1. Alternative Finance Briefing PaperSimon Deane-Johns, Consultant Solicitor, Keystone Law 1In its invitation to submit evidence of red tape that is inhibiting the development of disruptivebusiness models, the Cabinet Office notes the example of Zopa, a company that provides aplatform for members of the public to lend to each other, who found that financial regulationssimply didnt know how to deal with a business that didnt conform to an outdated idea of what alender isThis paper demonstrates that financial regulation similarly fails to deal with a range of non-bank,direct finance platforms (Platforms) that share some of the key characteristics of Zopas person-to-person lending platform (see Annex 1). Accordingly, financial regulation is failing to enable thecost efficient flow of surplus funds from ordinary people savers and investors to creditworthy peopleand businesses who need finance. In particular, as further explained in Annex 2, the currentregulatory framework:1. generates confusion amongst ordinary people as to the basis on which they may lawfully participate on alternative finance Platforms (even though some are licensed by the Office of Fair Trading);2. creates legal and regulatory issues that vary greatly depending on the structure of Platform and instrument adopted, particularly where investment is for return, rather than by way of donation (without return) to a good cause. This means that detailed legal advice is needed for any Platform and this is itself a barrier to entry for some schemes which may not pose any significant risk to the public. Platforms may also require a level of regulatory authorisation which may be inappropriate, again considering the low level of risk to the public.3. does not make alternative finance products eligible for the usual mechanisms through which ordinary people save and invest (as explained in Annex 2), and the inability to deduct bad debt before tax and the tax on interest charged to cover bad debt exposes individual participants on Platforms to much higher effective tax rates than their applicable statutory rates (see Annex 3);4. discourages ordinary savers and investors from adequately diversifying their investments;5. incentivises ordinary savers and investors to concentrate their money in bank cash deposits, and regulated stocks and shares;6. inhibits ordinary savers and investors from accessing fixed income returns that exceed long term savings rates;7. inhibits the development of peer-to-peer funding of other fixed term finance (e.g. mortgages and project/asset finance)8. protects traditional regulated financial services providers from competition.These regulatory failings could be resolved by creating a new regulated activity of operating aPlatform, for which the best-equipped regulatory authority would be the Financial ServicesAuthority (as replaced by the Financial Conduct Authority). In tandem, or as alternatives, there couldbe exemptions based on size of investment or risk (e.g. some schemes or platforms may involveminimal investment in what is sometimes a socially useful venture); lesser regulation/authorisationwithin existing classes of regulated activity (as for small payment services providers or small e-1Except as noted in Annexes 3 and 4.

2. money issuers) ; or the official endorsement of self-regulatory codes (as banks enjoy in relation tothe Banking Code, for example). Direct and indirect incentives that selectively favour incumbentbanks and investment funds should also be recognised and modified to balance the competitivelandscape. Detailed regulatory changes are explained in Annex 4.Regulation of the platform would be independent of any regulation that may apply to the type ofproduct offered to participants on the platform (e.g. loans, trade invoices, debentures to financerenewable energy and lending for social projects, as noted in Annex 1). However, exemptions fromregulations governing financial promotions and offers to the public could be granted for instrumentsthat are offered on Platforms.Proportionate regulation that obliges Platform operators to address operational risks common to allproducts would also enable economies of scale and sharing of consistent best practice, and leaveproduct providers and other competent regulators to focus solely on product-specific issues (e.g.consumer credit, charitable purposes). Similarly, participants on such Platforms do not need to betreated as if they are participating in the course of a business if the Platform itself meets all thecompliance requirements that a business of that kind would otherwise have to meet.Given the established nature of the financial regulatory framework and the dominance of incumbentbanks in the provision of debt finance to individuals and small businesses in particular, it isunrealistic to assume that new business models will thrive without some alteration to the regulatoryframework to enable rapid market entry and to facilitate strong, responsible growth.Simon Deane-JohnsConsultant SolicitorKeystone Law27 January 2012 3. Annex 1 Key Characteristics of Direct Finance Platforms1. Electronic platform based on internet technology, enabling low cost electronic business processes to manage