Since it first appeared in the UK in 2004, crowdfunding has become increasingly successful as a means of raising capital over the internet from the general public. Osborne Clarke operates at the forefront of the crowdfunding sector, and has advised many of the leading crowdfunding platforms on their set-up and on-going operations in the UK and across Europe. For a number of years we have been a driving force in encouraging the development of a business-friendly legal and regulatory regime for crowdfunding in the UK and are engaged in discussions about how to remove barriers to conducting business across Europe.
This note is designed to give both an overview of the regulation of the different crowdfunding techniques that are in common use today, and a look ahead to changes on the horizon for the UK crowdfunding regime.
(First published: Lexis®PSL document
produced in partnership with Osborne Clarke)
(Article updated 4 December 2014)
The different crowdfunding models
Crowdfunding works on the premise that persons seeking funding, such as entrepreneurs, showcase projects or companies on an internet platform and members of the public provide funding through the platform. There is no limit to the amount of individual contribution but, unlike more established methods of fund raising, many platforms permit participants to contribute as little as £10. Typically the entrepreneur will be required to specify a target amount and cut-off date, and will not receive funding unless this target is reached.
There are three broad crowdfunding models, each distinguishable by the return for the funder.
1. The donations and rewards models: individuals provide money to a company or project for benevolent reasons or for a non-monetary reward
Because the donations/reward models do not involve any form of financial investment return, they fall outside the scope of UK securities regulation. Crowdfunding originated from donations- and rewards-based platforms, where the interest of participants was to help a worthy or interesting cause for the sake of being associated with it, rather than to profit financially. The idea of combining worthy causes with financial returns led to the development of the investment and lending models, which are the focal points of several deep-pocketed institutions already operating in the financial services industry.
2. The lending model: individuals lend money to a company or project in return for repayment of the loan and interest on their investment
Crowdlending is commonly referred to as peer-to-peer lending or P2P, although when individuals lend to businesses, many refer to it as P2B. The making of non-consumer loans was generally not treated as a regulated activity and so the crowdfunding lending model developed quickly as an alternative to bank lending. However, from 1 April 2014, the new regulated activity of “operating an electronic platform in relation to lending” was introduced to the Financial Services and Markets Act (Regulated Activities Order) 2001 (the RAO). The activity only applies to loans where either:
(1) the lender is an individual; or
(2) the borrower is an individual and either:
(a) the loan is £25,000 or less; or
(b) the individual is not borrowing for business reasons.
In this context, “individual” includes a partnership with two or three partners. As most P2P platforms target individual lenders, the status of the borrower does not affect the requirement for the platform to be authorised. However, the nature of the lending does affect the regulatory regime that will apply to the platform, as more extensive rules apply to P2P platforms that facilitate consumer credit.
Firms operating P2P platforms before April 2014 were required to apply to the Financial Conduct Authority (the FCA) for interim permissions to continue carrying on the activity. The FCA has allotted a time window (generally between August and October 2015) to each platform operator with interim permissions during which they will be required to apply for full permission or lose their authorised status. It is generally accepted that the regulatory regime for P2P platforms constitutes “light touch” regulation, which is in keeping with the UK’s ambitions to encourage increased responsible SME business lending and make the UK an international hub for crowdfunding.
3. The investment model: individuals make investments in return for a share in the profits or revenue generated by the company/project
In the UK, the financial services regulatory regimes for corporate finance business and investment funds both tend to shape the structure of investment-based crowdfunding platforms. As both regimes have not traditionally been used to facilitate the participation of large numbers of retail investors, there was lobbying for the creation of a new regulatory regime specifically designed for investment-based crowdfunding. The FCA’s approach was to acknowledge the permissibility of investment-based crowdfunding as a valid business model operating under the existing regime, with minor amendments. For example, the FCA clarified its expectations of firms wishing to promote “non-readily realisable securities” (covering most unlisted shares and debentures): such investments can be sold on a non-advised basis provided firms ensure investors have the requisite level of understanding.
The FCA has also signalled its disapproval of platform operators making use of exemptions in order to avoid becoming subject to regulation, although the legal loopholes that crowdfunding firms had been using to operate outside the scope of regulation still exist.
What are the legal issues facing crowdfunding platforms?
The financial services regulatory regimes exist primarily to ensure investor protection through the regulation of financial services providers. Retail investors who have little or no knowledge of financial instruments are the most in need of protection. To the extent that crowdfunding combines indiscriminate online marketing with speculative start-up investment opportunities, it runs contrary to the core regulatory objective of providing consumer protection.
Advocates of crowdfunding point out that users know they are not buying ‘safe’ investments. Crowdfunding websites typically carry notices advising users to spread investments and never to spend more than they can afford to lose. Where so much legislative energy has been devoted to the development of a National Lottery and the Big Society, it is difficult to dismiss the social good behind crowdfunding, which facilitated retail participation in business innovation and enterprise. The key is to ensure that consumers are aware of the level of risk they are taking, that platforms are accountable for fraud, misrepresentation or improper accounting and that safeguards are put in place to reduce the risk of platforms going bust leaving un-administrable investments behind them.
The UK financial services regulatory regimes apply differently to the different crowdfunding models. The key issues are set out below.
The donations and rewards model
As funding under the donations and rewards models are provided as a donation or for non-financial reward, it does not involve the issuance of financial instruments or grant of consumer loans, and is therefore not subject to securities regulation in the UK.
The lending model
Financial promotions and regulated activities
From 1 April 2014, platforms carrying out the new regulated activity of “operating an electronic platform in relation to lending” became subject to regulation by the FCA under an interim permission regime. Firms with interim permissions generally need to apply for full authorisation between August and October 2015 or lose their permissions. Firms without interim permissions wishing to operate a P2P platform must apply for full authorisation. Where the participation is structured as a debt security, rather than a loan, the platform is subject to regulation pursuant to the investment model. Variations of the lending model can also lead to participants being offered units in a collective investment scheme.
Where platforms carry out the regulated lending activities without the required authorisation, the FCA has the power to take enforcement action in a number of forms, which could potentially include seeking out a court order to require the platform operator to put lenders or borrowers in the same position they would have been in if they had not entered into the loan agreement.
The Consumer Credit Act 1974 applies to consumer credit or consumer hire agreements where the borrower/hirer is not a body corporate or a partnership of four or more persons. From 1 April 2014, all consumer credit firms (previously regulated by the Office of Fair Trading) were required to register with the FCA and apply for interim permissions. The P2P lending interim permission regime was developed in the context of this wider transfer of lending regulation to the FCA.
The FCA’s Consumer Credit Sourcebook (CONC) applies to firms carrying out “credit-related regulated activities“. This applies both to the mainstream consumer credit activities and to operating a P2P platform. However the application to a P2P platform is greatly reduced where the loans in question are not credit agreements: namely where the borrower is not an individual or small partnership. Further conduct of business requirements apply in relation to living wills (arrangements for when the platform becomes insolvent) (SYSC chapter 4), client money (Client Asset sourcebook, chapter 7), publication of default statistics (COBS 14.3), and regulatory capital (Interim Prudential sourcebook for Investment Businesses (IPRU-INV), chapter 12), amongst others. It is therefore common for crowdlending platforms to restrict lending to bodies corporate.
The application of the consumer credit regime also has implications for whether the platform will fall under the scope of the UK Money Laundering Regulations, SI 2007/2157.
ISA status of peer-to-peer loans
In the 2014 budget, the Government confirmed that peer-to-peer loans would be made eligible for inclusion within Individual Savings Accounts (ISAs) and therefore subject to the tax benefits that the ISA wrapper entails. On 17 October 2014, HM Treasury launched a consultation into the ways in which this could be achieved, through amendments to the RAO and the ISA Regulations. The consultation closes on 12 December 2014. One of the most significant things P2P platforms will need to do for their loans to be eligible is demonstrate a sufficiently liquid secondary market enabling lenders to exit their loans or transfer to another ISA investment. Another question is whether the role of ISA plan manager is more likely to sit with providers of a wide range of financial products, or whether P2P platforms themselves will fulfil this role. There is also debate as to whether certain crowdfunded debt securities may attract ISA status as part of the expansion of the regime.
