On 17 August 2021, a portfolio strategy letter (the “Letter”) was published by the Financial Conduct Authority (the “FCA”) for firms belonging to the investment-based crowdfunding (“IBCF”) market.
The aim of the FCA’s Letter is to ensure that crowdfunding firms are promoting investment opportunities in an appropriate manner to assist consumers in gaining an understanding of the high level of risk associated with these kinds of speculative investments.
In the Letter, the FCA identified four key risks within the IBCF market, each one followed by their expectations of IBCF firms to address the risks accordingly and the work that the FCA intends to undertake to rectify these problem areas.
KEY RISKS
Inappropriate investments
Whilst the advancement of technology has made investing more readily accessible to the general public, the FCA recognised that, regardless of the existing restrictions, this wide availability of investment does not prevent consumers from investing in inappropriate high-risk investments. Too often, consumers lack an understanding of the underlying risks of investment and neglect the process of proper client categorisation. In addition, firms frequently fail to verify this key process of client categorisation to sufficiently protect consumers. As such, the FCA is concerned that consumers are not investing in their own best interests because they are holding over 10% of their investment portfolio in speculative and high risks investments, which can be significantly more harmful.
To tackle the above, the FCA has clarified its expectations of firms in order to rectify its concerns, which includes:
- ensuring customer’s understanding of the risks they will be exposed to;
- carefully considering the nature and risks of investments offered to investors in light of the investor’s client categorisation, their knowledge and experience;
- clearly informing potential investors of any analysis and due diligence the firm has undertaken;
- keeping records of client categorisation and other key information used to assess the appropriateness of the investment opportunity;
- being mindful of conflicts of interest and disclose to investors when conflicts of interest cannot be managed;
- treating customers on both sides of the investment fairly;
- taking reasonable steps to reduce risk of investors holding more than 10% of their portfolio in high risk and speculative investments; and
- adhering to rules and guidance set out in the FCA handbook.
Going forward, the FCA will undertake to monitor the activities of firms within the IBCF market more closely and will hold those within the senior management function accountable in the event that the FCA’s expectations have not been met.
Scams
When using crowdfunding platforms, investors are exposed to risks of fraud and scams, especially when adequate due diligence is not carried out by the hosting platforms. Moreover, these platforms may not have the appropriate cyber control system. As a result, investors’ data on these sites risk being lost or stolen, and subsequently being used in fraud.
As such, the FCA is adamant that firms not only have a clear understanding of the risks posed by their businesses, but also install proper safeguards, such as carrying out due diligence thoroughly and having high standards of infrastructure and cyber controls to tackle the risks of scams and fraud. Moreover, the FCA reiterated that firms are under a duty to act in the best interests of their consumers and to sufficiently educate them about these potential risks. The FCA will take steps to monitor firms’ compliance and will take steps to vary the permission or even cancel existing authorisation should it decide that firms have not proactively adhered to them.
Appointed representative oversight
In order to minimise the consumers’ inappropriate exposure to high-risk investment, the FCA is determined to seek assurances from the Chief Executive or the appointed representatives of the IBCF firms to ensure that robust systems are in place and that these individuals are overseeing the firms’ activity adequately and are held accountable for the actions of their firms.
To incentivise this and fund the additional work the FCA needs to undertake, a recent consultation was carried out on the introduction of a flat fee of £250 per appointed representative responsible for the oversight of the firm’s activity.
Disorderly firm failure
Due to the general lack of profitability, the FCA is concerned that IBCF firms will fail in a disorderly manner, resulting in the loss of client assets and other forms of consumer harms. As a result, the FCA urges firms to review its published guidance on its recommended approach to assess adequate financial resources. The FCA will also undertake regular reviews of the capital and liquidity of the firms to future proof any possibility of liquidity risks being crystalised. It is also essential that the IBCF firms have a credible wind-down plan with realistic estimation on cost and timing in the event the firm needs to be wound down.
As above, the FCA will actively monitor firms’ liquidity by increasing the use of data collected from the firm and will hold the senior management accountable for actions that do not meet the FCA’s expectations. The FCA will engage directly with the firms to understand what risks their business model poses and any potential changes.
NEXT STEPS
The FCA reiterated firms’ responsibility to ensure the above requirements are complied with. Appointed representatives or accountable individuals of the firms will be engaged directly by the FCA in accordance with the Senior Managers and Certificate Regime to ensure proper governance and oversight is in place.
To review the FCA’s publication of the portfolio strategy letter, please click here.
To review the FCA’s publication of CP21/8 on the introduction of a new flat fee, please click here.
To review the FCA’s Wind-Down Planning Guide, please click here.
For more information, and any guidance or advice on IBCF firms and the respective FCA publications, Cleveland & Co External in-house counsel™, your specialist outsourced legal team, are here to help.