operational risks (see paragraph 8 below) and customer access to transaction data via secure my account features;2. The Platform operator is not a party to the instruments on its platform and segregates investors/lenders funds, so has no credit/investment risk or balance sheet risk, and no temptation to engage in regulatory/tax arbitrage;3. Very small amounts can be subscribed/lent (typically a minimum of 10), giving lower income participants, or those with a small amount of savings, access to a broader range of asset classes;4. Finance is drawn from many lenders/investors at the outset, so there is no need to engage split a single loan/debenture into many pieces through securitisation and the risks that such vertical credit intermediation brings (i.e. mispricing of CDOs 2 and mistaken calculations of capital reserve requirements 3).5. Lenders/investors achieve diversification across many borrowers at the start, so there is no need for a series of bonds etc., to transform interest rates, maturity or borrower type.6. The one-to-one legal relationship between borrower and lender/investor (or their successors) is maintained for the life of each loan via the same technology platform (with a back-up available), so all the loan data is readily available to participants, enabling the ready assessment of performance and collections/enforcement activity;7. Risk remains visible, rather than being rendered opaque through fragmentation, re-packaging and re-grading of the underlying loans, guarding against moral hazard;8. Operational risks shared by all Platforms are the potential for borrower/issuer fraud, credit/investment risk, lack of internal controls and corporate governance, the potential for financial mismanagement and operator insolvency, internal fraud, lack of system integrity and availability, lack of business continuity and failure to manage customer complaints. As the direct finance continues to grow, there is also a growing risk that one or more operators will try to mimic existing platforms without appreciating the existence of some operational risks or the need for key internal controls to manage those risks;9. Low cost operations and lack of balance sheet exposure enables Platform operators to charge customers significantly less in fees and leave more of the profit margin with participants than banks or investment funds hence Platforms represent a more efficient and cost effective means than banks and investment funds for allocating ordinary peoples surplus cash to the financing needs of other individuals and businesses.2www.ny.frb.org/research/staff_reports/sr458.pdf3http://www.fsa.gov.uk/pubs/guidance/gc11_12.pdf 4. Types of UK-based Direct Finance Platforms [Note: The following list is included merely for thesake of discussion of potential future regulation. Neither the mention of a Platform below (nor thefailure to mention one) is intended to suggest that the relevant Platform operator in any wayendorses or agrees (or disagrees) with the contents of this paper or that the Platform is notoperating lawfully under applicable law].Person-to-person loansZopaRatesetterPerson/business to person student loansProdigy FinancePerson-to-business loansFunding CircleThin CatsPerson/business-to-business invoice discountingMarketInvoicePerson-to-social project loansBuzzbankPerson-to-business ethical investmentsEthexPeer-to-peer equity financeCrowdcube,Seedrs 5. Annex 2Regulatory Failings1. Internet-forum discussions amongst existing and potential Platform participants, as well as customer queries, reveal confusion and concern amongst ordinary people as to the basis on which some Platforms operate, even though some are licensed by the Office of Fair Trading under the Consumer Credit Act (CCA). Specifically, they are concerned about:a. whether they themselves might be carrying on a lending or investment business; andb. whether the operator is somehow acting unlawfully and may be closed down; 42. Platforms face a number of highly complex legal and regulatory requirements. Legal and regulatory issues vary greatly depending on the structure adopted. Apparently slight variations in fact can make a significant difference to the legal analysis and the regulatory outcome. This means that detailed legal advice is needed for any Platform and this is itself a barrier to entry for some schemes which may not pose any significant risk to the public. Platforms may also require a level of regulatory authorisation which may be inappropriate, again considering the risks that will be involved to the public.3. All individuals in the UK are encouraged to save or invest up to 10,680 per annum of their surplus cash in Individual Savings Accounts (ISAs) 5. Any income or capital gain received on assets within an ISA is exempt from tax. In essence, the current checklists or rules governing the eligibility of asset classes for ISAs only permit individuals to place their surplus funds in certain bank savings accounts and regulated investment funds. Individuals are anxious about the lack of return from bank savings accounts 6 and fees or commission charged by investment advisers and funds on investment products. Individuals are also interested in the