The transmission of funds between the investor and the crowd funded business may involve the platform operator providing ‘credit transfer’ or ‘money remittance’ services under the Payment Services Regulations 2009 (as amended) (PSRs) (SI 2009/209, sch. 1, Part 1(c) and 1(f)). A platform operator will require separate FCA authorisation if it is conducting payment services.
Many operators rely on the exemption for ‘commercial agents’ under the PSRs on the basis that they have authorisation to negotiate or conclude contracts on behalf of the funder and the fund seeker (SI 2009/209, sch 1, Part 2(b)). However, in some member states the commercial agent exemption is being applied very narrowly, to exclude situations where the agent acts for both the payer and the payee and the differences in application of the PSRs have been flagged by the European Commission in the recitals to the proposed revised Payment Services Directive (PSD2) as going beyond the intended scope of the exemption. To the extent that the exemption is narrowed, this may result in crowdlending platform operators needing to become authorised to provide payment services.
The investment model
The FSMA requires a prospectus to be published where transferable securities are offered to the public (FSMA 2000, s 85(1)). Most crowdfunding offers fall within an exemption for offers worth less than €5m in a period of 12 months. There are other exemptions that may be of use if single issues increase beyond this level.
The Companies Act 2006 also prohibits the offer of shares in a private limited company to the public (CA 2006, s 755). The involvement of the platform can be structured so as to reduce the risk of breach and issuers can be constituted as public companies.
Regulated activities: share issues
FSMA 2000 requires platform operators to become authorised by the FCA in order to conduct regulated activities (FSMA 2000, s 19). Conducting a regulated activity without authorisation is a criminal offence. Regulated activities associated with investment crowdfunding may include:
- bringing about transactions in securities issued by the party seeking funding (RAO, SI 2001/544, art 25(1));
- making arrangements with a view to transactions in securities (SI 2001/544, art 25(2)); or
- safeguarding and administering securities (custody) (SI 2001/544, art 40).
Less commonly, the platform operator could become involved in advising on securities, managing securities or dealing in securities (SI 2001/544, arts 53, 37), depending on the business proposition.
Where the party seeking funding does not issue shares in a company, platform operators may also need to consider whether they are carrying on the regulated activity of operating a collective investment scheme or operating an alternative investment fund (SI 2001/544, arts 51ZC, 51ZG). This is considered in more detail below.
Many investment crowdfunding platforms used to be structured using a combination of exclusions and exemptions from the regulated activities regime. This practice has become less common as a result of the recognition of crowdfunding as a legitimate form of regulated business. As with the lending model; if a platform is found to have been performing regulated activities without authorisation, the FCA has the power to seek a court order requiring the platform operator to put investors in the position they would have been in had they not entered into any agreement to invest.
Nonetheless, seeking authorisation is a costly and time-consuming process and, among other things, obliges the regulated firm to comply with the FCA’s conduct of business obligations (set out in COBS) to ensure that the investments arranged through the platform are appropriate for the investor on a case-by-case basis. This can prove challenging when dealing with the low value investor base often associated with crowdfunding. Many platforms are established as appointed representatives of authorised firms, benefiting from their regulatory permissions and bound by certain of the FCA Rules (not including capital requirements) as a matter of contract (Supervision sourcebook (SUP), chapter 12).
The offer of shares or other securities through the platform will generally constitute a financial promotion, namely an invitation or inducement to engage in investment activity. In essence, FSMA 2000 s.21 provides that financial promotions can only be communicated in two ways:
- the promotion is communicated or approved by an FCA authorised firm; or
- the promotion is communicated to certain classes of eligible recipient.
Where the crowdfunding platform is authorised, or uses an FCA authorised firm to approve the financial promotion, the contents of the promotion (which will capture most of the site as well as each individual investment proposition) will need to comply with the requirements of chapter 4 of COBS to ensure that they are clear, fair and not misleading.
Firms are required to restrict the promotion of non-readily realisable securities to certain categories of retail investor (COBS 4.7.7 and 4.7.8):
- certified high net worth investors;
- certified sophisticated investors;
- certified restricted investors; or
- advised investors (although this category is not common for crowdfunding).
