Proposed amendments to the financial services bill sdj 21 06 12

BRIEFING PAPER ON PROPOSED AMENDMENTS TO
THE FINANCIAL SERVICES BILL 1

Our regulated financial system is failing to enable the cost efficient flow of surplus funds from ordinary
savers and investors to creditworthy people and businesses who need finance. It is estimated that small
businesses face a funding gap of up to £59bn over the next 5 years, within an overall finance gap of up
to £190bn for UK business sector as a whole. 2 There is insufficient competition in the markets for
consumer and business finance, and it is vital that we find ways to encourage innovation and
competition and new entrants to these markets. 3

Yet new retail financial models and service providers are only gradually emerging to challenge banks and
provide alternative sources of finance. Common amongst these new services are online peer-to-peer
platforms on which most of the participants are either consumers or small businesses. The first of these
appeared in 2005 and only eight others have emerged during the past few years, as noted in Annex 1.
The operators of these direct finance platforms share an aim to provide simple, transparent, low cost
financial services without treating participants’ money as their own. There are key characteristics of
these platforms, explained in Annex 1, which substantially reduce the moral hazards posed by both
traditional banking and the vertical securitisation model inherent in ‘shadow banking’. 4

These alternative models have been slow to emerge partly because our regulatory authorities are only
empowered to concern themselves with competition amongst regulated firms, and the new models do
not fit neatly within our existing financial regulatory framework. Entrepreneurs complain that the
process of launching and developing new finance platforms has been overly complicated and expensive.
Some activities are unregulated, some partially regulated. Some operators have a choice as to whether
to structure their models as a regulated activity or not, and some have chosen a more complex

1
Briefing paper prepared by Simon Deane-Johns, Consultant Solicitor, Keystone Law, except where noted in the
Schedule of Amendments.
2
Boosting Finance Options For Business: http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-668-
boosting-finance-options-for-business.pdf
3
boosting-finance-options-for-business.pdf; “Towards a Common Financial Language”, a speech by Mr Andrew G
Haldane, Executive Director, Financial Stability, Bank of England: http://www.bis.org/review/r120315g.pdf; Report
of Lord Young to the Prime Minister of May 2012 “Make Business your Business: Supporting the Start-up and
development of Small Business” in which many of the platforms referred to in Annex 1 of this Report are referred
to with approval: http://www.startupbritain.org/resource/binary/userfiles/Make_Business_Your_Business_2.pdf)
4
“Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458.
www.ny.frb.org/research/staff_reports/sr458.pdf
SEL v1.2

regulatory structure to deliver the effect of a peer-to-peer offering than they would have preferred.
Investors are confused about whether they are acting unlawfully when using some platforms. In effect,
the current regulatory framework (coupled with personal tax incentives) discourages investors from
diversifying beyond regulated investment products. These factors also contribute to the erosion of UK
investors’ long term financial security, the distortion of the markets for both regulated and unregulated
financial services, and further inhibit innovation and competition in the markets for retail financial
services.

In these circumstances, it is unrealistic to assume that new business models will thrive without some
alteration to the regulatory framework. As a result, the peer-to-peer platform operators have openly
invited the government to establish definitive routes to market for direct finance platforms. 5 Three
firms established the Peer-to-Peer Finance Association to promote a set of Operating Principles as a
framework for controlling operational risks that are common to all platforms. 6 This self-regulatory
initiative was welcomed by the government in its response to the report of the Breedon Taskforce as
helping “raise awareness among SMEs and investors and establish industry standards to protect
investors and borrowers. 7 Yet the regulatory framework itself has not evolved in line with these
developments, and the Financial Services Bill fails to support any of these objectives. As such, the Bill
misses an opportunity to establish a sound foundation for the future regulation of new financial
services. 8

Accordingly, we are proposing the changes to the Financial Services Bill which are explained in further
detail in Annex 2. These amendments will:

