Alternative Lending: A Regulatory Focus on the SME Market GRANT THORNTON FINANCIAL SERVICES GROUP

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1 Alternative Lending: A Regulatory Focus on the SME Market GRANT THORNTON FINANCIAL SERVICES GROUP

2 The Financial Conduct Authority recently issued Consultation Paper 13/13 detailing its regulatory approach to crowdfunding and similar activities. Before it takes over the regulation of the consumer credit market from the Office of Fair Trading on 1 April 2014, the watchdog needs to consult on appropriate measures to protect borrowers and investors. Given the difficulties that small and medium-sized enterprises are currently encountering when seeking access to finance, the FCA is conscious of the need to adopt a balanced solution to protect both consumers and an industry that is gaining momentum. February 2014 FCA to publish statement and feedback to CP13/10 and CP13/13 April 2014 Responsibility for consumer credit regulation to transfer from the OFT to the FCA March 2014 FCA to publish final version of plain language guidance designed to help consumer credit firms and other stakeholders understand and navigate the new consumer credit regime April 2014 FCA to publish paper on key risks in the market in order to establish intervention priorities 2 ALTERNATIVE LENDING A REGULATORY FOCUS ON THE SME MARKET

3 We need to see more small, innovative, alternative banks and nonbanks. There are many new financing models which have been created, such as peer-to-peer lending, which have taken off like wildfire. I am now beginning to encounter companies around the country which would have gone under were it not for peer-to-peer lending. Vince Cable, Secretary of State for Business, Innovation and Skills October 2014 FCA will start considering applications for full authorisation from firms with interim permission 2019 Department for Business, Innovation and Skills and HM Treasury to carry out post-implementation review reforms April 2016 Full FCA consumer credit regime will come into effect replacing the interim permission regime 2019 FCA to complete a review of retained CCA conduct requirements and develop rule-based alternatives ALTERNATIVE LENDING A REGULATORY FOCUS ON THE SME MARKET 3

4 Traditionally, UK businesses have heavily relied upon banks to meet their funding needs. However, the prudential regulation that followed the financial crisis forced banks to boost capital ratios and, subsequently, had a cataclysmic effect on funds available for lending. The Breedon Report, which examined the financing of UK small and medium-sized enterprises (SMEs), concluded that there will be a finance gap of between 84 billion and 191 billion over the next five years 1. Although the Breedon Taskforce could not identify a single solution to this problem, it established that raising awareness of alternative finance methods would be key. The term alternative finance is capacious, thus is often applied subjectively. Commonly, alternative finance includes any form of finance provided by non-banking entities. It is thought that these innovative funding methods will have a crucial role in the creation and survival of SMEs as traditional lenders continue to tighten their lending criteria. Access to finance is particularly important for SMEs as it is often the principle facilitator that enables SMEs to execute their strategies and support operational business plans and processes. Therefore, improving credit flow to allow these businesses to invest and expand is vital, not only to avoid hindering their growth, but ultimately to circumvent impacting the national economy. It is estimated that these entities represent 50% of the UK s GDP and employ 60% of the workforce. 2. Alternative Finance Online Invoice Trading Supply Chain Finance Trade Finance Crowdfunding Retail Bond Market Equity Self- Issued Retail Bonds Asset- Based Lending Rewards Charity Peer-topeer 1 Breedon Report: Boosting Finance Options for Businesses page 3 2 The Business Zone: Viewpoint on the British Business Bank 4 ALTERNATIVE LENDING A REGULATORY FOCUS ON THE SME MARKET