broader range of asset classes to which Platforms enable access, including the opportunity to invest in start-up businesses as well as predictable long term returns offered by loans and debentures and the ability to earn income from financing alternative energy projects, for example, which act as a natural hedge against rising personal energy costs. Further, the low threshold for participation (typically as low as 10) makes these Platforms particularly attractive to those with small amounts to invest. However, the instruments accessible on those Platforms are not allowed to be included in ISAs. This creates a range of problems:a. Ordinary peoples returns from using their personal savings to participate on Platformsare subject to income tax and capital gains tax, but their returns from ISA bank savingsaccounts and regulated investment funds are not;b. Further, as explained in Annex 3, people participating on Platforms cannot deduct theirlosses from income before assessing their tax liability, and they must pay income tax on4This concern does not apply in the case of business lending platforms, including the invoice discountingmarket. In particular, the invoice discounting market is entirely unregulated, at least where all the money topay an invoice early comes from a single investor. However, concerns have been expressed that thediscounting or funding of a single trade invoice (or other debt instrument) using funds drawn from manyindividuals or businesses may constitute a Collective Investment Scheme, which can only be operated in theUK by an FSA-authorised firm and can only be marketed in very limited circumstances. The lack of clarity indefinitions such as Collective Investment Scheme also inhibit the growth of innovative funding schemes(seeAnnex 4).5http://www.hmrc.gov.uk/isa/faqs.htm. Pensions which are beyond the scope of this paper6Savings rates were found to average 0.41% after teaser rates expirehttp://news.bbc.co.uk/1/hi/business/8595016.stm 6. interest rate margin charged to cover bad debts. Therefore, the effective tax rate forindividual people lending to other people and businesses via Platforms is much higherthan their applicable statutory tax rate (regardless of whether they pay tax and basic orhigher rates) and certainly much higher than the effective tax rate enjoyed by banks andother financial businesses from the same activity; c. Banks can use money raised cheaply from an individual via ISA bank savings accounts tooffer finance in competition with that individual in the markets where Platformsoperate; 7 d. State aid rules prevent an EU member state from using state resources, including taxexemptions, to confer a selective advantage to an undertaking, which banks andregulated investment funds clearly enjoy over Platforms, in terms of access toindividuals savings via the ISA programme. 84. The various characteristics of the instruments generated by participants on Platforms distinguish them from bank savings accounts and units in regulated investment funds. This means adding those assets to a persons investment portfolio will improve diversification, increase the value of that portfolio and better secure that persons future. Yet: a. the confusion/concern about the lawfulness of participating on certain Platformsdescribed in paragraph 1 discourages ordinary savers and investors from adding newasset classes to diversify their investments, and b. the exposure to income tax and capital gains tax, and higher effective tax rates, act as adisincentive to doing so;5. Similarly, the factors mentioned above act as an incentive for ordinary savers and investors to concentrate their money in bank cash deposits, and regulated investment funds. This reduces diversification, making their investment portfolios less valuable than they might otherwise be, thereby steadily eroding the security of their long term financial position;6. The factors mentioned in 2 and 3 above distort the market for instruments accessed on Platforms, particularly fixed income instruments;7. The factors referred to above inhibit the development of existing and potential Platforms (e.g. to introduce crowdfunding to markets for mortgages, trade receivables and project/asset finance); and8. The factors referred to above protect traditional regulated financial services providers from competition in the markets for savings, investments, personal loans, business lending, trade receivables finance, project finance and equities.7Typical UK bank spreads between savings and loans are 11%: Moneyfacts, Ipsos MORI:http://blog.zopa.com/archives/2011/09/16/mori-research-on-bank-spreads/8http://www.bis.gov.uk/assets/biscore/consumer-issues/docs/10-951-state-aid-beginners-guide. The sameproblem may arise in the context of other tax incentive schemes - e.g. the Enterprise Investment Scheme(http://www.hmrc.gov.uk/eis/); the Enterprise Finance Guarantee scheme(http://www.rbs.co.uk/corporate/finance/g2/loans-and-overdrafts/small-firms-loan-guarantee.ashx) and theBusiness Finance Partnership under which the Government intends to invest up to 1bn through managedfunds that lend directly to mid-sized businesses and/or SMEs in the UK, while considering investing throughother channels: http://www.hm-treasury.gov.uk/d/business_finance_partnership.pdf). 