Financial Conduct Authority Regulatory Approach to Crowdfunding.pdf

7/27/2019 Financial Conduct Authority Regulatory Approach to Crowdfunding.pdf

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Financial Conduct Authority 1October 2013

CP13/13The FCAs regulatory approach to crowdfunding (and similar activities)

Abbreviations used in this paper 3

1. Overview 4

2. Regulatory considerations 10

3. Loan-based crowdunding 16

4. Investment-based crowdunding 36(and similar activities)

Annexes

1. Market ailure and cost beneit analysis 39

2. Compatibility statement 63

3. List o questions 67

4. Loan-based crowdunding 69platorm website review

Appendix

1. Drat Handbook text

Contents


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2 Financial Conduct AuthorityOctober 2013

The FCAs regulatory approach to crowdfunding (and similar activities)CP13/13

We are asking or comments on this Consultation Paper by 19 December 2013.

You can send them to us using the orm on our website at: www.ca.org.uk/your-ca/documents/consultation-papers/cp13-13-response-orm.

Or in writing to:

Jason Pope and Susan CooperPolicy, Risk and Research DivisionFinancial Conduct Authority25 The North ColonnadeCanary WharLondon E14 5HS

Email: [email protected]

We make all responses to ormal consultation available or public inspection unless the respondent requestsotherwise. We will not regard a standard conidentiality statement in an email message as a request ornon-disclosure.

Despite this, we may be asked to disclose a conidential response under the Freedom o Inormation Act2000. We may consult you i we receive such a request. Any decision we make not to disclose the responseis reviewable by the Inormation Commissioner and the Inormation Rights Tribunal.

You can download this Consultation Paper rom our website: www.ca.org.uk. Or contact our order lineor paper copies: 0845 608 2372.


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Financial Conduct Authority 3


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Abbreviations used in this paper

CMAR Client Money and Asset Return

CP Consultation Paper

DMD Distance Marketing Directive

FCA Financial Conduct Authority

FSCS Financial Services Compensation Scheme

FSMA Financial Services and Markets Act

HMRC Her Majestys Revenue and Customs

MiFID Markets in Financial Instruments Directive

OFT Oice o Fair Trading

PD Prospectus Directive

PRA Prudential Regulation Authority

UCIS Unregulated collective investment scheme

WACC Weighted average cost o capital


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1.

Overview

Introduction

1.1 Crowdunding is a way in which people, organisations and businesses (including business start-ups) can raise money through online portals (crowdunding platorms) to inance or re-inancetheir activities and enterprises.

1.2 On 1 April 2014, the regulation o the consumer credit market will transer rom the Oiceo Fair Trading (OFT) to the Financial Conduct Authority (FCA), including responsibility orregulating loan-based crowdunding, also known as peer-to-peer lending platorms.1 Thisconsultation paper (CP) is part o a series o papers which will determine the FCAs approachto the regulation o consumer credit activities. In this paper we propose regulations designedto protect investors, where other papers consider appropriate measures to protect borrowers.2

1.3 Crowdunding already alls within the scope o regulation by the FCA i it involves a person

carrying on a regulated activity in the UK, such as arranging deals in investments, or thecommunication o a inancial promotion. So, i a crowdunding platorm enables a business toraise money by arranging the sale o unlisted equity or debt securities, or units in an unregulatedcollective investment scheme, then this is investment-based crowdunding regulated by theFCA and the irm operating the crowdunding platorm needs to be authorised.3

1.4 Our present rulebook was not designed with crowdunding in mind, so in this CP we areconsulting on a revised approach to regulating irms that operate investment-basedcrowdunding platorms or market unlisted equity or debt securities.

Who does this consultation aect?

1.5 The paper will be relevant to any consumers and consumer organisations with an interest incrowdunding and similar activities.

1.6 From the industry, this CP aects irms that operate loan-based crowdunding platorms onwhich consumers can invest in loan agreements, and irms that plan to do so. At present, wehave identiied 25 such irms.

1 This is the activity detailed in article 36H o the Regulated Activities Order as operating an electronic system in relation to lending:

www.legislation.gov.uk/ukdsi/2013/9780111100493

2 High-level proposals for an FCA regime for consumer credit, CP13/7, March 2013 www.sa.gov.uk/static/pubs/cp/cp13-07.pd and

Detailed proposals for the FCA regime for consumer credit, CP13/10, October 2013, www.ca.org.uk/static/documents/consultation-papers/cp13-10.pd.

3 Exemptions may be available. For example i the irm operating the crowdunding platorm is an appointed representative o an

authorised person or an Enterprise Scheme they will not need to be directly authorised.


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1.7 This CP also applies to irms, and their appointed representatives, that operate investment-based crowdunding platorms on which consumers can buy investments such as unlistedequity or debt securities, or units in an unregulated collective investment scheme, and irmsthat plan to do so. At present, we have identiied ten irms and 11 appointed representativesthat operate such crowdunding platorms.

1.8 This CP also applies to any irm that, using any media, communicates direct oer inancialpromotions or unlisted equity or debt securities to retail clients, who do not receive regulatedadvice or investment management services in relation to those investments, and who are notcorporate inance contacts or venture capital contacts.

Context

1.9 While the OFT currently regulates consumer credit arranged via loan-based crowdundingplatorms, there is little regulatory protection or investors in loan agreements at present. Fromnext year, the FCA aims to provide appropriate protection both or consumers who provide themoney loaned, and consumers who borrow money via loan-based crowdunding platorms.

1.10 We do not currently regulate irms running loan-based crowdunding platorms, but wedo already regulate irms operating investment-based crowdunding platorms, and irmsmarketing unlisted equities and debt securities. At present, in addition to the usual corestandards that apply to all irms, to protect investors we have imposed restrictions on irmsapplying or authorisation to operate an investment-based crowdunding platorm. These

restrictions were considered on a case-by-case basis but tend to place limits on the type oclient with whom irms may transact. These limits restrict irms to dealing with proessionalclients and retail clients who are either sophisticated or high net worth. Our aim has beento protect retail investors who lack the knowledge, experience and resources to cope withpotentially signiicant losses when investing through these platorms, or in unlisted equities ordebt securities by other means.

1.11 Our present conduct o business rules were not designed with crowdunding businessmodels in mind. The current approach o applying restrictions on an individual irm basis atthe authorisation stage is not a long-term solution. Thereore, in this CP we are proposing anew approach to the regulation o investment-based crowdunding activities. Our proposalsshould mean crowdunding investment opportunities are available to more retail investors than

currently, but with appropriate saeguards to check that investors are able to understand andbear the risks involved.

1.12 We have also considered our competition objective in approaching our regulation o this sectorand the promotion o new orms o investment. Our proposals seek to provide adequateconsumer protections that do not create too many barriers to entry or signiicant regulatoryburdens or irms.


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Summary o our proposals

1.13 Crowdunding is a term that encompasses a range o business models. With some models,100% capital loss is more likely than not, but others appear more benign. However, makingany investment via crowdunding platorms does tend to involve higher risks than those thatapply to more traditional investments and deposits. Our approach relects this we aim toprovide appropriate and proportionate consumer protection and standards that can be appliedairly to diering types o irm.

Loan-based crowdunding1.14 At present, we consider that investment via loan-based crowdunding platorms is generally o

lower risk than that made via investment-based platorms. We recognise that the market hasthe potential to develop new and innovative models in the uture, however, where the risks,and possibly the rewards, are higher. We will keep our approach under review and consulturther i necessary.

1.15 The regime we propose to introduce in 2014 is based on our approach or investments and is,primarily, a disclosure-based regime. Our proposals will require irms to ensure that investorshave the inormation they need to be able to make inormed investment decisions and thatall communications are air, clear and not misleading. In addition to this, to protect investorinterests, we are consulting on a set o core requirements or irms. These are:

minimum prudential requirements that rms must meet in order to ensure their ongoingviability

rms should take reasonable steps to ensure existing loans continue to be managed in theevent o platorm ailure

rules that rms must ollow when holding client money, to minimise the risk o loss dueto raud, misuse, poor record-keeping and to provide or the return o client money in theevent o a rm ailure

rules on the resolution o disputes, and

reporting requirements or rms to send inormation to the FCA in relation to their nancialposition, client money holdings, complaints and loans they have arranged

Investment-based crowdunding (and similar activities)1.16 We are proposing to change our approach to the regulation o irms operating investment-based crowdunding platorms. We aim to make this market more accessible to retail clients, tohelp oster competition and to acilitate access to alternative inance options, while still aimingto ensure that only investors who can understand and bear the risks participate in the market.

