that is available by clicking here. Having now regulated the crowdfunding industry for 10 months, in the Report the FCA has provided comments relating to the regulation of both loan-based crowdfunding and investment-based crowdfunding. Overall, the FCA has reiterated that the rules were implemented to protect investors and to ensure that consumers had access to clear information which allowed them to assess the risks, as well as providing them with the core consumer protections.
Summary of the new rules that apply to loan-based crowdfunding regulation
On 1 April 2014, the regulation of consumer credit transferred from the Office of Fair Trading (OFT) to the FCA. A new regulated activity also came into force, being operating an electronic system in relation to lending. Firms that previously had the necessary licence from the OFT were able to apply for "interim permission" so that they could continue to carry on this regulated activity, while being required to apply for full FCA authorisation during a three-month period between which would be allocated to them between 1 August 2015 and 1 November 2015.
The regulation of loan-based crowdfunding platforms is summarised in the table below.
| Loan-based crowdfunding |
| 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. |
Investment-based crowdfunding
The regulated activities that relate to investment-based crowdfunding were previously regulated by the FCA. However, on 1 April 2014 the FCA introduced new rules that applied to the distribution of "non-readily realisable securities", generally being shares or debt securities in new or established businesses that are not listed on regulated stock markets and carry significant risks. In addition, new consumer protection rules for the sale of such securities were introduced, in particular in relation to their marketing. 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 in the table below.
| Investment-based crowdfunding – categories of permitted retail clients |
| 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% 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. |
Changes to the market
The FCA’s report included a number of statistics and other information which it obtained from data derived from the Nesta and University of Cambridge 2014 report on the crowdfunding sector (the Nesta Report). We have summarised some of these statistics and other information below.
| Loan-based crowdfunding | Investment-based crowdfunding |
| Business loans accounted for a greater proportion of the market than consumer loans (£749m and £547, respectively). | The amount raised on investment-based crowdfunding platforms is expected to be £84m, which is three times the amount raised in 2014 (£28m). |
| Over 100,000 loans were arranged on consumer-lending platforms, with the average loan amount borrowed by personal customers being £5,471. | The average equity amount raised is £199,095, with the average debt securities amount raised being £730,000. |
| The average loan amount borrowed by business customers was £73,222. | 95% of all funded deals were eligible for Enterprise Investment Scheme (EIS) and Seed EIS relief. |
| The average rejection rate for borrowers across all platforms is as high as 90%. | 62% of investors described themselves as retail investors with no previous experience of early stage or venture capital investment. |
| The average default rate for consumer-lending and business-lending is less than 1% (although some business-lending platforms have default rates that were significantly higher). | The average investor's portfolio size is £5,414, with one-third having invested less than £1,000. |
Authorisation
In relation to loan-based crowdfunding, as stated above firms that previously had the necessary licence from the OFT were able to apply for interim permission so that they could continue to carry on the regulated activity of operating an electronic system in relation to lending. The FCA said in the Report that 50 firms applied for interim permission, with a further six firms in this sector, or seeking to enter it, by the end of 2014.
In relation to investment-based crowdfunding, the FCA stated in the Report that there are currently 14 firms authorised to conduct regulated activities in relation to investment-based crowdfunding. There are a further 11 firms carrying on these regulated activities as appointed representatives of FCA-authorised firms. With a further 10 firms currently applying to the FCA for authorisation for investment-based crowdfunding activities, this brings the total number of firms in this market, or seeking to enter it, to 35 firms.
The FCA also gave some guidance in relation to what it expects to see in applications for the authorisation of crowdfunding businesses. With reference to the threshold conditions, applicants should:
- submit a suitable and detailed regulatory business plan;
- have adequate non-financial and financial resources;
- have an operational or close to operational website; and
- understand the requirements for FCA authorisation and the permission profile – i.e. apply for the regulated activities that are necessary for their business model.
