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Friday, 25 October 2013

French Crowdfunding Proposals

French officials are consulting on their own crowdfunding proposals until 15 November. These appear to be more consistent with the industry recommendations made last December, and seem somewhat more proportionate than the FCA's proposals for the UK.

Unfortunately, no official English version has been made available but Frederic Baud has kindly pointed me to an article by Aurélie Daniel on the proposals.

Frederic has explained that the intention is to use the transposition of the small payment institution provisions of the Payment Services Directive to require registration by donation-based and loan-based crowdfunding platforms. As a small payment institution, platforms would need capital of €40K, and be subject to a rolling 12 month average limit of €3 million transaction per month (that could be lowered to €1 million under proposals for PSD2). Above that threshold, platforms would need to be fully authorised as a payment institution, with minimum capital of €125K and higher amounts based on various optional calculations.

So far, that is completely consistent with the regulatory approach that the industry called for at the Peer-to-Peer Finance Policy Summit in London last December (which the FCA has ignored), and would represent a far lighter regime than the FCA has proposed for UK loan-based platforms. Regulating loan-based crowdfunding via payment services regulation is also consistent with the traditional view that simple loans are not 'debt securities' and therefore do not properly fall within the scope of specified investments currently regulated by the FCA.

But Aurélie points out that the French proposal contains controversial "upper limits for loan-based crowdfunding... [namely] a maximum loan amount around €250 per individual per project and a global maximum loan amount around €300,000 per project." While this might not trouble consumer loan-based platforms, it would negatively impact platforms that facilitate loans to businesses and for the purchase or development of larger assets such as commercial property. Ironically, the French appear to have reserved such loans for banks, and in this respect the FCA's proposals are of course more helpful. The limits apparently do not apply in relation to investment-based crowdfunding.

Thursday, 24 October 2013

FCA Crowdfunding Consultation

The FCA has today published its crowdfunding consultation, covering both crowd investment in equities and debt securities (which the FCA calls 'investment-based crowdfunding'), as well as the lender side of peer-to-peer lending ('loan-based crowdfunding'). The borrower side of loan-based crowdfunding was covered in the FCA's consumer credit consultation earlier this month. The consultation paper will be of interest not only to platform operators, but also to those looking to raise or contribute funds in a bid to escape bank products, in particular.

The FCA is clearly aware of the general anxiety that any rules it makes should not exclude the 'crowd'. But based on the FCA's summary of its proposals, in my view it has not struck the right balance (called for by the industry last December) for the reasons below. In summary:
  • The proposals seem to land quite heavily on peer-to-peer lending (perhaps partly because investment-based platforms are already subject to the investment regime). While in principle the FCA has followed the thrust of the P2PFA's Operating Principles (which was based on payments regulation) the decision to bring simple P2P loans into the investment regime will make it substantially more expensive in time and money to establish a platform. The costs of ongoing compliance will also increase, though largely through the undue complexity of the investment regime, rather than any substantive change in how operational risks are managed. In addition to potentially discouraging entrepreneurs from establishing a platform, the red tape requirement for a lender to be authorised, in addition to the platform, where 'lending in the course of a business' on a platform may discourage business and institutional participation, especially without clarity on where compliance responsibilities lie given that the lender's own operational systems aren't involved at all. There is little proportionality according to the relative risks associated with different types of loan (e.g. unsecured prime, secured, short term high rate and so on). However, there is some good news in that the FCA seems to advocate the introduction of a 'secondary market', where platforms don't already operate one, without apparent restrictions on how these should operate or whether one could participate without first lending into the 'primary market'.
  • The proposals for investment-based crowdfunding do at least allow for wider 'retail' participation than the FCA has seemed to support to date. However, people will be asked to certify that they will not invest more than 10% of their 'net investible portfolio' in unlisted shares or unlisted debt securities (excluding their primary residence, pensions and life cover), and they face an 'appropriateness test' if they aren't investing on advice. So it will still be much easier to stick a tenner on a pony, where the house always wins, rather than to back a local business in support of the economy. The risks that the FCA points to in justification for this can all be explained transparently on websites. But who in government will take responsibility for the strange inconsistencies in the way we are allowed to use our money?

Comments are due by 19 December, and it would be best to get involved. The FCA plans to review the overall crowdfunding regime again in 2016, so it could be a long wait before any problems missed will be rectified...

Loan-based crowdfunding

Firms operating loan-based crowdfunding platfroms are to be regulated from 1 April 2014 as ‘operating an electronic system in relation to lending’ (under article 36H of the Regulated Activities Order). The FCA is aware of about 25 firms in this category.

