Quantitative Analytics and Risk Management Director
The FCA Consultation Paper (CP13/13) and the resulting Policy Statement (PS14/4) outline the FCA’s position on investment (equity/debt security) crowdfunding, and how this differs from loan crowdfunding (P2P/P2B). These papers highlight the significant risks investors face when investing in unlisted securities that are hard to value independently or sell on a secondary market. As a result it is required that firms offering such investments on crowdfunding platforms (or using other media) only promote these to certain types of retail investors (discussed below). Where no advice has been provided to retail clients it is also proposed to apply the appropriateness test, so all firms (both MiFID and non-MiFID) would need to check that clients have the knowledge and or experience to understand the risks involved. This paper aggregates the current thinking from experts related to these rules and their impacts to investment crowdfunding.
Non-readily Realisable Securities
The FCA rules for investment crowdfunding apply to “non-readily realisable securities”: these are regarded as illiquid, hard-to-price securities for which there is no, or only a limited, secondary market. This new term catches all securities that are not “readily realisable securities” (e.g. listed shares), “packaged products” (e.g. authorised funds) or “non-mainstream pooled investments”. From a crowdfunding perspective this implies equity products and structured equity products (e.g. convertible notes) and mini-bond debt and structured debt products (e.g. mini-bonds with embedded optionality).
P2P/P2B and Investment Securities
FCA makes it clear in the Policy Statement PS14/4 the key distinctions between a loan and an investment security:
As highlighted by the FCA: Companies issuing unlisted debt securities are free to set the terms of the securities they issue, to suit themselves. For example, some firms issuing non-readily realisable, illiquid debt securities not only deny investors the opportunity to trade them on a recognised investment market, but also make them nontransferable. In contrast, a company or individual borrowing money under a P2P loan agreement facilitated through a loan-based crowdfunding platform usually does so under terms, which they do not control. Furthermore, individuals investing in the peer-to-peer or peer-to-business loan market can usually lower their overall risks by diversifying their investments more easily than investors in securities can.
The rules make it clear that investors on P2P/P2B platforms should be able to assess the risks and understand who will ultimately borrow their money. While this blurs the gap between loans and debt securities, the key differences mentioned above still remains i.e. who controls the terms of the initial debt offering and how is this managed going forward. As the P2P/P2B platforms control the loan terms (or enable the lenders to vote for rates) and manage debt on their books they are held to a higher standard of client money rules and have minimum capital requirements, which are not directly applicable to equity/debt investment security platforms.
Direct Offer Financial Promotions
For the purposes of consumer protection marketing and promotion of equity and debt securities is restricted. The rules only apply to direct offer financial promotions. These are promotions that contain an offer or invitation, and specify the manner of response or include a form by which a response can be made. Promotions which do not specify how to respond are not caught by the restriction. A communication which simply gives marketing information about the promoter of an offer, or information about who can be invited to invest, would fall outside the scope of the rule, but an information memorandum or offer document containing an application form will be caught. This implies that marketing emails and social media campaigns promoting projects that issue equity and debt securities on a crowdfunding platform would fall within the scope of the rules. The information in such promotional communications normally includes a summary of the investment and links to the campaign page, where a direct investment can be made.
Who is Affected by the Rules?
All authorised persons who communicate or approve the content of a direct offer financial promotion relating to a non-readily realisable security are affected by the new rules. This implies equity and debt security crowdfunding platforms, which are responsible for due diligence and onboarding of campaigns to their platforms, and facilitate the promotion of the investments are directly impacted by the rules.
Categories of Investor
Under the rules, direct offer financial promotions for non-readily realisable securities may only be made to certain types of investor. These are:
- Professional clients
- 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
- Retail clients who are venture capital contacts or corporate finance contacts
- Retail clients who are certified or self-certify as sophisticated investors
- Retail clients who are certified as high net worth investors
- Retail clients who certify that they have not invested, and will not invest, more than 10% of their net investible financial assets in non-readily realisable securities.
The last category of investor (called “restricted investors”) is new. There is a form of certification for such investors, which lasts for 12 months. However, it is worth noting that it is possible for a retail client on a crowdfunding platform to initially be classified as a “restricted investor” and, once they have made more than one investment in an unlisted company of no specific amount (including through the platform) they could self-certify themselves as a “sophisticated investor” and fall within this category relating to any future direct-offer financial promotions.
A further condition is imposed, which must be satisfied before the financial promotion can be communicated or approved. The firm itself, or the person who will arrange or deal in relation to the non-readily realisable security (e.g. the crowdfunding platform and its marketers), must comply with the COBS rules on appropriateness of investors to receive such communications. The appropriateness requirement is, broadly, to seek information from the investors that would enable an assessment to be made whether the investor has the knowledge and experience necessary to understand the risks connected with the non-readily realisable security. This is now being executed through use of simple online questionnaires for investors before they are allowed to receive promotional communications and invest in campaigns.
Enforcement and Review of the Rules
The rules came into force on 1 April 2014 and a short review was published in February 2015. The review concluded that since the rules were introduced the crowdfunding market has continued to grow rapidly. It was recognised that it is still early but, at present, there is no need to change the regulatory approach to crowdfunding, either to strengthen consumer protections or to relax the requirements that apply to firms. It was noted that plans are in place to carry out a full post-implementation review of the crowdfunding market and regulatory framework in 2016 to identify whether changes are required at that stage; and in the FCA will continue to monitor the market.
FCA 2013 Consultation Paper (CP13/13):
FCA 2014 Policy Statement (PS14/4):
FCA 2015 Review Paper: