Thought leadership from our experts

Crowdfunding – how should new business models be regulated?

Further UK regulatory initiatives should be expected in the crowdfunding sector soon. After completing its analysis of the risks as crowdfunding models develop, the FCA is likely to introduce various new rules – all in the interests of investor protection.


The FCA sought to plug a hole for loan based crowdfunding to solve a regulatory dilemma. Suitable regulation was always available for investment based crowdfunding but the FCA had to introduce something to plug the gap for loan based crowdfunding by virtue of CP 13/13 and PS 14/4.

Even post PS14/4, protections have really not been put in place for loan based crowdfunding1 in the same way as for most authorised businesses – there were moves in the right direction but not all the way. For example:

a) from April 2014 the capital must be at least £50,000, or more for bigger firms, but nonetheless it is still not the same as other established businesses might have; and

b) the FSCS does not apply for peer to peer lenders.

In July 2016, the FCA put out a Call for Input to a Post Implementation Review of the FCA's crowdfunding rules and we now have some of the outcomes of that Review.

The FCA is clearly of the view that aspects of the loan-based crowdfunding market currently pose some risks to their objectives. "We perceive risk of regulatory arbitrage in a loan-based sector and potential for investors to misunderstand the nature of the products offered. Whilst investment-based crowdfunding is facilitated entirely by fully authorised firms, most loan-based crowdfunding firms including the largest ones have so far operated under interim permissions. Where firms operating under interim permissions fail to meet the standards for full authorisation, this presents risks to their existing borrowers and lenders which require careful management."

The FCA's Interim Feedback Statement from December 2016 sets out the FCA's overview of the direction of travel and a Dear CEO letter explains the FCA's expectations of firms operating a loan based crowdfunding platform which facilitates loans to lending businesses of 28 February 2017.

Whilst the focus of the Post Implementation Review of the FCA's crowdfunding rules is on the loan-based crowdfunding sector, the FCA's field of view is wider. And in particular the FCA is looking holistically across the spectrum of alternative offerings and seeing if some crowdfunding offering sites are trying to fit propositions which should better fit within a different area of regulation.

The FCA's Interim Feedback

As a result of the Post-Implementation Review, it is likely that modification of a number of rules will be introduced:

  • for loan-based crowdfunding, specific consultations on strengthening rules on wind down plans; additional requirements or restrictions on cross platform investment; and extending mortgage lending standards to loan-based platforms.
  • more prescriptive requirements on the content and timing of disclosures by both loan based and investment based crowdfunding platforms.

In FS 16/13 the FCA:

- refers to the potential for arbitrage both with banking and investment management arising from loan-based crowdfunding;
- indicates that loan-based crowdfunding should not be described as a savings product, and quite rightly too. The FCA believe detriment is possible where investors regard loan-based crowdfunding as a type of deposit, the risks, particularly to capital, are different.

These factors will likely lead to FCA consultation on additional rules for the disclosures in financial promotions of crowdfunding to investors.

Whilst the FCA's primary focus is on the loan-based market, the FCA has concerns across both loan-based and investment-based sectors and will be proposing new rules for both. The FCA is undertaking further research. If necessary, it intends to publish a consultation on rule changes in 2017 with rules coming into force in 2018.

Scope of Article 36H

In addressing developments in loan based crowdfunding, the first point to note is the precise scope of the Article of the Regulated Activities Order which was invented to deal with it – Article 36H.

Article 36H only covers Article 36H agreements as defined in paragraph 4, and Condition 5 is that the lender is an individual or relevant person and Condition 6 includes that the borrower is an individual or relevant person, and the lender provides the borrower with credit less than or equal to £25,000, or the agreement is not entered into by the borrower wholly or predominantly for the purposes of a business carried on or intended to be carried on by the borrower. "Relevant persons" can include a partnership consisting of two or three persons, not all of them are bodies corporate or an unincorporated body of persons which does not consist entirely of bodies corporate and is not a partnership. So, operating an electronic system in relation to lending which is facilitating loans between lenders and borrowers who are not individuals or certain types of non-corporate business and where the amount borrowed is over £25,000 or the borrowing is for business purposes is not captured by the regulated activity.

