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TISA P2P Forum – Money lending to SMEs through P2P and by investment-based crowdfunding platforms – Legal and regulatory issues
Roger Blears, Senior Partner, RW Blears LLP, 11th November 2019
Money lending is a vital activity to those who borrow – and getting it back is as vital to those who lend.
The P2P market brings democracy into capitalism. For this reason alone, it is a very welcome development to the growth and health of our capital markets. P2P platforms allow me to choose, for all of us to choose, where we invest our money. We are the market – and whether we choose to make loans to fund sustainable green developments or healthcare companies or to make ethical loans to weavers in Denmark, that is our choice – and probably none of us will make loans to fund credit default swaps or subprime mortgages.
So, it is surprising, outside of the fields of consumer credit, home loans and the acceptance of deposits, that money lending has historically been subject to only light touch regulation given how vital it is to the provision and recycling of the capital needed to turn the wheels of industry. But this is now changing in the field of P2P Platforms, with the FCA introducing a new set of stringent, prescriptive rules to govern the risk management of these platforms, with effect from 9th December 2019.
It matters that we ask why these changes have been introduced and what are the legal issues that flow and that as a society we ensure that regulation is proportionate to the risks it addresses and does not snuff out innovation. Elon Musk would not be so creative if he were limited by a world which had decided, for reasons of health and safety, that it was a good idea to work to the 12mph speed limit for automobiles adopted by Connecticut in 1901.
2. P2P – v – investment-based crowdfunding
If I want to trade as a money lender using third party capital, there are two business models I can pursue. I can either form a company, accept responsibility as a director and raise capital by issuing shares or bonds and then trade as a corporate money lender making loans from my balance sheet, or, alternatively, I can raise capital on a ‘just in time’ P2P Platform basis by syndicating loans to investors as and when they are made.
These two models appear to be very different.
Investors in a corporate lender invest on a blind basis in reliance on the declared lending policy and the existing balance sheet of the corporate moneylender.
In contrast a P2P operator, if compliant with the peer to peer regulations, is not any sort of investment-based fund but an electronic transactional system for directly matchmaking borrower and lenders to specific loans and it is a great model in theory for pricing risk, because the price of the money will or should, if sufficient disclosure is made, always reflect the current risk of the loans.
Mr Brian Bartaby, CEO of the P2P platform Proplend commented in a recent edition of the P2P newsletter on the difficulty faced by some ‘just in time’ P2P transactional lending when funding residential developments by way of staged drawdowns. He drew attention to the fact that investor enthusiasm to fund the ‘day-one sum’ doesn’t always follow though to a willingness to fund later drawdowns if something goes wrong with the development and there is likely to be a delay to completion. If investors halt their funding of drawdowns mid-way through, then suddenly everyone is in trouble.
So, an obvious apparent difference is that a P2P platform can come up short on meeting its anticipated funding commitments because of its lack of discretionary reserves, reserves that you might find on the balance sheet of a corporate lender.
This difference, between lending from the balance sheet of a corporate money lender or via a P2P platform, can be blurred if a P2P operator has recourse to a provision fund to cover any borrower debts that go bad.
Interestingly the FCA says that P2P platform should exclude performance stats which have only been sustained where provision funds have been used. I question this. Surely all credit should accrue to a P2P operator that has the good sense and foresight to establish a provision fund. Its judgment as to the size of such a fund and when to use it is vital and reflects the expertise of the operator.
If a provision fund is to be used then the strength of the provision fund matters just as much as the balance sheet of a corporate money lender – in both cases we, the investors, will want to know just how deep are the reserves which underpin our risk and also, and just as importantly, who has first call on them.
The matchmaking by a P2P operator of multiple investors with multiple loans on a ‘pick and mix’ basis is also inherently more complex than the activities of a corporate money lender.
The administrator’s interim report on Lendy, demonstrates how easily a P2P operator can end up in a complete muddle if by design or default it does not operate as a matchmaking agent but, on a non-compliant basis, shows peer to peer loans from investors and advances to borrowers on its own balance sheet.
And, all other factors being even, P2P investments are also, potentially, inherently more risky than an investment in a company or a bank simply because investors do not benefit from a spreading of their risk across a wide portfolio of all loans made by the operator, as they would if their money was held by a bank; – but this is a risk of choice, if I want to make loans only to Danish weavers that is a risk I accept.
