Financial Regulation Consultation Paper 13/13: The FCA’s regulatory approach

to crowdfunding (and similar activities)

November 2013

5926

Pinsent Masons | Financial Regulation

In the Entrepreneurship 2020 Action Plan1 the European Commission stated that it will “ work with European investors in order to increase the flow of venture capital and crowdfunding into web start-ups” and invited the Member States to “assess the need of amending current national financial legislation with the aim of facilitating new, alternative forms of financing for start-ups and SMEs in general, in particular as regards platforms for crowd funding”.

On 24 October 2013 the Financial Conduct Authority (“FCA”) published its consultation paper on crowdfunding (“CP13/13”). It is the latest paper in advance of the FCA taking over the regulation of the consumer credit industry from the Office of Fair Trading (“OFT”) on 1 April 2014. The consultation paper sets out FCA’s proposed regulation of loan-based crowdfunding, The FCA’s regulations will apply to all firms that carry on the regulated activity detailed in article 36H of the Regulated Activities Order as ‘operating an electronic system in relation to lending’ (i.e. peer-to-peer lending). CP13/13 also includes proposals affecting the way the FCA regulates investment-based crowdfunding. The consultation is open until 19 December 2013 and the FCA will publish its final rules and guidance in February/March 2014. This briefing tracks the status and development of the reforms to the crowdfunding sector and summarises some of the key changes being proposed.

Who should read this briefing?•Loan-based crowdfunding platforms, on which consumers enter into loan agreements (‘loan-based crowdfunding’2)

•Investment-based crowdfunding platforms, on which consumers can invest in unlisted equity/debt securities, or units in an unregulated collective investment scheme (‘investment-based crowdfunding’3)

•Firms that communicate direct offer financial promotions for unlisted equity or debt securities to non-advised retail clients.

1. Entrepreneurship 2020 Action Plan - Reigniting the entrepreneurial spirit in Europe (COM(2012) 795 final). The Plan “sets out a renewed vision and a number of actions to be taken at both EU and Member States’ level to support entrepreneurship in Europe”.

2. ‘People lend money to individuals or businesses in the hope of a financial return in the form of interest payments and a repayment of capital over time’ (CP13/13, section 2.3).

3. ‘People invest directly or indirectly in new or established businesses by buying shares or debt securities, or units in an unregulated collective investment scheme’ (CP13/13, section 2.3).

1

In a Nutshell - What Firms Can Expect:•Loan-based crowdfunding – subject to regulation. Loan-based platforms will be subject to: (i) prudential standards; (ii) client-

money rules; (iii) (limited) cancellation rights; (iv) disclosure requirements; (v) reporting requirements; (vi) dispute resolution procedures; (vii) complaints regime

•Investment-based crowdfunding – subject to restrictions. Investment-based will be subject to: (i) investors restrictions; (ii) appropriateness assessment

•Transitional period available. Existing OFT licence holders will need to notify the FCA that they intend to benefit from the interim permission to continue to carry on regulated activities after 1 April 2014. All licensed holders will need to be fully authorised by 2016

•Unregulated activities. The FCA will not regulate donation-based and reward-based crowdfunding

•Exemptions. Exemptions are available for certain schemes (Enterprise Schemes, Industrial and Provident Societies marketing their own share issues).

5926

Scope of the new regulatory framework affecting loan-based crowdfunding The FCA has aimed to keep the scope of the regulation on crowdfunding such that it does not create ‘too many barriers to entry or significant regulatory burdens for firms’.

The regulatory framework for loan-based crowdfunding will be made up of a combination of:•FSMA and its secondary legislation (most notably the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (as

amended) (“RAO”))•Retained provisions in the CCA and its retained secondary legislation•Existing and new FCA rules and guidance.

To reflect the introduction of the new regime affecting crowdfunding platforms, the FCA will amend its Handbook, including Glossary, SYSC, IPRU(INV), COBS, CASS, SUP and DISP.

FCA regulation timetable – loan-based and investment-based crowdfundingIn our recent paper on Consumer Credit Regime, we have provided the general timetable for the transition between the OFT and the FCA supervision of consumer credit activities. Below we have detailed specific information in relation to the regulation of crowdfunding.

Loan-based crowdfunding•By 31 March 2014, where a firm already holds a licence to conduct debt administration and meets the new criteria for peer-to-peer

regulated activities, it can apply for an interim permission to continue operating•From 1 April 2014 new firms wishing to run loan-based crowdfunding will need to apply immediately for full authorisation and approval

of individuals carrying on certain controlled functions

•Before 1 April 2016, firms with interim permission must have applied for full authorisation.

