On 23 October 2019, FundingSecure Limited, the asset-based peer to peer ("P2P") lender, entered administration with £80m of loans belonging to its 3,500 customers at risk.
In doing so Funding Secure became the latest in a growing list of high profile failures in the P2P sector. Its demise provides yet another cautionary tale from which investors and regulators should take note.
Background to P2P lending
The arrival of Zopa's platform in 2005 is commonly viewed as the origin of today's £9.5 billion P2P sector in the UK. It was not until the recession in the late 2000's, however, that its growth really took off.
The combination of low interest rates and a generally reduced appetite for traditional lending in the wake of the 2008 banking crisis provided fertile ground for Zopa, and other new entrants into the P2P market such as Funding Circle and RateSetter, to expand.
These platforms offered a technologically innovative and so efficient method of linking needy borrowers with willing lenders. The loans were often unsecured, meaning they could be quickly arranged, and because the platforms offered their services solely online, overheads were lower than usual and the loans could be provided more cheaply. The credit-worthiness of the borrowers was not necessarily scrutinised in the same way as it traditionally would have been by a high street bank. The result was that both borrowers and lenders benefitted, with lower costs and attractive, almost fixed rates of return, over the term of the loans.
The P2P market diversified over the years and the platforms developed an increasingly wider range of business models. In addition to simply acting as a facilitator, some now structure the loans according to the profile of the lender, whilst others split the loans between a variety of borrowers, thus spreading the risk but adding to the administrative complexity of the platform. In a number of instances, the results obtained by the lender have become directly linked to the performance of the platform they lend on.
The risk and return that the lender might expect now also varies hugely on the nature of the underlying loan. The type of loan, for example SME finance, consumer credit or property finance, the term of the loan and the loan's repayment schedule each impact the lender's exposure.
Prior to 2014, P2P platforms usually operated under the auspices of the Office of Fair Trading and would be licensed for activities such as debt administration. With the introduction of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001, P2P platforms fell within the regulated activity of "operating an electronic system in relation to lending", and so came to be regulated by the Financial Conduct Authority ("FCA").
This meant that P2P platforms were required to comply with the Systems and Controls Rules, the Conduct of Business Rules and the Principles for Businesses. Some aspects of the Consumer Credit sourcebook would also apply to the platforms.
In October 2017 the FCA published a consultation paper in relation to the Financial Services and Compensation Scheme ("FSCS") in which it confirmed that bringing P2P lending under the FSCS regime was not justifiable. Lenders on P2P platforms were therefore not protected by the FSCS in the event their loans were not repaid, either partially or in full. In a small number of cases, however, compensation might be available if the FSCS deems the investor received unsuitable advice on the merits of P2P lending.
London Capital & Finance
Instead of borrowing via a P2P platform, some corporate borrowers seek P2P finance directly from the lenders themselves. In some instances, this was in the form of mini-bonds - in other words, unlisted debt securities marketed to retail investors.
The FSCS provides no protection for holders of mini-bonds and the issuing of mini-bonds is not a regulated activity under the Financial Services and Markets Act 2000, meaning the firms issuing them do not need to be FCA-authorised. Firms that promote the mini-bonds do fall within the regulatory regime, however.
Whilst mini-bonds can offer higher than average yields, this ultimately reflects the higher risks involved. The issuers are frequently small, nascent business and the mini-bonds are highly illiquid.
Mini-bonds were the debt security of choice for London Capital & Finance ("LC&F"). It raised £236 million following a marketing campaign ran on its behalf by Surge PLC, which attracted investors with fixed returns of up to 8% from the mini-bonds which could purportedly be held in the tax-free, innovative finance ISA.
LC&F advertised itself to potential investors as FCA-authorised, although did not draw attention to the authorisation being in respect of its promotion of the mini-bonds only.
The FCA was first warned about LC&F in 2015 by an independent financial advisor who, having been shown the scheme by a client, had investigated and seen "a lot of interconnection between the people they were lending to and the management of LCF themselves".