But it is not all these risks – the lack of discretionary reserves, complex matchmaking and risk appreciation and acceptance – on their own that are the drivers for new regulation, they are common place enough in a variety of guises in venture capital structures, it is the fact that digital marketing, capable of turbo-charging the flow of large amounts of capital direct from investors to borrowers in a way that sidesteps the regulated system of traditional banks, massively inflates these risks in a way which has the potential to do great harm to society if not checked.
P2P Platforms are a force to be reckoned with and therefore to be regulated, so that the industry can limit the ‘here today and gone tomorrow’ brigade leading retail investors en masse into the abyss of fraudulent schemes, chaotic arrangements or simply arrangements which carry the illusion of debt security but where investors will take much greater risks than they appreciate regarding the prospect of getting their money back – and, in all these cases, it is in the best interests of the industry, an industry which has a very bright future, to act together, working with the FCA and through TISA, to weed out the cowboys.
3. An operator’s duties at law
The recent decision by the Supreme Court in the case of Singularis Holdings Ltd – v – Daiwa Capital Markets Europe Ltd is a timely reminder that there is as body of common law to consider as well as FCA regulation. In Singularis, Daiwa, a bricks-and-mortar bank, was held to be in breach of an implicit duty of care to its customer Singularis, which had been the victim of Daiwa’s negligence.
Does a P2P platform owe a duty of care at common law to its lenders and borrowers? A P2P platform is not a bank but an agent who acts for two principals with potential conflicting interests, undertaking to its borrowers to receive payments and to its lenders to make payments. It provides a service to both lenders and borrowers. At the same time, it is not able to give each principal its undivided loyalty, particularly if the borrower defaults on his loan.
One well known operator states in its Borrower Terms that it will give “Borrowers and Guarantors the fairest customer experience” but when the chips are down it is very clear that the operator will act for the lender in recovering a loan.
FCA rules sidestep the conflicts of interest that arise for an operator when acting for two principals with competing interests, by providing that whilst an operator must treat its lenders as clients its borrowers are expressly excluded as being clients of the operator.
But at common law the position may well be that an agent will be in breach of a fiduciary duty owed to a borrower principal unless it obtains the express permission of the borrower to modify the normal fiduciary duties that an agent owes to its principal.
As regards duties owed to lender principals, the FCA approaches its regulatory role through the requirement that operators abide by its high-level principles as well as by detailed rules of business.
There has been much consultation and discussion as to whether something more might be needed by way of the imposition on authorised firms of a duty of care to their clients. The current position is that the Financial Services Duty of Care Bill 2019-2020 is currently being ushered through Parliament. This will require the Financial Conduct Authority to make rules for authorised persons to owe a duty of care to consumers in their regulated activities. I await with interest what these rules may provide as regards P2P Platforms.
4. Evolution of a framework: (1/2)
The new regulatory objective is a commendable one – that P2P Platforms must take responsibility for meeting the expectations they create, and PS 19/14 has been designed to try and ensure that this is the case.
The P2P Market has matured fast, leading to a risk and range of business models: operators taking decisions on behalf of investors, packaging loans to achieve headline rates of return, the syndication of loans via multiple P2P agreements; there is heightened investment risk with : consumer loans, loans financing property purchases, development projects; as well as Poor business practices regarding : disclosure of information to clients, charging structures, wind-down arrangements and record keeping and so Just as fast, the average retail investor (and borrower) is exposed to actual and potential harm (e.g. unsuitable investment products, inadequate compensation for risk taken, platform resilience).
The new rulebook is extensive, but I suspect that the FCA has only scratched the surface of the body of law likely to be developed for the regulation of P2P Platforms over time, particularly if new rules are later introduced to create a statutory duty of care to lenders.
5. Evolution of a framework (2/2)
The new regulations which come into force on 9th December are not supposed to stifle the innovation, but to help the operators, fundraisers and investors enjoy the full benefits of a well-run P2P sector in the long term. As ever, where regulation seeks to keep pace with invention, the draftsman must remain balanced on his tightrope.
Broadly speaking, the objects of the new rules and guidance are to: prescribe the new governance arrangements, systems and controls which P2P platforms must have in place to support the outcomes which they advertise, strengthen arrangements for the wind-down of platforms, apply marketing restrictions and introduce appropriateness assessments; and set out the minimum information that platforms must provide to investors.
6. Unpacking the new rulebook for P2P operators (1)
Separate risk management, compliance and internal audit functions must be established – which must be designed to detect any risk of failure by the operator with its obligations under the regulatory system – logic would suggest that these could be combined, but at the moment they appear as separate requirements.
