Civil Fraud Quarterly Round-Up: Q1 2021
In February 2016, less than a year after raising £800,000 through an online crowdfunding platform, the claims management company, Rebus, went into administration. This episode highlights the risks associated with equity crowdfunding and raises questions as to the extent of investor protection required. The FCA bolstered their rules protecting retail investors in October 2014. These rules are now being reviewed and the FCA has published a ‘Call for input’.
What is equity crowdfunding?
Equity crowdfunding (also known as investment-based crowdfunding) involves a large number of individuals investing in a business in return for share capital, usually through an online platform. The platforms allow retail investors to invest in early stage businesses, a practice which was previously the preserve of venture capitalists and professional investors.
Since 2011, the crowdfunding market has seen exponential growth and in 2015 over £300 million was invested on equity crowdfunding platforms in the UK. However, according to data from Beauhurst, the first half of 2016 saw the total number of UK equity crowdfunding deals fall for the first time in 5 years. The decline comes amid a general fall in deal numbers and investment amounts for high growth businesses at all stages. Amid turbulent political times, risk aversion has overshadowed the allure of investment in start-ups. Nonetheless, crowdfunding remains one of the leading sources of finance for early stage ventures.
The risks associated with investing in start-up businesses are well known. Businesses regularly fail, their shares suffer from a lack of liquidity and there is a threat of dilution on later funding rounds. Unsurprisingly, equity crowdfunding has attracted the attention of regulators.
How is equity crowdfunding regulated?
Businesses operating equity crowdfunding platforms (as well as loan-based) perform regulated activities (as defined by the Financial Services and Markets Act 2000 (“FSMA”)) and therefore require authorisation from the FCA.
Crowdfunding platforms offering shares or other securities are subject to the standard rules for investments set out in FSMA. For example, information relating to the proposed investments must be clear, fair and not misleading. Recognising the threat of equity crowdfunding to ordinary investors, on 1 April 2014, the FCA introduced additional rules for ‘non-readily realisable securities’ (i.e. unlisted securities with a limited secondary market). The rules only allow equity crowdfunding platforms to communicate a ‘direct-offer financial promotion’ (a “Promotion”) to certain categories of retail investor. A Promotion refers to an offer or invitation to participate in an investment which specifies the means by which the recipient should respond and may only be made to the following categories of retail investor:
1. certified high net worth investors;
2. certified sophisticated investors;
3. certified restricted investors; or
4. investors who have received professional advice.
In addition, for customers who have not received advice, the ‘appropriateness test’ applies. This means the crowdfunding platform must check whether the customer has the required knowledge and experience to understand the risks of investing. If they do not, a clear warning of the risks must be issued.
What is the FCA’s ‘Call for input’?
Upon releasing the new rules in 2014, the FCA promised a post-implementation review of the crowdfunding market and regulatory framework in 2016 (the “Review”). In order to carry out the Review, the FCA has released a ‘Call for input’ which describes the results of their initial market research and sets out a number of questions. The questions relate to a range of areas and the document contains some hints on the future direction of regulation. Three of the key issues raised in relation to investment-based crowdfunding are set out below.
1. Due diligence standards
The current regulations do not set a minimum standard of due diligence. Platforms are merely asked to make the extent of the analysis that has been undertaken clear. Citing concerns relating to financial crime and with a view to protecting the interests of investors, the FCA suggest that minimum standards may be introduced. An example of a minimum standard may be a requirement for a third party to review the business plan of a company seeking to raise funds.
2. Client assessment
As described above, firms are required to certify that a retail client meets certain criteria and satisfies the ‘appropriateness test’ before communicating a Promotion. The FCA wants to review the extent to which firms are meeting these requirements and whether clients are sufficiently informed to understand the risks and conduct basic due diligence. The FCA may consider publishing further guidance on how to ensure retail investors meet the criteria and introducing sanctions for firms who do not comply.
Equity crowdfunding platforms are required to provide potential investors with sufficient information so that they are reasonably able to understand the nature of the product and its risks. The Review will consider whether this high-level rule is sufficient to protect investors. The Call for input document discusses a range of potential options which include introducing new requirements or mandatory disclosures and penalising non-compliant platforms.
What happens next?
There are not yet any proposals to change the regulatory framework for crowdfunding platforms. Anyone with an interest in equity (or loan-based) crowdfunding is invited to submit their response to the FCA before 8 September 2016. The feedback will be used to inform the FCA’s continuing review of the market. Following the Review, the FCA will consider publishing a consultation paper with any proposed rule changes.
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