The FCA only took action on 10 December 2018, when it ordered LC&F to stop promoting the mini-bonds as it deemed them ineligible to be held in the ISAs, as advertised.
Three days later, the FCA froze LC&Fs assets.
On 30 January 2019, administrators were appointed. In the course of their investigations, they discovered that LC&F had paid its marketing agent, Surge, £60 million in commission and instead of the funds being applied across a large number of companies, LC&F only loaned the money to 12, with a number of instances of the money being sub-loaned.
The administrators have warned the 11,600 LC&F investors to expect as little as 20% of their money back. In March 2019 the SFO made 4 arrests in connection with LC&F's collapse, and the FCA has since referred itself for an independent investigation into its conduct of the matter and the existing regulatory regime surrounding the protection of retail investors of mini-bonds.
In some instances, the P2P financing is backed by property. Lenders are drawn to this not only because of the high rates of return, but also the perceived security they get from the nature of the asset they are lending against.
Lendy offered retail investors just this. In its marketing material it informed potential investors of its "four step due diligence process" and its "five phase credit assessment", and returns of up to 12% in exchange for lending their money against property.
Whilst it started life providing 12-month bridging loans on property purchases, its downfall was triggered when it began lending to property developers. The risk profile changed and its rate of defaults began to grow. Investors lost confidence and money dried up. Developers found they could no longer draw down and their developments came to a halt.
This cycle continued and the FCA was forced to intervene in Lendy in late 2017. Notwithstanding that, it then proceeded to grant Lendy full FCA authorisation in July 2018.
In May 2019, 10 months after receiving authorisation, the platform failed. 9,000 investors had invested a total of £152 million into the P2P lender at the time of its collapse. £600,000 of that was still owing to lenders following the FCA intervention in 2017. The Administrators subsequently discovered that out of Lendy's 54 corporate borrowers, 35 were either in or entering administration. They estimate the investors' recovery will be 58 pence in the pound before costs.
Some P2P platforms provide financing against other types of asset. In the case of FundingSecure, this was against items such as art, vintage cars and watches.
On its website, FundingSecure stated that it did not use borrowers' credit scores to determine who to lend to; instead it based its decisions on the value of the assets that were being put up as security. It advertised that lenders could achieve annual returns of up to 16%.
A series of defaults ultimately led to the platform's collapse. In one high-profile case, Matthew Green of Mayfair Fine Art Limited was able to sell paintings by Picasso, Chagall and Bonnard which he had provided as security against a loan of £2.32 million, before he defaulted.
Administrators were appointed at the end of October this year. 3,500 investors are potentially exposed to the losses of their loans totalling £80 million.
FCA criticism and new standby and wind-down requirements
The worrying frequency of P2P lenders failing has led to calls for the increased regulation of the sector. The fact that many of those who suffer as a result of the lenders collapsing are ordinary people- investing their inheritance or their pensions, or who are self-employed - has strengthened these calls.
The FCA's perceived inaction in relation to the recent collapses of LC&F and Lendy, despite being warned of the lenders' respective conduct, has placed the FCA itself in the spotlight. Lord Myners, the former City minister, has called for an independent review of the FCA's supervision of Lendy- in addition to the review currently being undertaken into its response to LC&F's business.
In June 2019 the FCA unveiled its much-anticipated plans for updated rules for the P2P sector. These aim to "prevent harm to investors, without stifling innovation", and they come into force on 9 December 2019. Amongst other matters, the new rules cover requirements in relation to the platforms' governance systems, the platforms' assessment of investors' knowledge and experience of P2P lending, and the provision of a minimum level of information to the investors. The lack of protection from the FSCS will also need to be highlighted. Perhaps most strikingly of all, the FCA is placing a limit on investments made by new investors to the P2P sector of 10% of their investable assets. This limit is disapplied if the investor has received regulated advice.
The new rules should force a number of smaller or badly-run P2P lenders out of the industry, which is largely positive. There are currently fears that over 10 lenders are close to collapse, and for the investors in those, the new rules will likely accelerate their losses.
This article first appeared in Recovery magazine in the 2019 winter edition.