Now since it is primarily the IT infrastructure which has been the engine of the new market’s growth and the driver for regulation, it might seem a surprising omission that nowhere in the new rules is there any requirement for the beta testing or operational certification of an operator’s system as being fit for purpose. Is this an oversight?
Operators of P2P platforms will be required to have in place what I will call “standby arrangements” in the event of their platform failure, and, in case such arrangements are ever invoked, a resolution manual which describes all aspects of how their P2P business is operated so that P2P agreements will have a reasonable likelihood of being managed and administered in accordance with the contract terms in the event of platform failure.– a manual that must be made available to the FCA immediately on request from 9th December 2019. This might suggest that such arrangements must involve another person taking over the management but in fact this is optional.
When designing standby arrangements, the new rules recommend that an operator should take into account the general law to ensure that an insolvency of the operator does not prejudice the operation of the platform – for example this might require consideration as to whether or not a fund set aside to cover the costs of standby arrangements will not form part of the insolvent company’s general assets – and also that the operator should consider the need to obtain professional advice on the adequacy of its arrangements. A list of other matters to be considered when designing standby arrangements is also helpfully provided. Woe betide he who fails to evidence that he did not consider each and every item on this list.
The FCA may have taken the view that the process of putting in place standby arrangements may involve the functionality of the system being challenged and tested by third parties; – but given that the involvement of third parties is optional, this won’t always be the case.
7. Unpacking the new rulebook for P2P operators (2)
The new specialist regime lays down very prescriptive rules for a minimum level of credit assessment where the P2P operator is setting the price (i.e. interest rate) of its P2P agreements to ensure that the price is fair and reflective of the risk profile of a prospective loan in the light of that credit risk assessment. This assessment must be based on sufficient information obtained from the borrower; – and, where necessary, other relevant sources of information.
An operator must have a robust modelling capability to calculate target rates effectively so that if a portfolio of loans is to be chosen for an investor with an advertised rate of return then the operator must be able to show with reasonable certainty that such a rate can be met.
The requirements for record keeping anticipate FCA inspections and oversight of proper compliance with these new rules.
Loans must be repriced loans in the case of certain events risk of or actual borrower default, where the operator has facilitated an early lender exit.
Where a firm offers a contingency fund on a discretionary basis, a prescribed risk warning is required and additional information must also be provided including as to the fund’s ownership, the source of funds and how discretionary payments may be made.
This policy must be provided on every page of each website and mobile application of the firm accessible by prospective lenders.
Quarterly information must be made public by the operator on the fund’s size relative to total amounts outstanding and what proportion of outstandings have been paid using the fund.
The direct offer financial promotion rules will also be extended to include P2P agreements. As this is a topic to be addressed by the panel later on, I won’t cover it in my talk now.
8. SME lending by corporate money lenders
The assumption was made in the consultation paper CP18/20 that investment-based crowdfunding platforms are typically subject to requirements stemming from MiFID or the AIFMD and that their business models tend to be relatively simple. Perhaps.
If I form an investment-based company, I might crowdfund share capital from those investors who want business property relief from inheritance tax, alternatively by the issuance of IFISA-eligible bonds to those who want tax-free interest. I could offer both shares and bonds but, most likely, I would be well advised not to do so from the same company because this clearly introduces a layer of complexity and potential conflicts between the interests of shareholders and the interests of bond holders, which are best avoided.
If I want to offer investors a form of access to the FSCS, something not available for direct investors in either BPR qualifying shares or IFISA qualifying bonds of for investment in P2P Platforms I might promote a discretionary fund management service which offers investors an income and access strategy based on the purchase of bonds, or a succession strategy based on the purchase of shares, or permutations between these two strategies, in order to create the diversity of choice which ensures that the service I offer as a discretionary fund manager is regulated by MiFID and so can be promoted freely and is not a collective investment scheme which can only be promoted on a very restricted basis.
The promotion of my bonds or shares will of course be regulated by the Companies Act 2006, FSMA 2000 and subordinated legislation, but they will not be subject to the restriction on promoting non-mainstream pooled investments (“NMPI”) provided my bonds are non-convertible or exchangeable. Shares and bonds are unlikely to be readily realisable and therefore the direct offer financial promotion restriction will also apply. To be eligible for inclusion within an IFISA account bonds must also be transferable. But that’s it. There are no other applicable FCA regulations that cover the operations of a corporate money lender providing loans to SMEs.
An investment-based crowdfunding company will need to comply with an established body of corporate and insolvency law but otherwise it will carry on business as directed by its board of directors with no regulation by the FCA. Not all board decisions will be straightforward. As investors’ capital is pooled; – so if a corporate money lender suffers a bad debt, unless it has been funded by a series of limited recourse bonds, the loss will negatively impact all bond holders on a pari passu basis, even those who invested after the loan was made. With a P2P Platform, the loss of a bad debt only accrues to the investors who own the debt. Therefore, on occasion, the board of an investment-based crowdfunding platform will need to manage its loan portfolio with an eye to different series of bonds maturing at different times. Life may not always be so simple.
9. Infrastructure funding
The future is bright and orange for the growth in the markets for P2P Platforms and corporate money lenders.
Many millions of pounds were invested though the EIS scheme in solar assets. All schemes are now over five years old and yield bearing. Holdings of EIS shares do not pay tax free dividends and so IFISA bonds can be used to refinance EIS holdings so that investors receive their solar yield tax free.
We are amidst General election campaigning where Labour promise to spend £55bn per annum on new infrastructure and the Tories a measly £25bn. Both are short. In March this year HMT published their consultation on the Infrastructure Finance Review in which they predicted an infrastructure spend over the next ten years of approximately £600bn – that is £60bn per year – but of which HMT would want half to be raised from the private sector.
It is possibly a happy coincidence that the latest ISA statistics published by HMRC disclose an aggregate balance on cash ISAs of approximately £276bn. There is clearly scope for some of the cash balances to be transferred across to IFISA accounts so that investment-based crowdfunded Public Corporations might finance the rebuilding of our national infrastructure.
This opportunity presents itself by accident. The ISA regulations adopt a wide definition of what is a ‘company’: i.e., ‘any body corporate having a share capital’, subject to some exceptions which are not relevant for present purposes. This goes beyond entities which are merely incorporated under the Companies Act 2006 and can also include public corporations whose shares are held by the Government.
The ISA regulations adopt the terminology of the Regulated Activities Order which uses the term ‘debenture’ when referring to bonds.
The definition they import ordinarily excludes debentures issued by bodies corporate whose shares are held by a state, but significantly this exclusion is, by default, to judge from conversations with HMT, ignored when the term ‘debenture’ is used in the ISA regulations, and therefore bonds or debentures issued by public corporations, because of this modification, are eligible for inclusion within an IFISA account.
This means that specialist state owned Public Infrastructure Finance Corporations could feasibly raise their capital from the public subscription of IFISA bonds. As an incentive to encourage public investment the government could front-run the risks, perhaps through the provision of a partial guarantee of bond returns; structured either as a pari passu guarantee or a first loss guarantee.
The case for this approach to public infrastructure funding is set out in a response to the HMT consultation which we jointly made with Goji and Amberside Investors.
10. The facilitation of bondholders’ rights
The ISA regulations require that an authorised person must facilitate the exercise of bond holders’ rights. This is a vital responsibility and calls for a “bond trustee’ with a remit which goes far beyond the passive and mechanical role played by security trustees. It can only be a matter of time before the FCA legislates to make the facilitation of bond holders’ rights a regulated activity with a remit as stringent as that now being imposed on operators of P2P Platforms.
11. Partial subordination?
Many corporate money lenders are comparable to the renaissance banks of the 15th century, full of ambition but low on capital reserves. The Netflix 2nd Series of “Medici” opens with a story about the Duke of Milan defaulting on a large loan owed to the Medici bank. This unfortunate circumstance coincides with the Pope asking the bank to repay his deposits. The solution to this crisis in the 15th century was for the head of the Medici family to marry the daughter of an influential papal courtier and to murder all the directors of the rival bank in Florence which had been stirring up trouble for the Medici’s in Rome. Such simple solutions present themselves only once in a millennium.
12. Retained Profit Reserve
If I were to make one final point it would be that the Companies Act 2006 might usefully be amended so that thinly capitalised money lenders should partially subordinate the participation rights of directors and shareholders to the rights of bondholders until a retained profit reserve has been established sufficient to cover a measure of loss from poor performance.
For example, a Retained Profit Reserve might provide that:
“No profits will be distributed to shareholders of the Company until a reserve has been created which, when added to shareholder capital, is equal to 5% of the outstanding bond capital; plus accrued but unpaid interest; plus any provision for non-repayment of loans by SME borrowers.”
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