1.17 Our proposals are not expected to aect:

rms carrying on designated investment business that is corporate nance business orventure capital business when they communicate with corporate nance contacts orventure capital contacts, and

rms carrying on regulated activities or proessional clients


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1.18 In this CP we are proposing to restrict the direct oer inancial promotion o unlisted shares ordebt securities4 by irms to one or more o the ollowing types o client:

retail clients who are certied or sel-certiy as sophisticated investors, or

retail clients who are certied as high net worth investors, or

retail clients who conrm that, in relation to the investment promoted, they will receiveregulated investment advice or investment management services rom an authorisedperson, or

retail clients who certiy that they will not invest more than 10% o their net investibleportolio in unlisted shares or unlisted debt securities (i.e. excluding their primary residence,pensions and lie cover)

1.19 Where advice is not provided, we will expect irms to apply an appropriateness test beoreselling them promotions or unlisted equity or debt securities. This is to ensure that only thoseclients who have the knowledge or experience to understand the risks can invest.

1.20 Where crowdunding platorms allow investment in units in unregulated collective investmentschemes, the existing marketing restrictions will apply.5

1.21 In summary, we are proposing the ollowing measures.

Loan-based crowdunding: we propose to apply core FCA provisions, including conduct

o business rules (in particular, around disclosure and promotions), minimum capitalrequirements, client money protection rules, dispute resolution rules and a requirement orrms to take reasonable steps to ensure existing loans continue to be administered i therm goes out o business.

Investment-based crowdunding: we propose limits on the ability o rms to promotethese platorms and a requirement that, where no advice has been provided, rms checkthat customers understand the risks involved.

FCA statutory objectives

1.22 These proposals are designed to advance the FCAs objectives o:

securing an appropriate degree o protection or consumers, and

promoting eective competition in the interests o consumers

4 The websites o irms operating investment-based crowdunding platorms are direct oer inancial promotions or unlisted shares or

debt securities.

5 Firms may only promote these schemes to certain types o customer. We have recently consulted on changes to these restrictions.Restrictions on the retail distribution of unregulated collective investment schemes and close substitutes, FCA PS13/3, June 2013:

www.ca.org.uk/static/documents/policy-statements/ps13-03.pd. The rules were made in the Unregulated collective investment

schemes and close substitutes instrument2013, FCA 2013/46: http://media.shandbook.ino/Legislation/2013/FCA_2013_46.pd


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Equality and diversity considerations

1.23 We consider that crowdunding platorms may carry particular risks or some people withprotected characteristics under the Equalities Act 2010.

Those with learning diculties or mental capacity limitations may have limited capacity tounderstand ully the risks associated with crowdunding.

Individuals reliant on pensions and lacking disposable income are more likely to havesignicant sums in savings, to be concerned about low interest rates on savings and to besearching or higher yield elsewhere, which may lead them to invest signicant amountson crowdunding platorms, potentially taking inappropriate levels o risk with their money.

The web-based and social-networking nature o crowdunding could also pose a riskto young, inexperienced investors who may be attracted to the concept without a ullunderstanding o the risks.

1.24 To mitigate these risks, we propose to place a particular ocus on the quality o irms disclosure,including inancial promotions, to ensure that risks are adequately disclosed and beneits arenot emphasised without a prominent indication o the downside potential.

Q1: Do you have any comments on our assessment o theequality and diversity considerations?

Future plans

1.25 At present we distinguish between loan-based and investment-based crowdunding models,and are proposing a lighter-touch approach or loan-based platorms. This is based on ourobservation that, in general, loan-based crowdunding activities appear to be o lower risk thaninvestment-based activities.

1.26 Following the introduction o our rules, we will monitor the market closely. I we identiyproblems we will act quickly to reduce the risk o harm to consumers, either through supervisionand enorcement action with individual irms or by introducing new rules. For example, weare able to ban inancial promotions including websites i we consider that they do not

meet our standards and, i necessary, we can introduce temporary product intervention ruleswithout consultation to make changes to the regime. We also plan to conduct a ormal reviewo the crowdunding regime in 2016.


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Next steps

What do you need to do next?1.27 We want to know what you think o our proposals. Please send us your comments by

19 December 2013. The FCA is due to introduce consumer credit regulation on 1 April 2014.Beore this date and this consultation, we have sought to engage with key stakeholders as aras possible, discussing our concerns and developing thoughts with them. Consequently, weanticipate that many o the proposals in this consultation will be amiliar to key stakeholders.We are happy to meet with interested parties during the consultation period to help themunderstand our proposals and will, as ever, consider requests or extending the deadline inecessary.

How?1.28 Use the online response orm on our website or write to us at the address on page 2.

What will we do?1.29 We will consider your eedback and publish our rules in a Policy Statement in February or

March 2014.


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2.

Regulatory considerations

2.1 In this chapter we comment on the types o crowdunding activities that are or will besubject to FCA regulation, and those which are unregulated. We also comment on regulatoryconsiderations that apply to loan-based and investment-based crowdunding, the timetable,and our assessment o the key risks.

Distinguishing between regulated and unregulated crowdunding

2.2 It is not always clear when crowdunding activities all, or will all, within the scope o FCAregulation. Depending on the business model, it is possible that irms will all within the scopeo the Payment Services Regulations 2009. In this chapter, we aim to clariy when irms runningcrowdunding platorms will need authorisation by the FCA and when they do not. As ever, itremains the responsibility o irms to assess whether they all within our regime and to applyor authorisation i necessary.

2.3 We have identiied ive main types o crowdunding.

Donation-based: people give money to enterprises or organisations whose activities orpurchases they want to support.

Pre-payment or rewards-based: people give money to receive a reward, service or product(such as tickets or an event, an innovative product, a download o a book or a newcomputer game).

Exempt: people invest or lend money using organisations or investments that satisy therequirements in statutory exemptions to be considered exempt rom the need or FCA

authorisation or regulation (such as Enterprise Schemes or withdrawable shares issued byIndustrial and Provident Societies).

Loan-based: people lend money to individuals or businesses in the hope o a nancial returnin the orm o interest payments and a repayment o capital over time (this excludes somebusiness-to-business loans).

Investment-based: people invest directly or indirectly in new or established businesses bybuying shares or debt securities, or units in an unregulated collective investment scheme.


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Unregulated activities2.4 The FCA does not regulate irms that only operate donations-based, pre-payment or rewards-based crowdunding platorms. These irms do not need FCA authorisation.

Exempt activities2.5 The FCA does not regulate organisations or activities i statutory exemptions apply to exempt

them rom the need or FCA authorisation or regulation. For example, i certain requirementsare met, the FCA does not regulate Enterprise Schemes, or Industrial and Provident Societiesmarketing their own withdrawable share issues.

2.6 Firms thinking o using exemptions will need to consider the relevant legislation and theirbusiness models careully to ensure they do not engage in business or which they needauthorisation.

Regulated activities2.7 We regulate irms operating crowdunding platorms i, in doing so, they are carrying on a

regulated activity,6 without an exemption applying. For example, irms need to be authorisedi they are:

arranging (bringing about) deals in specied investments (article 25(1)), agreeing to carry ona regulated activity (article 64), or

establishing, operating or winding up an unregulated collective investment scheme (article51(1)(a))

2.8 From April 2014 there will be a new regulated activity o operating an electronic system inrelation to lending (article 36H) (i.e. operating a loan-based crowdunding platorm).7

2.9 It is possible or a irm operating a crowdunding platorm to carry on other regulated activities,such as the placing activities that are typically carried on by stockbroking irms: makingarrangements with a view to transactions in investments (article 25(2)), dealing in investmentsas agent (article 21), advising on investments (article 53), or managing investments (article 37).