The FCA sees loan-based crowdfunding as "generally of lower risk than that made via investment-based platforms" although it sees the potential for innovation that may bring higher risks, so will keep the sector under review. For the time being, however, the FCA is consulting on:
  • minimum prudential requirements that firms must meet in order to ensure their ongoing viability (£20,000 to £50,000 minimum capital and a further 0.3% to 0.1% of volumes on a scale of £50m to £500m);
  • the requirement for firms to take reasonable steps to ensure existing loans continue to be managed in the event of platform failure;
  • rules that firms must follow when holding client money, to minimise the risk of loss due to fraud, misuse, poor record-keeping and in the event of a firm's failure;
  • rules on the resolution of disputes, and
  • reporting requirements for firms to the FCA in relation to their financial position, client money holdings, complaints and loans arranged.
It is reassuring that all these issues (other than FCA reporting obligations), have long been addressed by the Peer-to-Peer Finance Association in its Operating Principles. However, those were modelled on payment services regulation (under the Payment Services Regulations 2009), whereas the FCA proposes to apply more or less the full weight of its retail investment regulation on the sector for little real benefit. For instance, the effect of the voluminous client money 'sourcebook' ('CASS') is not terribly different to payment services segregation requirements that would only need to be tweaked slightly). Firms might decide to outsource the handling of client money to other authorised firms, rather than accept the additional red tape that CASS creates (as investment-based platforms tend to do).

Unfortunately, too, the FCA interprets the Consumer Credit Directive to mean that any person or firm lending in the course of business via loan-based crowdfunding platforms will need to be authorised as they are carrying on a regulated activity. That interpretation is inconsistent with the FCA's view that such a person is actually an investor in loans, rather than a lender, but may be driven by the use of the word 'creditor' in the Directive. Moreover, such dual authorisation makes no sense, given that all the operational activities associated with the marketing, creation and servicing of the loans takes place in the platform operator's systems, rather than the lender (even where that lender is, say, a bank). In other words, the lending is being done in the course of the platform operator's business, not any business being run by the lender. Responsibility for compliance in such circumstances is not clear. How is a business lender supposed to comply with consumer credit rules when it is not directly advertising, processing loan applications or servicing the loans? Further, the FCA (like the OFT) declines to give any guidance on what it means to be 'lending in the course of a business', other than to refer to its existing guidance around the 'business test'. Early case law cited in HMRC guidance on this topic, however, requires an assessment of the operational reality which in this case suggests lenders on loan-based crowfunding platforms are not lending in the course of a business operated by them but in the course of a business of the platform operator.

In my view, the FCA's interpretation of the Consumer Credit Directive is another example of UK officials failing to take a purposive approach to interpreting EU law and needlessly creating a rod for our own backs. I doubt very much whether the purpose of the Directive was to ensure dual regulation in the context of loan-based crowdfunding.

Notwithstanding the 'low risk' classification, the FCA plans to treat investments on loan-based crowdfunding platforms largely as it does other designated investments (though there is no guidance on what distinguishes a 'loan' from 'debt securities' in the FCA's view). So rules that apply to firms arranging transactions in designated investments will therefore also apply to firms running loan-based crowdfunding platforms. As a result, such firms will have to comply with two separate FCA rule books - one for borrowers ("CONC"), and one for lenders (now to be called 'investors') ("COBS"), including rules applicable to 'financial promotions'. 

Finally, the FCA seems to advocate the inclusion of a 'secondary market' on loan-based platforms, in the context of a discussion on cancellation rights. The FCA does not explain its view as to whether or how certain exemptions to the right to cancel apply, for instance, where the lender is not acting in a commercial or professional capacity, the main service contract is not a 'distance contract' so the loan can't be a 'secondary contract' for cancellation purposes or the lender makes an irrevocable offer to lend within the cancellation period.

As to the nature of the 'secondary market itself', in its cost benefit analysis, the FCA also points to the fact that most of the main platforms have one and states:
"we estimate a one-off cost of 20 days of web programming to add secondary market functionality to platforms. We assume a cost per day of web programmer time of £200.29 This would mean that adding a secondary market to a platform could create a one-off cost of around £4,000. We also estimate ongoing costs of four hours per day to oversee the functioning of the secondary market. We estimate a cost per hour of £10 for administration work in small to medium firms, so the annual ongoing cost per firm of this option would be £10,000. It appears that, as platforms mature, they prefer to offer a secondary market, so in the long term most platforms are likely to aim to introduce a secondary market."
At last, a little ray of pragmatism, perhaps. But on what functional specification was this estimate based?