7. Annex 3 Quantifying the Non-Deduction of Bad Debts Tax Distortionin Markets for Personal and Business Loans 9Overview of this Annex1. Firstly Effective Tax Rates (ETRs) are described. Secondly the issue of Non-deduction of Bad Debts is laid out. Next the resulting ETRs are presented and explained, using a common rate of return.Effective Tax Rate Method2. Effective Tax Rate (ETR) methodology helps illustrate the scale of any distortion caused by thetax regime on income from capital. ETR methodology of this type is usually quoted as having itsgenesis in the work by King and Fullerton (1984): The taxation of Income From Capital. Theirwork has been developed and applied by many in the years since. In this note only a relativelysimple version of the calculation is needed as only personal income tax applies.3. Put simply the tax wedge is the return to the lender before deducting tax (but after othercosts), less the return after deducting tax (and costs). The ETR is the tax wedge divided by thereturn to the lender before deducting tax (but after other costs). Without a tax distortion, theETR will equal the lenders statutory tax rate (e.g. 40% for higher rate taxpayers) 10. Ideally ETRson equally desirable investments will be the same and the tax regime will not harmfully distortthe choice faced by investors making those investments.The Bad-Debt Deduction Issue4. Assume the expected return to lenders via a Platform is the rate of interest paid by borrowers less a 1% management fee and the expected level of bad debts. Ideally this would also be the return subject to the lenders personal tax rate. Where high street banks are the intermediaries this is the case. The ETR would then be 40% if the lender was a higher rate (HR) taxpayer, 20% if they were a basic rate (BR) taxpayer, and so on. No tax distortion would arise either between lending via high street banks and via the Platform, or within the Platforms markets of varying risk. This would be a good outcome.5. But bad debts accruing to Lenders via the Platform are not deductible from interest income received within the Platform before determining the liability to tax; and lenders must also pay tax on the interest income necessary to cover bad debts, although they do not benefit from this income. As a result, a significant tax distortion to exists. The extent of this distortion is quantified by the ETRs shown below. The ETRs can greatly exceed the statutory rate; the ETR rising with the level of expected bad debts, and with the applicable statutory personal tax rate.9 This material for this Annex was provided by a private investor who does not wish to be identified.10 The effective tax rate is perhaps more intuitive as it will equal the statutory tax rate (eg 40%) in the absenceof distortion. But if there is a distortion the change in the ETR also depends on the level of return (i.e. level ofinterest) chosen to illustrate the problem. Since this level of return chosen is always one of analyticaljudgement, slight variation in the ETR measure arising from differences in such judgement can causeunnecessary confusion. The tax wedge on the other hand is, at least in this case, dependent on the level ofexpected bad debt and the lenders personal tax rate only. Having specified these, the tax wedge has theadvantage of being stable whatever the overall level of return set. In practice both are usually consideredwhen assessing tax distortions to capital returns. 8. Assuming lending on a Platform and by retail banks are equally desirable, any difference in their ETRs is a bad outcome.Results6. Table 1 below shows how the tax distortion increases with the risk of bad debt. Each column from left to right gives a step in the calculation.7. Firstly a suitable benchmark interest rate needs to be chosen. If we assume a Platform is a small player and interest rates over markets of varying risk are set by high-street banks, the return after all costs (bad debts and fees) but before personal tax should be broadly the same. So this analysis firstly assumes the return net of the Platforms 1% fee and of expected bad debts is the same for all a Platforms credit/term markets.8. The level of return after costs but before tax should be one that lenders could get in their alternative investment choice. The level has been set at 5%, it being broadly what might usually be achieved in long term savings accounts in retail banks.Table 1: ETRs assuming a common return after costs but before tax, HR lendersBenchmark rate of interest 5.0% iafter costs before taxMarginal Personal Tax Rate40% t Without DistortionWith Distortion Rate AdditionExpectedMarketFee Charged to Tax Effective Net al Tax Total Tax Effective NetBad Debts Borrower Wedge Tax Rate Return on Bad Wedge Tax Rate Return Debt(1)(2)(3) (5) (6)(7)(8) (9) (10) (11) =i+(1)+(2) =i*t =(5)/i =i-(5) =(2)*t =(5)+(8)=(9)/i =i-(9) 3 Year Loans 11%0.5% 6.5% 2% 40%3.0% 0.2%2.2% 44%2.8% 21%1.0% 7.0% 2% 40%3.0% 0.4%2.4% 48%2.6% 31%2.9% 8.9% 2% 40%3.0% 1.2%3.2% 63%1.8% 41%5.2%11.2% 2% 40%3.0% 2.1%4.1% 82%0.9% 51%5.0%11.0% 2% 40%3.0% 2.0%4.0% 80%1.0% 9. 5 Year Loans 11%0.4% 6.4% 2% 40%3.0% 0.2%2.2% 43%2.8% 21%0.8% 6.8% 2% 40%3.0% 0.3%2.3% 46%2.7% 31%2.3% 8.3% 2% 40%3.0% 0.9%2.9% 58%2.1% 41%4.2%10.2% 2% 40%3.0% 1.7%3.7% 74%1.3% 51%3.1% 9.1% 2% 40%3.0% 1.2%3.2% 65%1.8%9. The table shows the additional tax wedge rises to just over 2% in the worst case of 3 year loans in the risk category C. That doubles the tax take, and the ETR is 82%. But the table also shows that in this market the net return to a HR taxpayer is only 0.9% after tax. It could be assumed HR taxpayers are effectively priced out of this market, and a number of others with large ETRs. The case for BR taxpayers is shown in Table 1A.Table A1: ETRs assuming a common return after costs but before tax, Basic Rate lendersBenchmark rate of interest 5.0%iafter costs before taxMarginal Personal Tax Rate20%t Without DistortionWith Distortion Rate AdditionExpectedMarketFee Charged to Tax Effective Net al Tax Total Tax Effective NetBad Debts Borrower Wedge Tax Rate Return on Bad Wedge Tax Rate Return Debt(1)(2)(3) (5) (6)(7)(8) (9) (10) (11) =i+(1)+(2) =i*t =(5)/i =i-(5) =(2)*t =(5)+(8)=(9)/i =i-(9) 3 Year Loans 11%0.5% 6.5% 1.0% 20%4.0% 0.1%1.1% 22%3.9% 21%1.0% 7.0% 1.0% 20%4.0% 0.2%1.2% 24%3.8% 31%2.9% 8.9% 1.0% 20%4.0% 0.6%1.6% 32%3.4% 41%5.2%11.2% 1.0% 20%4.0% 1.0%2.0% 41%3.0% 51%5.0%11.0% 1.0% 20%4.0% 1.0%2.0% 40%3.0% 10. 5 Year Loans1 1% 0.4% 6.4%1.0% 20% 4.0% 0.1% 1.1% 22% 3.9%2 1% 0.8% 6.8%1.0% 20% 4.0% 0.2% 1.2% 23% 3.8%3 1% 2.3% 8.3%1.0% 20% 4.0% 0.5% 1.5% 29% 3.5%4 1% 4.2% 10.2% 1.0% 20% 4.0% 0.8% 1.8% 37% 3.2%5 1% 3.1% 9.1%1.0% 20% 4.0% 0.6% 1.6% 32% 3.4% 11. Annex 4 Proportionate Regulation of Platforms 11The various regulatory failings identified in Annex 2 and the common operational risks identified inparagraph 8 of Annex 1 could be resolved by creating a new regulated activity of operating aPlatform, for which the best-equipped regulatory authority would be the Financial ServicesAuthority (as replaced by the Financial Conduct Authority). In tandem, or as alternatives, there couldbe exemptions based on size of investment or risk (e.g. some schemes or platforms may involveminimal investment in what is sometimes a socially useful venture); lesser regulation/authorisationwithin existing classes of regulated activity (as for small payment services providers or small e-money issuers); or the official endorsement of self-regulatory codes (as banks enjoy in relation tothe Banking Code 12).It is also important that the new regulated activity does not expand the scope of regulation tooutlaw existing activity that is not regulated. For example, it should remain lawful to operate aninvoice discounting business where the discounting of each invoice is financed directly by a singleinvestor. While an operation that enabled a number of investors to directly pay a single invoice at adiscount would benefit from the proposed regulatory reform.Regulation of the Platform should be independent of any regulation that may apply to theparticipants at either end of a transaction and the type of product offered to participants on theplatform (e.g. loans, trade invoices, debentures to finance renewable energy and lending for socialprojects, as noted in Annex 1) though as noted in Annex 4 in some cases such product regulationcould also be clarified or amended. However, exemptions form regulations governing financialpromotions and offers to the public could be granted specifically for instruments that are offered onPlatforms.Proportionate regulation that obliges Platform operators to address operational risks common to allproducts would also enable economies of scale and sharing of consistent best practice, and leaveproduct providers and other competent regulators to focus solely on product-specific issues (e.g.consumer credit, charitable purposes). Similarly, participants on such Platforms do not need to betreated as if they are participating in the course of a business if the Platform itself meets all thecompliance requirements that a business of that kind would otherwise have to meet.Accordingly, the proposals for rectifying both the regulatory failings and the risk of Platform failuremay be summarised as follows, and are more fully specified in the Schedule to this Annex:1. Create a new regulated activity of operating a Platform, the conditions of authorisation for which would require Platforms to adopt operational risk management measures similar to those provided for in the Operating Principles of the Peer-to-Peer Finance Association. 