2.10 In summary, irms operating investment-based crowdunding platorms are already subject toour regulation, and irms operating loan-based crowdunding platorms will be subject to ourregulation rom next April.

2.11 Appointed representatives o authorised irms are exempt rom the need or authorisation orregulated investment-based crowdunding activities (but not loan-based activities) or whichtheir principal has accepted responsibility.8 The principal irm is responsible or ensuring theirappointed representatives activities, systems and controls comply with the FCA Handbook.

6 Regulated activities are speciied in the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001(SI 2001/544) as

amended.

7 The new activity only applies to loans meeting certain criteria. These include: the investor and/or borrower must be i) an individual;

ii) a partnership consisting o two or three persons not all o whom are bodies corporate; or iii) an unincorporated body o persons

which does not consist entirely o bodies corporate and is not a partnership. This means that business-to-business loans that do notmeet these criteria will not be regulated by the FCA.

8 It is currently only possible or principal irms, not appointed representatives, to perorm the new regulated activity in relation to

loan-based crowdunding.


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2.12 Some crowdunding platorms provide access to social investments, ethical investments orenvironmental investments. These are investments oered with the objective o providing,in part or in ull, a wider non-inancial beneit rather than a purely inancial (capital growth/income generation) beneit or investors. I an activity alls within the scope o FCA regulationbecause it involves arranging the sale o unlisted shares, or example, then, regardless o theinvestment objective, our rules apply in the same way they apply to any other regulated activity.

Q2: Do you agree with our assessment o unregulated,exempt and regulated crowdunding activities?

FCA regulation o crowdunding and transitional provisions: the timetable

2.13 The timerame or introducing rules in relation to crowdunding is challenging. As we wantirms to have adequate time to adjust their business models, we are proposing a series otransitional provisions.

2.14 The ollowing summarises our proposed transitional approach to the uture regulation o loan-based crowdunding.

Firms with a valid OFT licence on 31 March 2014 will be able to continue carrying on theconsumer credit activities or which they are licensed until they become ully authorised (whichthey must apply to do by 1 April 2016), as long as they notiy us o some basic inormationand pay a ee. This is consistent with the approach we are adopting or the credit activity

perormed by these platorms. These rms will be granted an interim permission. Loan-basedcrowdunding rms that do not yet have a consumer credit licence rom the OFT may, thereore,like to consider applying or one now to simpliy their introduction to regulation by the FCA.

Beore 1 April 2016, all rms with an interim permission that want to carry on regulatedactivities should have applied or approval o individuals carrying on certain controlledunctions and ull authorisation.

New rms running loan-based crowdunding platorms rom 1 April 2014 or rms that do nothold a consumer credit licence rom the OFT on 31 March 2014 will need to apply immediatelyor ull authorisation and approval or individuals carrying on certain controlled unctions.

Minimum prudential requirements will not start until a rm is ully authorised.

We are proposing to introduce a transitional period or certain rules, allowing rms withan interim permission until 1 October 2014 to adjust their processes to meet the standardsrequired by these rules.

2.15 For investment-based crowdunding (and similar activities) we are proposing to introduce atransitional period allowing irms and their appointed representatives the option o eithercomplying with the new rules rom 1 April 2014, or complying with existing rules until 1October 2014 and then applying the new rules rom that date.

Q3: Do you agree with our proposals or transitionalperiods?


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Investing money via loan-based crowdunding platorms in the course o business

2.16 We have been asked how the new regulated activity applies where the investor is a inancialservices irm and is providing inance in the course o business.

2.17 The Consumer Credit Directive requires us to ensure that irms lending by way o business arecorrectly authorised. Our interpretation is that it is not suicient or us to regulate only theplatorm on which the credit is acilitated: irms lending in the course o business via loan-basedcrowdunding platorms still need to be authorised as they are carrying on a regulated activity.

2.18 Our Handbook already sets out guidance on what it means to be acting by way o business.9

This notes that, whether or not an activity is carried on by way o business is ultimately aquestion o judgement that takes account o several actors (none o which is likely to beconclusive). These include the degree o continuity, the existence o a commercial element, thescale o the activity and the proportion which the activity bears to other activities carried on bythe same person but which are not regulated.

Risks to investors

2.19 In this section we describe the key risks we have identiied or investors on crowdunding platorms.

Risks applying to all types o crowdunding activity

Consumer understanding, inexperience and behaviours2.20 Investors need to be able to understand the risks to which they will be exposed, and the

dierent approaches ollowed by dierent platorms, beore making a decision to transact.In most cases there will be a signiicant degree o inormation asymmetry in place with theconsumer knowing very little about the investment on oer. Most investors on crowdundingplatorms do not receive advice, thereore we consider the inormation that will be disclosedon crowdunding platorms about the investments and services oered to be the main wayconsumers will understand the value o the product and the charges that will apply.

2.21 With traditional savings and investments products currently oering poor returns, consumers

may be enticed by promises o high returns apparently available through crowdunding. As aairly recent market development, inexperienced investors may not adequately assess the risksinvolved. They may not appreciate the dierences between traditional investments or depositsand the riskier crowdunded loan agreements and investments. For example, they may notrealise that deposits are protected by the Financial Services Compensation Scheme (FSCS) andloan-based crowdunding is not.

Conicts o interest2.22 Firms running crowdunding platorms are subject to a number o conlicts o interest that could

lead to consumer detriment. For example, i platorm remuneration is linked to transactions (asis usually the case), and i new platorms are seeking to establish a presence in the marketquickly, new irms may be motivated to downplay risks and over-emphasise possible returns.

9 See chapter 2.3 o our perimeter guidance: http://shandbook.ino/FS/html/FCA/PERG/2/3


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Fraud and money laundering2.23 Fraud is a key risk acing investors looking to lend or invest on crowdunding platorms. Tomitigate this risk, some irms that operate crowdunding platorms appear to have morerigorous due diligence processes in place than others. I there are numerous or high-proileinstances o raud this will aect the conidence that consumers have in the crowdundingsector. Firms will need to ensure they have systems and controls in place to mitigate the risk otheir sites being used or money laundering.

Platorm ailure and poor administration2.24 Platorm ailure may harm investors. Existing loans and investments will still need to be

administered, with repayments or dividends allocated appropriately among investors and latepayments by borrowers ollowed up. I the irm running the platorm goes out o business,responsibility or this could all to individual investors but, particularly where their stake in aparticular investment is small, it may not be economical or them to do so.

Risks applying to loan-based crowdunding

Non-repayment o loans2.25 The main risk acing investors on loan-based crowdunding platorms is non-repayment o

capital or non-payment o interest, either because o borrower deault, raud or irm ailure.These risks will vary and mitigating them will depend on the level o due diligence carried outby the platorms and the investors. A number o irms operating loan-based crowdundingplatorms have adopted approaches to reduce the risk o deault, including the ollowing:

only dealing with borrowers with good creditworthiness

putting contingency unds in place that aim to cover lost capital in the event o borrowerdeault, and

acilitating secured loans, where there is collateral that may be sold to repay capital

2.26 However, irms carry out diering levels o due diligence and have diering approaches tovetting and accepting borrowers, so there will be models carrying greater and lesser amountso risk. For example, platorms acilitating short-term, high-interest loans would be oeringhigher risk investments.

The Financial Services Compensation Scheme2.27 When consumers deposit money with banks or building societies they are protected by the

FSCS i the irm is in deault and cannot meet claims against it. Consumers who invest in loanagreements do not have equivalent access to the scheme.

Risks applying to investment-based crowdunding

2.28 Overall, we consider investment-based crowdunding to be high risk.


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Start-up business ailures2.29 Research indicates that around 50% to 70% o business start-ups ail completely.10 So consumersinvesting in such companies need to understand that it is likely they will lose 100% o any moneyinvested. To assess and mitigate this risk a due diligence assessment should be carried out on thepersons seeking unding. As indicated in our guidance or consumers, this could be carried outby the irm operating the crowdunding platorm or by the investor, or both.