As suggested in the CP13/13, loan-based crowdfunding firms that do not yet have a CCA licence from the OFT should consider applying for one now in order to benefit from the transitional regime from 1 April 2014.

Investment-based crowdfunding (and similar activities)The FCA has proposed the introduction of a transitional period allowing firms and their appointed representatives the option of either complying with the new rules from 1 April 2014, or complying with existing rules until 1 October 2014 (applying new rules from that date).

Background to the CP13/13 – changes affecting the consumer credit regimeIn our paper on Consumer Credit Regime we have covered the transition from the OFT to the FCA, starting from 1 April 2014. The FCA’s responsibilities will include the regulation of loan-based crowdfunding. Whilst investment-based crowdfunding is already a regulated activity, the FCA has decided to draw up new rules governing that market and also introduce regulation to the loan-based crowdfunding under a “lighter touch” regime. The differing rules are justified because loan-based crowdfunding activities ‘appear to be of lower risk than investment-based activities’. Furthermore, the FCA has also considered its competition objective in approaching its regulation in the sector and the promotion of new forms of investment.

2

Pinsent Masons | Financial Regulation

Loan-based crowdfunding – overview of the proposed regulationFCA’s CP13/13 sets out the envisaged regulatory framework applicable to loan-based crowdfunding from 1 April 2014 onwards, as summarised below.

Prudential standardsFirms will be required to comply with prudential requirements to hold the higher of: (i) a fixed minimum amount; and (ii) a percentage of a volume-based measure. The fixed minimum amount until 31 March 2017 will be £20,000, after which date it will be increased to £50,000. The volume-based measure will take into account the amount of funds loaned on the platform, and will be:•0.3% of the volume of loaned funds up to £50m

•0.2% of the volume of loaned funds above £50m up to £500m

•0.1% of the volume of loaned funds above £500m.

However, if a firm is subject to more than one prudential regime (e.g. they are already prudentially regulated by the FCA or the PRA), they must meet the higher of the requirements to which they are subject. The FCA proposes to require firms to recalculate their prudential requirement if the total value of their loaned funds increases more than 15%. Section 3.30 - 3.33 of the CP13/13 provides details on the proposed calculation methodology and transitional provisions.

Client money – general rules Some firms are already subject to compliance with CASS rules, to the extent they hold client money.

The CP13/13 extends certain CASS requirements to all loan-based crowdfunding platforms that receive money from clients for the purposes of lending it out to borrowers – the firms would hold client money as trustees and would have to have in place adequate arrangements to safeguard it.

The main CASS rules that the FCA proposes to apply to loan-based crowdfunding include: having adequate organisational requirements in place, performing record keeping and internal reconciliation, having CASS Resolution Packs in place.

Client money – in the event of insolvency or a primary pooling eventCASS provides that, in case of insolvency, a primary pooling event will occur. The FCA expects that the money held by a platform at the time of a primary pooling event, including money repaid by borrowers but not yet paid out to investors, should be repaid by the insolvency practitioner acting on behalf of the failed platform to the relevant investors. Money received after a primary pooling event should not be pooled with the money held prior to the pooling event and returned to investors without delay.Alternatively, if the firm has adequate arrangements in place in case of failure, it may simply continue to return any money due to investors on the basis of the fees collected from borrowers.

Client money – in the event of failure of a third partyFailure of a third party (such as the bank that holds the client money account) is classified as a secondary pooling event. The firm may have to either repay clients an amount equal to any shortfall as a result of the bank’s failure, or calculate the amount lost and each clients pro-rata share in that loss.

It is important to note that investors in this scenario may have recourse to the Financial Services Compensation Scheme (“FSCS”) if the failing institution is a bank (and provided the FSCS eligibility requirements are met).

Protection in the event of failure of the firm running the platformThe FCA is proposing to introduce a rule pursuant to which firms must have arrangements in place to ensure that loans continue to be administered if the firm goes out of business. In such an event the FCA would expect the following actions to take place:

•Client money to be distributed to investors according to CASS

•New client bank account to be set up to receive ongoing payments for existing loans under our client money rules

•No new loans to be made and existing loans will remain valid under their original terms

•The firm’s arrangements to be such that they enable the firm to manage those existing loans, apportioning repayments to the right investor and following up late repayments.