13 This could11 I am indebted to Tony Watts, a fellow consultant solicitor at Keystone Law and specialist in financialregulation, for specifying the specific regulatory changes in paragraphs 1-5 of the Schedule to this Annex hisinput is based on his experience of advising in the area of alternative investment structures; and to KarlPocock, also a fellow consultant at Keystone Law for specifying the regulatory changes in paragraphs 6 and 7 ofthe Schedule to this Annex.12 http://www.bankingcode.org.uk/pdfdocs/Bulletin%2031.pdf13 http://www.p2pfinanceassociation.org.uk/ 12. allow for hybrid businesses and small firm categories, as is the case under Payment Services Regulations 2009, for example. There could be less onerous registration requirements or exemptions for small or otherwise lower-risk Platforms. Much of this can be done by changing secondary legislation as explained further below, and there should be simplified Rules and Guidance in the FSA Handbook.2. Review the exclusions or exemptions from the need to be authorised in conjunction with 1 to remove areas of overlap and dual-regulation.3. Clarify what is a business for these purposes, which currently varies in line with EU-driven regulation and activity type (currently potentially most restrictive in relation to domestic mortgages or secured loans).4. Make changes to the rules governing promotions and offers to the public, which currently may impact even where a Platform is clearly not required to be licensed/authorised.5. Issue authoritative, clear, permissive guidance (from FSA/FCA or HMT) in areas where changes cannot easily be made e.g. due to EU legislation such as MIFID.6. Confer ISA-status on instruments available via Platforms, to resolve the problems referred to in paragraphs 4-9 of Annex 2.7. Remove the bad debt tax distortion for instruments available via Platforms, to address the problems explained in Annex 3. 13. Schedule of Detailed Changes Necessary.1. Review UK definitions of regulated activity incorporate operating a platform as separate activity and/or introduce less onerous registration requirements or exemptions for lower- risk schemes. The Operating Principles of the Peer-to-Peer Finance Association require members to adopt certain operational risk management controls in the following areas: 14 1. Senior management systems and controls; 2. Minimum amounts of capital (minimum 100,000); 3. Segregation of participants funds; 4. Clear rules governing use of the platform, consistent with the Operating Principles; 5. Marketing and customer communications that are clear, fair and not misleading; 6. Secure and reliable IT systems; 7. Fair complaints handling; and 8. The orderly administration of contracts in the event a platform ceases to operate; 9. Appropriate credit assessment and anti-fraud measures (including customer identificationand fraud screening). In addition to requiring such controls, the government should clarify that individuals (and their agents or trustees) will be deemed not to be participating on a Platform in the course of any business. In addition to creating a separate class of regulated activity with a specific authorisation, perimeter guidance and/or new regulations should clarify that such activity does not fall within other forms of regulated activity, including in particular:Accepting DepositsFSMA 2001 (Regulated Activities) Order 2001 (RAO) Article 5 et seq.Potentially relevant to some platforms involving savings and lending -typeproducts.Dealing in investmentsFSMA 2001 (Regulated Activities) Order 2001 Articles 14/21. Potentiallyas principal or agent relevant to Platforms where debt or equity securities are bought and sold.Arranging This is almost always relevant to Platforms involving debt securitiesTransactions in (debentures). Arranging is a particularly difficult term because of itsInvestments RAO open texture - an expression politely adopted by the courts to coverArticle 25. lack of clarity and uncertainty. The situation as regards arranging hasbecome more uncertain because of recent High Court decisions 15 withwhich the FSA has publicly expressed disagreement. It is genuinely verydifficult to advise clients as to what constitutes arranging in anycircumstances. There are exemptions (see 2. Below) but their scope isunclear.Operating a CollectiveRAO Article 51.This is often relevant to innovative funding schemes,Investment Scheme particularly those that involve any degree of collective management,14 http://www.p2pfinanceassociation.org.uk/15 See particularly Watersheds Ltd v (1) David Da Costa (2) Paul Gentleman (2009) [2009] EWHC 1299 (QB) 14. whatever type of asset (including debt) is involved. Again the uncertainties in this area have been the subject of criticism and comment in decided cases and by industry bodies seem Financial Markets Law Committee http://www.fmlc.org/papers/Ltr2HMTre86Nov11.pdf 16 Further, any number of individuals should be able to provide the funding towards any single instrument financed (e.g. a single mortgage, large invoice or debenture);Activities relating to RAO Articles 61-63E Entering/ administering Regulated Mortgagedomestic mortgages Contract. These may be relevant to any form of lending secured on a debtors house (even lending for business purposes There should also be a very simple FSA/FCA Handbook Specialist Sourcebook similar to that applicable to Recognised Investment Exchanges/Clearing Houses and Collective Investment Schemes; and a simple Handbook Guide similar to that applicable to Service Companies.2. Review exemptions from regulated activity. Innovative funding solutions often employ elaborate mechanisms to ensure that they are outside the definition of regulated activity for example, making investee companies subsidiaries of the Platform operator during the investment process to benefit from exemptions in relation to arranging transactions for group companies. These can be unwieldy and artificial. Other definitions may help but there is considerable debate about their scope. For example, the Article 31 RAO exemption (Arranging the acceptance of debentures in connection with loans) is potentially useful but its scope is very uncertain. The breadth and open texture of the arranging activity have been the subject of public debate with decisions of the High Court being publicly disapproved by the FSA. Similarly , there are detailed carve-outs in respect of collective investment schemes (in the FSMA 2001 (Collective Investment schemes) Order 2005 (CIS Order) but these are also often obscure and the need for their existence at all raises the question as to how far the basic CIS definition is intended to go. 17 New exemptions could be added relating to operating a Platform possibly for low-risk schemes. If a new regulated activity of operating a Platform were to be introduced, it would still be necessary to review exemptions to ensure clarity (there is heavy overlap between all the provisions in this area). Exemptions can only be effective, however, if consistent with EU requirements. Even if there is to be no specialist activity of operating a platform, there may still be scope to simplify FSA Rules relating to arrangers etc. so that those operating a Platform who are FSA- authorised - for example because they accept that they fall within the category of arranging investments can clearly operate without disproportionate burdens. Examples of where simplification could be introduced include:16 The FMLC are lobbying HMT to change the definition in any event as party of the current regulatory reformprogramme.17 see the public criticism and lobbying of the Financial Markets Law Committee:http://www.fmlc.org/papers/Ltr2HMTre86Nov11.pdf 15. Training and competence requirements which are unclear in their application to platform providers; Capital requirements; Financial promotions requirements as discussed below.3. Clarify commercial element making changes to legislation as necessary. Broadly, in order to require licensing under relevant legislation there needs to be a business element there is a threshold below which activity is not regarded as being a business and so is outside the need to be authorised/regulated. The criteria do, however, vary even under FSMA there are different tests for different activities. This may affect not only the operators of Platforms but also in some circumstances participants. For example, what constitutes carrying on a regulated activity by way of business under FSMA is different for domestic mortgage lending (i.e. those broadly secured on property 40% or more of which is used as a dwelling) from other areas (such as arranging in relation to securities and the FSA Guidance is that even an isolated transaction can satisfy the business test for entering into mortgages as lender 18. This would have a significant effect on any platform that wished to make available secured loans for any purpose because of its possible impact on participants.4. Review promotional requirements change where these can be changed to incorporate innovative finance solutions, otherwise issue authoritative guidance. Even where a provider of services is not required to be regulated, it is still likely to encounter problems under the rules concerning promotions and offers, namely: 1. Financial Promotions under FSMA; 2. Offers of securities to the public under the Prospectus Directive; 3. Offers of securities to the public under the Companies Act 2006. In practice, the most difficult area concerns the financial promotions regime. The basic rule is that invitations or inducements to engage in investment activity are required to be communicated/approved by an FSA-authorised person or to fall within an exemption (exemptions are set out in the FSMA 2001 (Financial Promotion) Order 2005 (FPO). Those commonly used are those relating to high net worth individuals (FPO Article 48) or self-certified sophisticated investors (FPO Article 50A). However, these are extremely complex, requiring detailed financial promotions rules including the artificial and unwieldy practice of making investee companies subsidiaries for the purpose of the investment process. Platform operators could be given more general exemptions and the FSA Rules relating to financial promotions could be clarified and/or modified accordingly. Other areas are also relevant to offers of securities including debt securities. They are subject to the Prospectus Directive requirements in Part VI FSMA though this causes less difficulty because of the useful carve-outs including offers involving less than 5m. Alongside these, however, are the restrictions on offers to the public by private companies in Companies Act s.18 See FSA PERG 4.3.7-4.3.9 16. 