Unauthorised advice2.30 In some cases, irms operating a crowdunding platorm may be making a personal

recommendation. Firms will need to careully consider their business model to avoid unintentionallygiving advice, simpliied advice or providing a discretionary portolio management service. Iinvestment advice is given by a irm then authorisation or this activity will be required and irmswill need to comply with the relevant rules.

Proessionals pick the best oers2.31 Proessional investors may know more about investment in some enterprises and be better able

to select the best investments, leaving options with higher risk or poor value to retail investors.So that they can make decisions on an inormed basis, retail investors need to be satisied thatthey have enough reliable inormation to enable them to understand:

the nature o the investment or service oered

the nature o the parties involved

the risks applying, and

the charges that will be payable

No dividends and equity dilution2.32 Investors in unlisted shares in a start-up or young company, even i the company remains a going-

concern, ace the risk o never receiving a return on their investment i those controlling the companydecide not to issue dividends. And, i the business is sold or becomes listed, investors may ind theirshare in the proits is reduced i the value o shares is diluted by subsequent issues o new shares.Investors need to understand that they will have almost no control over these decisions.

No secondary market2.33 Ater purchasing unlisted equity in a company, even i it remains a going-concern, investors will

usually ind there is no, or only a limited, secondary market or their investments. Consumersinvesting in such equity need to understand that they will probably have to wait until anevent occurs, such as the sale o the company, a management buy-out or a lotation, beoregetting a return. Consumers should realise that, in the event o their death, ownership o theseinvestments will probably need to be transerred to their beneiciaries.

Q4: Do you think there are other risks relating tocrowdunding that we should consider and seekto address?

10 The Oice o National Statistics, Business Demography 2011, 13 December 2012, shows UK ive-year survival rate or businesses

born in 2006 and still active in 2011 was 45% (ailure rate 55%). The health industry ive-year survival rate was 60% (ailure

rate 40%), but the hotel and catering ive-year survival rate was 35.7% (ailure rate 64.3%). http://www.ons.gov.uk/ons/

dcp171778_291893.pd Figures are consistent with the one- and three-year survival rates published or irms registered between1995 and 2004 in the Department o Trade and Industry 2007 publication Survival Rates of VAT-registered enterprises, 2007,

suggesting that the 2008 inancial crisis has not unduly aected the ailure rates. http://stats1.bis.gov.uk/ed/survival/htm/Key%20

Results1.htm


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3.

Loan-based crowdfunding

3.1 In this chapter we outline our proposals or the protection o investors using loan-basedcrowdunding platorms. We propose to treat investments on these platorms in a similarmanner to other investments, making them subject to similar rules.11

3.2 The regime we envisage will apply the FCA principles or businesses and set core requirementsor irms in terms o their capital position, treatment o client money and dispute resolution.Beyond that, we are consulting primarily on the introduction o a disclosure-based regime thatrequires irms to ensure that all communications are air, clear and not misleading. We are alsoproposing a requirement or irms to have in place measures to protect investors in the evento platorm ailure.

Investments on loan-based crowdunding platorms

3.3 The risks acing the people lending money on loan-based crowdunding platorms dier romthe risks acing borrowers using the same platorms and our regulatory approach needs torecognise their needs and apply a tailored set o protections. We thereore believe it is necessaryto consult on the introduction o rules that protect both investors and borrowers.12

3.4 In this paper we reer to the people lending money as investors and the transaction romtheir point-o-view as an investment. We have chosen to do this, rather than to reer to themas lenders and their transaction as lending to avoid conusion with regulated irms thatlend money. We consider this the right approach even though the new regulated activity, andconsequently some o the Handbook text on which we are consulting, reers to these clientsas lenders.

3.5 We plan to treat investments on loan-based crowdunding platorms largely as we do otherdesignated investments. Rules that apply to irms arranging transactions in designatedinvestments will thereore also apply to irms running loan-based crowdunding platorms. Oneimplication o this is that irms running loan-based crowdunding platorms will need to reerto two conduct o business rulebooks: one that sets rules or investors and one or borrowers.

11 For readers new to FCA regulation, this guide helps explain the dierent components o our Handbook: www.ca.org.uk/static/documents/handbook/readers-guide.pd

12 For more inormation on our proposals or rules to protect borrowers, see High-level proposals for an FCA regime for consumer

credit, CP13/7, March 2013 and Detailed proposals for the FCA regime for consumer credit, CP13/10, October 2013.


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October 2013

The Financial Services Compensation Scheme

3.6 We are not proposing to include loan-based crowdunding platorms within the remit o theFSCS. When looking at the amount o loss investors might suer i a platorm ailed and theamount that would be covered by the FSCS, it is not clear that there is justiication to includethem within the FSCS jurisdiction. Further, customers are likely to think their money is protectedto a much greater extent than is the case. Even i recourse were available, the FSCS could onlyprovide protection i:

an FCA-authorised rm has ailed and cannot meet claims against it

the claimant is eligible to claim to the FSCS

the claim relates to an activity protected by the FSCS, and

the rm owes a civil liability to the claimant, e.g. it is liable to the claimant or breach ocontract or in negligence. Proving this is likely to be dicult.

3.7 In practice, cover might be available in limited circumstances only, or example i either theplatorm or the bank in which the money is held (prior to investment) ailed beore the moneywas invested. Customers aected in these ways should already be protected to an extent.

In the rst situation, our client money rules provide or the return o client money to clientsin the event o a rms insolvency (see the section below or more detail o this process).

In relation to the second situation, where a bank ails, bank deposits are already subject toFSCS jurisdiction so urther protection is unnecessary. So long as the client money account isset up in accordance with our client money rules, each client will have benecial ownershipo their own money within the client account and will, thereore, be protected by theFSCS.13

3.8 We are proposing a change to the participant irm Glossary deinition which will make it clearinvestment on loan-based crowdunding platorms is not within the FSCS remit. As describedlater in this chapter, in the section on disclosure rules, we also expect irms to disclose the lacko access to the FSCS to potential investors.

Q5: Do you agree that we should not include loan-based

crowdunding platorms within the remit o the FSCS?

Our proposals or the regulation o investment on loan-basedcrowdunding platorms

3.9 In the ollowing sections we set out our approach to regulating irms that operate loan-basedcrowdunding platorms. The description is intended as a helpul summary or irms o someo the key concepts in our rules. It is not a complete description o the relevant rules and irmsmust reer to the Handbook to ensure compliance.

13 The FSCS can pay each client up to 85,000 per ailed institution. Depositors may still receive a share o their savings above this limit

ollowing any distribution o assets as part o the insolvency process or a ailed bank. This would be a matter or the insolvency

practitioner to determine and any recovery would, by necessity, vary according to the circumstances o the speciic ailure.


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Related areas on which we are consulting3.10 In the irst consultation on the regulation o consumer credit.14 We have made it clear that arange o high level requirements apply. These include:

the threshold conditions or authorisation

the FCA Principles or Businesses

senior management arrangements, systems and controls, and

general provisions

3.11 While the earlier consultation ocused on consumer credit activities, these high-level regulationswill apply both to the consumer credit activities and the investment activities o irms runningloan-based crowdunding platorms.

Prudential standards3.12 We set requirements on the amount o prudential resources authorised irms must hold to help

them withstand any uture inancial shocks.

3.13 We aim to set prudential resource requirements (which we reer to as prudential standards)that relect the inancial and business risks posed by irms. Due to the relative inancy o thismarket we have tried to minimise the burden that our prudential standards will have on irms,especially in the early years o our regime. As a result, we are proposing to transition our regimeover several years, so it only comes ully into orce on 1 April 2017.

What are prudential standards and why are they important?3.14 Prudential standards have two key elements:

prudential requirements, which are the obligations we place on rms to hold certainamounts o specied nancial resources or regulatory purposes, and

prudential resources, which describe what nancial resources a rm actually holds

3.15 Comparing the amount o prudential resources a irm holds with its prudential requirementtells us i a irm is meeting its requirement or not.

