The EU Parliament is about to adopt a crowdfunding regulation that will enable ‘European crowdfunding service providers’ (ECSPs) to facilitate businesses raising funding directly from investors across the EU far more easily than they can today. The regulation calls for the related funds flows to be handled under payment services regulation, and adds operational and prudential requirements related to lending and investment in securities. Since helping start Zopa, the first peer-to-peer lending platform, in the UK in 2005 I have acted for many peer-to-peer lending platforms and some crowd-investment platforms in the UK, as well as advising in relation to e-money and payment services since 1999. If you have plans in this area, please get in touch.
What is ‘crowdfunding’?
Crowdfunding initially meant raising donations from many people, and sometimes the donors received a nominal reward, like an album or different gifts according to the size of their donation. From 2005 that model evolved into any internet-based, digital platform that matches multiple retail investors’ offers with a fundraiser’s request for either a loan or some kind of investment funding on a direct, one-to-one basis without issuing a prospectus. Each investor has an account where they log-in to view investment opportunities and agree their own loan or purchase of a security instrument (share or bond) directly with the borrower/fundraiser. The platform operator administers the instruments on behalf of the investors as if they were one, as far as the borrower/fundraiser is concerned, while each investor can hold or sell their investment as each of them pleases. The platform operator charges certain administration fees to cover its costs, but does not participate in the funding deal itself.
That’s different to depositing your money with a bank, or investing in an investment fund, where the bank or fund manager is in control of how that money is then bundled and allocated to borrowers/fundraisers, and keeps any profit it can make as well as charging fees to cover its costs. In a crowdfunding model, the typical bank or fund manager’s profit stays with the investors and fundraisers, and the platform only makes a profit on the difference between its fees and actual costs.
A Very Short History of Crowdfunding Regulation
When we started Zopa in 2005, we basically structured it as a payments platform with consumer credit and investment rules to govern the lending activity. Since then, Zopa and other platforms repeatedly called on the UK government, and later the EU to regulate crowdfunding in similar fashion, with payment service-style regulation to govern funds flows and additional regulation to govern the lending/investing transactions. That’s because payments regulation envisages a payment transaction between two parties (payer and payee), while credit or investment regulation typically envisages the sale of a financial product by a firm to its client.
By 2012, the European Commission had also indicated that it preferred the payments-based approach, but the UK’s Treasury and Financial Conduct Authority disagreed. In 2014, the FCA shoe-horned P2P lending into a confusing mishmash of consumer credit and investment regulation, and an array of other rules sprinkled throughout its monolithic Handbook. Other EU member states followed different paths, most building on payments regulation to a greater or lesser extent.
Now, the EU Parliament is about to implement the Commission’s payments-based approach, which will apply throughout the EU. This will enable ECSPs to access the entire single market through a single authorisation based on a single set of rules allowing for investor protection requirements to be tailored to suit either loan-based or securities-based business crowdfunding services. ECSPs can either get their own payment services authorisation and passports, or involve an existing payment service provider with the right passports to handle the funds flow.
The next step is for Parliament to adopt the regulation at second reading, after which it can be published in the Official Journal. It will enter into force directly in each member state, without the need for local legislation (except to exclude ECSPs from the Directive on markets in financial instruments (MiFID)). Authorisation and compliance will be supervised by national regulators in cooperation European Securities and Markets Authority (ESMA).
Scope of the EU Crowdfunding Regulation
The new regulation is a more efficient and cost-effective framework for businesses to raise money from the public across the EU, compared to the traditional regulatory frameworks. But beware that this means if the fundraising activity falls outside the description of ‘crowdfunding’ under this regulation, it is likely that the more awkward and costly traditional regulations will apply. It will not necessarily mean that the activity is simply unregulated.
In technical terms, the EU regulation defines a ‘crowdfunding service’ to mean “the matching of business funding interest of investors and project owners through the use of a crowdfunding platform” and to consist of facilitating loans and/or the placing ‘transferable securities’ (without a firm commitment basis) and ‘admitted instruments for crowdfunding purposes’ issued by project owners or a special purpose vehicle (and the reception and transmission of related client orders).
‘Admitted instruments for crowdfunding purposes’ are “shares of a private limited liability company, which are not subject to restrictions that would effectively prevent them from being transferred, including restrictions to the way in which those shares are offered or advertised to the public.”
A ‘crowdfunding platform’ is defined as any publicly accessible internet-based information system operated or managed by [an authorised] crowdfunding service provider.
Out of scope:
This regulation only covers business finance. So the people who seek funding through a ‘crowdfunding platform’ (“project owners”) cannot be consumers.
In addition, project owners cannot raise more than €5m every 12 months. This minimises the potential for systemic risk from this sector.
There are certain operational requirements on ECSPs, such as to act honestly, fairly and professionally in accordance with the best interests of their clients. And limited discretionary management is possible. Only one illiquid or indivisible asset can be offered through each ‘special purpose vehicle’ (company or other corporate body).
Policies and procedures for effective and prudent management must include segregation of duties, business continuity and the prevention of conflicts of interest, in a manner that promotes the integrity of the market and the interest of their clients, as well as certain types of risk management and minimum levels of due diligence on project owners.
There are extensive requirements for the management of loan portfolios and related regulatory technical standards to be issued by the European Banking Authority in cooperation with ESMA.
There are also specific requirements for investor information, marketing, cooling-off, secondary markets (bulletin boards), complaints handling, outsourcing, safeguarding and regulatory reporting.
If the ECSP wishes to handle payments itself, then it must be authorised or registered as a payment service provider (either a payment institution or e-money institution). Otherwise, it must involve a regulated payment service provider to handle the funds. This is somewhat at odds with the interpretation by some EU regulators that to require authorisation as a payment service provider a firm must be offering a payment service by way of business in its own right, rather than as ancillary to another activity.
Unless they already meet certain higher capital requirements, ECSPs must maintain the higher of €25 000 and 25% of the fixed overheads of the previous year, reviewed annually, including the cost of servicing its loans for three months, either in own funds and/or insurance.
ECSPs must apply for authorisation under their local member state regulator in a similar way to payment service providers and provide similar information. Directors and senior managers must be ‘fit and proper’ with suitable experience.
Certain authorised firms, such as payment service providers, do not have to resubmit information already provided where such information or documents remain up-to-date and are accessible to the authority. Those seeking multiple authorisations need only submit the same information once.
The authorities have 25 working days to assess whether an application is complete (unlikely) and set a deadline for further information to be submitted. They have 3 months from deeming the application complete to decide whether to authorise.
No physical presence is required outside the ECSPs home member state, and a similar passporting arrangement applies as for payment services.
And like payment service providers, ECSPs can also engage in any other lawful business activity.
If you have plans in this area, please get in touch.