755 et seq. It is not clear why there should be different ideas and conceptions of offers to the public in different sets of legislation.5. Where a change to activities/exemption is not currently possible issue authoritative and detailed Guidance. The relevant financial regulations discussed above derive from both UK and some EU requirements. This is an important distinction because many of the EU requirements come from maximum harmonisation directives and so cannot simply be waived or changed by UK authorities/regulators. For example, it may not be possible to change definitions of activities under the Markets in Financial Instruments Directive (MIFID), the Payment Services Directive or the E-Money Directive. This is especially relevant to debt securities and other debentures which are regarded as transferable securities under EU law (and this is usually interpreted, following EC guidance, as involving debt securities in private companies). The result is that it is always necessary to consider whether Platform activity comes within any of the relevant MIFID activity/service the most relevant being: Payment Services/E-money. Executing transactions in investments under MIFID. Receiving and transmitting orders under MIFID; and Placement other than on a firm commitment basis under MIFID. The consequences of Platform activity falling within any of these categories is that many of the exemptions under RAO are disregarded because MIFID (with its limited range of carve-outs) overrides member state law within its scope. It may not be possible to change this at the moment because EU maximum harmonisation legislation does not permit deviation 19. Here innovative finance schemes would benefit from authoritative and detailed guidance as to what crosses the line into these schemes. The MIFID activity of placement of transferable securities is particularly difficult, with its uncertainty as to what level of activity constitutes this activity/service. Again the EU business element is different in some cases in MIFID applying to those whose regular occupation or activity is carrying on the relevant activity/service on a professional basis. It is not clear how far this differs from the relevant FSMA test and authoritative guidance on this in so far as it impacts Platform activity would be very useful.6. Equal Tax Incentives In order to enable ordinary investors to use their ISA allowances to access the financial products available via a Platform, it would be necessary to align the above regulatory changes with the definition of qualifying investments for a stocks and shares component (Regulation 7 of the Individual Savings Account Regulations 1998 (SI 1998/1870) (the ISA Regulations). Subsequent amendments may also be needed to the ISA Regulations to ensure that they adequately cater for the new qualifying investment. The advantage to the individual investor would be that income and capital gains arising from a loan or investment made via a Platform19 An Article 4 MIFID derogation may be possible in some circumstances. 17. would be tax free (pursuant to Regulation 22). This may have a dual role: on the one hand encouraging individual investors to make funds accessible to borrowers through the Platform and, secondly, it may also result in more competitive rates being offered by the individual investor to the benefit of the borrower. If interest payable under a loan made via a Platform was tax free there may be a mismatch where the borrower is able to deduct the interest paid against its taxable income. This slight loss of revenue to the Treasury would be limited by the financial limits already imposed on ISAs. Furthermore, to stimulate lending at reasonable rates to businesses, for example, this slight loss is perhaps a cost that may be considered reasonable. In addition, it is assumed that any losses arising through the Platform from loans contained in an ISA would not be capable of being utilised against other taxable profit. This would follow the treatment of losses arising on shares held in an ISA. This disadvantage would, to a certain extent at least, counteract the cost of tax free interest and interest deductibility to the Treasury.7. Tax Treatment of Bad Debt In order to encourage individual investors to make loans via a Platform and remove the bad debt tax distortion explained in Annex 3, it is important to align the tax treatment of bad debt arising via Platforms and the tax treatment of impairment losses accorded to banks and other finance businesses. For the basis of this alignment it is assumed that in most if not all cases UK banks are subject to UK corporation tax and, specifically in relation to the taxation of their lending businesses, the loan relationship rules contained in Parts 5 and 6 of the Corporation Tax Act 2009. The loan relationship rules, in very broad terms, rely heavily on the accounting treatment used by the creditor when allowing the creditor to obtain tax relief on a bad debt (subject to specific exemptions). Simply applying the loan relationship rules to individuals (making loans via a Platform) as they apply to banks is likely to be too complicated and cumbersome for individuals. It would therefore be preferable to broadly replicate, in simple terms, the general economic result that would arise if applying the loan relationship rules to an individuals bad debt that has arisen via a Platform. This would remove the bad debt tax distortion for individuals (and achieve parity with banks) without the additional cost of having to follow the loan relationship rules, which have been drawn up specifically for businesses within UK corporation tax.