3.16 Prudential standards are important because they aim to minimise the risk o harm to consumersby ensuring that irms behave prudently in monitoring and managing business and inancialrisks. Experience tells us that i a irm is in inancial diiculty or it ails, it can cause harmand disruption or consumers. A irm under inancial/prudential strain is more vulnerableto behaving in a way that increases the probability o consumers suering loss. Prudentialstandards support the FCAs statutory objectives and conduct responsibilities o irms by aimingto ensure that irms have suicient prudential resources to cover operational and complianceailures and/or pay redress.

14 High-level proposals for an FCA regime for consumer credit, CP13/7, March 2013


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October 2013

3.17 The FCA approach documentJourney to the FCA outlines the FCAs prudential vision and howthe FCA prudential approach will aim to minimise the risk o consumer harm as a result o irmsbeing under inancial stress, while also improving the strength and integrity o the inancialsystem.15

Why are we proposing prudential standards or loan-based crowdunding?3.18 When developing our proposals we weighed up the harm that consumers might ace i a

irm was to be under inancial stress against the cost o introducing prudential requirements.We believe that the risk inherent in loan-based crowdunding irms means that prudentialstandards are a key regulatory tool in minimising harm to consumers.

3.19 In terms o harm, we consider loan-based crowdunding irms to pose a high risk to consumersbecause they may hold and/or control client money beore lending this money to the borrowers.Firms holding client money typically need more time to wind-down. Furthermore, i a irm wereto ail, it is extremely likely that there will be loan contracts that have not matured. Havingprudential resources gives irms time during which they can continue providing their serviceswhile updating and transerring records, thereby improving the opportunity or a more orderlywind-down or transer o business to another irm.

3.20 There are similarities between loan-based and investment-based crowdunding platorms.They are both intermediary platorms acilitating investment opportunities where investorsmoney is at risk o loss. The main dierence is the underlying instrument. Investment-basedcrowdunding irms are already subject to prudential requirements and, thereore, to ensurea degree o equivalence, we believe that irms running loan-based platorms should also bebound by prudential standards.

Prudential standards or loan-based crowdunding frms3.21 In summer 2013 we asked a number o irms running loan-based crowdunding platorms or

inormation on their operations. We thank all irms that took the time to respond and haveused the inormation they provided to inorm our policy on this and other matters. As a result,we believe that we have been able to design an appropriate regime or irms captured by ourproposals. We have striven to design a regime that:

is not overly complex, and

balances the need to protect consumers while at the same time aiming to acilitate marketcompetition

3.22 We propose that the prudential requirements or irms subject to our rules will be the higher o:

a xed minimum amount, and

a percentage o a volume-based measure

3.23 The ixed minimum amount that irms will be required to hold in our ull regime will be50,000. However, irms will not have to meet this requirement until 1 April 2017. Untilthen there will be a transitional ixed minimum requirement or irms o 20,000. For moreinormation on irms requirements beore 1 April 2017, please see the transitional provisionssection below.

15 FCA,Journey to the FCA, October 2012: www.ca.org.uk/your-ca/documents/sa-journey-to-the-ca


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3.24 The volume-based measure is a percentage o the total amount o loaned unds on theplatorm. To take into account economies o scale this percentage will reduce i more unds areloaned on the platorm. This will be calculated as the sum o the ollowing:

0.3% o the volume o loaned unds up to 50m

0.2% o the volume o loaned unds above 50m up to 500m, and

0.1% o the volume o loaned unds above 500m

3.25 Firms will be subject to the volume-based measure when they become ully authorised. Thismeasure will be calculated annually based on the irms accounting reerence date and willconsist o all unds that are being lent by investors to borrowers.

3.26 We believe that the metric total amount o loaned unds is the most appropriate in aligninga irms prudential requirement with the risk o harm that the irm poses to consumers. Forexample, the metric captures:

the likelihood o rms holding large amounts o client money at any point in time

the length o time it will take to wind-down a rm, and

the complexity o the rm including its size and number o customers

3.27 We also propose to require irms to recalculate their prudential requirement i the total value

o their loaned unds increases signiicantly (more than 15%). I this increase causes a changeto the irms prudential requirement, the irm must notiy the FCA so we can ensure theirprudential requirements are always up-to-date and accurate.

3.28 To ensure compliance with our rules, a irms prudential resources have to be greater than theirprudential requirements at all times. Failure to comply with these requirements could result inenorcement action.

3.29 I a irm is subject to more than one prudential regime (i.e. they are already prudentiallyregulated by the FCA or the PRA), they must meet the higher o the requirements to whichthey are subject.

Prudential resources3.30 Under our proposals irms will use the ollowing equation to calculate their prudential resources.This approach is similar to other existing FCA prudential regimes.

Table 1: How frms will calculate their prudential resources16

Prudential resourcescalculation

Share capital + reserves + interim net prots16 + eligible subordinated

debt investments in its own shares intangible assets investments insubsidiaries interim net losses

Q6: Do you agree with th Prudential standards proposedor loan-based crowdunding frms? I not, whatamendments would you make and why?

16 Interim net proits must be veriied by the irms external auditor, net o tax, anticipated dividends or proprietors drawings and other

appropriations.


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October 2013

Transitional provisions3.31 We are not proposing to apply the prudential requirements to all irms at the same time. Inline with the proposed prudential rules or debt management irms, we propose that existingOFT-regulated loan-based crowdunding irms will not be subject to our prudential standardsuntil they become ully authorised.

3.32 Firms that do not have a consumer credit licence beore 1 April 2014 will not be part o ourinterim permission regime. These irms will need to be ully authorised and will be immediatelysubject to our prudential standards.

3.33 We are conscious that, initially, irms may ind it challenging to meet our prudential requirements.Thereore, we propose to allow a period o transition or all irms, whether they hold an interimpermission or are ully authorised rom 1 April 2014.

Until 1 April 2017, the xed minimum prudential requirement or rms will be 20,000.This will reduce barriers to entry or rms in the early part o our regime and also providerms with adequate time to prepare or, and to meet, our ull prudential standards regimerom 1 April 2017.

And, until 1 April 2017, rms will not need to deduct investments in subsidiaries andintangible assets when calculating their prudential resources.

Table 2: How frms will calculate their prudential resources under our transitionalarrangements

Prudential resources calculation up to31 March 2017

Share capital + reserves + interim net prots + eligible

subordinated debt - investments in its own shares -interim net losses

Table 3: Summary o prudential standards regime or loan-based crowdunding frms

Transitional regime

(until 31 March 2017)

Full regime

(rom 1 April 2017)

Higher o:

Fixed minimum = 20,000

Variable volume-based measure =

0.3% o the volume o loaned unds upto 50m

0.2% o the volume o loaned unds above50m up to 500m, and

0.1% o the volume o loaned unds above

500m

Higher o:

Fixed minimum = 50,000

Variable volume-based measure =

0.3% o the volume o loaned unds upto 50m

0.2% o the volume o loaned unds above50m up to 500m and

0.1% o the volume o loaned unds

above 500m


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Table 4: Timeline o transitional arrangements

1 April

20141 April

20161 April

2017

Firms with interimpermission will not besubject to our transitional

prudential regime until theybecome fully authorised.

New rms from 1 April 2014will have to be fully authorisedand therefore subject to ourtransitional prudential regime(higher of the xed minimumof 20,000 or thevolume-based measure andonly deduct certain itemsfrom their nancial resourcescalculation).

All interim permissionrms will be fullyauthorised by the

FCA and subject to ourtransitional prudentialregime.

The transitionalarrangements will fallaway and all rms will

be subject to the fullprudential regime.

Q7: Do you agree with the transitional approach proposedor the prudential requirements or loan-basedcrowdunding frms?

Client money rules3.34 Firms that hold client money in relation to investment business are subject to the client money

rules contained in our Client Assets sourcebook (CASS).17 These rules require irms to ensureadequate protection o client money when the irm is responsible or it.

