Part 1: the UK landscape

Part 1 – the UK landscape

This is the first article in a four-part series covering UK and EU crowdfunding regulation. Part 1 considers how crowdfunding is regulated in the UK, Part 2 will look more closely at peer-to-peer (P2P) lending, Part 3 will explore how crowdfunding is regulated across the EU, and Part 4 will consider the effects of the new EU regulation on European crowdfunding service providers.

What is crowdfunding?

In the UK, there are four main types of crowdfunding:

Loan-based crowdfunding (also known as peer-to-peer (or P2P) lending) – this is where the crowd lend money to the borrower in return for repayment (with interest) over a period of time.
Investment-based crowdfunding – this is where the crowd invest in the borrower by buying investments such as shares or debentures.
Donation-based crowdfunding – this is where the crowd donate to the borrower (usually charitable organisations) which they want to support, without receiving any financial or material return.
Reward-based crowdfunding – this is where the crowd donate to the borrower in return for a non-financial reward (goods or services) at a later stage.

How is crowdfunding regulated in the UK?

In the UK, the FCA regulates loan-based and investment-based crowdfunding. Many of the rules relating to these types of crowdfunding came into force in 2014, when the crowdfunding market was still developing. The FCA does not regulate donation-based and reward-based crowdfunding, but does regulate certain payment services provided in connection with these types of crowdfunding.

Although some issues are common to both loan-based and investment-based crowdfunding, the two types of crowdfunding are regulated in different ways (explored further below).

In addition to FCA regulation, the UK Crowdfunding Association (UKCFA) was set up as a self-regulatory trade body in 2013. It upholds certain standards, requiring its members to agree to the UKCFA code of conduct. This code of conduct focuses mainly on protecting investors.

Loan-based crowdfunding

This type of crowdfunding started life as a particular class of consumer credit activity, and in 2013 it was added as a new regulated activity under the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (the RAO).

Under Article 36H of the RAO, loan-based crowdfunding is referred to as "operating an electronic system which enables the operator to facilitate persons becoming the lender and borrow". These two persons can both be consumers, or consumers and businesses.

If a crowdfunding platform meets the conditions in Article 36H (which will be explored further in Part 2 of this series), and is not exempt, it is likely to be carrying out a regulated activity which requires authorisation by the FCA.

Once authorised, there are various rules, designed to protect consumers making investments using loan-based crowdfunding platforms, which must be adhered to. The regime currently applicable to P2P platforms is primarily based on the FCA's Principles for Businesses (PRIN), and the Systems and Controls (SYSC), Conduct of Business (COBS) and Consumer Credit (CONC) sourcebooks.

The FCA has warned consumers investing via loan-based crowdfunding platforms that they will not have access to the Financial Services Compensation Scheme (FSCS) for losses resulting from borrower defaults or for capital losses on equity acquired through the platform. Additionally, there are higher risks in this area than simply holding money on deposit: consumers may not always be able to cash investments in quickly, and they may lose some or all of the money invested.

Investment-based crowdfunding

Unlike loan-based crowdfunding, investment-based crowdfunding does not constitute a standalone regulated activity. Instead, it is caught by the existing activities under the RAO, including "arranging deals in investments" and "making arrangements with a view to transactions in investments".

One of the reasons for this difference in regulation is that equity crowdfunding models are generally more simple than loan-based models, which tend to be more complex and take a more active role in the crowdfunding campaign (for example, by taking decisions on behalf of investors).

Nonetheless, the FCA regards investment-based crowdfunding as a high-risk investment activity, due to the potential for capital losses, and players in this space should be aware that the FCA's recent ban on the marketing of speculative illiquid securities (SISs), such as "mini-bonds", to retail investors extends to investment-based crowdfunding platforms and other intermediaries offering or otherwise providing services in relation to SISs.

As with loan-based crowdfunding, once authorised, investment-based crowdfunding platforms will have to comply with various FCA rules and sourcebooks. The FCA has not specified which parts of the FCA Handbook are relevant for investment-based crowdfunding platforms, but it can be assumed that much of the FCA Handbook will apply in the same way as it does for P2P platforms.

In addition, the FCA has confirmed that existing requirements regarding offering private shares to the public under the Companies Act 2006 and the UK's prospectus and listing regime apply in the context of investment-based crowdfunding.

Authorisation

In both circumstances, online platforms facilitating loan-based and investment-based crowdfunding are likely to be carrying on a regulated activity and therefore require FCA authorisation (unless the platform can rely on an exclusion).

The FCA expects crowdfunding platforms applying for authorisation to ensure that their activities fall within the scope of the particular permission(s) applied for. In particular, the FCA has reminded firms that if a lending business borrows through a platform, and then lends that money on to others, it may be deemed to be "accepting deposits" within the meaning of Article 5 of the RAO. If the crowdfunding platform does not have permission to do this, it would be in breach of FSMA.

Crowdfunding platforms should therefore carefully consider all the activities they will be carrying on and apply for all relevant permissions.

Further regulation of high-risk investments in the pipeline

The FCA is currently looking to strengthen its financial promotion rules for high risk-investments (which includes shares or bonds bought through a crowdfunding platform and P2P loans) and is expected to consult later in 2021 on further measures aimed at reducing the harm to consumers caused by investing in "inappropriate high-risk investments".

Payment services

The transmission of funds between an investor and a borrower might involve a crowdfunding platform carrying out payment services under the Payment Services Regulations 2017 (PSRs).

Previously, many crowdfunding platforms relied on the commercial agent exclusion, however the Payment Services Directive (PSD2) narrowed this exclusion, so that it only applies to transactions where the commercial agent (that is, the crowdfunding platform) acts on behalf of one side of the transaction (that is, acting for either the borrower or the investor), not on both sides. Consequently, a number of platform business models are unlikely to benefit from this exclusion and may fall within the scope of the PSRs.

As this is a complex area, operators of crowdfunding platforms, transferring funds between participants, often opt to use third party online processing providers to process payments on their behalf.