Where a borrower on a loan-based crowdfunding platform is an individual, as defined in the Consumer Credit Act – a consumer or sole trader or small partnership (or other unincorporated body) borrowing less than £25,000 for the purposes of the borrower's business, the credit agreement will be a regulated credit agreement unless a specific exemption applies. If the investor (as lender) is lending in the course of a business (which is likely to be the case for institutional investors and possibly some other cases), the agreement is subject to the full requirements of the CCA and the investor will need FCA authorisation and to comply with the rules in the FCA's Consumer Credit Sourcebook (CONC) applicable to lenders. In addition, the peer to peer platform will need authorisation for the activity of operating an electronic system in relation to lending (Article 36H) where, amongst other things, the platform facilitates persons becoming a lender and a borrower under an Article 36H agreement:

  • if the lending is not in the course of business, the agreement may still be a regulated credit agreement but is a "non-commercial agreement" for the purposes of the CCA. In addition, the lender will not need FCA authorisation for lending. For example, the non-commercial lender will not need to comply with the CCA requirements on pre-contract credit information or the form, content and execution of the credit agreement.
  • To address this gap in borrower protection, the FCA introduced new rules in CONC specifically for P2P platforms. Even if lending is non-commercial, the platform will need to make adequate pre-contract explanation of the proposed credit agreement including key risks to the borrower, and to undertake an assessment of the borrower's credit worthiness. It will also need to provide a 14 day right of withdrawal to the borrower similar to that under the CCA, and to comply with the CONC rules and arrears, default and recovery – see paragraph 2 at Call for Input, FCA July 2016.

Scope for arbitrage?

Article 36H should not of itself be regarded as a solution for a new business model. It was only invented to solve a regulatory dilemma because there was a gap in regulation of some platforms which arranged these sorts of activities.

More complicated peer to peer business models are being developed and the risk is that they can increasingly look similar in substance to other more existing types of regulated activities. For these, it is important that the relevant regimes for those existing types of regulated activities should be followed.

As the FCA point out, to do otherwise, they would do so "without being subject to the same regulatory requirements or offering the same consumer protection." If the FCA conclude that there is likely consumer detriment, they will consider introducing additional rules to reduce or remove the potential for that risk for arbitrage.

This risk of arbitrage has been identified both in relation to

  • investment management and investment funds and
  • also in relation to deposit taking/banking.

Do these platforms stray into asset management?

The basic concern here is whether some platforms are operating informal collective investment schemes.

Article 36H was invented for where there are individual persons becoming lenders to borrowers. What some are trying to do though is have some "collection vehicle" in the middle, whether it is the platform itself or some fund in the middle. That changes the nature of it such that Article 36H should probably not, of itself, provide a regulatory solution.

Whenever an arrangement effectively collects monies together from different persons, one inevitably gets into investment fund territory, and then the question is how to look at the investment fund options.

The UK definition of "collective investment scheme" has always been extremely wide-ranging, with exemptions where government decide that a particular arrangement which should not constitute a collective investment scheme, and so should not be caught.

The issue is not a simple one, and it has various component parts:

  • First, is there an (informal) collective investment scheme?

The risk of investment-based crowdfunding platforms in some way offering some form of informal collective investment scheme which could be an unregulated collective investment scheme of itself was always understood.

In January 2016, HM Treasury purposefully amended secondary legislation so that firms carrying on the activity of operating an electronic system in relation to lending (Article 36H) were not regarded as operating collective investment schemes. In the 2015 Explanatory Memorandum for this provision, HM Treasury took the view that the two business models were distinct and should accordingly be regulated under different frameworks: As there was some overlap both in the activities the operators of such systems carried on and in the way in which the two were defined, this might create uncertainty about the framework under which a firm ought to be regulated. The uncertainty was undesirable and therefore a statutory instrument was introduced whereby, if a peer to peer lending platform were also considered to be a collective investment scheme, it would not also be a collective investment scheme. It was thought inappropriate given that the UK had a specific regulatory regime for peer to peer lending platforms under which they were considered to be regulated proportionately, and consumers were provided with appropriate protection to have double regulation.

