On June 4, 2019, the United Kingdom Financial Conduct Authority (the "FCA") published its policy statement PS19/14 (the "Policy Statement") following responses to its July 2018 consultation paper CP18/20 (the "Consultation Paper") on certain new rules and guidance applicable to loan-based1 ("peer-to-peer" or "P2P") and investment-based crowdfunding platforms2. This post focusses on the new policies, rules and guidance as they relate to P2P platforms only.
The majority of the new rules and related guidance come into force on December 9, 2019. Additionally, certain of the FCA's existing rules relating to home finance products were extended to P2P platforms from June 4, 2019. Platforms affected by these final rules and guidance should take steps to comply with the same by these commencement dates.
Changes have been made in the following 5 broad categories, each of which is addressed briefly below: (i) risk management and control mechanisms; (ii) governance arrangements; (iii) marketing restrictions and appropriateness assessment; (iv) wind-down arrangements and resolution manual; and (v) disclosure requirements.
I. Risk Management and Control Mechanisms
If P2P platforms determine the price of loans on behalf of investors, an appropriate risk management framework is required in order for those platforms to understand and price appropriately the credit risk of the loans they facilitate. The FCA's rules in this regard can be found in new section 18.12 of its Conduct of Business Sourcebook ("COBS")3. Included in this section are requirements for credit risk assessments to be carried out by P2P platforms in connection with pricing loans and also in connection with subsequently choosing a portfolio to generate a given target rate of return.
Credit risk assessment when pricing P2P loans
The Policy Statement records that the FCA recognises that a P2P platform's "capabilities in credit risk assessment can be a source of competitive advantage" and they "should have an incentive to innovate in credit risk analysis". As such, these new credit risk assessment rules are intended to create a minimum common standard that should be regarded as a prerequisite for a P2P platform providing this service. Further, the Policy Statement clarifies that, in addition to the minimum common standards, scenario analysis or stress-testing may also be appropriate (but is not a requirement), depending on the business model of a P2P platform.
At a minimum, in order to effectively determine the price of P2P loans on behalf of investors, P2P platforms should: (i) gather sufficient information about the borrower to be able to competently assess the borrower's credit risk; (ii) categorise borrowers by their credit risk in a systemic and structured manner; and (iii) set the price so it is fair and appropriate and reflects the risk profile of the borrower.
Credit risk assessment when choosing the portfolio to generate a given target rate of return
In its Consultation Paper, the FCA observed that providing "a product that offers a target rate of return amounts [in the FCA's view] to the provision of a complex financial service" which requires commensurate controls. The Policy Statement records that, in the context of the potentially misleading nature of target rates of return, a "proportionate way of dealing with the risk is to ensure the advertised target rate of return is based on a reasonable calculation/assessment process."4 In this context, P2P platforms' risk management framework must allow it to "conclude with reasonable certainty that investors can achieve the advertised return within the advertised parameters."
A P2P platform's risk management framework should also: (i) ensure that investors are only exposed to loans that, at the time they are allocated to an investor, meet the risk parameters advertised at the time the investor invests; and (ii) be adequate to assess price and value over time, including at a minimum, containing a provision for re-valuing loans in certain circumstances5, including those that have defaulted to ensure transfer at a fair price. The Policy Statement also clarifies that the frequency of re-valuing will depend on a P2P platform's business model.
According to the Policy Statement, the FCA is of the view that P2P platforms should "be held to comparable standards to firms conducting certain types of investment business (for example, arranging deals in investments or dealing as agent)." In this context, the new rules build on (and can be found alongside) the existing high level requirement6 that P2P platforms must have robust governance arrangements, set out in the FCA's Senior Management, Systems and Controls sourcebook ("SYSC")7.
In addition to the existing governance requirements, the FCA's new rules contemplate the creation of three new functions: (i) an independent risk management function; (ii) an independent internal audit function; and (ii) a permanent and effective compliance function.
The requirement to have an independent risk management and independent internal audit functions depends on the nature, scale and complexity of the P2P platform's business and the nature and range of the services it carries out. The FCA has not proposed a specific threshold for when these requirements will be applicable. It has however clarified in the Policy Statement that "discretionary platforms that set the price and choose the investor's portfolio to generate a target rate of return are likely to meet [the] threshold".