Left unanswered are a bunch of awkward issues, such as the distinction between loans and debt securities (now that both seem to be specified investments), how 'hybrid' loan-based and investment-based crowdfunding platforms should be treated, how a platform might facilitate loans above and below the £25k per loan cap, that some types of loan-based platform are lower risk than others and should receive more proportionate treatment (e.g. secured vs unsecured, or smaller numbers of customers) and confirmation that platforms do not qualify as certain other forms of investment activity (as well as others identified in Annex 2 of a submission on the Financial Services Bill in June 2012).

The new rules will take effect from 1 April 2014, but firms with 'interim permission' will have until 1 October 2014 to comply.

Investment-based crowdfunding

A crowd-funding platform needs to be authorised if it carries out the regulated activity of enabling a business to raise money by arranging the sale of unlisted equity or debt securities, or units in an unregulated collective investment scheme. The FCA is aware of about 10 authorised firms and 11 appointed representatives of authorised firms in this sector. However, exemptions may be available. For example if the firm operating the crowdfunding platform is an appointed representative of an authorised person or an Enterprise Scheme they will not need to be directly authorised.  

While the FCA already authorises investment-based platforms under existing investment regulation, the FCA concedes that the current rules don't really fit. The FCA has imposed restrictions on the authorised platforms on a case-by-case basis, which "restrict firms to dealing with professional clients and retail clients who are either sophisticated or high net worth." However, the FCA believes that its new proposals "should mean crowdfunding investment opportunities are available to more retail investors than currently, but with appropriate safeguards to check that investors are able to understand and bear the risks involved." The FCA also intends "to provide adequate consumer protections that do not create too many barriers to entry or significant regulatory burdens for firms." The new rules will take effect from 1 April 2014, but firms will have until 1 October 2014 to comply.

The FCA is proposing to limit the direct offer financial promotion of unlisted shares or debt securities (including websites) by firms to one or more of the following types of client:
  • retail clients who are certified or self-certify as sophisticated investors, or
  • retail clients who are certified as high net worth investors, or
  • retail clients who confirm that, in relation to the investment promoted, they will receive regulated investment advice or investment management services from an authorised person, or
  • retail clients who certify that they will not invest more than 10% of their net investible portfolio in unlisted shares or unlisted debt securities (i.e. excluding their primary residence, pensions and life cover).
Where advice is not provided, firms will need to apply an appropriateness test before selling them promotions for unlisted equity or debt securities.

Where crowdfunding platforms allow investment in units in unregulated collective investment schemes, the existing marketing restrictions will apply. These can only be promoted to certain types of customer, and changes to those restrictions were also recently consulted on and were made here.

Left unanswered are a bunch of awkward issues, such as the distinction between loans and debt securities (now that both seem to be specified investments), how the financial promotion rules actually apply, how 'hybrid' loan-based and investment-based platforms should be treated, and confirmation that platforms do not qualify as certain other forms of investment activity (as well as those identified in Annex 2 of a submission on the Financial Services Bill in June 2012).

The FCA considers investment-based crowdfunding to be high risk, owing to the the high rate of start-up business failures, the possibility of unauthorised advice, professionals picking the best offers, lack of dividends, equity dilution and the lack of a secondary market.

It seems bold to assume that professionals are any better than others at 'picking the best offers'. Research reveals that no one can predict which businesses will be successful. However, these risks can all be explained. What the FCA proposals views don't account for is the ability for people to lose unlimited amounts by betting on the ponies without going through any hoops at all. The FCA states that it has "no evidence to show that the wrong type of investor is investing in unlisted shares or debt securities" but concedes that "it is possible our current regulatory approach is effectively preventing this." Why is someone who bets on the ponies, for example, the 'wrong type' to be investing in a start-up?

From a policy standpoint, if it's ok for somebody to stick a tenner on the next race, when the betting shop is the real winner, then surely, so as long as the risks are clearly explained, the same person should be able to back a small business, where the economy is the winner. 

But who in government will take responsibility for this inconsistency?

Wednesday, 23 October 2013

SEC Crowd Investment Rules

Today, the US Securities Exchange Commission (SEC) finally published its rules to enable securities-based crowdfunding (or 'crowd investing') under certain exemptions from Federal securities registration requirements (Title III of the JOBS Act). 

The proposal document is some 585 pages long, so it may take some time to fully digest the proposals. Comments are open for 90 days. That review is complicated by various State laws that are being rushed through to permit intra-state crowd investing out of frustration at what is perceived as SEC foot-dragging. And, on this side of the Pond, the FCA's own consultation on crowdfunding, due out this week. A lawyer's work is never done [sighs].

As a reminder, the JOBS Act exemptions apply to transactions by an issuer that meet requirements which include:
  • the amount raised must not exceed $1 million in a 12 month period (adjusted for inflation at least every five years); 
  • individual investments in a 12 month period are limited to the greater of: 
  • $2,000 or 5 percent of annual income or net worth, if annual income or net worth of the investor is less than $100,000; and 
  • 10 percent of annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more (adjusted for inflation at least every five years); and 
  • transactions must be conducted through an intermediary that is either registered as a broker, or is registered as a new type of entity called a “funding portal” that is exempt from broker/dealer registration;
  • issuers and the intermediaries must provide certain information to investors and potential investors, take certain other actions and provide notices and other information to the Commission;
  • the securities acquired through this exemption are also to be exempt from registration requirements.
Happy reading!

Friday, 18 October 2013

Will EU Red Tape Kill Store Cards And Loyalty Schemes?

Following my earlier SCL article on PSD2, I've had a few more thoughts on the European Commission's proposals aimed at ‘limited network’ services, such as retail store cards, gift cards, fuel cards and loyalty programmes. Remember, the Commission wants the changes agreed by Spring 2014, and Member states will have two years to implement them. It will be another five years before the Commission revies the effect of the changes, so this is the last chance to rectify the mistakes in PSD1 and avoid more in PSD2...

You will recall (no doubt) that the PSD exempts payment transactions based on payment instruments accepted only within the issuer's premises or certain 'limited networks'. Such instruments are also exempt from the definition of 'electronic money' in EMD2 by reference to the PSD exemption. While this exemption survives under PSD2, operators will be obliged to notify the regulator if the average of their transactions in the preceding 12 months exceeds €1m per month. The regulator may then disagree that the exemption applies. This catches 'closed loop' stored value and other instruments such as retail store cards, gift cards, fuel cards and loyalty programmes. Yet, as discussed previously here and here when the UK Treasury considered self-regulation to ring-fence funds in this area, there is no evidence of any harm to consumers in such scenarios, compared to the collapse of retail pre-payment schemes such as those offered by Farepak or tour operators which appear not be caught.

Here are my additional thoughts:
  1. Other than simply the volume/value, there seems to be implied an additional basis on which a regulator might decide that a service which otherwise fell within limited network exemption below the threshold average of €1m per month would no longer qualify when it reached that threshold. What basis would that be?

  2. If the regulator were to disagree that the limited network exemption under PSD2 applies, is the service provider automatically guilty of an offence without any possibility of an orderly transition to full authorisation or finding an authorised payment institution or PSD agent to operate the service?

  3. Similarly, if the regulator were to disagree that the limited network exemption under PSD2 applies to a ‘closed loop’ stored value service, does that amount to a decision that the exemption from the definition of “electronic money” under EMD2 would also cease to apply to that service? If so, a service provider who was lawfully operating within the exemption below the volume threshold would suddenly find itself in breach of both PSD2 and EMD2, again without any possibility of an orderly transition to full authorisation or finding an authorised e-money institution to operate the service.

  4. Outcomes such as those in scenarios 2 and 3 above seem to conflict with the privilege against self-incrimination and may be otherwise unacceptable from a public policy standpoint (e.g. the avoidance of retrospective regulation). Practically speaking, this mechanism could also drive every service provider with a programme operating anywhere near the volume threshold to approach the regulator for an indication of whether it’s programme would, if it reached the threshold, be deemed in breach. However, even doing that would open up a similar risk that the regulator may disagree that the exemption applies, with the ugly consequences that may follow. Accordingly, we may find that the operators of all limited network payment schemes apply for authorisation, or use an authorised firm to operate their schemes merely as a precaution against the possible commission of an offence. Or they cancel their programmes altogether. 
Surely such 'regulatory creep' is not the intention...?

Friday, 4 October 2013

Cheaper, Faster EU Patents?

The cost of obtaining an EU-wide patent is likely to come down when the 'unitary patent package' is finalised, according to the European Commission in its recent consultation document on Crowdfunding in the EU

In turn, this should make it easier for inventors to protect their inventions and seek funding more openly on crowdfunding sites.

Austria broke ranks on 7 August to ratify the agreement on a unified patent court. No one else yet.

Thursday, 3 October 2013

The Future of EU Payments Regulation?

I thought it would only ruin the Summer. But it's taken me until Autumn to get my head around the European Commission's plans for a new Payment Services Directive, or 'PSD2' (nope, that's not the train). I'm told that leaves falling from the local trees is purely coincidental and not some kind of arboreal reaction to the complexity.

At any rate, my review of the proposals is now up on the SCL website, along with my earlier article on how card acquiring really works.

If you receive payments by direct debit or you operate an online marketplace, gift card programme, loyalty scheme, mobile/digital wallet, bill payment service, telecoms network, payment initiation service, account information service or a small payment institution you should be particularly concerned. Existing institutions will need to work carefully through the detail.

All will need to take the time to explain to the Commission how their services actually work, and how the regulations might unduly constrain innovation and competition.

The Commission aims to get the changes adopted by Spring 2014, and Member states will have two years to implement. The Commission is giving itself a further five years to review its effectiveness, so it will be along time before we have another opportunity to rectify the mistakes...

Image from EuropeanBusinessReview.

Crowdfunding: Brussels Sprouts!

At last, the European Commission has realised that peer-to-peer finance might really be more efficient than banks at getting funding to those who need it. In Brussels, that translates roughly into "let's regulate". So, today the Commission launched a consultation aimed at understanding "crowdfunding: its potential benefits, risks, and the design of an optimal policy framework to untap the potential of this new form of financing."

The consultation paper is here, and responses are due by 31 December. The relevant Commission officials can be reached here

If my experience of the Commission's approach to regulating other aspects of e-commerce is anything to go by, it will be a huge challenge to educate officials - particularly for fast-moving entrepreneurs who have little time or resources to spare. 

Yet the risk of awkward, confusing and disproportionate regulation is high, so no one resident in the EEA can afford to be complacent.

So, at the very least, I'd recommend that any UK platforms and/or trade bodies capitalise on the evidence they've submitted to UK officials and Parliamentary committees over the past year or so, including whatever submissions are made in the current round of FCA consultations on peer-to-peer lending and crowd-investment

FCA's Consumer Credit Rules

The UK's Financial Conduct Authority (FCA) has published its detailed proposals for regulating consumer credit from 1 April 2014. Specific areas of focus include payday lending (Chapter 6), debt management (Chapters 7 and 9) and peer-to-peer lending (Chapter 8). The detailed rules are in the Appendices.

Peer-to-peer lending (P2P lending) is mentioned in the context of protection for borrowers and the transition arrangements for those who hold a Consumer Credit Licence or wish to take advantage of the interim permission regime. However, a separate consultation paper will cover the new regime for peer-to-peer finance or 'crowdfunding' platforms more generally, including protection for consumers who lend or invest through such platforms. I understand that is likely to be issued around 17 October. 

The consultation period ends on 3 December, and responses may be made online here. The final rules are expected in March 2014. 

The FCA's rules related to borrowing on P2P lending platforms are consistent with the way the consumer borrowing platforms already operate. Which is no surprise, since they have been calling for proportionate regulation for years now, and adopted their own self-regulatory code in July 2011. The key protective rules may be summarised as follows:
  • It is proposed that platform operators cannot be an appointed representative of another firm 
  • FCA proposes similar provisions in relation to pre-contractual explanations and creditworthiness for P2P lending. 
  • introduces the concept of a 'P2P agreement' as a distinct form of regulated agreement
  • the platform must provide adequate explanations of the key features of the credit agreement to borrowers (including identifying the key risks) before the agreement is made (see CONC 4.4)
  • the platform must assess the creditworthiness of borrowers before granting credit (see CONC 5.5) 
  •  rules relating to ‘financial promotions’ (see CONC 3 (where applicable)) 
  • the platform must include in the agreement between borrower and lender a right for the borrower to withdraw from the agreement, without giving any reason, by giving verbal or written notice, within 14 days of the agreement being made (see CONC 11.2) 
  • peer-to-peer lending platforms should be required to provide notices and information sheets to borrowers in arrears or default, directing them to sources of free and impartial debt advice (see CONC 7.18 to 7.20) 
  • equivalent rules should be applied to the peer-to-peer lending platforms that help borrowers get high-cost short-term credit as to those applied to lenders providing such credit (see CONC 6.7.17 to 26 and 7.6.12 to 14) 
  • peer-to-peer lending platforms should be required to provide a specific risk-warning to a borrower if the loan is secured against the borrower’s home – see CONC 4.4.5) 
  • equivalent rules should be applied to peer-to-peer lending platforms carrying on debt collection (see CONC 7) and credit information services, including credit repair (see CONC 8.10) as to other consumer credit firms carrying on the same activities
  • Borrowers with loans not regulated under the CCA (because of one of the exemptions) who borrow from firms currently authorised by the FCA will generally have access to FOS in relation to these loans.
Interestingly, the FCA does not anticipate that requirements with respect to P2P lending will affect mutual societies.