Supervision
The FCA outlined its approach to supervising crowdfunding platforms during 2014. For investment-based crowdfunding platforms this included engaging with senior management, monitoring websites and reviewing monthly management information. As a result, the FCA has made a number of interventions, mainly to ensure the proper protection of consumers (for example, ensuring only that appropriate investors could invest and that financial promotions are clear, fair and not misleading). Some firms also failed to satisfy their expected regulatory capital requirements.
For loan-based crowdfunding platforms, this same approach was taken along with additional supervisory visits to assess the governance and controls of five market participants and to understand the risks that the sector poses to the FCA's statutory objectives. Overall, the FCA was happy with what it observed including in relation to credit risk, anti-money laundering and "know your customer" checks.
Website and financial promotion reviews
During 2014 the FCA has proactively monitored financial promotions relating to the crowdfunding industry. Between April and October 2015, the FCA reviewed 25 websites (both loan-based crowdfunding and equity-based crowdfunding) to ensure compliance with the financial promotion rules.
In relation to investment-based crowdfunding platforms, the FCA identified a number of issues in relation to financial promotions on websites and through social media. The most common issues included:
- that the financial promotions lacked balance and benefits were emphasised without a prominent indication of the risks involved;
- insufficient, omitted or cherry-picking of information, leading to a potentially misleading or unrealistically optimistic impression of the investment; and
- downplaying important information (for example, risk warnings being diminished by claims that no capital had been lost or the relevant risk warnings being less prominent than performance information.
In relation to loan-based crowdfunding, the FCA identified similar issues but also highlighted that:
- promotions comparing crowdfunding investing to savings accounts and other banking accounts gave the impression that lending through loan-based crowdfunding was secure;
- insufficient information being provided relating to the taxation position;
- an omission or lack of prominence of the representative annual percentage rate; and
- promotions giving prominence to the benefits without also providing an indication of the risks.
Having conducted this review, the FCA contacted all relevant firms to inform them of the findings. The FCA said that all firms co-operated, were keen to comply and made the required changes "with immediate effect".
In August 2014, the FCA published a consultation on its supervisory approach to financial promotions in social media. In the Report, the FCA highlighted that this consultation is likely to be of interest to crowdfunding platform providers and its final guidance on this subject is expected to be published in the first quarter of 2015.
The FCA specifically mentioned in the Report the position of so-called "mini-bonds", which are bonds issued by small businesses through crowdfunding platforms. The FCA said these firms are, for example, failing to adequately explain the risks involved with mini-bonds, are not mentioning that mini-bonds are not covered by the Financial Services Compensation Scheme and making comparisons with other products with important differences (such as retail bonds).
The FCA also mentioned in the Report the position of firms registered under the Co-operative and Community Benefit Societies Act 2014 (CBS Act). Such firms may market interests through crowdfunding platforms and, when they do so, must ensure they continue to comply with the CBS Act.
Global growth
The FCA also highlighted in the Report that the International Organisation of Securities Commissions (IOSCO) published a staff working paper on crowdfunding and reported that the global market for investment-based and loan-based crowdfunding has doubled year-on-year in recent years. IOSCO’s report found that UK investment and loan-based crowdfunding platforms are amongst the top major platforms in the world, along with USA and China. The FCA believes that of those jurisdictions where crowdfunding takes place and is also regulated, the UK provides a favourable regulatory framework.
The FCA is also involved in discussions with the European Banking Authority and the European Securities and Markets Authority in relation to the regulation of crowdfunding at a European level.
Future of crowdfunding regulation
The FCA confirmed in the Report that, while the crowdfunding industry has grown rapidly, it does not see any need to change its current regulatory approach to crowdfunding platforms. However, the FCA will continue to monitor the crowdfunding industry and take appropriate action where necessary.
The FCA plans to carry out a post-implementation review of the crowdfunding market and regulatory framework in 2016. The FCA also mentioned in the Report that there may be changes to the regulatory framework relating to crowdfunding as a result of further work taking place at European level.
Social Media cookies collect information about you sharing information from our website via social media tools, or analytics to understand your browsing between social media tools or our Social Media campaigns and our own websites. We do this to optimise the mix of channels to provide you with our content. Details concerning the tools in use are in our privacy policy.