Scope of this note

This section splits into two - essentially the different features of the two types: loan based vesus investment based funding.

Loan-based crowdfunding

Through loan-based crowdfunding, people and businesses lend money to individuals or businesses and hope to get their profit return through interest and capital repayment. This also covers peer-to-peer (P2P or P2B) lending. The FCA does not regulate business-to-business (B2B) loans but it is hard to see a firm progress without a licence from FCA, put simply, people expect it.

Investment-based crowdfunding

This is also known as equity-based crowdfunding. Through investment-based crowdfunding, people invest in shares in the businesses. This could be redeemable preference shares, which are quasi debt, or any other share based instrument, including debt convertible into shares on default, and for either existing or new firms. Investment Based Crowdfunding is a lot smaller than the loan-based crowdfunding sector, and also sadly considerably more complex.

The two types are very distinct markets subject to very different regulation.

Loan-based crowdfunding

Loan-based crowdfunding is actually just a class of consumer credit activity. This is a platform or online marketplace that simply acts as a matchmaker for lenders and borrowers.

What type of Consumer Credit activity is it? Under article 36H of the RAO, loan-based crowdfunding is referred to as the regulated activity of "operating an electronic system in relation to lending". The rules focus on making clear information available. Obviously some core standards are also applied around client money and system minimum standards. But the actual permission is just that. In addition Credit broking, Debt administration and Debt-collecting is normally attached, because most platforms end up doing one of those activities, or risk doing so even if only on behalf of a lender.

The FCA rules are in the Consumer Credit sourcebook (CONC) for P2P lending. The individual borrowing via the credit agreement will almost certainly find it a regulated credit agreement - even if the borrrowing is for a business activity from a non regulated lender! If the lender or borrower is doing this as a business, then they will (obviously) need to be authorised and regulated themselves as well. Similarly if the borrower is in business of borrowing (like a bank would be) then they too need a licence (see the next section)

If the lending is not in the course of business and just an "occasional punt", the agreement may still be regulated as stated above, but only as a "non-commercial agreement" for the FCA. The lender in this case will not need FCA authorisation for lending, even if the agreement itself is regulated! The FCA spotted this strange loophole and the possibility that it could be exploited by P2P, and as a result there are special rules in CONC specifically for this, that apply to the P2P platforms.

The platform or P2P lender firm must, under the FCA rules:

1. Provide a pre-contract explanation of the proposed credit agreement, including key risks to the borrower (CONC 4.3).
2. Assess the borrower's creditworthiness (CONC 5.5).
3. Comply with TCF rules relating to arrears, default and recovery (CONC 7.17-7.19).
4. Provide the 14-day right of withdrawal from the agreement (CONC 11.2).
5. Make sure that promotions of P2P agreements must be fair, clear and not misleading etc as per CONC 3.7A.

None of this is difficult and probably are what most businesses are trying to achieve anyway.

It has come to light that a lot of P2P is actually between the platforms themselves. So in February 2017, the FCA published a "Dear CEO" letter explaining that if a lending business borrows through a platform and then lends that money to others, it is probably acting as a bank or deposit making institution. That is a serious thing, with criminal penalties etc. They followed this up with a request for confirmation from firms in this market to explain that what they were doing was not banking.

At time of writing it remains to be seen how many firms fell on the wrong side of the law on that one and what action the FCA may take.

Investment-based crowdfunding

Investment-based crowdfunding platforms are also matchmakers. Only in this case they match investors in unlisted shares of businesses. The FCA determine the unlisted shares as "non-readily realisable securities" to companies seeking to sell their shares. These shares are not listed on regulated stock markets - which of course themselves act as P2P platforms, and so must be treated with great care by all involved.

Investment-based crowdfunding involves at least three parties.

1. The project owner seeking the finance.
2. The platform that acts as intermediary,
3. The investor who represents the "crowd" in "crowdfunding".

And the focus falls squarely on the intermediary platform.

Sometimes these platforms chunk a group of investments to help the crowdfunders choose between the offerings. This is a Collective Investment Scheme (unregulated), otherwise known as a Non Mainstream Pooled Investment - a word that strikes fear into the heart of nearly every IFA and out of bounds entirely to retail customers who may want advice on it.

Arranging the transactions has always been regulated, and this is something the platforms manifestly do undertake. Unsurprisingly given the potential for scams in this area, the FCA regards investment-based crowdfunding as a high-risk activity. CrowdCube, Seedrs and Syndicate Room are all examples of investment-based crowdfunding firms.

FCA regulating the crowdfunding market:

In March 2015, the FCA published finalised guidance (FG15/4) relating to its supervisory approach to financial promotions in social media. In December 2016, the FCA published a feedback statement (FS16/13) setting out interim feedback explained below. In summary, the FCA believes it needs to adjust and amend its own rules. The review was due by the Summer of 2017, but is now due, as of October 2017 "in due course".

These are the key issues that the FCA were and are looking at, which means you need to take particular care in these areas when presenting plans to the FCA to get a licence, or preparing for a visit after you have got the licence, or just in general.

FCA views on investment-based crowdfunding

Since April 2014, with regard to retail clients, firms may only make direct offer financial promotions of non-readily realisable securities, NMPI or unlisted securities if it is done via an IFA or equivalent. By and large the IFAs will not give regulated advice in this area. Due to the UCIS scandals of 2003 to 2012, this restricts investment to HNW or High Net Worth investors, as defined. The definitions are complicated, and the correct burden of proof of categorisation is also devilishly complicated.

The FCA's rules also require firms to check whether retail clients understand the risks if they do not take regulated advice and once again this area is fraught with complications. (COBS 4.7.7R(3)). The FCA expects P2Pfirms to be able to assess this as part of the online registration process with a crowdfunding website. Additional COBS requirements for firms concern the communication of the offers, the fairness, language and clarity of description used to describe these offers, and the awareness of the risk associated with them.

If a firm carries on a regulated crowdfunding activity, it must obtain FCA authorisation to avoid breaching the general prohibition in section 19 of FSMA. This means they need to apply with business plans, template website available for inspection and show that the individuals are fit and proper.

The firm needs to apply for:

• Operating an electronic system in relation to lending
• Credit broking
• Debt administration
• Debt-collecting, and
• Entering into regulated credit agreements as lender.
• Arranging deals in investments and (sometimes) providing advice.
• Managing investments
• Safeguarding and administering assets.

The capital adequacy rises from "solvent" under items 1-5 to £20k under 6, €50k under 7 and €100k under 8.

If have digested any of the above you will realise by now that this is a serious application that requires advice - which is precisely why IFAC have written this paper for you!

Risks of crowdfunding-lending

• Regulatory arbitrage - ie a back door route to pure banking and investment management business.
• There appears to be an increased pooling of credit risk for investors - possibly as investors / lenders club together in un-regulated groupings.
• Maturity mismatch products being offered on platforms. Borrowers take the money on the usual terms of, say, ten years, but investors are lending with far shorter terms...so it is back door banking with identical risks: lend long + borrow short = liquidity risk.
• The FCA is concerned with wind down plans not being sufficient.
• Retail and institutional investors are getting different deals - risk of conflicts of interest, including the cross investment between platforms issue, as loans are parcelled between platforms- which could give rise to contamination risk
• Loan-based crowdfunding platforms can offer regulated mortgage contracts apparently without applying MCOBS.
• Poor Standards of disclosure. FCA cite misleading comparisons and investor lender misunderstandings.

Risks of crowdfunding - investment

• It is difficult to compare platforms. The assets are products are complex offerings.
• It is difficult to gauge the risks investing via a platform.
• Financial promotions do not seem very "clear, fair and not misleading."
• Firms have very complex structures of ownership and management.
• There appear to be a lot of conflicts of interest - not least with inter platform growth.

Future is bright

Following FS16/13 FCA intends to change the rules to address the above problems - "in due course."

The EU, however, has taken a remarkably sanguine approach to crowdfunding and has stated that the current market is small, local and is rapidly changing, and therefore requires no "policy intervention".

IFAC handle applications for crowdfunding platforms.

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