FCA proposing to tighten up rules for loan-based crowdfunding platforms
In the second quarter of this year, the FCA is due to publish its policy statement on the changes to the regulatory framework for crowdfunding platforms. The consultation paper published in July commented on the FCA’s review of the industry, highlighting areas of poor practice and setting out proposals for changes as detailed below.
The FCA regulates two forms of crowdfunding:
- Loan-based crowdfunding – usually called peer-to-peer (P2P) lending platforms through which investors lend money directly to consumers or businesses, to make a financial return from interest payments and the repayment of capital over time.
- Investment-based crowdfunding platforms where investors can invest directly in businesses by buying investments such as shares or debentures.
The FCA’s consultation paper (Click here) focuses on P2P lending, which has developed a wider range of business models, with many such platforms now taking a more active role on behalf of the investor (discretionary platforms).
FCA findings of poor business practices
The FCA’s review of the crowdfunding industry found some poor business practices particularly among P2P platforms relating to disclosure of information to clients, charging structures, wind-down arrangements and record keeping. The FCA is concerned that these failings resulted in some investors not being given clear or accurate information, which led them to purchase unsuitable products without an understanding of the true investment risks to which they are exposed. One example given by the FCA is where past performance has been included in advertisements without a clear warning that this does not indicate future performance.
The FCA is particularly concerned with discretionary platforms which highlight a target rate of return on investment. The platform in this model chooses who to lend to on behalf of the investors. Some investors may see this offering as more akin to a structured or savings product rather than a crowdfunding investment without understanding the associated risks.
The FCA also notes a failure by some platforms to state that the investments are not covered by the Financial Services Compensation Scheme (FSCS).
Proposed Changes for P2P Platforms
In its consultation paper, the FCA is proposing making changes to marketing and disclosure requirements, systems and controls and wind down provisions as further detailed below.
One of the key changes is the proposal to extend the marketing restrictions that currently apply to investment-based crowdfunding platforms to P2P platforms. This would restrict direct offer financial promotions to be made to the following persons only:
- Certified or self-certified sophisticated investors;
- Certified high net worth investors;
- Prospective investors who confirm before a promotion is made that they will receive investment advice or investment management services from an authorised person; or
- Prospective investors who certify that they will not invest more than 10% of their net investible portfolio in P2P agreements.
This latter restriction has caused the most controversy in the industry.
The consultation paper also proposes that platforms will need to comply with the FCA’s rules on appropriateness to ensure investors are assessed as having the knowledge or experience to understand the risks involved before they invest.
The FCA is proposing to require platforms to provide more information on the services they provide including:
- the nature and extent of the due diligence the platform undertakes in respect of borrowers;
- a description of how loan risk is assessed, including a description of the criteria that must be met by the borrower before the platform considers the borrower eligible for a P2P agreement;
- whether and what role the platform will play in determining the price of a P2P agreement;
- where investors do not have the choice to enter into specific P2P agreements, what role the platform will play in choosing P2P agreements for an investor;
- where a platform offers a portfolio of loans to investors, what role it will play in composing that portfolio;
- an explanation of how any tax liability for lenders arising from investment in P2P agreements would be calculated;
- an explanation of the procedure for dealing with a loan in late payment or default;
- a clear statement that that there is no recourse to the FSCS;
- if a platform offers a secondary market facility and, if so, the procedure for a lender to access their money before the term of the P2P agreement has expired and the risk to their investment of doing so;
- whether the firm displays P2P agreements that lenders wish to exit and that other investors may choose to enter into; and
- whether the firm decides if the P2P agreement should be transferred to another investor without involving either investor in that decision.
The FCA is also proposing to require certain information about the investment to be disclosed to investors depending on the model of the P2P business including the price of the agreement, when the agreement is due to mature and the likely actual return. For discretionary platforms, for example the minimum and maximum interest rates that will be payable will need to be disclosed.
Ongoing disclosures to investors are also proposed so that investors can for example access details of the price of the P2P agreement and outstanding capital and interest payments.
Charging structures already need to be disclosed to investors. However, the FCA is proposing to require platforms to clearly detail the amounts deducted from interest repayments paid by the borrower.
The FCA is also proposing to require platforms to publish an outcomes statement within four months of the end of the financial year which includes the expected and actual default rate of all P2P agreements the platform has facilitated, with a summary of the assumptions used for expected future default rates. For platforms offering a target rate, the outcomes statement should include the actual return achieved.
Systems and controls
The consultation paper proposes that risk management frameworks be required to mitigate risks to investors. This will require platforms to as a minimum:
- Gather sufficient information about the borrower to be able to competently assess the borrower’s credit risk (for example platforms should check in the case of a borrower that is a company, that the company exists and that the founders are who they say they are. Statements as to future commercial success should be subject to a basic plausibility check for example if licences are required, have these been obtained);
- Categorise borrowers by their credit risk in a systematic and structured way (taking into account the probability of default and the loss given default); and
- Sets the price of the agreement so it is fair and appropriate and reflects the risk profile of the borrower.
The risk management framework needs to be appropriately tested and should consider how predicted outcomes compare to actual outcomes over time.
In addition, a P2P platform should have an independent risk management function depending on the nature, scale and complexity of the business who would report to senior management on matters of risk. Likewise, where appropriate, a P2P platform should establish and maintain an internal audit function. In addition, the FCA is proposing that all P2P platforms maintain a permanent and effective compliance function.
It is important to note that the Senior Managers and Certification Regime will apply to crowdfunding platforms from 9 December 2019.
Wind down plans
The FCA is proposing to require platforms to have arrangements in place to ensure that the P2P agreements they facilitate will have a reasonable likelihood of being managed and administered in accordance with the terms of the agreement. The FCA is also proposing further guidance for platforms on what wind down arrangements might include in practice. For example, as part of its wind down plans, a platform may need to get prior and informed consent from investors for a transfer from the platform to another firm and/or to fund any increased costs in the management or administration of their P2P loans.
In additional to the disclosure obligations above, platforms will be required to inform investors of the potential outcomes should the platform cease to operate and the name of any third party with whom wind down arrangements have been made.
Finally, although the crowdfunding industry has not yet ventured into regulated home finance, this is something platforms are considering. The FCA is proposing that such business would be subject to the FCA’s Mortgage and Home Finance Conduct of Business Sourcebook (MCOB) where relevant.
Much of the proposals in the consultation seem sensible and will put the restrictions that are currently applied to investment-based crowdfunding platforms in place for P2P platforms. Retail investors should of course have access to such crowdfunding options provided the risks and charges are clearly disclosed by the platforms. We will wait to see whether the controversial 10% of investible portfolio restriction is retained by the FCA when the policy statement is released in the next quarter.
If you have any questions on this article or P2P agreements more generally please contact Jessica Arrol Caws in our Financial Services Regulatory Team.