3

59264

Cancellation rightsThe Distance Marketing Directive requires that most financial contracts give the customers the right to cancellation, subject to certain limitation. To the extent that the products offered on a platform do not have a secondary market, the 14-cancellation right provisions apply.

Disclosure rulesPlatforms already have to comply with general FCA disclosure guidelines according to which all communications from firms must be fair, clear and not misleading.

The FCA has carried out a review of the market in order to assess whether its general principles were complied with and provided some guidance in relation to what level of disclosure firms will be expected to apply. In general, the FCA listed the minimum set of information a website should contain, as follows:•Information on the firm•Information on the service

•Information on the performance of the products

•Information on guarantees/security mechanisms in place

•Comparative information

•Periodic information to customers.

The box below looks more in detail into the practices that the FCA considers not in line with its guidelines.

ACT NOW – crowdfunding website review – issues identified by the FCA One important aspect of the CP13/13 is its report on the FCA’s review of the loan-based crowdfunding platform websites. The review was carried out against COBS 4 disclosure requirements that the FCA aims to impose to the firms going forward. The FCA’s findings were that none of the 21 websites reviewed fully met the standards for fair and balanced promotions. One of the points that the FCA stresses in its report is that it found that the risks of investments were downplayed.

Other areas of concern:

•Misleading and potentially unfair comparisons with bank deposits

•Use of ‘high headline’ rates of return rather than actual rates

•Partial and unfair disclosure of past and future performance in relation to default rates

•Absence of a taxation section, setting out the consequences of tax on investment returns

•Absence of an explanation in relation to the risk of fraud and money laundering

•Incomplete explanation when there is no recourse to the FSCS or FOS.

The FCA noted that use of social media, including tweets, blogs and forums still need to meet FCA’s expectations. Firms are recommended to address FCA’s concerns in relation to disclosure as a matter of priority.

Pinsent Masons | Financial Regulation

Dispute resolution and access to the Financial Ombudsman Service The FCA expects firms to have in place an adequate complaint procedure. Custumers would complain to the firm first, and then to the Financial Ombudsman Service (“FOS”) if the firm fails to respond within eight weeks from the complaint or the response is unsatisfactory.

Reporting requirementsThe FCA introduces a number of reporting requirements of different nature:

•Reporting under the CCA rules

•Reporting of financial positions to the FCA in case of significant increase of funds loaned (i.e. 15%)

•Reporting for client money purposes

•Reporting on clients investments (to enable the FCA to monitor investor experience)

•Reporting on complaints received.

These are detailed under sections 3.82-3.88 of the CP13/13.

Investment-based crowdfunding – overview of the proposed regulationInvestment-based crowdfunding has been supervised by the FCA on an individual basis, by placing restrictions at the point of authorisation on firms operating investment-based platforms. The FCA now proposes to restrict the type of investors to whom platforms offer unlisted shares or debt securities, including unregulated collective investment schemes. Firms will be able to promote and sell the above products only to the following types of investors:

•Retail clients who are certified or self-certify as sophisticated investors

•Retail clients who are certified as high net worth investors

•Retail clients who confirm before a promotion is made that they will receive regulated investment advice

•Retail clients who certify that they will not invest more than 10% of their net investible portfolio in the above securities.

According to recent estimates4, the crowdfunding industry grew 65% in 2012 – whilst it is generally seen as a sustainable, alternative option to bank lending, it is attracting more and more regulatory scrutiny. Firms will need to keep abreast with the upcoming developments in this space.

54. Massolution 2013, Crowdfunding Industry Report

59266

Crowdfunding outside the UK – looking beyond our bordersThere are a number of initiatives beyond our borders aimed to regulate crowdfunding in its different forms. Set out below is a map showing the countries where specific legislative or regulatory proposals have been considered or have been implemented. The map does not taken into account existing regulatory and legislative framework that would apply to crowdfunding in absence of a specific regime.

The following sections of this briefing will address more in detail the European and the US initiative.

Crowdfunding regulation in EuropeOn 3 October 2013 the European Commission launched a consultation with the aim to explore how initiatives ad EU level could promote crowdfunding in the member States.

The EU Commission papers outlines the various forms of crowdfunding, and the typical risks associated with it.

The consultation asks participants how to ‘unleash the full potential of crowdfunding’ and prompts a view as to whether a EU-wide crowdfunding regime would contribute to the expansion of the phenomenon.