5 As businesses are continuing to struggle to get credit from their banks, developing alternative lending channels is essential so firms are less reliant on banks. Vince Cable, Secretary of State for Business, Innovation and Skills The importance of alternative lending channels The government acknowledges the gravity of the funding gap and has adopted various measures in order to promote lending such as the Funding for Lending Scheme or the Enterprise Finance Guarantee. Particularly, the Growth Accelerator programme, supported by Grant Thornton, helps companies to overcome their barriers to growth by offering private expertise in one of four areas: access to finance, business development, growth through innovation and leadership and management training. Additionally, efforts to raise awareness about alternative funding methods and regulate the industry are underway. The recent and significant growth of the crowdfunding sector has drawn attention to this emerging industry. With more than 492 million lent in 2012, crowdfunding is providing SMEs with invaluable access to finance, yet remains unregulated. Despite being an ancient concept that was originally used to fund the base of the Statue of Liberty, crowdfunding is currently in vogue. It consists of financing businesses and loans with contributions from a large number of sources, often using an online platform. The internet and online platforms have increased the ease with which those in need of finance are connected to those disappointed with the low returns currently offered by traditional banks. There are numerous varieties of crowdfunding: some are charitable donations that provide intangible benefits, others do offer financial returns and the third category grants a combination of both. Consumer credit arranged via loan-based crowdfunding platforms was originally regulated by the Office of Fair Trading (OFT). These lenders were obliged to comply with the guidance this body issued; however, from April 2014 they will be regulated by the Financial Conduct Authority (FCA). The latter shares the government s desire of making these alternative forms of finance more secure and accessible. The FCA has accepted a challenging undertaking: it must offer sufficient protection to borrowers and investors alike; nevertheless, it needs to adopt a proportionate, risk-based approach as stringent regulation would severely hinder the industry before it has fully developed. Private Placements Business Angels Venture Capital Corporate Venturing Business Growth Fund Private Equity Public Equity Markers Pension-Led Funding Asset-Based Lending ALTERNATIVE LENDING A REGULATORY FOCUS ON THE SME MARKET 5

6 The characterisation of peer-to-peer simple loans versus debt-based crowdfunding models as low-risk versus highrisk is, in our view, a mistake. On 24 October 2013, the FCA issued a Consultation Paper on its regulatory approach to crowdfunding and similar activities (CP13/13). Chair of the UK Crowdfunding Association Christopher Woolard, the FCA s Director of Policy, Risk and Research, described the purpose of the suggested rules as follows: Consumers need to be clear on what they are getting into and what the risks of crowdfunding are. Our rules provide this clarity and extra protection for consumers, balanced by a desire to ensure firms and individuals continue to have access to this innovative source of funding 3. In its paper, the FCA distinguishes between investment-based crowdfunding and loan-based crowdfunding. The former, which consists of investing in businesses by buying unlisted shares or unlisted debt securities, is already regulated by the FCA. Nonetheless, the regulator has seized this opportunity to underline the risk associated with investment-based funding and highlight that such forms of finance should only be promoted to people who understand their inherent dangers or to those that can financially cope with potential losses. Thus, investors will need to attest that they will not deposit more than 10% of their net investible portfolio and, if they are not under investment advice, they will need to pass an appropriateness test. In contrast, the regulator s approach to loanbased crowdfunding platforms is much lighter as they are considered to be lower risk. Essentially, the FCA will treat these platforms as any other designated investment, with an exception: peer-topeer lenders will not be covered by the Financial Services Compensation Scheme (FSCS) and the regulator expects firms to disclose the lack of coverage to potential investors. Platforms will have to comply with two of the FCA s rulebooks: The Conduct of Business Sourcebook (COBS) for investors and the Consumer Credit Sourcebook (CONC) for borrowers. Financial promotions rules will also be applicable. The FCA s proposals for loan-based platforms can be summarised as follows: 1. Firms will have to comply with minimum prudential requirements in order to ensure their on-going viability. The regulator recognises the potential negative impact that disproportionate prudential requirements could have in the market; preventively, it has proposed a three-year transition period before these measures come into force. 2. Platform operators will have to create programmes that ensure loans can be managed in case of platform failure. 3. Those lenders holding client money will need to apply the existing client money rules contained in the Client Assets sourcebook (CASS). Therefore, firms will need to put in place adequate organisational requirements to safeguard clients rights To comply with the Distance Marketing Directive, consumers will be given cancellation rights. They will have the opportunity to cancel the loan or withdraw their funds from the platform within 14 calendar days. 5. Approved lenders will be required to report their financial position, complaints received and their client money holdings to the regulator. 6. The information disclosed to consumers will need to follow the financial promotions rules. As a result, current practices such as comparing lending platforms interest rates with deposit account rates will be forbidden. Consequently, a more adequate description of the investments nature and risks 5 is expected. 3 The Financial Conduct Authority outlines how it will regulate crowdfunding: 4 CASS COBS 2.2 and COBS ALTERNATIVE LENDING A REGULATORY FOCUS ON THE SME MARKET

7 The balance the Regulator strikes between consumer protection and encouraging competition, will dictate whether this industry survives or thrives. Reactions to the FCA consultation paper As anticipated, the consultation paper provoked swift reactions. While regulation is expected to increase consumer confidence, and was largely welcomed by the industry, there was also much controversy. The chair of the UK Crowdfunding Association (UKCFA) stated that: The characterisation of peer-to-peer simple loans versus debt-based crowdfunding models as lowrisk versus high-risk is, in our view, a mistake 6. The Association has publicly announced that it will lobby for a more granular breakdown of the investment opportunities offered by the crowdfunding sector 7. Indeed, some consider that the FCA s projected regime is over-simplified; for instance, there is no proportionality according to the risk associated to the different types of loan. The impact that these reforms will have in the industry is yet to be seen. The regulator acknowledges that higher consumer protection comes at a price. So far, it has published a costbenefit analysis which indicates that the proposed rules will result in certain companies leaving the peer-to-peer industry and that compliance costs will be permanently higher for those that survive 8. Inevitably, greater accountability will have a negative impact on the rates that have so drawn customers to alternative lenders. According to the FCA s calendar, those companies that hold an OFT licence, will need to apply for interim permission before the 1 April Therefore, this is the perfect time for firms to assess whether they are ready to comply with the regulator s demands or whether they need to undergo a strategic decision-making process to assess the implications of compliance upon their business model and, ultimately, their survival in a redefined marketplace. Platforms with interim permission will be able to apply for full authorisation from the 1 October Before the 1 April 2016, all prospective regulated firms must ensure that those individuals in control functions are registered as Approved Persons by the FCA 9. Although the regulator has conferred a reasonably long transition period, and many of its proposals are a close reflection of the Peerto-Peer Association code of conduct, firms will still need to operate a profound review of their existing governance and control strategy and put into place new regulatory reporting mechanisms. Financial promotions will require specific attention in order to comply with some of the FCA s key principles: treating customers fairly and providing information which is clear, fair and not misleading to help them make informed decisions. Alternative lenders must not forget that, as the regulator itself stated, the FCA has much stronger enforcement powers than the OFT. While the estimated 840 million that will be lent by alternative finance providers in 2014 only represents 2% of annual UK business lending, the fact that this amount has grown at a rate of 90% 10 year-on-year cannot be disregarded. Peer-to-Peer lenders have been described as game-changers ; not only due to the seductive rates they offer, but because both borrowers and investors are captivated by their speed and simplicity. Although they have been defined as a passing fad by some bankers, the industry benefits from the government s support. Whether the regulator will manage to strike a fair balance between customer protection and encouraging competition in the lending sector is yet to be seen. 6 The FT 28/11/2013: Crowdfunders and peer-to-peer lenders draw lines in the sand 7 Crowdfunding & Regulation: A response to FCA consultation paper CP13/13 (Daniel Kieran) 8 CP 10/13 9 CP 13/13 page Nesta: The Rise of Future Finance. The UK Alternative Finance Benchmarking Report. ALTERNATIVE LENDING A REGULATORY FOCUS ON THE SME MARKET 7

8 Contact us Chris Tattersall Partner T +44 (0) E chris.j.tattersall@uk.gt.com Mark Fielden Tax Director T +44 (0) E mark.r.fielden@uk.gt.com 2014 Grant Thornton UK LLP. All rights reserved. Grant Thornton refers to the brand under which the Grant Thornton member firms provide assurance, tax and advisory services to their clients and/or refers to one or more member firms, as the context requires. Grant Thornton UK LLP is a member firm of Grant Thornton International Ltd (GTIL). GTIL and the member firms are not a worldwide partnership. GTIL and each member firm is a separate legal entity. Services are delivered by the member firms. GTIL does not provide services to clients. GTIL and its member firms are not agents of, and do not obligate, one another and are not liable for one another s acts or omissions. This publication has been prepared only as a guide. No responsibility can be accepted by us for loss occasioned to any person acting or refraining from acting as a result of any material in this publication. grant-thornton.co.uk Grant Thornton UK V23714