Consumer protection in the crowdfunding era
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In the new era of crowdfunding finance, what level of protection does a consumer have?
Start-up companies have a well-established reputation for being prone to failure. Some estimates hold that 80-90% fail within their first 18 months. As crowdfunding has become an industry that attracts many start-up companies, the potential for financial failure and consumer interests becoming compromised is great. The Financial Conduct Authority (FCA) has responded to this and recognised the importance of protecting the consumer from this potentially high-risk form of finance by requiring that certain crowdfunding operators be subject to authorisation. The major consequence of those platforms becoming authorised by the FCA is that they will have to comply with a host of regulatory requirements and adhere to particular minimum standards of conduct and operation.
An explanation of crowdfunding
Crowdfunding can be described as a way of raising money from a large number of people to finance or refinance an activity. This is typically done online through crowdfunding websites, but can also be carried out via other methods. As businesses – and particularly start-ups – began to recognise the benefits of using crowdfunding as an alternative way to raise capital, the industry grew exponentially. This growth has not gone unnoticed by the FCA and as is often the case with innovations in the financial industry, along with growth comes regulation.
There are several types of crowdfunding which should be distinguished:
- donation-based – where people simply give money to fund a particular objective, receiving no direct tangible benefit in return;
- reward-based – where people give money to fund a project and in return receive some sort of reward. This is often used by small entrepreneurs looking to develop a product. For example, the money donated may provide the capital for the product to be manufactured and, in return, the donor will receive a finished product;
- loan-based – where people lend money to an individual or business in the expectation of receiving interest payments and a return of capital over a period of time; and
- investment-based – this typically involves people giving money to a company in return for shares in that company. The expectation is to then see a return on the initial investment by way of dividends if that company is successful.
Which types of crowdfunding are regulated?
The primary function of the FCA is to regulate the financial services industry in the United Kingdom in order to protect consumers, and promote stability and competition within the industry. Their primary concern with crowdfunding is to protect the consumer, as it is often individuals who will be contributing money. The FCA has not published any regulation to date concerning donation-based or reward-based crowdfunding, as neither of these activities have any real investment properties. However, the FCA does explicitly regulate both loan-based and investment-based crowdfunding. This is because it finds that these two forms present significant risk to consumers. By regulating the industry, a standard level of conduct and financial safeguards are required to better protect the consumer.
Regulation of loan-based crowdfunding
Under the FCA rules, the crowdfunding platform will be the regulated entity as it acts as the facilitator for the transaction between the lender and the borrower. Broadly, a loan-based platform would be regulated if it:
- performs a selection process whereby potential borrowers and lenders are matched;
- acts as a conduit by receiving payments under the loan agreements which are then passed onto the lender;
- is responsible for enforcing any payments due under the loan agreements; or
- facilitates a loan agreement where either:
(i) the lender is an individual (or a partnership or unincorporated association whose members include an individual) which lends money to a borrower; or
(ii) the borrower is an individual (or a partnership or unincorporated association whose members include an individual) and either borrows no more than £25,000 or is not entering the loan agreement for business purposes.
If the platform does have to be regulated, it must submit an application to the FCA for authorisation and will not be able to lawfully carry on its business as a loan based crowdfunding platform until authorisation is granted.
Consequences of regulation
Loan-based platforms must maintain an amount of regulatory capital which is the higher of either £20,000 or a particular percentage of the total value of funds which are provided to borrowers.
The FCA requires that authorised firms submit reports regularly, providing certain information including prudential data, accounts, investor complaints and loans arranged over the previous quarter.
Client money rules
Loan-based platforms will have to comply with the FCA client money rules which set down a specific regime for the handling of client money by firms.
Conduct of business
In order to protect the consumer, the FCA will require the loan-based platform to comply with the conduct of business rules and certain provisions regarding customer complaints and compensation.
Administration of existing loans
A key requirement for regulated loan-based platforms is to have arrangements in place to ensure that, in the event that the platform ceases to carry out loan-based crowdfunding business, existing loan agreements will continue to be managed and administered. This is to ensure that neither the borrowers nor the lenders are unfairly disadvantaged by such an event.
Regulation of investment-based crowdfunding
Investment-based crowdfunding platforms are more widely regulated by the FCA than those which are loan-based. As such, the main criterion for regulation is that the platform makes arrangements where parties are (or would be) able to deal in securities through the platform. Therefore, if a potential investor is able to subscribe for shares in a company through the investment-based platform, that platform must be regulated.
Consequences of regulation
Investment-based platforms must also comply with certain reporting requirements, client money rules, regulatory capital requirements and conduct of business standards. However, the FCA also imposes strict rules regarding who the shares can be directly offered to. A “direct offer” means an explicit offer or invitation which specifies a manner of response.
Essentially, if the shares are difficult to price and are illiquid (generally this will be the case for small and medium-sized enterprises), the FCA provides that they may only be directly offered to the following types of investor:
- professional clients;
- retail clients who confirm that they will seek regulated investment advice or management services in relation to the investment that is promoted;
- retail clients who are venture capital or corporate finance contacts;
- retail clients who are certified sophisticated investors;
- retail clients who are certified high-net-worth investors; and
- retail clients who certify that they will not invest more than 10% of their “net investible assets” in unlisted equity and debt securities (ie, they certify that they will only invest a maximum of 10% of their assets other than those that affect their primary residence, pensions and life cover).
For the present time, crowdfunding continues to be ripe ground for small businesses seeking start-up finance. As such, participating in loan-based or investment-based crowdfunding will continue to be an inherently risky activity due to the unpredictable nature of start-up companies. No amount of regulation could entirely negate this risk. What the FCA’s regulatory regime aims to do is notify the consumer of these risks and ensure that where an individual does participate, the crowdfunding platform behaves in a way which the FCA deems to be appropriate.
Erin Vickers is a first-year trainee in the regulatory team at Cooley (UK) LLP.