More than six years after the European Commission outlined its proposals for building a capital markets union in its Green Paper, an important milestone towards the establishment of such a union – the Regulation on European Crowdfunding Service Providers (ECSPR) – enters into force today. The long-awaited regulation aims at creating a level playing field for European crowdfunding service providers (CSP).
Crowdfunding is increasingly an established form of alternative finance for consumers, start-ups, and small- and medium-sized enterprises (SMEs). The volume of the European online alternative finance market overall was in 2020 estimated to be worth around €8.5bn ($9.9bn). Peer-to-peer (P2P) and marketplace consumer lending proved to be the largest model represented in Europe, with around €2.5bn derived from this model in 2020 alone. By contrast, the P2P business lending market totalled about €1.55bn in 2020.
The provision of crowdfunding services generally involves three types of actors:
- a project owner that proposes the project to be funded;
- investors who fund the proposed project; and
- an intermediating organisation in the form of a CSP which brings together project owners and investors through an online platform.
Due to authorisation requirements under national law, some crowdfunding markets (eg Germany) also see the involvement of fronting banks that grant loans to the project owners and sell these loans or parts thereof to the investors.
Crowdfunding market in the EU
Despite the increasing volume, national legislation has often stood in the way of further growth. While the Capital Requirements Directive (CRD) aims at harmonising regulation for banks across the EU, there has so far been no equivalent that would have applied to the broking of loan agreements and the provision of crowdfunding services.
In Germany, for example, investors and project owners on crowdlending platforms may even be subject to authorisation requirements for deposit taking and lending business, which restricted true P2P lending in Germany. The CSP itself usually qualifies as a loan broker or as a broker of financial assets and, therefore, only requires a licence under the German Trade Regulation (Gewerbeordnung). Other jurisdictions, such as France and the Netherlands have had specific crowdfunding and crowdlending legislation in place for some time that is specifically targeted at crowdfunding and crowdlending.
Regulation on European Crowdfunding Service Providers
The ECSPR now addresses these issues and aims to harmonise crowdfunding regulation across the EU and further foster the growth of the crowdfunding services industry.
The ECSPR applies to:
- lending-based crowdfunding (crowdlending); and
- investment-based crowdfunding.
The ECSPR does not apply to:
- crowdfunding services that are provided to project owners that are consumers; and
- crowdfunding offers with a consideration of more than €5m.
As such, outside the aforementioned scope of the ECSPR, national rules on crowdfunding will also continue to apply.
The scope of the regulation shows that it aims at the provision of financing for SMEs only, despite the P2P consumer market being the most significant sector of the online alternative finance market in Europe. However, consumers can be investors in crowdfunding projects.
A legal person that intends to provide crowdfunding services within the scope of the ECSPR must apply for authorisation as a CSP. However, the authorisation requirement will only fully enter into force on 10 November 2022. The authorisation application must be submitted to the competent Member State authority; in Germany, this is the BaFin. The ESMA has already published a draft RTS that further specifies the contents of the application and the application form.
The centrepiece of the ECSPR is the European passport. Once the CSP has been granted its authorisation, it may start providing crowdfunding services in other Member States after submitting a notification to the home state supervisor.
The authorisation also allows the CSP to offer individual portfolio management services with respect to loans, where an investor gives the CSP a mandate specifying the parameters of loans that he/she wants to invest into. The CSP then chooses the loans for the investor based on the investor’s preferences. However, the authorisation obtained under the ECSPR does not grant CSPs the right to provide individual or collective asset management services.
Another functionality of the authorisation is a ‘bulletin board’ on which a CSP can allow its clients to advertise interest in buying and selling loans, transferable securities or admitted instruments for crowdfunding purposes that were originally offered on its crowdfunding platforms. This secondary loan market shall, however, be limited in scope. The CSP cannot implement protocols that bring together multiple third-party buying and selling interests in financial instruments in a way that results in a contract; the bulletin board shall, therefore, not consist of an internal matching system that executes client orders on a multilateral basis. This would trigger additional licensing requirements for the provision of an MTF.
