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P2P Lending – A Summary of Applicable Laws and Regulations

by Peter Renton on April 2, 2013

[Editor's note: No jokes today - yes the Warren Buffett piece yesterday was an April Fools Joke. Today, we bring you a guest post from Samuel Hu, an attorney with Chapman & Cutler LLP, who has done a great deal of analysis of the legal framework within which the p2p lending companies operate. He has produced a detailed report on this topic and provides a brief commentary about it here.]

First, I want to thank Peter for the opportunity to post a brief summary of the work we’ve been doing with respect to legal issues affecting p2p lending.  As the title of the post suggests, I have recently co-authored an article (download it here) that was based on our experience advising operators and prospective operators of p2p lending platforms as well as institutional investors in p2p loans.

The article we put together covers four general topics: i) securities laws; ii) laws affecting lenders; iii) borrower protection laws; and iv) bankruptcy considerations.

However, instead of summarizing the paper I thought I’d take this opportunity to throw out a few thoughts that came up while researching the paper and I hope to generate some discussion on where the p2p lending industry may be headed.

As most of you know, shortly after p2p lending industry was launched, the SEC determined that a company that sells loan notes through an internet platform, in combination with that company’s undertaking to service the loans and perform certain other services entails the issuance of a “security”.  As such, both Prosper and Lending Club have spent significant time and money to file a registration statement with the SEC and have undertaken ongoing filing requirements in order to continue issuing p2p loans.  And without their leadership in the area, most of us would not have the opportunity to earn the returns we have been provided by investing in p2p loans.

Having said that, we note in the article that if p2p loans are sold only to ‘accredited investors’, a p2p lending company could by-pass the SEC registration requirement as well as the state regulations that currently prevent people located in certain states from being a lender on Prosper or LendingClub.

Question No. 1

Given the lower barrier to entry, why are there not more p2p sites focused solely on institutional/accredited investors (especially as compared to the proliferation of equity crowd funding sites)?

In the article, we also outline an argument (albeit tenuous) that under certain circumstances (and if certain laws are passed), the SEC may require a p2p company to retain a portion of the risk of each loan that it originates (the so-called “risk-retention rule”).  These proposed rules are meant to address one of the perceived causes of the great recession – namely, the originate-to-distribute model of mortgage origination.  According to proponents of the risk-retention rules, because mortgage originators did not have any “skin in the game”, they were not adequately incentivized to follow prudent underwriting standards.

Question No. 2

Whether or not there is a legal requirement to do so, would the p2p lending industry benefit from a requirement that a p2p company retain a small percentage of each loan it originates (keeping in mind that the return to lenders will likely need to be lower in order to compensate the p2p companies accordingly)?

The final part of the article discusses the risk of buying p2p loans associated with an insolvency of the p2p company.  We also discuss some of the ways that a p2p company can isolate lenders from this bankruptcy risk.  One method is the use of a bankruptcy-remote vehicle to hold the loans on behalf of the lenders.  For those of you with a structured-finance or securitization background, you will recognize that this construct is widely use for financing a wide variety of assets including mortgages, car loans and credit card receivables.

Question No. 3

What are the next asset classes (beyond consumer loans) to be financed by p2p ‘technology’?  Residential mortgages? Commercial mortgages? Accounts receivables? Others?

I hope this post generates some discussion and I would enjoy speaking with anyone regarding the comments above or the contents of our article.  Please feel free to e-mail me at samuelhu@chapman.com if you have any questions or just leave a comment below.

{ 10 comments… read them below or add one }

Fred April 2, 2013 at 10:33 am

Samuel (& Peter Manbeck):

Thanks for doing this research and sharing it to us. Impressive work — especially since we don’t have to pay for it! :)

I now just realize that perhaps one of the reasons for delayed loan origination (after being 100% funded) is this SEC “shelf” registration?

On Question 1.
a. There were no institutional investors during the infancy of LC and Prospers. Perhaps they thought that if they had limited the platforms to only accredited investors, there would not have been enough lenders to invest on the loans.
b. LC stated that the barrier-to-entry is high due to “regulatory approvals, technology, track record” (http://additionalstatistics.lendingclub.com/?p=27).

On Question 2: I like the idea that the operators keep some of the loans they issued on their books. Assuming they would also get NAR about 9% on these loans, I am not sure about your statement “the return to lenders will likely need to be lower in order to compensate the p2p companies accordingly.” I would think the return would be about the same; except the lenders would get a slightly smaller slice of the loan amount. If LC bought 5% of the loan amount they issued, then the lenders only have 95%.

On Question 3:
I think Realty Mogul is now doing P2P on residential property (only for accredited investors). It would be interesting to see if P2P can slowly replace the securitization business on the various types of cash flow streams. Institutional investors (Pension Funds, Hedge Funds, Insurance Companies, Sovereign, etc.) would jump to this idea if they could save a few percent on the securitization fees.

Reply

samuel hu April 3, 2013 at 7:38 am

Thanks Fred –
regarding your question on about the delay from 100% to origination – I suspect that filing the prospectus supplement may cause some of the delay but that step is really straightforward – I think the delay is mainly caused by internal procedures that LC and Prosper go through before ‘officially’ originating a note

regarding q. 2 – the reason why return to lenders will likely go down is because if the p2p company needs to ‘co-invest’ in the notes, they will need to raise capital to make the investment – that capital will likely come in the form of equity and the equity investors are going to want more than 9% return. the extra return will need to come out of the return to other lenders (assuming that the borrower rates don’t go up). this is the basic problem banks are facing and why the new capital rules etc. are causing a decrease in the return on equity (and holding down their share prices)

thanks again for reading and hopefully we’ll see p2p technology disrupt traditional finance in the very near future

Reply

Amcap April 2, 2013 at 6:14 pm

Fantastic work…but where’s the tax!? :)

On Question 2 – did we ever settle that NSMIA issue? It sounded like folks generally concluded that using a SPE would confound LC’s attempt to take advantage of blue sky law preemption via an IPO. I think this is one of many areas where the idea of extending a securitization-like model to the general investing public presents a novel problem. In a typical structured finance transaction, they aren’t usually too worried about state-level blue sky laws because all of the investors are going to be accredited.

Reply

samuel hu April 3, 2013 at 7:43 am

thanks Amcap – we thought about the tax issue but its really more of an investor issue v.s. as opposed to an issue for the p2p companies.

regarding that NSMIA issue – i’m still of the view that an IPO for the equity of a p2p company will not necessarily allow the p2p notes to be exempt from blue-sky laws as I don’t think the p2p notes can be classified as senior securities with respect to the equity. however, i am happy to have that discussion with anyone who thinks otherwise.

i agree that the securitization model won’t work since the issuer of the p2p notes is not the same entity as the company that will be raising equity through an IPO.

Reply

Yvan De Munck April 2, 2013 at 8:38 pm

On Question # 1, there are 2 new kids on the block getting ready to launch and going precisely the route described here, i.e. accredited investors only, hence the argument they will be able to move fast and scale rapidly, avoiding a lot of the regulatory red tape.
On # 2, I’m more sanguine, i.e. no real need to keep a piece on the books. It’ll change the model too much, but also, we’re talking about very short duration assets here, hence much lower risk.
On # 3, you can think of and will ultimately see pretty much every other credit category being disrupted and p2p’d (…), starting with small business loans, car loans, mortgages, receivables, etc.

Reply

Peter Renton April 3, 2013 at 8:44 am

Thanks for the responses Sam.

On question number one this is something that continues to confound me. There is a huge proliferation of crowdfunding sites getting ready for the implementation of the JOBS Act and some of these are already open for accredited investors only. But there is no corresponding proliferation of sites for p2p lending.

Here are my theories behind this lack of competition to Lending Club and Prosper:
1. In the early days of p2p lending there was more competition but only two companies survived the SEC registration process so it is still a deterrent.
2. In the UK there is very little barrier to entry and so a thriving p2p lending environment has flourished.
3. Entrepreneurs look at the $75 million or more than both companies have taken without turning a profit and realize it takes a long time to scale.

Despite the fact that new p2p companies could launch without an S1 registration and focus on accredited investors I believe that other SEC regulations are stopping them. Rules regarding open solicitation of investors are a huge hindrance to more open competition I believe.

Reply

Neal S. April 4, 2013 at 1:06 pm

Mr. Hu,

Thank, you for providing the article, it’s very helpful!

As to the section on risk retention, it sounds like Dodd-Frank, under the currently proposed regulations, would require Prosper to retain 5% of each note once the two year grace period expires. Lending Club, because it does not have a bankruptcy remote, would not be subject to the requirement. Did I get that right?

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samuel hu April 4, 2013 at 2:41 pm

Thank you Neal – unfortunately I can’t comment on how the proposed rules may or may not be applied with respect to a particular company. Each case will have to be reviewed on a fact-by-fact basis but if you have any other questions, please don’t hesitate to reach out.

Reply

Jilliene Helman April 11, 2013 at 1:48 am

This is really fantastic.

@Samuel – I only wish this was published a year ago when we got started!

@ Fred – you are spot on. We are funding residential rehabs (loans secured by residential real estate) at http://www.realtymogul.com

@Yvan – more and more people will enter this space with accredited investors, but it is still incredibly expensive if you are taking investors for all states. Filing Form Ds (for Reg D 506 transactions) is going to be very difficult for anybody in this industry to scale and I think we will have to see more regulations change.

@ Peter – I agree whole heatedly. This is a massive undertaking and is not for the faint of heart entrepreneur.

Thanks again to Samuel and team. Great stuff.

Reply

Yuli May 29, 2013 at 8:59 am

P2P Lending companies have to file Form S-1 to provide investors with long term notes, but a company that provide short terms notes does also have to follow the same regulations with the SEC (NY state)?

Reply

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