3.35 For loan-based crowdunding platorms, money received rom a client or the purposes olending out to borrowers and repayments rom borrowers to be provided back to clients

whether received physically or electronically will be regarded, while the irm is holding it, asclient money held by the irm or or on behal o the client in relation to investment business.The irm holds this money as trustee and must thereore make adequate arrangements tosaeguard it. We thereore propose to apply the existing client money rules (or investmentbusiness) to this activity with some minor amendments. We recently consulted on changesto the client money rules and other sections o CASS in CP13/5.18 We encourage readers toread this other consultation as it will also be relevant or the loan-based crowdunding market.However, irms running loan-based crowdunding may be subject to the existing Client Assetssourcebook or a period beore any changes ollowing CP13/5 come into orce. They may,thereore, need to uture-proo their systems to accommodate any changes made ollowingCP13/5.

17 http://shandbook.ino/FS/html/FCA/CASS/7

18 FCA, CP13/5, Review of the client assets regime for investment business: www.ca.org.uk/static/documents/consultation-papers/

cp13-05.pd, July 2013


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October 2013

3.36 The table below gives an indication o some o the main rules that we propose to apply to irmsoperating loan-based crowdunding platorms, based on our understanding o the businessmodels we have observed.19 The second column indicates where we have proposed changesto the relevant area o rules in CP13/5.2021222324252627

Table 5: Applying client money provisions to loan-based crowdunding platorms

Requirements Relevant sections o CP13/5

Firms must notiy us each year o their current classication

as small, medium or large or the purposes o client moneyrules.20 This classication exercise has implications or therequency o client money reports and senior management

responsibility or client money procedures.21

No changes are proposed to these

provisions.

Firms classed as medium or large are required to have asingle member o sta approved to take responsibility orCASS oversight.22 Firms classed as small must allocate thisresponsibility to a member o the rms governing body.

No changes are proposed to theseprovisions.

Firms holding client money have a duciary duty to theirclients and can only pay out money in such a way as

discharges this duty.23

See the sections on Money ceasing

to be client money and Transers obusiness (paragraphs 4.39 to 4.47).

Firms must have adequate organisational requirements tosaeguard clients rights.24


Firms must deposit client money at an appropriateinstitution (or rms running loan-based crowdundingplatorms, this will be a bank)25 and undertake relevant due

diligence in relation to this third party.26

See the ollowing sections:

Client bank accounts (general)(paragraphs 4.56 to 4.62)

Unbreakable term depositaccounts (paragraphs 4.63 to 4.66)

Immediate segregation (paragraphs4.67 to 4.70)

Physical receipt and allocation clientmoney (paragraphs 4.74 to 4.81)

Prudent over-segregation(paragraphs 4.82 to 4.86)

Firms must keep records and accounts so they can always

distinguish client money held or one client rom clientmoney held or another. To meet this requirement, rmsmust conduct internal and external reconciliations.27

See the section on Reconciliations and

record keeping (paragraphs 4.104 to4.122).

19 For the sake o clarity, since irms running loan-based crowdunding platorms will be undertaking investment business, they will

be subject to all o CASS as relevant. The table is not exhaustive and, i a irm undertakes any other investment business than loan-

based crowdunding, all the relevant rules will apply.

20 Firm classiication under CASS 1A.2 is based on an annual stratiication exercise. Firms holding less than 1m in client money are

classed as CASS small irms, irms holding an amount o client money greater than or equal to 1m but less than or equal to 1bn

are CASS medium irms, and irms holding more than 1bn in client money are CASS large irms.

21 For more inormation see chapter 5 o FSA, PS10/16, Client Assets Sourcebook (Enhancements) Instrument, www.ca.org.uk/static/

pubs/policy/ps10_16.pd, October 2010

22 Controlled Function 10A, listed in SUP10A.4.4R

23 CASS 7.2.15R to 7.2.17R

24 CASS 7.3

25 The rules also permit irms to invest the money into units o Qualiying Money Market Funds as a method o segregation; however,this is subject to certain conditions such as a irm having the relevant permissions.

26 CASS 7.4.1R to 7.4.12R, CASS 7.4.14G to 7.4.17G and CASS 7.4.22G to 7.4.23G

27 CASS 7.6


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Requirements Relevant sections o CP13/5

Client money must be held under statutory trust.28 None o the proposed changes is

relevant to rms running loan-basedcrowdunding platorms.

Firms must, when opening a client bank account, obtain thebanks acknowledgement that the money in the account is

held or the rms clients and that the bank cannot recoverthe rms debts rom the client bank account.29

See the section on Acknowledgementletters (paragraphs 4.123 to 4.133).

Firms must carry out internal reconciliations o records andaccounts o client money. We would expect loan-basedcrowdunding platorms to use method 2 under paragraph

6 o CASS 7 Annex 1G.

See the section on Reconciliations andrecord keeping (paragraphs 4.104 to4.122).

A set process when dealing with client money in the event

o rm ailure, or in the event o the ailure o the bankwhere a rm holds client money.30

See the chapter on Prioritising speed

(Chapter 2).

Firms must be able to retrieve a CASS Resolution Pack asset out. This inormation will help an insolvency practitioneri there is a primary pooling event.31


Q8: Do you agree that frms running loan-basedcrowdunding platorms should be subject to our clientmoney rules?28293031

Transers o client money on a going-concern basis

3.37 We are not planning to make any changes to our rules to provide or the transer o clientmoney i a platorm wishes to stop perorming its role. Depending on the circumstances, todischarge its duties to the client money it holds, a irm might be subject to existing provisionsin CASS or in the proposed rules at CASS 7.2.17BR o the drat instrument in CP13/5. Thisrule provides relatively strict requirements or a transer o client money. Alternatively, a irmcould simply arrange or payments under existing loans to be routed through another party (inaccordance with any contracts in place) and ensure any remaining money held by the irm ispaid to investors beore cancelling its permissions.

Client money in the event o an insolvency or a primary pooling event3.38 On certain events, such as an insolvency, CASS provides that a primary pooling event will occur.

Our client money distribution rules (CASS 7A) provide or how to distribute client money to

clients ollowing a primary pooling event. We are not proposing any changes to these rulesin view o crowdunding and similar activities, but this section gives an overview o how wewould expect this to work.

3.39 It is important to note that while the client money rules provide or the return o money toclients i a irm ails, they do not amount to a compensation regime. Clients share any shortallin the amount o client money held at time o the primary pooling event on a pro-rata basis,and the insolvency practitioners costs o distributing client money to clients is paid or out othe pool o client money, also borne by clients on a pro-rata basis. Also, a shortall could be dueto losses relating to a dierent type o business carried out by the irm.

28 CASS 7.729 CASS 7.8

30 CASS 7A

31 CASS 10 CASS Resolution Pack


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October 2013

3.40 We would expect, under our rules, that the money held by a platorm at the time o a primarypooling event, including money repaid by borrowers but not yet paid out to investors, shouldbe repaid by the insolvency practitioner acting on behal o the ailed platorm to the relevantinvestors. This is because all repayments by borrowers should go towards repaying the loansthey have taken, so we would expect this money to be paid to investors (less any ees due tothe irm). We do not envisage that payments will be made to borrowers where they have paidmoney to the platorm and this has not yet been paid to investors, i.e. we are not proposingto make borrowers clients o the platorm. This is because we think that there may be risktranser in the contracts, which is to say that the borrowers obligation to make a repayment isdischarged under the contract when the borrower makes a payment to the platorm.

Q9: Do you agree that money held by the ailed platorm atthe primary pooling event should be returned only torelevant investors?

Q10: I contracts do not provide or risk transer in the waydescribed above, should CASS include a rule to requirethis in order to protect borrowers?

3.41 Money received ater a primary pooling event should not be pooled with the money held priorto the pooling event, and should be held in accordance with CASS and paid to the relevantclient (investor) without delay. I the ailed irm wishes to cancel its permissions, it may needto ensure that payments rom the borrowers could be re-routed appropriately so that theplatorm did not receive any more money due to investors. At this point, the irm could thencancel its permissions it is unlikely that the irms permissions would be cancelled i it was

continuing to receive money rom clients. Alternatively, i the irm, under our proposals ora platorms arrangements in the event o its ailure, is able to administer the repayment oexisting loans on the basis o the ees collected rom borrowers, the irm could simply continueto return any money due to investors.