If the crowdfunding entails investing in a collective investment scheme, there is a more restrictive financial promotion regime.
Collective investment schemes
Where the profit share being offered to investors is not channelled through a trading corporate issuer/shareholder relationship (e.g. the investor receives a contractual entitlement to profits from a project), the investment may be characterised as units in a collective investment scheme (FSMA 2000, s 235). Because crowdfunding generally entails the pooling of investor contributions or the pooling of profits and/or income prior to distribution to the investor, the investment can also fall under the alternative investment funds regime, as set out below.
Operating a collective investment scheme and managing an alternative investment fund (AIF) are regulated activities and must be conducted by an FCA authorised firm (SI 2001/544, arts 51ZC and 51ZE); see above. There is potential for either the platform operator or the fund seeking party to be the person who would conduct the regulated activity, depending on how the arrangements are structured.
The promotion of single project collective investment schemes is subject to greater restriction than the promotion of shares, even when the promotion is communicated or approved by an FCA authorised firm (FSMA 2000, s238, 240). These restrictions also apply to other forms of non-mainstream pooled investment, such as shares in a special purpose vehicle.
It is necessary, therefore, to apply further restrictions to the classes of potential funder of a collective investment scheme or special purpose vehicle than those that apply to funders of non-readily realisable securities. The potential categories of exempt funder to whom units can be promoted are often narrower than for shares, because of limitations on the scope of the self-certified high net worth and sophisticated individual financial promotion exemptions (FSMA 2000 (Promotion of Collective Investment Schemes) (Exemptions) Order 2001, SI 2001/1060 and COBS 4.12).
Alternative investment funds
A range of measures implementing the EU’s Alternative Investment Fund Managers Directive 2011/61/EU (AIFMD) came into force in the UK from 22 July 2013, creating a new pan-European concept of “alternative investment fund” that sits alongside the existing UK regime for collective investment schemes. Broadly, most collective investment schemes will constitute alternative investment funds. The converse is not true in the context of crowdfunding, as a body corporate can constitute an alternative investment fund, whereas bodies corporate are generally excluded from the collective investment scheme definition.
Managing an alternative investment fund is a regulated activity that also permits the firm to operate a collective investment scheme. Although the full scope of the AIFMD does not apply to managers with funds under management below €500m (subject to conditions on leverage and redemptions that most crowdfunding funds would meet, otherwise €100m), managers below that threshold still need to be permitted to manage an alternative investment fund pursuant to UK regulation.
The financial promotion regime for alternative investment funds in the UK is broadly dependent on whether the fund is a collective investment scheme or a company, as considered above.
The AIFMD contains a mechanism for promoting alternative investment funds across Europe, but this would not be available for a sub-threshold manager unless it opted in to complying with the full scope of the directive. A discussion of the full implications of the AIFMD is beyond the scope of this article.
What next for crowdfunding?
The continuing rapid growth in the crowdfunding industry shows no sign of abating. P2P lending has proved to be by far the largest growth sector, with £749m being raised towards P2B lending and £547m raised towards consumer lending in 2014 (see the 2014 Alternative Finance Industry report produced by NESTA and the University of Cambridge). Both the donations and lending models may also benefit from further support in the form of the UK Government’s £80m Community First matched-funding scheme, which will run until 2015.
In contrast with a number of other countries, the UK approach is widely praised for having encouraged the development of the crowdfunding sector. In the US, which blazed the crowdfunding trail on a global scale, the JOBS Act was regarded to be a step in the right direction for crowdfunding. However, its stalled implementation (the Securities and Exchange Commission is now almost two years late for the implementation deadline of December 2012) has meant that it has lost momentum. Some individual states (such as Texas) have taken action in the face of the national void to enact their own, far more lenient state-specific rules. The resulting fragmented approach between states makes it difficult for platforms to prepare a consistent marketing strategy to reach a mass audience. The interest shown by the European Commission in removing administrative barriers to cross-border activity and the interest of the UK Financial Services Commissioner bode well for Europe and its largest crowdfunding market, the UK, to take the lead as the primary global centre for crowdfunding going forwards.