Financial Services Regulation

Crowdfunding - UK regulatory implications

The Financial Conduct Authority (FCA) is responsible for regulating certain forms of crowdfunding platforms in the UK.

The term crowdfunding is commonly used to describe a method of obtaining finance for a particular initiative from a large pool of financial backers using online portals (crowdfunding platforms). There are different forms of crowdfunding and both loan-based and investment-based crowdfunding are regulated. Other forms of crowdfunding such as rewards-based or donations-based crowdfunding are not regulated.

Loan based crowdfunding involves investors lending for financial returns on their loan in the form of interest. This is also referred to as peer-to-peer (p2p) lending, which allows the lending of money while bypassing traditional banks.
Investment–based crowdfunding involves equity investors either receiving an equity stake in an enterprise for their investment, such as shares in a company or it may also involve investment in a fund that invests as a nominated agent.  With success the value of the investment should increase but if not, the value could also go down.

The size of the crowdfunding market in the UK is steadily increasing. For example, loan-based crowdfunding platforms in 2014 are calculated by Nesta and the University of Cambridge (Nesta 2014) to be almost £1.3 billion. The sector was almost three times larger in 2014 than in 2013 (when it raised around £480 million). The amount raised on investment- based crowdfunding platforms in 2014 in the UK is expected to be £84 million. This is also three times the amount raised in 2013 at £28 million.  

From a regulatory perspective there are various issues that require consideration. Crowdfunding activities can involve the undertaking of regulated activities under section 19 of the Financial Services and Markets Act 2000 (FSMA) and also the issuing of financial promotions which can potentially contravene section 21 of FSMA. Crowdfunding that contains any public offers of securities can require, amongst other things, the provision of a prospectus or investment memorandum to investors that are invited to subscribe in such securities. Crowdfunding platforms will also need to consider whether their activity constitutes a collective investment scheme under section 235 (1) FSMA or an Alternative Investment Fund (AIF) under the Alternative Investment Fund Managers Directive (AIFMD).

Crowdfunding platforms will therefore need to consider obtaining FCA authorisation for their business. FCA authorisation of crowdfunding platforms provides investors with certain benefits, such as the use of the Financial Ombudsman Service in the event of complaints or for compensation claims the applicability of the Financial Services Compensation Scheme, although the Compensation Scheme will not apply to loan based platforms. However, obtaining authorisation can be a long and cumbersome process for crowdfunding platforms with on-going regulatory obligations once authorisation has been achieved.

There are differences in some of the applicable regulations applying to investment-based and loan- based crowdfunding platforms.

Investment based platforms

The operation of investment-based crowdfunding platforms will require authorisation from the FCA if regulated activities set out in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) are being engaged in without an appropriate exemption under the legislation being applicable. This would cover for example, firms arranging deals in relation to shares or units in a collective investment scheme.

Within the area of financial promotions, the FCA has provided a new definition for securities it wishes to regulate within investment-based crowdfunding. These are defined as “non-readily realisable securities” and they cover debt or equity securities of small and medium enterprises which are hard to price or are illiquid as well as unlisted shares and or debt securities. The FCA has clarified that when considering shares of companies traded on a platform only those securities admitted (or about to be admitted) to an official listing, recognised investment exchange or designated investment exchange would not be included within the definition of a non-readily realisable security.

From a financial promotion perspective there is a specific restriction on direct offer financial promotions where there is no secondary market for the underlying asset. This means that a communication or promotion of a non-realisable security to a retail client must comply with the following: the communication or promotion must be to either a certified high net worth investor, certified or self certified sophisticated investor, a certified restricted investor, or in circumstances where the firm itself will comply with the FCA suitability requirements in relation to the investment promoted or it is confirmed by the customer before the communication is made that another FCA authorised firm will comply with the suitability requirements, the customer is a corporate finance or venture capital contact under FCA rules, they are retail clients who certify that they will invest no more than 10% of their net investible portfolio in unlisted equity or debt securities.    

Loan based platforms

A new regulated activity relating to the operation of loan based crowdfunding platforms covering both peer-to-peer (P2P) lending and peer-to business (P2B) lending was introduced. This new regulated activity (effective as from 1st April 2014) is the operating of an electronic system in relation to lending (article 36H RAO). With the introduction of this regulated activity the scope of FCA regulation on crowdfunding has greatly increased.

The FCA handbook has introduced new rules covering loan-based crowdfunding to protect investors lending via such platforms from the non repayment of their capital and interest. These include the application of conduct of business rules, minimum capital requirements, client money protection, the requirement for appropriate measures to be undertaken to allow the continued administration of loans if the firm fails, dispute resolution rules, reporting requirements.

The financial promotions regime will apply to communications made ensuring that these are fair, clear and not misleading. 

FCA Authorisation

The FCA has set out a list of threshold conditions (or minimum criteria) that it expects to be fulfilled by applicants that are applying for authorisation to undertake regulated crowdfunding businesses.   These conditions include the following:

  • Provide a suitable business plan detailing the regulatory business plan setting out the planned activities (and related risks), budget and resources (human, systems and capital);
  • Demonstrate adequate non-financial resources (i.e. the management board has adequate knowledge and experience of financial regulation);
  • Demonstrate adequate financial resources when submitting their application (i.e. not looking at future fundraising to reach that requirement);
  • Have a website that is either up-and-running or at a suitably advanced stage (including a test site or app, or screen shots of a planned website or app, that would demonstrate the user interface and functionality available to users) to demonstrate how it will operate should the firm be authorised;
  • Understand the requirements for FCA authorisation and the permission profile for which they wish to apply, then submit a complete application (including an outline of which regulated activities the firm plans to conduct).

Conclusion

There have been significant changes made in the regulation of crowdfunding in the UK. These additional regulations have been introduced in recognition of the increased importance of the crowdfunding market which has been growing rapidly. The FCA has undertaken a review of the regulatory regime for crowdfunding (February 2015) and acknowledged the growth in the market but concluded that the current regime on regulation was considered adequate for the time being. The FCA has indicated that a further full review of the crowdfunding market and regulatory framework is to be undertaken in 2016. 

Companies that intend to apply for authorisation to undertake regulated crowdfunding activities and those that are authorised will need to ensure that they are fully aware of the requirements from a legal, financial and organisational perspective and ensure that they are up to date on the regulatory issues concerning their business.

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