Q11: Do you agree with our understanding o how moneyreceived ater a primary pooling event will be treated?


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Client money in the event o ailure o a third party3.42 We reer to ailure o a third party, such as a bank that holds the client money account, as asecondary pooling event. In this event, the irm may, depending on the circumstances, have to:

repay clients (or pay the money into another client bank account) an amount equal to anyshortall as a result o the banks ailure, or

calculate the amount lost and each clients pro-rata share in that loss

3.43 Firms must notiy the FCA as soon as possible o secondary pooling events.

3.44 Investors may have recourse to the FSCS i the bank at which the client money account is heldails. This depends on a number o actors, including whether or not the bank in question is anFSCS participant irm. Clients may be able to claim or losses (see the section o this chapter onthe FSCS or more detail) depending on the circumstances.

Protections in the event o ailure o the frm running the platorm3.45 Our proposed capital requirements should reduce the probability o the ailure o irms running

loan-based crowdunding platorms but there is still a possibility that this may happen inthe uture.

3.46 As the loan agreements acilitated on these platorms are generally made between investorsand borrowers, the ailure o the platorm might not necessarily lead to losses in itsel. However,the costs o the insolvency practitioner distributing the money to clients must be paid or outo the pool o client money, and any loss must be shared on a pro-rata basis so investors could

suer a loss i there is not suicient money to complete the distribution.

3.47 I a platorm does ail, existing loans must still be administered and this may be diicult orindividual investors. With some platorms, or example, investors do not know the identity othe borrowers to whom they have lent money. An investors stake in a particular loan may besmall, meaning that it is not economic to chase missing payments. These actors may encourageborrowers to deault on loans leading to a real risk o harm to consumers. There is anecdotalevidence that this has happened in the past when platorms have gone out o business.

3.48 So we are proposing to introduce a rule that irms must have arrangements in place to ensurethat loans continue to be administered i the irm goes out o business. In such an event wewould expect the ollowing actions to take place:

client money should be distributed to investors under our client money rules

a new client bank account should be set up to receive ongoing payments or existing loansunder our client money rules

no new loans should be made and existing loans will remain valid under their original terms,and

the rms arrangements to manage those existing loans, apportioning repayments to theright investors and ollowing up late repayments or borrower deaults should come intoeect


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October 2013

3.49 The arrangements could be with another loan-based crowdunding platorm irm, a debtadministrator or unded by ongoing ees taken rom repayments on existing loans but a contractshould exist to allow a smooth transition o responsibilities to the new administrators.32

3.50 The rules we are proposing aim to ensure the alignment o the irms arrangements in the event oplatorm ailure with the client money rules, so that the two work together and are not in conlict.

Q12: Do you agree that frms operating loan-basedcrowdunding platorms should be required to havearrangements in place so that existing loans continue tobe administered in the event o platorm ailure?

Cancellation rights3.51 The Distance Marketing Directive (DMD) requires that most inancial services contracts made at

a distance (that is, without the simultaneous physical presence o the supplier or intermediaryand the customer) give customers the right to cancellation, without penalty and without givinga reason. Where this applies, customers generally have the right to withdraw their moneywithin the irst 14 calendar days. The DMD does not allow consumers to waive this right.

3.52 Cancellation rights may, thereore, be available to investors on loan-based crowdundingplatorms unless an exception exists.

There is no right to cancel distance contracts or investments whose price depends onfuctuations in the nancial market outside the rms control.33 Thereore, where platormsinclude a secondary market and investors are able to sell their interest in a loan at prevailing

market prices, there is no automatic right to cancel the contract.

The DMD cancellation rights only apply to services provided to consumers.34 Investors whoare investing money via loan-based crowdunding platorms in the course o business arenot regarded as consumers and do not benet rom the DMD cancellation rights.

The cancellation period need not be adhered to in circumstances where the perormanceo a contract has been ully completed by both parties at the consumers request beore theright o withdrawal is exercised.35

3.53 So, the DMD creates 14-day cancellation rights or consumers investing on platorms that oerno secondary market. Where there is a secondary market, consumers wishing to access their

capital early can do so. In other cases, it seems appropriate that consumers have a period otime at the start o the contract to change their minds.

32 I the administration irm is to be set up and unded rom ongoing ees taken rom repayments on existing loans, it needs to have the

relevant authorisation and irms should consider what happens as the pool o existing loans reduces over time. Since there will be no

new loans, the ee income will all over time and irms must be able to administer the existing loan book until it is ully closed.33 COBS 15 Annex 1 1.10R(1)

34 The term consumeris deined here: http://shandbook.ino/FS/glossary-html/handbook/Glossary/C?deinition=G210

35 COBS 15 Annex 1 1.10R(2)


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3.54 In these cases, we recognise that it is not easible to allow each investor the chance to withdrawrom a particular loan agreement ater agreeing to und it. We think that the cancellation periodshould attach to the investors decision to register with a platorm rather than to investment ina speciic loan.36 In eect, thereore, it seems likely that irms without a secondary market atpresent and which choose not to introduce one will elect to run one o two systems:

either a rm may allow consumers to invest in loan agreements but repay them their moneywithin the rst 14 days, i requested,37 or

consumers will not be able to invest money in loan agreements within the rst 14 days oregistering with a platorm

3.55 Firms running loan-based crowdunding platorms should note that they are already subjectto the DMD under the Financial Services (Distance Marketing) Regulations 2004 and shouldalready comply with it, where appropriate.38 As such, the general transitional period that weplan to grant to irms with an interim permission will not apply to cancellation rights.

Q13: Do you agree with our interpretation o the DistanceMarketing Directive cancellation rights or frmsoperating loan-based crowdunding platorms?

Disclosure rules3.56 The core concept at the heart o our disclosure requirements is that all communications rom

the irm must be air, clear and not misleading.39 This central concept is explained urtherwith a set o rules that apply when the irm is communicating to a retail client.40 All such

communications must, or example, be accurate and provide suicient inormation or theclients needs. Communications must include a air and prominent description o relevant riskswhere beneits are discussed. They must be presented in a manner likely to be understood bythe target audience. And they must not downplay important inormation and warnings.

3.57 From our initial review o the market, we are concerned that a number o platorms would bein breach o these requirements. See Annex 4 or urther detail on the indings o our review.Common issues we observed include:

a lack o balance, where disclosures emphasise benets without a prominent indication o risks

insucient inormation disclosure leading to a potentially misleading or unrealistically

optimistic impression o the product, and

downplaying important inormation

36 Under the successive operations principle in COBS 15 Annex 1 1.11R

37 Firms must repay consumers without undue delay and no later than within 30 calendar days. The irm may deduct money or any

service provided beore the cancellation. This amount must be proportionate to the service provided and must not act as a penalty

or cancellation.

38 www.legislation.gov.uk/uksi/2004/2095/contents/made

39 Principle 7 and COBS 4.2.1R(1)40 Retail clients are deined in COBS 3.4. In short, a retail investor is a client who is neither a proessional client nor an eligible

counterparty. Proessional clients and eligible counterparties are deined in COBS 3 and, generally speaking, are institutional clients

and individuals who invest by way o business. Our general rule or irms communicating with retail clients appear in COBS 4.5.2R.


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October 2013

3.58 Websites sometimes, or example, have a banner headline rate o return that is oten in doubleigures, without an explanation o the impact o charges, deault rates and taxation. In somecases, it appears that the actual returns to customers can be substantially less than the headlinerate. Inormation on product risks has been obscured when on a separate page or at the endo a long page o inormation, relying on investors to click through to it or scroll down. Somewebsites only provide risk warnings ater customers register.

3.59 We have also observed that some websites reer to the investments in loan agreements almostas i they are deposits. For example, the use o comparisons with deposit rates and reerencesto investors as savers may be problematic. Investing via loan-based crowdunding platormsis o higher risk than making a deposit and it is not comparing like-with-like to reer overtly tolower deposit returns without explaining these risks. In some cases, too, actual returns atercharges and expected deault rates may be lower than the returns on deposits.

3.60 Firms need to review their websites and change some o these misleading practices. We willbe paying close attention to communications and remind irms that we have the ability to baninancial promotions including websites i we consider that they do not meet our standards.