The consultation ends on 20 December 2013 and respondents can complete the questionnaire on line at the following link: http://ec.europa.eu/yourvoice/ipm/forms/dispatch?form=CROWDFUNDING.

Pinsent Masons | Financial Regulation

7

Crowdfunding regulation in the USOn 23 October 2013, the U.S. Securities and Exchange Commission (SEC) released its proposed rules on crowdfunding under Title III of the Jumpstart Our Business Startups (JOBS) Act that allow start-ups and small businesses to raise capital by offering and selling securities over the internet.

Despite the benefits of this capital raising structure, crowdfunding has not involved the issuance of an equity interest in a particular business or venture because this would trigger the application of the U.S. securities laws. The Securities Act of 1933 requires that offers and sales of securities are registered with the SEC, unless an exemption is available. Prior to the proposed rules, there was no private placement exemption available for crowdfunding because of restrictions on general advertising and purchaser qualification requirements.

The SEC is seeking public comment on the proposed rules, called “Regulation Crowdfunding,” for a 90-day period. The SEC will then review the comments and determine whether to adopt the proposed rules.

Under the proposed rules:•New Section 4(a)(6) of the Securities Act of 1933 would be implemented, which provides an exemption from the registration

requirements of Securities Act Section 5 for certain crowdfunding transactions

•A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period•Investors, over the course of a 12-month period, would be permitted to invest up to:

- $2,000 or five percent of their annual net worth, whichever is greater, if both their annual income and net worth are less than $100,000 - 10 percent of their annual income or net worth, whichever, is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding

•Transactions must be conducted through an intermediary that either is registered as a broker-dealer, such as CircleUp, or is registered as a new type of entity called a “funding portal.” Broker-dealers and funding portals may not offer investment advice, solicit investments or compensate employees based on sales. However, these intermediaries would be required to provide investors with educational materials and reduce the risk of fraud

•Companies conducting a crowdfunding offering would be required to disclose certain information, including the following: - Information about officers and directors as well as owners of 20% or more of the company - A description of its business and how the proceeds will be used - The price to the public of the securities being offered, the target offering amount and the deadline to reach the target offering amount

- Financial statements of the company, including audited financial statements for offerings of more than $500,000 - Annual reports must be filed with the SEC and provided to the company’s investors

•Certain companies would not be eligible to use the crowdfunding exemption, including: non-US companies, companies that already are SEC reporting companies, and Investment companies.

On 23 October 2013, the Financial Industry Regulatory Authority (FINRA) also issued its own parallel set of proposed rules – referred to as the “Funding Portal Rules” – and related forms for SEC-registered funding portals. The comment period will expire on 3 February 2014.

5926

Margherita CarettaAssociateT: +44 (0)20 7490 6218M: +44 (0)7887 833176E: margherita.caretta@pinsentmasons.com

Melanie PanzoneSenior AssociateT: +44 (0)20 7667 0187M: +44 (0)7826 918225E: melanie.panzone@pinsentmasons.com

John VerweySenior AssociateT: +44 (0)20 7490 6612M: +44 (0)7747 860256E: john.verwey@pinsentmasons.com

Ian RobertsPartnerT: +44 (0)20 7418 7139M: +44 (0)7876 561562E: ian.roberts@pinsentmasons.com

Monica GognaPartnerT: +44 (0)20 7490 9695M: +44 (0)7500 760840E: monica.gogna@pinsentmasons.com

For more information, please contact:

8

5926www.Out-Law.comwww.pinsentmasons.com

Pinsent Masons LLP is a limited liability partnership registered in England & Wales (registered number: OC333653) authorised and regulated by the Solicitors Regulation Authority and the appropriate regulatory body in the other jurisdictions in which it operates. The word ‘partner’, used in relation to the LLP, refers to a member of the LLP or an employee or consultant of the

LLP or any affiliated firm of equivalent standing. A list of the members of the LLP, and of those non-members who are designated as partners, is displayed at the LLP’s registered office: 30 Crown Place, London EC2A 4ES, United Kingdom. We use ‘Pinsent Masons’ to refer to Pinsent Masons LLP, its subsidiaries and any affiliates which it or its partners operate as separate

businesses for regulatory or other reasons. Reference to ‘Pinsent Masons’ is to Pinsent Masons LLP and/or one or more of those subsidiaries or affiliates as the context requires. © Pinsent Masons LLP 2013.

For a full list of our locations around the globe please visit our websites: