You Want Another 'Clarion Call' To Regulate Crowd Investing?!

On Monday, Lord Sharkey and Baroness Kramer proposed a 'probing amendment' to the Financial Services Bill to add "The activity of establishing, operating or winding up a crowdfunding scheme" (see here, from column 832). In support of this, Lord Sharkey cited the example of the US JOBS Act and the fact that most new jobs are created by small businesses. He also cited a report by the Association for UK Interactive Entertainment (UKIE). Oddly, however, in declining to support the latest amendment, Lord Sassoon said (at column 835), "there has been no clarion call from industry for more regulation." This appears to arise out of some confusion over the meaning of the term 'crowdfunding', which is being used in some circles to refer to all direct finance platforms, regardless of whether they facilitate donations, lending or investment in debentures and shares.

This is in fact the third amendment that relates to peer-to-peer or direct finance platforms, the first pair of amendments having been debated on 18 July (see columns 325 to 332). All three are really part of the same debate insofar as they share common types of operational risks, regardless of the type of instrument available on the platform. In that earlier debate (at column 330), Lord Sassoon confirmed that "changes being made as part of the Bill under Clause 6 would make it legally possible to bring direct platforms into scope." From the immediate context, he seemed to be only referring to peer-to-peer lending, since that amendment deals with "Rights under any contract under which one person provides another with credit". However, this should also permit regulation of crowd investing in other debt insturments (debentures), leaving open the question of whether equity-based crowd investing can be definitively brought in scope. 

Lord Sassoon said the financial regulatory framework is flexible enough to enable crowd investing, and he says the FSA's note on crowd investing shows that the matter is in hand. But he did add, rather tellingly, that "industry standards and further FSA and FCA guidance may have an important role to play in future." 

That seems an unnecessarily cryptic reference to the Government's recent response to the Red Tape Challenge on challenger businesses, which is why the suggested lack of a 'clarion call' seems rather odd. That Red Tape Challenge indeed yielded a 'clarion call' from industry for proportionate regulation to clear the way for various forms of direct finance. Follow-up submissions produced in consultation with various platforms dealt with both crowd investing and peer-to-peer lending, as did submissions in support of the July amendments in the House of Lords. 

And, as the government's creation of a cross-departmental working group suggests, there is a lot of work yet to be done in response to that call.

Taxing Bad Debt

In January, I submitted to the Red Tape Challenge on Disruptive Business Models and the Breedon Taskforce a paper explaining how the government could encourage the development of peer-to-peer finance platforms. Since then, there has been some discussion about potential regulatory changes, as well as the basis on which individual lenders might deduct any bad debt they incur on loans to people and businesses before tax (as banks are allowed to do).  

In other words, personal investors/taxpayers should be entitled to a similar tax framework to the one used by the banks they are competing with in the provision of loans. For example, loans via two peer-to-peer (or direct finance) platforms are listed among the rates available today on MoneySupermarket for a personal loan of £5,000 over 3 years to a borrower with an "excellent profile". There are also competitive rates listed from another direct finance platform in the business loans section.

Denying ordinary taxpayers this tax benefit not only discourages them diversifying their investments, but also limits the flow of competitively priced funding for creditworthy people and businesses. It also means, perversely, that your bank can use your cheap ISA cash to compete against you in the lending markets - and gain a tax deduction on any bad debt that you cannot. So the tax rules are both anti-competitive and confer a selective advantage on some players in the personal and business lending markets - a state aid issue.

To allow you to deduct any bad debt from your income before tax, HMRC will no doubt want to know that your loans were made responsibly at arms-length and that there were decent attempts at recovering missed payments. Here are the criteria on which direct finance platforms ensure this: 

1. The platform operator is not a party to the instruments on its platform and segregates investors’/lenders’ funds, so it has no credit/investment risk, no temptation to engage in regulatory/tax arbitrage and derives no benefit from the segregated funds nor any of the tax benefit available to participating lenders;

2. Finance is drawn from many lenders at the outset according to objective criteria, so lenders are competing against each other on price and not merely choosing friends/family members to lend to;

3. Lenders can achieve diversification across many borrowers at the start, removing the need for subsequent costly re-packaging or securitisation;

4. The one-to-one legal relationship between each borrower and lender is maintained for the life of each loan via the same technology platform (with a back-up available), so all the loan data is readily available to participants and for collections/enforcement activity as well as creating an audit trail for tax purposes;

5. The platform operators abide by applicable legislation such as anti-money laundering regulations: HMRC will want to know who the participants are too so they need to be properly identified;

6. The platform operators can provide information on lenders’ income to HMRC to allow them to collect taxes if desired.

 Of course, none of this would be an issue for the ordinary person, if you could simply lend your ISA money via a direct finance platform, instead of having to put in a savings account or in regulated stocks and shares.