Lending Club IPO Packs More than the Usual Legal Drama

Brian Korn, Pepper Hamilton LLP[Editor’s Note: This is a guest post by Brian Korn. He is the Co-Head of the Crowdfunding and Peer-to-Peer Lending Group at Pepper Hamilton LLP. Brian has become one of the leading legal experts in the country on p2p lending and he is a regular speaker at industry conferences. We asked him to write about the Lending Club IPO from a legal perspective, commenting on some of the lesser known issues, including whether Lending Club will become available to investors in all 50 states post-IPO.]

The upcoming initial public offering of LendingClub Corporation will be a true “coming of age” event in the peer-to-peer lending industry.  Though Lending Club and its chief rival, Prosper Marketplace, have been in business for about eight years, the industry has seen tremendous momentum in the past two years.  Lending Club passed $5 billion in loans originated in June and Prosper crossed $2 billion just last week.

Industry executives often describe the potential of the industry as being vast and virtually limitless.  “We are in the first inning,” Ron Suber, President of Prosper often says.

Lending Club and Prosper originate loans through a funding bank, purchase the loans and then either sell whole loans to institutions or issue “borrower payment dependent notes” (or member payment dependent notes depending on the platform) to the investing public.  But because the notes are not listed on a national securities exchange such as NYSE or Nasdaq, Lending Club and Prosper must apply for permission from each state in which it wants to distribute notes.  About 20 states have refused to allow sales of notes, meaning investors in those states cannot invest in payment-dependent notes.  Some very large states are included on this list – Texas, Pennsylvania, New Jersey and Ohio to name a few.

Several emerging peer-to-peer platforms such as Peerform and Patch of Land sell payment-dependent notes to accredited investors in “private placements” that are exempt from SEC registration under Rule 506 of the Securities Act of 1933 (also known as Regulation D).  By offering notes to accredited investors, sales can be made in all states without state approval.  This concept is known as “federal preemption.”

Preemption for Payment-Dependent Notes?

Federal preemption applies, in addition to Rule 506, to securities listed on a national securities exchange or any securities issued by the same issuer that are “pari passu” or senior to listed securities.  So when General Electric sells bonds, they are preempted from state securities laws (also known as “blue sky laws”) because those securities are senior to GE common stock.  When Lending Club lists common stock on the NYSE in connection with its upcoming IPO, payment-dependent notes will also be preempted, opening the door to sales to the public in all 50 states and DC.  Notes are debt instruments of the company and under the rules of corporate liquidation, debt is senior to equity.

Some states have quietly voiced concern over the prospect of preemption for payment-dependent notes, likely because such milestone will remove state authority to regulate peer-to-peer note offerings in the state.  States that currently do not allow payment-dependent notes to be sold may attempt to continue to restrict sales following the IPO.  State legal arguments are that since no liquidation of Lending Club would have a payment-dependent noteholder paid ahead of a common stockholder, how can notes tied to a single loan with no recourse to any other assets of the company be senior to common stock, which has an ultimate liquidation claim to the assets of the company?

States rarely get involved in fighting preemption issues, but payment-dependent notes represent a new battlefront.  State securities regulators are fighting preemption (and ultimate disintermediation) on multiple levels besides payment-dependent notes, including Regulation A+ (the small offering exemption) and crowdfunding – all of which allow the SEC to grant state law preemption under the JOBS Act of 2012.  State regulators have a powerful lobbying force and may be able to successfully fight federal preemption efforts.  Moreover, states are forming a national registration system to counter claims that the state-by-state approval process is too cumbersome.

Will Lending Club Become Available to Investors in All 50 States?

So will Lending Club’s payment-dependent notes become available to investors in all 50 states after the IPO? Lending Club has written a risk factor in its IPO prospectus that preemption from state law is not a certainty.  As a result, we could see some new states accept federal preemption and begin to offer payment-dependent notes while others may fight, causing a delay.  If multiple states take different views of the same language of federal law (“pari passu or senior”) then the decision will be decided by the SEC and ultimately the courts, which will have  far-reaching implications beyond peer-to-peer.