A second key element of the ECSPR is the level playing field that it creates for crowdlending across the EU. Participating in crowdlending may in some jurisdictions, such as Germany, trigger additional licensing requirements for the investors and project owners. The ECSPR now addresses this by preventing Member States from applying any authorisation requirements to project owners and investors for participating in crowdfunding activities via an authorised CSP. As such, this safe-haven provision may be a key factor for a substantial growth of the P2P market, especially in jurisdictions that would otherwise apply additional licensing requirements.
Crowdfunding services can be exposed to substantial money laundering and terrorist financing risks. However, CSPs that are authorised under the ECSPR do not qualify as obliged entities under the European AML legislation and are, therefore, also not subject to the AML requirements that apply to banks or investment firms. According to the European Commission, the ECSPR already contains sufficient safeguards for crowdfunding services providers falling under its scope. The ECSPR obliges CSPs to conduct due diligence on project owners, in particular with regard to AML criminal record checks and potential business activities in high-risk countries.
While these requirements fall significantly short of the level of AMLD requirements, they are still a step up from the current non-existent AML obligations of brokers of loans and financial assets under European law. CSPs outside the scope of the ECSPR will, however, become subject to the full set of AML obligations under the new AML package introduced by the European Commission in July 2021. For an overview on this extensive reform proposal, see our separate blog post.
Organisational and conduct obligations
CSPs are exempt from MiFID II requirements. The ECSPR instead provides for a set of organisational and conduct obligations that are roughly based on MiFID II requirements but less onerous. This certainly holds true for the “best execution” requirement and the obligation to avoid conflict of interests. CSPs will also be required to ensure adequate risk management governance and hold a sufficient amount of their own funds that will, however, not be comparable to requirements that apply to credit institutions or investment firms under the CRR or IFR, respectively.
Ongoing information obligations and investor protection
The ECSPR aims at significantly improving the level of information that investors may obtain, thereby leading to a more educated investment decision. CSPs will be required to provide prospective investors with a key investment information sheet (KIIS) drawn up by the project owner. The ECSPR deliberately dispenses with a lengthy and costly approval procedure with regard to the KIIS in order to foster efficient investments. However, the investor protection requirements further include obligations that will lead to significant practical difficulties. For example, CSPs will be obligated to require prospective non-sophisticated investors to simulate their ability to bear losses, calculated on a basis of 10 per cent of their net worth – a requirement that is yet untested in capital markets law.
Practical implications for the crowdfunding sector
The ECSPR is an important step towards the harmonisation of the crowdfunding market in the EU. The European passport in combination with the level playing field will enable CSPs to operate more efficiently and open up to a truly European crowd.
By reducing regulatory diversity and thereby leading to lower transactional costs for CSPs, the ECSPR presents itself as another important step towards a Capital Markets Union. It remains to be seen if, when and how currently existing business models in the crowdfunding sector, in particular P2P lending structures using fronting banks, will adapt to the new regime under the ECSPR. This may also lead to further consolidation among market players.
While the ECSPR addresses many central aspects for the CSPs, project owners and investors, it also leaves important questions unanswered. Civil liability of the CSPs, for example, will continue to be a matter for the Member States. Aspects of law where Member States may still exercise their discretion could, therefore, continue to play an important role in deciding where CSPs choose to operate.
Another aspect that is yet unclear is the pre-contractual reflection period of four business days, during which non-sophisticated investors may revoke their offer. The interplay between the reflection period and the withdrawal right under the Directive on distance marketing of consumer financial services on the one hand, and the requirements for the contractual implementations of the reflection period on the other hand, require further guidance by competent regulators.
Lastly, and perhaps most importantly, the interplay between the authorisation under the ECSPR and national law still seems to be unclear. For CSPs that aim at providing financing to SMEs as well as consumers, authorisations under the ECSPR as well as national law may have to be obtained, which would counteract the good intentions of the ECSPR.
The Regulation aims to harmonise crowdfunding regulation across the EU and further foster the growth of the crowdfunding services industry