3.61 In the ollowing sections we set out some o our key requirements or inormation that has tobe disclosed and how it must be disclosed.

Inormation about the frm3.62 Retail clients must receive certain inormation about the irm, including:

contact details

a statement that the rm is authorised41

details o what perormance reports the client can expect

the rms conficts o interest policy

inormation on costs and charges, and

details o the rms client money saeguards42

3.63 The irm must also have a written basic agreement with the client setting out the essential

rights and obligations o the irm and the client.

43

This inormation must be supplied in goodtime beore the irm provides a service and the client makes a transaction.

41 Firms should reer to the appropriate orms o words set out in GEN 4 Annex 1 R or GEN 4 Annex 1A R as appropriate

42 COBS 6.1

43 COBS 8.1


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Inormation about the service3.64 We are not proposing to mandate the orm and content o investment disclosure documents aswe do with some other investments commonly used by retail clients (such as the key investorinormation document or collective investment schemes or the key eatures documentationthat must be provided with, or example, lie policies and personal pension schemes). Wedo not believe that the dierent models adopted by loan-based crowdunding platorms iteasily into the standardised ormat o these documents so we do not propose to require irmsto ollow them at this time. Instead, we propose to apply existing high-level requirements torequire irms to ensure that they provide an adequate description o the investments natureand risks.44 Under this approach, irms need to provide relevant inormation to enable theinvestor to make inormed investment decisions.

3.65 We consider the ollowing to be relevant aspects or disclosure:

The key risk acing investors is borrower deault. It remains to be seen, or example, howthe investments will perorm i interest rates increase and borrowers struggle to repayother debts with variable rates.45 Investors should understand the current deault rate, anyexpectations or uture deault rates, and how reliable the estimates are. Investors shouldalso know that current and expected deault rates may not remain stable.

Dierent rms employ dierent approaches to due diligence. We expect it to be clear toinvestors how much due diligence has been conducted and whether the investor should beconducting urther research o their own.

Some platorms grade the level o risk associated with particular loans. Where this is the case,

investors should be told what the dierent levels o risk mean and how borrower creditworthinesshas been assessed. Where platorms do not oer dierent risk grades or the loans they makeavailable, they should still make clear to investors what level o risk is being taken.

Some platorms oer secured loans, others do not. It should be clear to investors whethertheir loan is secured. I it is, it should be clear how the loan is secured, how the underlyingasset is valued and how the asset would be treated in the event o platorm ailure.

Platorms oten ocus on rates o return available. Customers must understand what theactual rates o return are likely to be ater charges and expected deault rates.

The way taxation is calculated or investors transacting on loan-based crowdunding

platorms must be set out clearly. Investors must understand what tax obligations they aceand what impact tax will have on the return on their investment.

Since there is no standard practice across the market, it should be clear how the rmdenes what is meant by a late payment and deault on a loan. Firms are obliged to actin the best interests o customers and these denitions should be reasonable.46 We wouldnot expect, or example, a loan to be classed as in late payment rather than in deault ia substantial period has passed.

44 COBS 2.2 and COBS 14.3

45 While interest rates on loans acilitated by loan-based crowdunding platorms are generally ixed over the term o the loan, other

economic conditions are not. For example, an individual borrower with a mortgage on the average standard variable rate (3.56% inJune 2013) might struggle to meet ongoing payments i the Bank o England base rate (0.5% in June 2013) increased to the long-

term average o around 4% and the ull increase were passed on to mortgage borrowers.

46 Principle 6 and COBS 2.1.1R(1)


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The process to be ollowed when loans enter deault should be clear. Again, there is noindustry standard and customers should know how ar the platorm will go to securepayment and where responsibility lies or chasing non-payment and arranging interventionrom debt collection agencies.

Platorms should make clear what would happen i an investor wants to exit rom aninvestment beore its maturity. There may be a secondary market, or example, but any limitsor risks should be disclosed. Alternatively, i there is no option to sell out o an investmentearly, this should be disclosed.

It should be clear to investors what would happen i the rm running the platorm ails. Inparticular, the lack o recourse to the FSCS should be explained clearly.

As discussed below in the section on dispute resolution, the process or making complaintsand recourse to the Financial Ombudsman Service should be set out.

3.66 As well as general disclosures o the nature and risks o investment on the platorm, dependingon the platorm structure, there may also be speciic inormation about loans that should bedisclosed. This inormation could include:

the expected rate o return rom a specic loan, taking account o charges, expected deaultrates and the possible implications o taxation, and

where investors are choosing to make loans to specic borrowers, the creditworthinessassessment (required under the consumer credit rules) should be disclosed to investors

3.67 As each loan-based crowdunding platorm can have an entirely dierent business model, thislist should not be regarded as exhaustive. Firms should consider what disclosures are relevantin light o the nature and risks o their platorm.

3.68 As with the inormation about the irm, this inormation must be supplied in good time beorethe client makes a transaction. While inormation need not be supplied all at one time, it isessential that all communications meet the high-level requirements. In particular, irms shouldnot supply inormation on beneits without also providing a air and prominent indication orisks at the same time. We do not expect to see only beneits described on the irst pages that aconsumer views, with inormation on the risks o investment only supplied later in the customerjourney, perhaps only ater the customer has registered with the platorm.

Financial promotion rules3.69 An invitation or inducement to engage in investment activity, communicated in the course

o business, is a inancial promotion.47 A inancial promotion that speciies the manner oresponse or includes a orm by which any response may be made is regarded as a direct oerinancial promotion in our rules.48 Promotions on platorms that allow online transactions are,clearly, within the scope o these deinitions.

47 More inormation on our expectations or inancial promotions is available here: www.ca.org.uk/irms/being-regulated/inancial-

promotions

48 COBS 4.7


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3.70 Unless they have identiied that an exemption applies, irms should have processes in placeto ensure they comply with the inancial promotion rules when communicating or approvinginancial promotions.49 They should keep a record o all inancial promotions that theycommunicate or approve.50

3.71 In particular, direct oer inancial promotions must contain all appropriate inormation aboutthe investment so that the client is reasonably able to understand the nature and risks involvedand, consequently, to make investment decisions on an inormed basis.

Perormance inormation3.72 I irms provide inormation on past perormance or uture perormance, they must do so in

accordance with certain rules.51

Where past perormance inormation is provided (such as deault rates over the last sixmonths), it must not be the most prominent eature o a communication; there must bea warning that past perormance may not be repeated; and, to avoid cherry-picking thebest data, the inormation must include past perormance or complete 12-month periods,showing inormation or at least ve years perormance where that is available, or the ullperiod where it is not.

Future perormance (including estimated uture deault rates), must be based on reasonableassumptions and objective data, not past perormance; the eect o ees and other chargesmust be disclosed; and, there must be a prominent warning that such orecasts are not areliable indicator o uture results. I objective data is not available, it will not be possible orrms to give uture perormance inormation.

Guarantees, protections and security mechanisms3.73 Our rules and guidance detail how irms should explain terms that imply the existence o security

mechanisms.52 In order to provide air, clear and not misleading disclosures, when using termssuch as guaranteed, protected or secure, or reerring to contingency unds, irms shouldprovide inormation to make it clear what these terms mean or the consumer. They should, inparticular, explain any limits that apply. I they do not, consumers could misunderstand whatis actually oered.

Comparative inormation3.74 We have noticed some platorms in the loan-based crowdunding market include comparisons

between interest rates and deposit account rates. Our rules state that comparative inormation

must be meaningul and presented in a air and balanced way, comparing like with like.

53

3.75 As loan-based crowdunding is not directly comparable to holding money on deposit, giventhe additional risks, we consider that some loan-based crowdunding platorms would be inbreach o our rules i they applied today. I such comparative data is presented in uture, to becompliant, it should be accompanied by a air and prominent indication o the risks o loan-based crowdunding relative to the risks applying to deposits. This indication should not bedisguised, diminished or obscured, but should carry equal weight to the comparison and n

Documents

Financial Conduct Authority Regulatory Approach to Crowdfunding.pdf