1. Oblige the financial regulatory authorities (and the new Financial Conduct Authority in particular) to
be more outward looking in promoting competition and encouraging innovation; and
2. Introduce a new, proportionately regulated activity of operating a direct finance platform consistent
with the Operating Rules of the Peer-to-Peer Finance Association, with consequential amendments
to the rules related to regulated activities and instruments, financial promotions, and the public
offering of securities. This reflects the approach taken under the Payment Services Directive and the

5
boosting-finance-options-for-business.pdf;
http://www.redtapechallenge.cabinetoffice.gov.uk/themehome/disruptive-business-model/
6
http://www.p2pfinanceassociation.org.uk/
7
Boosting Finance Options For Business: Government Response to the Industry Taskforce:
http://www.bis.gov.uk/assets/biscore/enterprise/docs/b/12-669-boosting-finance-options-government-
response.pdf
8
It is also in contrast to the situation in the USA, where the JOBS Act has recently introduced a proportionate
regime for securities crowdfunding platforms – see “Implementing the JOBS Act in the UK” prepared by Tony
Watts of Keystone Law in the schedule to Annex 2 below.

Electronic Money Directive to carve out the operation of low risk payment services from the historic
‘banking monopoly’. 9

We are proposing proportionate regulation of direct finance platforms on a ‘horizontal’ basis, rather
than by reference to the instruments accessible on those platforms. This will:

• Enable economies of scale and sharing of consistent ‘best practice’, leaving product providers and
other competent regulators to focus solely on product-specific issues under, for example, consumer
credit or charities regulation; and
• Alleviate the need to treat participants on such direct finance platforms as if they are participating in
the course of a ‘business’, since the platform itself would meet all the compliance requirements that
a business of that kind would otherwise have to meet.

We also recommend that the Treasury should:

• investigate and report on the extent to which direct and indirect tax incentives (including ISAs and
pension investment rules) selectively favour banks and regulated investment funds so as to distort
effective tax rates (as described in Annex 3) and competition in the retail markets for financial
services; and
• engage with the European Commission to try to ensure that applicable EU directives and regulations
mirror the proposed amendments to the Financial Services Bill.

9
Implemented in the UK via the Payment Services Regulations 2009 and the Electronic Money Regulations 2011.

Annex 1
Key Characteristics of Direct Finance Platforms

1. An electronic or digital platform based on internet technology, enabling low cost business
operations and customer access to transaction data via secure ‘my account’ features;

2. The direct finance platform operator is not a party to the instruments on its platform and segregates
participants’ funds from the operators’ own funds – accordingly, the operator has no credit or
investment risk or balance sheet risk, and no temptation to engage in regulatory or tax arbitrage;

3. Very small amounts can be subscribed or lent (typically a minimum of £10);

4. Finance is drawn by each single recipient from many lenders or investors at the outset, avoiding the
need to split a single loan or debenture into many bonds through securitisation at a later point in
time, with all the risks that entails (i.e. mispricing 10 and mistaken calculations of capital reserve
requirements 11).

5. Similarly, each lender or investor may diversify their funds by financing many different people or
businesses on a range of different terms at the outset, again avoiding the need for securitisation as a
mechanism for enabling investors to access different interest rates, maturities or borrower types.

6. The one-to-one legal relationship between borrower and lender or investor (or their successors) is
maintained for the life of each instrument via the same technology platform (with a back-up
available), so that all the performance data is readily available to participants, enabling cost-
effective and efficient risk monitoring, collections and enforcement activity;

7. Low cost operations and lack of balance sheet exposure enables direct finance platform operators to
charge customers significantly less in fees and leave more of the profit margin with participants than
banks or investment funds; 12

8. Operational risks that all direct finance platforms must manage are:
a) the potential for borrower or issuer fraud;
b) the potential for financial mismanagement, internal fraud and operator insolvency;
c) the potential lack of system integrity and availability or other lack of business continuity;
and
d) the potential for unfairness in handling customer complaints.

10
“Shadow Banking”, Federal Reserve Bank of New York Staff Report No. 458.
www.ny.frb.org/research/staff_reports/sr458.pdf
11
http://www.fsa.gov.uk/pubs/guidance/gc11_12.pdf
12
“Bank staff costs take bigger share of pot”, Financial Times, June 5, 2012: www.ft.com/cms/s/0/d4fe3186-ac0d-
11e1-a8a0-00144feabdc0.html#axzz1xI6Uo3tc

Types of UK-based Direct Finance Platforms – [Note: The following list is included merely for the sake
of discussion of potential future regulation. Neither the mention of a platform below (nor the failure
to mention one) is intended to suggest that the relevant direct finance platform operator in any way
endorses or agrees (or disagrees) with the contents of this paper or that the direct finance platform is
not operating lawfully under applicable law].

Person-to-person loans
Zopa
Ratesetter

Person/business to person student loans
Prodigy Finance

Person-to-business loans
Funding Circle
Thin Cats

Person/business-to-business invoice discounting
MarketInvoice

Person-to-social project loans
Buzzbank

Peer-to-peer equity finance
Crowdcube,
Seedrs

Peer-to-peer foreign exchange
Kantox

Annex 2
Proposed Amendments to the Financial Services Bill

Explanation and Summary of Proposals

Our proposed amendments would:

1. Open up the Competition Objective: The financial regulatory authorities (and the FCA in particular)
should be more outward looking in promoting competition and encouraging innovation. Specifically,
our proposals would requiring the FCA to:

a. Evaluate developments in the markets for unregulated financial services in assessing
whether there is effective competition in the interests of consumers and SMEs within the
markets for regulated financial services;

b. Evaluate whether there are emerging business models, services or products in the markets
for unregulated financial services that represent better outcomes for consumers and SMEs
than those within the markets for regulated financial services and, if so:

i. Evaluate whether the current regulation of financial services is adversely affecting
the responsible growth of those emerging business models, services and products;
and

ii. Evaluate whether those emerging business models, services and products ought to
be included or otherwise accommodated by or within the regulatory framework
(including via permitted self-regulation, co-regulation or perimeter guidance) and
recommend appropriate changes to the relevant UK and EU authorities.

2. Create a new regulated activity of operating a direct finance platform: This should allow for ‘hybrid’
businesses and small firm categories, as is the case under Payment Services Regulations 2009, for
example, which marks a similar initiative to carve out low risk financial services from the traditional
financial service providers. To avoid confusion, inconsistency and dual regulation, we propose
limited exemptions from the provisions relating to financial promotions, Financial Services and
Markets Act (FSMA), MiFID and the Prospectus Directive (where possible), and the Companies Acts.
This could also be done by replicating the US JOBS Act 13 – currently based on platforms involving
shares or debt securities but which could be adapted for loans (see the Schedule of Amendments
below). The conditions of authorisation and registration would require direct finance platform

13
Jumpstart Our Business Startups Act: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-
112hr3606enr.pdf

operators to adopt operational risk management measures similar to those provided for in the
Operating Principles of the Peer-to-Peer Finance Association. 14 This aims to ensure:

a. adequate senior management systems and controls for managing enterprise or operational
risk;
b. Minimum capital, based on Operating Costs (with a minimum of £100,000);
c. Segregation and safeguarding of participants’ funds;
d. Clear rules governing use of the platform, consistent with the Operating Principles;
e. Marketing and customer communications that are clear, fair and not misleading;
f. Rules as to risk warnings and customer acceptance;
g. for shares or debt securities – minimum information that should be disclosed by issuers.
h. Secure and reliable IT systems;
i. Fair complaints handling;
j. The orderly administration of contracts in the event a platform ceases to operate; and
k. Appropriate credit assessment or proportionate due diligence and anti-fraud measures.

3. Exemptions from other regulated activities: 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.

4. Clarity on scope of the “business test”: It is not necessary to regulate individuals (and their agents or
trustees) who participate on a direct finance platform as if they were acting in the course of any
business, since the appropriate compliance requirements can be implemented by the platform,
including anti-money laundering and anti-fraud checks. The criteria for determining what is done in
the course of a business under FSMA are different for different activities. For example, what
constitutes carrying on a regulated activity by way of business under FSMA is different for domestic
mortgage lending from “arranging” in relation to securities. And even an isolated transaction can
satisfy the “business” test for entering into mortgages as lender 15.

5. Promotional requirements: 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. FSMA 2001 (Financial Promotion) Order 2005 (”FPO”);
2. Offers of securities to the public under the Prospectus Directive;
3. Offers of securities to the public under the Companies Act 2006.

14
http://www.p2pfinanceassociation.org.uk/
15
See FSA PERG 4.3.7-4.3.9

Direct finance platform operators should be given general exemptions from these rules and the FSA
Rules relating to financial promotions could be clarified and/or modified accordingly.
The basic rule is that invitations or inducements to engage in investment activity are required to be
communicated or approved by an FSA-authorised person or to fall within an exemption under the
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.

Offers of equity and debt securities are subject to:

a. 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; and
b. the restrictions on offers to the public by private companies in Companies Act s. 755 et seq.

It is not clear why there should be different conceptions of offers to the public in the different sets
of legislation.

6. Guidance on approach to regulation: Certain exemptions can only be effective if consistent with EU
requirements under any applicable maximum harmonisation directives, which cannot be waived or
changed by the UK legislature or regulatory authorities. The most relevant here are the Markets in
Financial Instruments Directive (“MiFID”), the Payment Services Directive or the E-Money Directive.
The result is that it is always necessary to consider whether direct finance platform activity comes
within any of the relevant activities or services – the most relevant being:
• Executing transactions in investments under MiFID.
• Receiving and transmitting orders under MiFID; and
• Placement other than on a firm commitment basis under MiFID.
• Providing payment services and/or issuing E-money.

MiFID, in particular, introduces a considerable degree of complexity and uncertainty in relation to
“transferable securities”. The consequences of a direct finance platform’s activity falling within any
MiFID categories is that many of the exemptions under RAO are disregarded – because MiFID has a
more limited range of carve-outs and overrides UK law within its scope. 16 Key issues are:

a. what level of activity constitutes the MiFID activity of “placement of transferable securities”.
b. the EU “business” element is different in some cases, and it is not clear how far this differs
from the relevant FSMA test.

16
An Article 4 MiFID derogation may be possible in some circumstances.

Schedule of Amendments.

Competition Objective

(1) Amend the “1E The competition objective” to provide as follows: -

(1) The competition objective is: promoting effective competition in the
interests of consumers and businesses up to medium-sized enterprises in the markets for—

(a) regulated financial services, or

(b) services provided by a recognised investment exchange in
carrying on regulated activities in respect of which it is by virtue
of section 285(2) exempt from the general prohibition.

(2) The matters to which the FCA shall have regard in considering the
effectiveness of competition in the market for any services mentioned
in subsection (1) include—

(a) the needs of different consumers who use or may use those
services, including their need for information that enables them
to make informed choices,

(b) the ease with which consumers who obtain those services can
change the person from whom they obtain them,

(c) the ease with which new entrants can enter the market,

(d) developments in the markets for unregulated financial services that are in the interests of
consumers and businesses up to medium-sized enterprises,

(e) whether there are emerging business models, services or products in the markets for
unregulated financial services that represent better outcomes for consumers and businesses up to
medium-sized enterprises than those within the markets for regulated financial services and, if so,

(i) whether the regulation of financial services is adversely affecting the responsible growth of
those emerging business models, services or products, and

(ii) whether those emerging business models, services and products ought to be included or
otherwise accommodated by or within the regulation of financial services (including via
permitted self-regulation, co-regulation or perimeter guidance) and, if so, recommend
appropriate changes to such regulation, and

(d) how far competition is encouraging innovation.

(3)_ “medium-sized enterprise” means an enterprise which is an enterprise as defined in Article 1
and Article 2(1) and (3) of the Annex to Recommendation 2003/361/EC;17

New regulated activity of “operating a direct finance platform”.

(2) To the extent permissible under applicable law, add a provision to the Financial Services Bill requiring
the Treasury to make regulations to:
a. establish a new authorisation regime for direct platform operators. The new regime
should not apply to credit institutions, electronic money institutions, payment
institutions or other authorised firms, unless they choose to become a direct finance
platform.
b. require the Authority to establish a register of direct finance platform operators. The
regulations should set out:
i. the procedures and conditions for authorisation or registration; and
ii. the circumstances in which registration may be varied or cancelled.
c. Oblige bodies requiring registration to be either registered as an authorised direct
finance platform operator or as a small direct finance platform operator. Classification
would depend on the aggregate value of transactions entered into on their platforms or
the value of transactions that any one participant can enter into on their platforms.
d. require a direct finance operator to meet certain operational conditions. These would
aim to ensure:

i. The maintenance of adequate senior management systems and internal operational
risk controls;
ii. The maintenance of a minimum of £100,000 capital (‘own funds’), or such lesser
amount as may be appropriate, depending on whether or not participants’ money
or assets are held by the platform operator;
iii. Segregation and safeguarding of participants’ funds (where held) – the Treasury
should be empowered to order a bank to support safeguarding where necessary,
with insurance as an alternative means of safeguarding;
iv. Clear, non-discretionary rules governing use of its platform, binding on the operator
and all participants;
v. Clear, fair and not misleading marketing and customer communications;
vi. Secure and reliable information technology systems;
vii. Fair complaints handling, with access to the Financial Ombudsman Service;
viii. The orderly administration of contracts in the event a platform ceases to operate;
ix. Appropriate credit assessment and anti-fraud measures (including customer due
diligence).
x. Rules as to risk warnings and customer acceptance;

17
The category of micro, small and medium-sized enterprises (SMEs) is made up of enterprises which employ fewer
than 250 persons and which have an annual turnover not exceeding EUR 50 million, and/or an annual balance sheet
total not exceeding EUR 43 million.

xi. for shares or debt securities – minimum information that should be disclosed by
issuers.
xii. Appropriate record-keeping and proportionate financial disclosures;
xiii. Notification and appropriate management control of material outsourcing;
xiv. notifying the FSA of any change in their circumstances relevant to the conditions of
their registration.

e. Limit transferability. A direct finance platform operator should only facilitate the
transfer of ownership in a direct finance instrument that was entered into via that
operator’s own direct finance platform or transferred to its platform from another
direct finance platform (but this should not affect the transferability of such an
instrument in the course of a separately regulated activity);
f. Enable portability where appropriate. Other than instruments that are dependent on
underwriting and on-going relationships between borrower or issuer of the instrument
and the platform operator, a direct finance instrument should be readily transferable by
the owner from the direct finance platform on which it was originated to another direct
finance platform that offers the same instrument, subject to the administrative
capabilities and acceptance of the requested transfer by the second direct finance
platform operator;
g. Enable effective supervision and enforcement. The regulations should confer on the FCA
functions in relation to the supervision and enforcement of certain provisions of the
regulations.
h. Prevent false claims of authorisation. The regulations should make it an offence for a
person to operate, or falsely claim to operate, a direct finance platform in the United
Kingdom unless it is one of the other permitted categories of direct finance platform
operator.
i. Enable alternative dispute resolution. The regulations should provide for the Financial
Ombudsman Service to be available to receive complaints about the activities of direct
finance platform operators.

