WHITE PAPER: Regulation of Crowdfunding
protecting people from the risks associated with crowdfunding
Introduction
This white paper continues consideration of the issues set out in the preceding green paper.1 It recaps, and builds on, the possible harms which were identified in the green paper and then sets out and discusses the basic structure of a potential regulatory regime to minimise those harms.
The harms
In the green paper, three types of harm were identified: donor, taxpayer, and systemic. The latter two relate to the impact on government and court resources, and knock-on effects of those impacts where campaign groups use crowdfunding to advance particular causes or political positions.
As the green paper focused on legal advice and litigation, the first harm was also articulated by reference to them. Donor harm, as set out in the green paper, can be summarised as
harm caused to a donor because they are prevented from exercising a free choice in their decisions relating to donation due to either a lack of information, or the information they are provided with being misleading.
When framed in that way, by removing the references to legal advice and litigation, it becomes clear the potential for harm occurs in any situation where crowdfunding occurs.
Refocusing the policy to meet the harms
This work will, therefore, refocus on crowdfunding in a more general sense. Introducing a regime which applies to all crowdfunding, and then including some specific provisions to deal with the particular issues raised where the funding relates to legal advice or litigation, will help to ensure the same standard applies to all crowdfunders and also reduce duplication in the legislative landscape.
Defining crowdfunding and crowdfunders
The first thing it is necessary to do is to set out what activity should be caught by any new regulatory regime.
As a result of publishing the green paper, a tentative definition was proposed:
This elicited some helpful discussion:
Both these responses drive at the same question: how do you ensure a regulatory burden is not imposed where the risk of harm is low, or where the law should not seek to intervene? Balanced against that risk is the possibility of creating loopholes which mean behaviour which needs to be regulated is able to slip outside of the regulatory net.
For example, it would be possible to avoid capturing some of the smaller fundraisers by setting a de minimis on funds raised before regulation begins to bite. This would, however, present a possible loophole where a person sets up a crowdfunding appeal as a small fundraiser and then goes on to raise a significant amount of funds. This would be open to abuse by deliberately setting a target below the regulatory de minimis and then simply over collecting.
One way to prevent the abuse is to bring within the scheme all fundraising and then disapply some or all of the requirements where certain conditions are and continue to be met.
The following working definitions are, therefore, suggested as a foundation from which to build a regulatory regime:
“regulated crowdfunding” means the solicitation, by a person, of funds from any other person; and
“regulated fundraiser” means the person engaged in regulated crowdfunding.
Clearly some fundraising will need to be removed from the regime, for example raising capital through issue of shares or applying for loans or overdrafts from finance providers. Likewise, payment for goods and services and familial loans should fall outside the regime.
In the original tentative definition charitable fundraising was excepted. However, the current oversight of charitable fundraising is under the voluntary fundraising regulator code.2 The Charity Commission will only intervene in a limited number of circumstances which include risk to public confidence in the charity or charity sector, or criminality. As much of the behaviour which can give rise to harm is unlikely to meet the criminality standard (absent the introduction of a regulatory regime such as the one envisioned by this white paper) it is no longer intended to except charities.
The regime
In order to reduce the risk of harm to donors, the regime needs to cover the raising of funds, the oversight and use of funds, and the return, in appropriate circumstances, of those funds to the donors. It also needs to provide mechanisms for intervention at each of those stages.
In designing the regime, it is possible to draw some inspiration from existing regulatory regimes in other areas. For example, the Consumer Protection from Unfair Trading Regulations 2008 include a general prohibition on unfair commercial practices and then go on to set out what would make a practice unfair.3 A similar approach could be taken to regulating crowdfunding, with the regime building out the details of prohibited practices from the single prohibition.
The basic prohibition
The following basic prohibition is, therefore, suggested as the core principle of the new regulatory regime:
Unfair practices in regulated fundraising are prohibited.
The detail of what those practices are will then be set out in further detail in Chapters of the relevant Part of the legislation. At a minimum, the regime should focus on putting donors in a position of informed consent when they make the donation, and protecting that consent from subsequent abuse by the fundraiser using the donated funds inappropriately or for some unconnected purpose.
A duty of good faith and diligence
One potential unfair practice could be for the fundraiser to act contrary to good faith and the standard of diligence which ought to apply to regulated fundraisers. This would provide an important safety net where a fundraiser has sought to step outside the more detailed provisions of other prohibited practices, or where their conduct is simply below the standard anyone soliciting donations should be expected to meet.
Misleading action
Another unfair practice could be where fundraisers engage in behaviour which is, or is likely to be, misleading. This would require them to have taken positive steps, for example: the provision of misleading information, the making of misleading claims, or the presentation of something in a misleading way.
It may also relate to their conduct once donations have been received. If, for example, the fundraiser applies the funds for purposes which were not consented to by the donors at the point of donation.
Misleading omission
This particular practice could apply where a fundraiser has failed to do something they should have done. For example, a fundraiser may have failed to provide information they are required to provide by law or they may have hidden information which, if properly communicated, could have led to a different decision being taken by the donor.
Aggressive fundraising practices
This type of unfair practice could be where a fundraiser has targeted a particular vulnerability of a donor, or class of donors, or has persistently failed to comply with basic standards of integrity in their fundraising. It might, for example, capture circumstances where a person relies on a lack of understanding of the legal system in such a way that donors might be misled into thinking an unobtainable outcome may be achieved by legal action.
Automatically unfair practices
These practices would not require any proof that they had, or would be likely to have, any impact on a decision to donate funds. They would be those practices which fundraisers simply should not engage in. For example, it could include using donated funds to pay for administration or using the funds for another purpose from that which was set out in the fundraiser.
Requirements for transparency
One key way in which potential harm to donors could be greatly reduced, whilst ensuring crowdfunding remains a viable way to raise funds, is by ensuring they are put in the best possible position to make an informed decision. Legal advice and litigation crowdfunding is a good example of where a lack of information is problematic in a number of ways.
First, some crowdfunders in the legal sphere fail to adequately set out the possible outcomes of a case. There is a general lack of legal education in the UK which leads to people, for example, believing that a finding government has acted unlawfully means criminal prosecutions for misconduct in public office are automatically available.
Second, some crowdfunders make exaggerated claims about what they will deliver if a case is successful. Some, arguably, make exaggerated claims about the strength of the underpinning legal case. Others remain silent about advice they have received which shows a case has an uphill struggle. Of course, similar issues also arise in respect of crowdfunding which is not related to legal cases, with crowdfunders making exaggerated claims about the particular cause for which they are raising funds.
Third, some crowdfunders redirect funds. This can happen in two ways: first, by using some of the funds to pay for administration expenses; and, second, by using surplus funds for causes other than the one donated to. Again, these are issues which can, and do, arise in crowdfunders that aren’t related to legal cases.
In order to tackle this harm, a new regulatory regime should place a requirement on crowdfunders to be transparent. In order to minimise the risk of regulatory gap, the requirement should be phrased such that all material information must be provided. A minimum standard could then be set using a non-exhaustive list of information that will, in all circumstances, be material.
The following is a tentative list of information which will always be material:
The identity of the funder;
Where the funder is raising money on behalf of another person, the identity of that person;
The specific purpose(s) for which the funds are being raised;
The way in which the funds will be used;
The reason why the fundraiser is seeking funds including why, where they have access to sufficient funding by other means, other funding is not being used;
The manner in which use of the funds will be controlled;
The right to withdraw funding and seek a refund, together with the point at which withdrawal of funding for a refund will no longer be available;
The fact that the fundraiser is regulated and information regarding how to make a complaint to the regulator.
As this project progresses, this list may change.
Controls on use of funds
Alongside transparency, ensuring the donated funds are used for the purpose for which they were donated is key to reducing donor harm. Fundraisers should be placed under a positive duty to only use the funds for the purposes for which they were donated. Where there is a surplus of funds, either because more was raised than needed to achieve the purpose or because the purpose is no longer achievable, fundraisers will be placed under a positive duty to return funding on a pro-rated basis to donors.
Donors should have a right to withdraw uncommitted funds.
Fundraisers will be able to seek permission from the donor to repurpose the funds. A request to repurpose the funds will be treated as though it is a new solicitation and the information requirements will apply equally as they would to an entirely new fundraiser. Repurposing of the funds will require an expressed consent from the donor.
A fundraiser will be able to use a proportion of donated funds for general expenses. However, this should be listed as a purpose for which the funds might be used and should be subject to expressed, informed, consent.
One additional consideration is whether funds should be paid into escrow in order to protect them from misuse. This would place an additional burden which would, for many fundraisers, be unnecessary. However, fundraisers should be placed under an obligation to keep accounts of donations and how they are spent.
One further issue also arises in relation to controls on the use of funds. There are examples of people crowdfunding to pay damages or compensation where they have been successfully sued. These often arise in defamation cases, raising the possibility that there is a reduced disincentive to defame because the financial consequences are not felt by the person engaging in defamatory conduct. There is a debate to be had, therefore, as to whether, as a matter of public policy, there should be a ban on using crowdfunding to meet damages or compensation claims.
As a tentative conclusion, there is merit in banning the use of crowdfunding to pay damages and compensation so as to ensure that restitution falls where it is intended to and both claimants and defendants are not put in a privileged position because the losing defendant has a sufficient public profile to raise the funds in question.
Enforcement
In order to be an effective regulatory regime, it is necessary to design a system of enforcement which ensures robust standards are maintained and those who fail to meet them are dealt with properly. As with any system of enforcement, it should be made up of a number of elements to provide a “toolkit” to achieve good regulatory outcomes in a proportionate and fair manner.
A new enforcement agency
The first thing to do, when designing a new enforcement system, is to consider who is best placed to exercise the new functions. There is an argument for identifying a current regulator to exercise the powers a new system will implement. The regulatory landscape is already a crowded one, with people often falling within the ambit of a number of regulators who focus on different aspects of what they do. Adding to that number is, without doubt, adding to the regulatory burden some people will face. However, although the regime envisioned in this work is similar to consumer protection, it is not an obvious fit with any of the current statutory regulators or law enforcement agencies.
It would also be possible to provide functions and powers to the current Fundraising Regulator4 and transition them from a voluntary body into one which enforces legal standards. Moving from assessing compliance with a voluntary code of conduct to investigating potential breaches of a more robust regime, together with taking subsequent enforcement action, would represent a significant shift in focus and necessary capability from what the Fundraising Regulator currently undertakes.
Such a shift means there are few benefits from conferring these functions on them, yet they will face the same tasks in establishing themselves as the new, enhanced, regulator as an entirely new body would.
It is, therefore, tentatively concluded that establishing a new agency would be preferrable to conferring functions on an existing body. There is a tangential benefit with taking this approach to drafting the future legislation: if, at a future date, it is concluded an existing body may be well placed it is a simple drafting change to confer these functions on that body.
Enforcement outcomes
In designing a new regulatory regime it is important to keep in mind three fundamental principles:
Proportionality
A regime should place no more of a regulatory burden than is necessary to counteract the harms it is seeking to address.
Deterrence
The regime should deter people from causing the harm it is intended to prevent and should punish those who do.
Compliance
The regime should be easy to comply with and should encourage those within its ambit to achieve a high level of compliance.
Criminal offences
The new regulatory regime should include criminal offences so that poor behaviour can be discouraged and, where it occurs, appropriately punished. It is proposed that the regime would include the following offences:
Breaching the prohibition on unfair fundraising practices
Being involved in a regulated fundraiser whilst subject to a banning order5
Obstruction of the regulator.
Civil injunctions
Alongside criminal offences, the regulator would be given the power to apply for civil injunctions to prevent continuing or future breaches of the regulations. These could impose specific conditions aimed at improving or ensuring compliance, or preventing future harm by banning individuals or companies from involvement in regulated fundraising.
They could impose conditions relating to repayment of unfairly obtained funds including, in appropriate circumstances, a requirement that the fundraiser raises capital in order to meet the repayment.
It might also be sensible to provide for a modified version of an undertaking where a person can undertake not to engage in further harmful conduct. In order to ensure these are useful tools, undertakings would need to be given similar status to a court order.6
Investigatory powers
In order to perform their function, the new agency will need to be able to investigate potential breaches of the regime and, where they have occurred, take action to prevent those breaches continuing or being repeated.
The main powers likely to be needed are as follows.
Power to require information
This power could be used to compel a person to provide information for the purposes of the new agency performing its function. This would provide a means to obtain information from third parties where they have concerns about providing it (for example contractual terms), and could be used as a way to obtain information from the person under investigation. Any use against a person under investigation would need to protect legal privilege and also respect their right not to self-incriminate.
Power to engage in “test purchases” covertly
This is an important intelligence and evidence gathering tool, where the agency could go through the same process as a donor in order to assess the information donors are given. It is necessary to provide for this to be undertaken covertly as it may form part of an early stage of an investigation and the risk of tipping off needs to be avoided.
Power to enter premises and to search and seize
This power would enable the regulator to obtain and preserve evidence which is held by the fundraiser. Safeguards on the use of this power would include:
making it exercisable in respect of business addresses only where notice has been provided or a warrant has been obtained;
making it exercisable in respect of domestic premises only where a warrant has been obtained.
Warrants would be issued by a Justice of the Peace where
(1) a person has failed to provide information where required by the regulator; or
(2) there are reasonable grounds to suspect a breach of the prohibition or an offence contrary to the Fraud Act 2006 has been committed.
AND
(3) there are reasonable grounds to suspect material is, or is likely to be found, on the premises or be accessible from the premises which is likely to be of substantial investigatory or evidential value.
AND
(4) there are reasonable grounds to believe the premises are domestic premises; or
(5) there are reasonable grounds to believe it would frustrate the purpose of the entry if permission were sought from the occupier.
In drafting the relevant legislation, it will be important to ensure powers to search and seize are not frustrated by entry by consent. It will also be necessary to provide access to legally privileged information where the suspected misconduct relates to misleading donors about the legal advice relating to crowdfunded legal cases.
Power to set standards
A final tool in the agency’s arsenal would be the power to set standards by issuing a code of conduct with force of law. Failure to comply with the code would be a prohibited unfair practice.
Giving the regulator this power would enable regulation to stay nimble and take account of emerging best practice or harmful behaviour without the need to identify parliamentary time to further legislate. This should help to minimise the risk of regulation failing to keep pace.
Tentative conclusions and next steps
There are good arguments for progressing this project to draft legislation stage. The lack of regulation of crowdfunding continues to put people at risk of harm, and it has been possible to design a sufficiently cogent proposal to be able to translate policy into legislation.
Draft legislation will, therefore, be drafted in due course.
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A banning order would be imposed under the civil enforcement regime or as part of a sentencing following a finding of guilt in a criminal prosecution.
As an undertaking is, in many ways, analogous to a consent order there are not strong reasons to prevent them being enforced in a like manner.