The issue now is that that view is probably being revisited – and changed.

A characteristic for loan-based crowdfunding is the matching of multiple lenders to a single borrower with many lenders making small (micro) loans to meet a borrower's (macro) borrowing requirement. So those lenders are effectively sharing the risk although there is no pooled vehicle as such in between the lender and borrower – there is a direct lending relationship just for small amounts which make up the total borrowing requirement.

Some platforms though have been developing some sort of provision fund, often by way of the platform directing a small fraction of lenders' investments to the provision fund, so pooling might arise. The FCA indicate that this may mean that some firms are operating loan-based crowdfunding platforms which are also operating collective investment schemes.

Noting the emergence of a broader pooling of credit risk in the FCA's Call for Input, July 2016, there is the prospect of a review of the crowdfunding rules: Pooling is something that the FCA clearly wish to investigate in more detail.

"There are some consumer benefits from this development but the firms operating these platforms are not currently subject to the same requirements as asset managers running regulated pooled investment funds. Where firms' business models are more complex or opaque to investors, [the FCA] may need to raise requirements. [The FCA] will be looking into this further as part of [its] review to determine the extent to which the risk detriment is likely and whether [the FCA] will need to consider changes to the Rules."

A characteristic for loan-based crowdfunding is the matching of multiple lenders to a single borrower with many lenders making small (micro) loans to meet a borrower's (macro) borrowing requirement. So those lenders are effectively sharing the risk although there is no pooled vehicle as such in between the lender and borrower – there is a direct lending relationship just for small amounts which make up the total borrowing requirement.

Some platforms though have been developing some sort of provision fund, often by way of the platform directing a small fraction of lenders' investments to the provision fund, so pooling might arise. The FCA indicate that this may mean that some firms are operating loan-based crowdfunding platforms which are also operating collective investment schemes.

  • Does the platform constitute an alternative investment fund?

We now have two investment fund definitions, one the old UK collective investment scheme and the second one the EU alternative investment fund (or AIF) definition under the Alternative Investment Fund Managers Directive (AIFMD). So the position has become even more complicated. The AIFMD provisions sit on top of our old UK collective investment schemes (CIS) regime and our long established constraints on promoting unregulated collective investment schemes.

Although, as mentioned above, an HM Treasury SI precludes an Article 36H platform from being regarded as a collective investment scheme – it may still be an alternative investment fund under AIFMD, a provision from which UK legislators cannot waive requirements.

There is currently a risk that a platform can constitute an alternative investment fund for which there ought to be appropriate treatment under AIFMD provisions – with some person managing an AIF.

  • How should grey areas be treated?

There have always been some grey areas on the margins of different types of regulated activity, and especially around the investment funds definition(s). Many of these were considered in detail when AIFMD was introduced.

Over the years, many portfolio management arrangements have been reviewed in relation to the CIS definition, and now in relation both to the CIS and the AIF definition.

Take for example portfolio management arrangements which are managed on a common basis. Generally, portfolio management agreements should be regarded as separate contracts and not together regarded as comprising a collective investment scheme. Nonetheless, generally, the view has been taken that most EIS funds are not collective investment schemes but may be an alternative investment fund, and so need an appointed alternative investment fund manager or AIFM. This would require appropriate permission. It is though possible for very similar products to be outside of the scope of an alternative investment should those contracts each be managed separately with separate portfolios which do not have pooling as defined for AIFMD purposes. Consequently, the product fits either within the fund sector or within the established MiFID type regulation for discretionary portfolio management. It does not fall into a hole.

The point which the FCA are making in respect of the peer to peer lending space is that there may be an investment fund issue which has not been fully explored and secondly, if some of the peer to peer platforms are straying into investment fund territory, there is concern that the peer to peer regulatory arrangements simply would not be adequate to deal with the regulatory risks. The FCA is therefore not just concerned about blurred lines across to the asset management business model but the fact that some business lines are, in effect, avoiding the full panoply of regulation which currently applies to asset management conducted under an asset management business model.

The FCA clearly want to explore this further and to the extent to which peer to peer is becoming a substitute for asset management.