(3) – Definitions: to the extent permissible under applicable law, for the purposes of section (2) above,
the following definitions shall apply:
a. “the 2000 Act” means the Financial Services and Markets Act 2000;
b. “authorised direct finance platform operator” means a person included by the Authority
in the register as an authorised direct finance platform operator;
c. “the Authority” means the Financial Services Authority (as replaced by the Financial
Conduct Authority);
d. “consumer” means an individual who is acting for purposes other than a trade, business
or profession;
e. “direct finance instrument” means a contract made in writing in accordance with non-
discretionary rules via a direct finance platform between only two parties, each of

whom is either a consumer or a medium-sized enterprise (“A” and “B”), under which A
agrees to pay to B an amount of funds on terms that constitute:
i. a loan;
ii. a share or a stock in the share capital of a corporation;
iii. a debenture;
iv. the pre-payment of a trade invoice for a total amount;
v. a donation;
vi. the matching of one or more payments in one currency with one or more
payments in another currency, at a specific time and in a specific amount, so
that A and B each receive payment of an equivalent amount in the other
currency.

In each case, where the total amount financed by all contracts entered into with B in
connection with the same offering does not exceed €5m; and except to the extent
expressly permitted, excludes:

vii. a “payment transaction” and a “payment instrument” as those terms are
defined in the Payment Services Regulations 2009;
viii. instruments included in Part II of Schedule 2 of the 2000 Act 18, except to the
extend they are referred to in paragraph 2(e)(i)-(v);

f. “direct finance platform” means an electronic system, operated by a direct finance
platform operator, which brings together multiple participants, the majority of whom
are consumers and/or micro-enterprises, in the system and in accordance with non-
discretionary rules that are binding on the direct finance platform operator and the
participants;
g. “direct platform operator” means an authorised direct finance platform operator or a
small direct finance platform operator;
h. “funds” means banknotes and coins, scriptural money, and electronic money as defined
in Article 1(3)(b) of the electronic money directive;
i. “medium-sized enterprise” means an enterprise which, at the time at which the
contract for payment services is entered into, is an enterprise as defined in Article 1 and
Article 2(1) and (3) of the Annex to Recommendation 2003/361/EC; 19
j. “the register” means the register maintained by the Authority under the regulations;
k. “small direct finance platform operator” means a person included by the Authority in
the register as a small direct finance platform operator.

18
http://www.legislation.gov.uk/ukpga/2000/8/schedule/2
19
The category of micro, small and medium-sized enterprises (SMEs) is made up of enterprises which employ fewer
than 250 persons and which have an annual turnover not exceeding EUR 50 million, and/or an annual balance sheet
total not exceeding EUR 43 million.

Exemptions from other forms of regulated activity.

(4) To the extent permissible under applicable law, add a provision to the Financial Services Bill
requiring the Treasury to amend such the instruments (including those in column 2 of the table
below), and require the FCA to amend its rules and related guidance, so as to ensure that the
regulated activity of operating a direct finance platform does not fall within other forms of regulated
activity (including those in column 1 of the table below): 20

20
I am indebted to Tony Watts, a fellow consultant solicitor at Keystone Law and specialist in financial regulation, for
specifying the regulatory changes in paragraphs 4 and following of this Schedule of Amendments – his input is based on his
experience of advising in the area of alternative investment structures.

1. Activity 2. Instrument 3. Commentary
Accepting FSMA 2001 (Regulated Potentially relevant to some platforms
Deposits Activities) Order 2001 involving savings and lending -type products.
(“RAO”) Article 5 et seq.

Dealing in Articles 14/21, RAO Potentially relevant to Platforms where debt or
investments as equity securities are bought and sold.
principal or
agent

Arranging
Transactions in Article 25, RAO This is almost always relevant to Platforms
Investments involving debt securities (“debentures”).
“Arranging” is a particularly difficult term
because of its “open texture” - an expression
politely adopted by the courts to cover lack of
clarity and uncertainty. The situation as
regards “arranging” has become more
uncertain because of recent High Court
decisions 21 with which the FSA has publicly
expressed disagreement. It is genuinely very
difficult to advise clients as to what constitutes
“arranging” in any circumstances. There are
exemptions but their scope is unclear.

Operating a Article 51, RAO This is often relevant to innovative funding
Collective schemes, particularly those that involve any
Investment degree of collective management, whatever
Scheme 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. 22
Further, any number of individuals should be
able to provide the funding towards any single
instrument financed (e.g. a large invoice or
debenture);

21
See particularly Watersheds Ltd v (1) David Da Costa (2) Paul Gentleman (2009) [2009] EWHC 1299 (QB)
22
The Financial Markets Law Committee (FMLC) are lobbying HMT to change the definition in any event as party of
the current regulatory reform programme: – see http://www.fmlc.org/papers/Ltr2HMTre86Nov11.pdf.

Activities relating Articles 61-63E, RAO Entering/ administering Regulated Mortgage
to domestic Contract. These may be relevant to any form of
mortgages lending secured on a debtor’s house (even
lending for business purposes

Clarity on the scope of the “business test”.

(5) Add a provision to the Financial Services Bill requiring the Treasury to amend such instruments,
and require the FCA to amend its rules and related guidance, so as to ensure that participants on a
direct finance platform are not considered to be acting in the course of any business solely by virtue
of their participation on a direct finance platform, even if they are otherwise operating as a business
(including a FSMA-authorised business).

Promotional requirements.

requiring the Treasury to amend such instruments, and require the FCA to amend its rules and
related guidance, so as to exempt direct finance platform operators from provisions relating to:
1. Financial promotions under FSMA 2001 (Financial Promotion) Order 2005 (”FPO”);
2. Offers of securities to the public under the Prospectus Directive (Part VI of FSMA);
3. Offers of securities to the public under the Companies Act 2006 (s. 755 et seq.).

EU Requirements.

requiring the Treasury to amend such instruments, and require the FCA to amend its rules and
related guidance, so as to issue authoritative and detailed guidance as to what activities are or are
not permissible in the context of operating a direct finance platform in connection with other
potentially relevant regulated activities, including those under FMSA, MiFID, the Companies Act
2006, the Payment Services Regulations 2009.

Implementing the JOBS Act in the UK.

(8) The Treasury may, as a means of implementing the effect of some of the foregoing, introduce
changes to FSMA and other instruments consistent with the “JOBS Act” in the US 23 in the manner
described in the chart below (further detailed technical explanations are available on request):

23
Jumpstart Our Business Startups Act: http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-
112hr3606enr.pdf

The JOBS Act has two routes:
1. Those operating a platform on a not for profit basis not requiring
authorisation;
Step 1: Clarify UK
and EU authorisation 2. Those operating on a commercial basis subject to proportionate SEC
requirements licensing subject to conditions.

This could be replicated in UK legislation by:
• Clarifying equivalent “not for profit” exemption;
• Introducing a new activity (as a type of “arranging”) of operating
direct funding platform via section 6 of the Financial Services Bill
(amending FSMA s.22 and Schedule 2). But regulation will also need
changes to subordinate legislation and FSA Rules (see schedule of
amendments above for details).

JOBS Act summarised:
Step 2: Clarify conditions
under which • Annual limits for issuers
proportionate regulation • Investor information/questionnaires
of platforms operates. • Risk warnings
• Required contents of issuer offer document.
• Fraud prevention/confidentiality.

These could be included in primary legislation or the Bill should
• Require HMT to insert conditions in subordinate legislation –
amending existing Statutes and instruments; and
• Require FCA to make further rules (which the JOBS ACT required the
SEC to do within a specified period).

See schedule of amendments above for details.

The JOBS Act clarifies when offers through crowdfunding sites do not
involve “offers to the public”. This should also be achieved via the Bill
3. Clarify issue as to clarifying Companies Act s.755-756 – Note that s. 92 of the Bill already
what is an offer to the amends s.755 Companies Act 2006 in certain respects.
public through direct
finance platform. See schedule of amendments above for details of clarification required.