Similar to the risk management and internal audit functions, the compliance function should also be independent, unless it would be disproportionate to the P2P platform to do so8.
The Policy Statement further clarifies that the individual responsible at a P2P platform for the establishment and maintenance of its risk management framework must be a person that is "sufficiently senior to influence strategic decisions" and should be approved for both (i) a significant influence controlled function and (ii) a senior manager function for purposes of the Senior Managers and Certification Regime9. As such, this responsibility can be allocated to individuals performing any of the roles of Chief Executive, Executive Director, Partner, Chair, Compliance Oversight, or Money Laundering Reporting Officer.
III. Marketing restrictions and Appropriateness assessment
The Policy Statement records that one of the FCA's aims is to "ensure that only consumers capable of understanding the risks and of bearing the consequences invest in P2P agreements." In that context, the FCA has extended to P2P platforms the marketing restriction in COBS 4.7.7R (which already applies to investment-based platforms).
This marketing restriction requires P2P platforms to determine if its direct offer financial promotions ("DOFPs") communications are being made to retail investors and if so, to determine whether that retail investor meets the criteria set out in COBS 4.7.7R. One such criteria is that the retail investor is certified as a "restricted investor", namely it will not invest more than 10% of its net investible assets in P2P agreements in the 12 months following certification10. This restriction ensures that less experienced customers are appropriately protected, taking into account the fact that these investments are not covered by the Financial Services Compensation Scheme.
The FCA has also developed additional guidance (COBS 4.7.13 G) in relation to the application of the marketing restriction to ensure a proportionate approach and to promote consistent implementation. The guidance suggests that P2P platforms can communicate key information about their specific risk characteristics and the investments they offer, so long as the communication does not have the characteristics of a DOFP11.
Before a P2P platform can accept an instruction to invest from a client, it must perform an appropriateness assessment. This assessment considers a client's knowledge and experience of the P2P investment. The risk factors to be covered by the assessment are specified in the FCA's guidance (COBS 10.2.9 G).
IV. Wind-down arrangements and Resolution manual
The FCA has strengthened the existing rules on developing and implementing a plan for the wind-down arrangements of P2P platforms. The Policy Statement records that the FCA wanted to clarify that P2P platforms must have "arrangements to ensure that the P2P agreements they facilitate would have a reasonable likelihood of being managed and administered, on an ongoing basis and in accordance with the contract terms, even if the platform ceased to carry out those functions itself."
P2P platforms were already required to notify investors of their wind-down arrangements (SYSC 4.1.8B R). The FCA has now clarified that this disclosure is required "pre-sale", before a platform carries on the relevant business for an investor.
The FCA has also clarified in new rule SYSC 4.1.8A R(3) that wind-down arrangements should not be biased toward protecting any particular type of customer over another.
P2P platforms must also produce and keep up-to-date a "P2P resolution manual" that would facilitate resolution in the event of insolvency. The new rule SYSC 4.1.8DB sets out a list of the minimum information that should be included in the resolution manual. The Policy Statement clarifies that this list is not intended to be exhaustive and each platform will need to consider what information should be covered to meet the overarching requirement. The Policy Statement further clarifies that the FCA will not require this resolution manual to be included in a P2P platform's annual return to the FCA, though it must be made available to it on request.
V. Disclosure requirements
Information relating to the role of the platform and the investment
The Policy Statement records the FCA's view that it is "important that investors [have] sufficient information about the risks they [are] exposed to, the nature of the investment opportunity and the role of the platform." It has clarified its expectations in this regard in a set of new rules which set out the minimum information which must be made available to investors12.
The new disclosure obligations include information about: (i) the role of the platform; and (ii) the investment, which includes ongoing disclosures and, where the platform sets the price, an outcome statement. The FCA further clarified that "platforms should provide investors with sufficient information to help them understand their tax obligations and the potential impact of their investment returns."
With respect to the disclosure of information about the investment, the Policy Statement clarified the following:
- if a platform operates an auction business model, it must provide a summary description of how the final price will be set;
- where loss data are provided, it would be misleading to include payments from any contingency fund;
- disclosure of data on past performance should not include payments made to lenders from a contingency fund;
- disclosure of aggregated information is permissible, however, pricing and fee data should also be made available to investors at an individual loan level at any point in time;
- investors should be able to access information on an individual loan interest rate at any point in time even if the decision to invest was made on the basis of an aggregate target rate of return; and
- investors must be able to access data on annual percentage rate and borrower fees for individual loans.