Are platforms in fact deposit taking?

The second main area for concern is whether platforms might themselves be taking deposits which constitutes banking business. This was always the more likely issue which might arise than the one discussed above for asset management.

There is a certain point where, if you push activities too far, you end up going into the mainstream. In the same way as most investment-based crowd funding platforms evolve into normal asset management territory but on a web-based operation, so loan based activities might be expected to reach into deposit taking. So are loan-based crowdfunding platforms accepting deposits?

When first considered in FCA CP 13/3, it seemed to be understood that loan-based crowdfunding platforms would not be operating as banks themselves (although arguably replicating such). Monies received from the client for the purposes of lending out to borrowers and repayments from borrowers to be provided back to clients, whether received physically or electronically, would be regarded by the firm as holding it as client money held by the firm for and on behalf of the client in relation to investment business. The firm would hold this money as trustee and must therefore make adequate arrangements to safeguard it. Consequently, the FCA decided to apply client money rules from CASS with some minor amendments. This presupposed that the loan agreements facilitated on the platforms were generally made between investors and borrowers, so the failure of the platform of itself might not necessarily lead to losses.

This is rather different from, and can be distinguished from, where a platform might be operating a lending business or where any business operates through a platform, then there can be accepting of deposits and so banking business which requires FCA permissions. The FCA's view expressed in its 28th February 2017 Dear CEO letter is that "where a borrower uses funds provided via a loan-based crowdfunding platform for on-lending, they are likely to require a permission to accept deposits."

Regulation 5 of the RAO on accepting deposits is very straightforward (and always has been) with wording derived from the Banking Act 1987:

"Accepting deposits as a specified kind of activity if:

a) money received by way of deposit is lent to others, or

b) any other activity by the person accepting the deposits is financed wholly, or to a material extent, out of the capital of, or interest on, money received by way of deposit.

"Deposit" means a sum of money other than money excluded by [any of Articles 6-9A] paid on terms:

a) under which it will be repaid, with or without interest or premium, and either on demand or at a time or in circumstances agreed by, or on behalf of, the person making the payment and the person receiving it; and

b) which are not referable to the provision of property (other than currency) or services or the giving of security."

In relation to this, focus has always been paid to the "accepting deposits" element with the rest of the text explaining that, rather than looking at the issue of "lending on to others". Nonetheless, the paragraph (a) text quoted above does indicate that accepting deposits covers "money received by way of deposits which is lent to others".

It is this first limb of the Regulation 5 accepting deposits definition on which the FCA is now relying in order to indicate, and potentially prevent, some of the expansions of loan-based crowdfunding platforms in its "Dear CEO" letter of 28 February 2017.

The key issue to address therefore is whether or not there is a lending business that takes money from others (whether directly or through a crowdfunding platform) and then lends the borrowed funds on to others. (If so, the "by way of business" text is likely satisfied if one is going to run this by way of a business venture and one cannot really rely on Article 2 about doing things on particular occasions – it is a weak basis on which to build a business model and mostly should be discounted as irrelevant.)

The FCA, as usual, rely upon the Principles and Threshold Conditions. A platform facilitating acceptance of deposits by a borrower which on-lends which does not hold the correct permission would lead that platform itself to be acting in a manner inconsistent with FCA expectations for regulated firms: it may be in breach of:

- Principle 6 treating customers fairly and

- Threshold Conditions 2E (suitability) and 2F (business model).

The February 2017 publication of the FCA's specific approach indicates its concern that, if some peer to peer lending models wish to build their business models out into what is really accepting deposits, they need to move into the mainstream area of accepting deposits. Indeed some are starting to do so.

The clear message from the FCA is that avoiding the full panoply of banking regulation when in fact there is banking activity of accepting deposits being undertaken is not an approach which they will allow to continue.

Are the wrong sorts of platform models being offered to the wrong sort of investors?

For all crowdfunding platform models, the FCA are concerned that a promotion of a risky product might be made to the "wrong type of investor". In particular, they wish to restrict what can be promoted to retail investors. The FCA worry about "the wrong type of investor" investing in unlisted shares or debt securities, although in FS 16/13 they indicate they have no evidence of this!