Annex 3

Quantifying the Non-Deduction of Bad Debts Tax Distortion
in Markets for Personal and Business Loans 24

Overview of this Annex
1. 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 Method
2. Effective Tax Rate (ETR) methodology helps illustrate the scale of any distortion caused by the tax
regime on income from capital. ETR methodology of this type is usually quoted as having its genesis
in the work by King and Fullerton (1984): The taxation of Income From Capital. Their work has been
developed and applied by many in the years since. In this note only a relatively simple 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 other costs),
less the return after deducting tax (and costs). The ETR is the tax wedge divided by the return to the
lender before deducting tax (but after other costs). Without a tax distortion, the ETR will equal the
lender’s statutory tax rate (e.g. 40% for higher rate taxpayers) 25. Ideally ETRs on equally desirable
investments will be the same and the tax regime will not harmfully distort the choice faced by
investors making those investments.

The Bad-Debt Deduction Issue
4. 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 lender’s 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 Platform’s markets of varying risk. This would be a
good outcome.

24
This material for this Annex was provided by a private investor who does not wish to be identified.
25
The effective tax rate is perhaps more intuitive as it will equal the statutory tax rate (eg 40%) in the absence of
distortion. But if there is a distortion the change in the ETR also depends on the level of return (i.e. level of
interest) chosen to illustrate the problem. Since this level of return chosen is always one of analytical judgement,
slight variation in the ETR measure arising from differences in such judgement can cause unnecessary confusion.
The tax wedge on the other hand is, at least in this case, dependent on the level of expected bad debt and the
lenders personal tax rate only. Having specified these, the tax wedge has the advantage of being stable whatever
the overall level of return set. In practice both are usually considered when assessing tax distortions to capital
returns.

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. Assuming lending on a
Platform and by retail banks are equally desirable, any difference in their ETRs is a bad outcome.

Results
6. 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 Platform’s 1% fee and of expected bad debts is the same for all
a Platform’s 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 lenders

Benchmark rate of interest 5.0% i
after costs before tax
Marginal Personal Tax Rate 40% t

Without Distortion With Distortion
Rate Addition
Expected
Market Fee Charged to Tax Effective Net al Tax Total Tax Effective Net
Bad 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
1 1% 0.5% 6.5% 2% 40% 3.0% 0.2% 2.2% 44% 2.8%
2 1% 1.0% 7.0% 2% 40% 3.0% 0.4% 2.4% 48% 2.6%
3 1% 2.9% 8.9% 2% 40% 3.0% 1.2% 3.2% 63% 1.8%
4 1% 5.2% 11.2% 2% 40% 3.0% 2.1% 4.1% 82% 0.9%
5 1% 5.0% 11.0% 2% 40% 3.0% 2.0% 4.0% 80% 1.0%
5 Year Loans
1 1% 0.4% 6.4% 2% 40% 3.0% 0.2% 2.2% 43% 2.8%
2 1% 0.8% 6.8% 2% 40% 3.0% 0.3% 2.3% 46% 2.7%
3 1% 2.3% 8.3% 2% 40% 3.0% 0.9% 2.9% 58% 2.1%
4 1% 4.2% 10.2% 2% 40% 3.0% 1.7% 3.7% 74% 1.3%
5 1% 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 lenders

Benchmark rate of interest 5.0% i
after costs before tax
Marginal Personal Tax Rate 20% t

Without Distortion With Distortion
Rate Addition
Expected
Market Fee Charged to Tax Effective Net al Tax Total Tax Effective Net
Bad 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
1 1% 0.5% 6.5% 1.0% 20% 4.0% 0.1% 1.1% 22% 3.9%
2 1% 1.0% 7.0% 1.0% 20% 4.0% 0.2% 1.2% 24% 3.8%
3 1% 2.9% 8.9% 1.0% 20% 4.0% 0.6% 1.6% 32% 3.4%
4 1% 5.2% 11.2% 1.0% 20% 4.0% 1.0% 2.0% 41% 3.0%
5 1% 5.0% 11.0% 1.0% 20% 4.0% 1.0% 2.0% 40% 3.0%
5 Year Loans
1 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%

Proposed amendments to the financial services bill sdj 21 06 12

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