The FCA has not sought to develop a standard template for disclosure in respect of all forms of information that are required to be disclosed. It has however set out new rules for standard disclosure in connection with contingency funds13. The FCA is of the view that because "contingency funds are set up by platforms for a specific purpose, at a cost to investors and/or lenders and marketed as a benefit", it is appropriate that there be full transparency.
In addition, the FCA has standardised the definition of "default" for P2P platforms14. The new rules provide that P2P platforms will not only be required to give investors disclosure on actual defaults, but also on P2P loans that are likely to default. (COBS 18.12.31 R (11)).
Mortgages and home finance
While, according to the Policy Statement, there is not currently a UK P2P market for regulated home finance, the FCA is of the view that if P2P platforms move into residential secured lending "they would be likely to be carrying on the regulated home finance arranging activity" and as such would be subject to parts of the FCA's Mortgage and Home Finance Conduct of Business sourcebook ("MCOB") (which are similar to Canadian consumer protection laws). As a result, since June 4, 2019, the below sections of MCOB apply to P2P platforms (as if they were the provider) if they are carrying on a regulated business in the United Kingdom in relation to a home finance transaction where the lender or provider does not require authorisation to enter into the transaction:
- MCOB 2 - general conduct of business rules;
- MCOB 3A – governing how a firm communicates financial promotions to home finance consumers.
- Relevant parts of MCOB 4 and 5 – relating to pre-contractual disclosure;
- MCOB 6 and 7 – relating to offer stage and post-contractual disclosure rules;
- Relevant parts of MCOB 10 or 10A – setting out the method for calculating the annual percentage rate associated with the product;
- MCOB 11 - P2P platforms must assess whether a consumer can afford the sums due prior to entering into the home finance contract or making a variation to the terms of the contract;
- MCOB 12 – regarding fees and charges, including early repayment and payment shortfall charges; and
- MCOB 13 – relating to arrears, payment shortfalls and repossessions.
The foregoing new rules and guidance seek to protect investors, by providing for a proportionate regulatory framework that would not stifle innovation in the P2P sector. Overall, the FCA has indicated that the new rules and guidance in COBS and SYSC and the extension of certain rules in MCOB are intended to create a better investment environment for investors, home finance customers and P2P platforms, in which investors have all necessary information about the services provided by a P2P platform as well as clear and accurate information regarding the risk of the investment in order to make a suitable investment decision. Further, the extension of certain provisions of MCOB to P2P platforms aims to provide home finance consumers with a similar level of protection to what they would otherwise receive if the provider were authorised.
1 Individuals and corporations/institutions lend money directly to consumers or businesses.
2 Investors invest directly in businesses by buying investments such as shares, debentures or other debt securities.
3 COBS applies to any firm that either has or ought to have permission to carry on the regulated activity in the United Kingdom of operating an electronic system in relation to lending.
4 See COBS 18.12.15G for FCA guidance on what it considers a "reasonable calculation and assessment process".
5 See COBS 18.12.16 for a non-exhaustive list of circumstances when a P2P platform should re-price loans.
6 SYSC 4.1.1R.
7 Provisions of SYSC apply to UK/EU and third country firms in different manners. Some provisions of SYSC apply as rules, others only as guidance.
8 See SYSC 6.1.5R. P2P platforms will need to explain why it would be disproportionate to have this function be independent of other functions.
9 On December 9, 2019, the Senior Managers and Certification Regime will be extended to all FCA solo-regulated firms, including P2P platforms.
10 Investors can re-classify as "sophisticated investors", thereby removing the 10% limit, after they have made two or more P2P investments in the past 2 years.
11 For example, it does not contain details of how to apply or make an offer or contain an application form.
12 See COBS 18.12.
13 See COBS 18.12.33 to 18.12.38.
14 See the Glossary of definitions. The FCA clarified in the Policy Statement that this definition should also be applied by P2P platforms when they report information about their defaults under regulatory reporting requirements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.