The concern fits with a longstanding view that retail investors should only see liquid listed assets. Their initiatives in devising COBS and revising COBS 4.12 for restricting promotion of non-mainstream pooled investments clearly demonstrates this. The FCA took the view that the risk applying to units in unregulated collective investment schemes, warrants and derivatives are not dissimilar to those that apply to unlisted shares and debt securities and so introduced rather complicated provisions under PS 14/4.

Note that, in introducing the new COBS 4.7.7, the FCA took the view that Article 36H loan agreements should not be treated like other debt securities, asserting that the former involved lending to individuals rather than companies; were usually paid over three to five years; and were currently thought likely to have low default rates. Now the FCA seem to be considering changing its mind?

Looking at the investment-based platform arrangements for which an assessment is required for promotion of non-readily realised pooled securities and/or non-mainstream pooled investments, and so where categorisation of certain types of investors is currently undertaken, the FCA raise a concern with compliance with the existing rules. Where relevant, the service provider must ensure people sign up as, for example:

a) certified high net worth investors meeting the COBS 4.12.6 requirements,

b) certified sophisticated investors under COBS 4.12.7 or

c) self-certified sophisticated investors under COBS 4.12.8.

Whilst we all know about the Guidance in COBS 4.12.9 and 4.12.10 regarding criteria for considering people to be high net worth or sophisticated, one question coming out of the FS 16/13 is that there is an assertion that, even if so signed up, investors may not justifiably fall within these categories. As the FCA observe "It is unclear how a firm could meet its obligations to act honestly, fairly and professionally in accordance with the best interests of its clients if they certify them as high net worth or sophisticated without undertaking any analysis."

Effectively what the FCA are saying is that some current market practice is insufficient to meet current rules.

It is worth noting that, as part of the recently announced Investment Platform Market Study (post completion of the Asset Management Market Study), all areas of platform intermediation are now an area of FCA focus.

Managing conflicts of interest

There are clearly some sort of conflict of interest concerns.

Regarding Question 17 in FS 16/13, the FCA observe that they believe that "It is important that crowdfunding platforms treat those on both sides of the transactions they facilitate as clients. This does not create conflicts of interest, it clarifies that conflicts of interest are likely and must be considered appropriately."

It is becoming increasingly evident that "who is providing services to whom" should be made crystal clear and, in some of the more complicated platform offerings, this is an area which could be improved. The fact that conflicts of interest arise is linked to current uncertainties in some crowdfunding models.

What is the best approach to take?

It is almost inevitable that there will be some form of regulatory framework applying to a crowdfunding business model. The issue with the on-line platforms of late has been that there have been a variety of new business models trying to come around the edges of regulation.

The FCA is indicating – not unexpectedly – in FS 16/13 that avoiding regulation designed to deal with certain risks for certain business models is not a basis they will support. They will likely look to take action soon in relation to business models which they think are trying to "dodge regulation". Various initiatives are now in process – including the Investment Platforms Market Study for which the Terms of Reference were published in July.

There is always of course a need for regulation to evolve as business models evolve. The best way is for those with new business propositions to work with the FCA to agree the basis on which they should be regulated. In devising any platform, the provider(s) would be well advised to try and work with the regulator and embrace the relevant regulations, so as to work out how best to fit in with the regulatory requirements.

Where grey area issues are identified as new business models are being developed, there is the opportunity to engage with the FCA – whether as part of the normal authorisation process or, if the matter is sufficiently innovative to be relevant for their sandbox initiative, within the FCA's Project Innovate Unit. Whichever route is chosen though, it is important to work with regulation rather than try to work around it or against it.

  1. The FCA have used the term "loan based crowdfunding" to cover a number of different models – some facilitates loans from individual investors to other individuals (peer to peer lending) whilst others facilitate loans from individuals to businesses (peer to business lending), and others allow a combination. The FCA also thought that this term covered a spectrum of different crowdfunding models – some include more than one type of crowdfunding model and therefore they took this as an all encompassing term. Loan based crowdfunding includes peer to peer lending.