Out-Law News 4 min. read

Peer-to-peer lending platforms to be regulated alongside reforms to investment-based crowdfunding

Peer-to-peer lending platforms will need to comply with a number of financial services rules and consumer protection requirements under a new regulatory framework governing crowdfunding.

The Financial Conduct Authority (FCA) has outlined plans to make firms operating loan-based crowdfunding platforms subject to regulation (106-page /688KB PDF) from April next year. It has also proposed reforms to its existing regulatory approach to investment-based crowdfunding.

The FCA's approach should "offer more protection to crowdfunding investors", corporate law expert Jennifer Malcolm of Pinsent Masons, the law firm behind Out-Law.com, said.

Crowdfunding is a mechanism to which some businesses turn to raise capital. There are a number of online funding platforms that link those businesses with individuals or groups willing to invest in their project. In return for that investment, individuals are generally presented with specified rewards, such as a share in the profits of projects or a stake in the business. Another form of crowdfunding involves peer-to-peer lending which encompasses simple loan agreements between two or more parties.

Investment-based crowdfunding is already a regulated activity, but the FCA has now 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", it said.

Under the new regime loan-based crowdfunding platform operators will be required to hold in place a cash reserve or a proportion of loaned funds to protect themselves against financial difficulties.

Those platforms would also be deemed to be trustees of clients' or borrowers' cash when facilitating transactions between the two. As a result they will have to comply with existing client money rules which include, among other things, a requirement to deposit the money with a bank and have processes in place to account for the failure of borrowing businesses.

The loan-based crowdfunding platforms would also, generally, have to allow a 14-day grace period to pass before passing funds to borrowers to account for consumers' cancellation rights under EU consumer protection laws, the FCA said. This general rule would apply unless "platforms include a secondary market and investors are able to sell their interest in a loan at prevailing market prices", it said.

The platforms would also be subject to disclosure rules, meaning they would be barred from presenting promotional material to clients that is not fair, clear or is misleading. The FCA said it could ban websites that fail to explain properly how charges or tax, for example, could impact on lenders' rate of return. The companies would also be obliged to present information about risks risks so as they can make "an informed choice" about whether to proceed with lending.

Other rules, including in relation to how the platforms display details about past and future performance or compare rates with those offered by rivals, would also form part of the new regulatory regime.

"The FCA rule book wasn't designed with crowdfunding in mind and the FCA's consultation paper is a welcome move by the regulator to offer more protection to crowdfunding investors," Malcolm said. "The consultation paper seems to strike a good balance between putting in place further regulation of crowdfunding investment platforms whilst allowing crowdfunding investment opportunities to grow and fill the gap left by the lack of bank funding for young companies."

"As most investors in crowdfunding platforms don't receive advice, the FCA has recognised the importance of crowdfunding firms providing investors who lack experience and resources with enough information to allow them to make informed investment decisions and ensure that communications to investors are fair and not misleading," she added. "Of particular interest to loan-based crowdfunding investors will be the FCA's proposal that platforms will need to take steps to ensure that loans will still be administered if the platform goes out of business and any comparison of interest rates with regular savings accounts interest rates must be clear and not misleading."

Malcolm also said that it was important for the FCA to draw a distinction between loan-based crowdfunding and investment-based crowdfunding due to the risk-profile of each activity. Between 50-70% of start-up businesses are thought to fail.

"The proposals will make the crowdfunding market more accessible, will help foster competition and facilitate access to alternative finance options while also providing additional consumer protection," the FCA said in a statement.

"It is interesting to see that a relatively fledging industry with 25 identified participants has resulted in a consultation paper constituting over 100 pages, this clearly indicates that the FCA forsees this industry ramping up in a rapid fashion and wishes to regulate the industry as it develops," said financial regulation expert Monica Gogna of Pinsent Masons.

"What is clear that both existing and new participants in the peer to peer market should be ready for a lot of change in the regulator's approach to their industry: this will include additional rules on disclosure, minimum prudential requirements, business continuity measures, rules on resolving disputes, including the application of FOS, and ongoing reporting requirements," said Gogna. "The question is whether this industry which currently operates on a lean and mean basis will be able to deal with this additional regulatory burden to the exacting standards that the FCA expect whilst still offering a better, more profitable alternative to the consumer."

Christopher Woolard, the FCA’s director of policy, risk and research, said: "Consumers need to be clear on what they’re getting into and what the risks of crowdfunding are. Our rules provide this clarity and extra protection for consumers, balanced by a desire to ensure firms and individuals continue to have access to this innovative source of funding."

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