Thus, it is not clear on whether Lending Club’s payment-dependent notes will become available to investors in states that currently do not permit the sale of notes. If a few states decide to fight the preemption issue, then it could force this issue into the court systems and meaningfully delay any action.  If the states decide not to fight the preemption issue, then Lending Club’s notes could be rolled out if all 50 states sooner rather than later.  In the meantime, many industry observers are watching this legal drama with great interest.

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JJ Hendricks
Nov. 3, 2014 5:56 pm

Do you have a general time frame for when the initial parts of this happen? Obviously court part could take a long time if it gets there, but what about the state approval or fight of preemption?

Brian Korn
Nov. 3, 2014 11:20 pm
Reply to  JJ Hendricks

Here’s how I think this plays out. Absent a state making a preemptive strike (pun intended), LC goes public and the fractional note marketplace becomes available shortly to investors in the currently restricted states. Each state will determine whether to challenge and then LendingClub approaches the SEC with a request to quash the attempt to subvert preemption by the challenging states. The SEC Corp. Fin. staff will review this situation and make a determination about whether the payment-dependent notes are preempted. Perhaps they already have. If the SEC grants preemption the state will either drop the matter or appeal for a TRO to the SEC administrative law judge and eventually to local federal district court, federal appeals court and ultimately SCOTUS. If the SEC does not grant preemption the onus is on LC to decide whether to fight through a similar appellate process. This could take years to wrestle to the ground, but I predict the SEC can broker a compromise. Perhaps even horse-trading for Reg. A+ non-preemption behind closed doors.

Dan B
Dan B
Nov. 3, 2014 7:57 pm

Thank you for exploring this. It is often stated here in a matter of fact manner that the post IPO reality will automatically mean that the “Blue Sky” exemption will act as a magic wand & override all else making it so that investors in any state can become lenders. My understanding of this exemption is very limited but as you have shown it is not quite that automatic or simple.

One of the things that is never discussed here is why there are certain states that don’t allow p2p lenders. The generic p2p industry friendly response that is usually thrown around here is one which these states are on some quest to protect their residents from this or that fraud &/or p2p has made some strategic decision not to go get each & every state board to allow the investment with the understanding that an eventual going public will take care of things anyway. But the specific reasons aren’t ever discussed.

I have always found these arguments & responses highly convenient, to say the least.. Is it not true that there are actually various divergent reasons & views even among the “not allowed” states as to why these notes aren’t allowed in their state? In other words, each state may have some common & also some unique objections? The GAO report from a few years back seemed to suggest that this is the case, if I recall.

Also, as you know, Prosper has a BRV in place for its retail investors. LC does not. I’ve been harping on this for at least a year to no avail. Peter recently suggested that LC doesn’t want to set one up because doing so will prevent it from being covered to this same blue sky exemption we’re speaking of.Now I’m no lawyer but I’ve told Peter that this makes no sense at all since Prosper has one & one can only assume that they intend to go public at some point & would have the same desire to also allow investors from all states. Your thoughts? I’m running out the door here, but look forward to your responses.

Brian Korn
Nov. 3, 2014 11:27 pm
Reply to  Dan B

Dan- Great observation. The reasons are varied. Some states mired LC and Prosper in never-ending paperwork but did not object. Some states rejected because at the time P2P was novel and unproven. Some states feared losing fear income. State regulators may have had a change of heart since then, some may have retired/changed over. The platforms have not been pushing the states in my view because of the intense demand from institutions buying whole loans, which buy 75% or more of the loan output and for whom state issues are irrelevant. There is no rational reason of course why all investors in PA and NJ need protection and those in NY and CA do not. There is no “red state, blue state” issue here either. GA and LA allow and MA does not.

Dan B
Dan B
Nov. 4, 2014 9:46 am
Reply to  Brian Korn

Thank you. I didn’t think this had anything to do with a blue or red state argument. Again, I’m no expert but it is my understanding that another stumbling block is that certain states like Ohio for example, simply don’t allow companies that are not consistently profitable from issuing debt directly to residents of their state. However residents are free to obtain them through the secondary market.

I’ve been around all this for 5 years now & I think that one of the main issues is a general lack of agreement as to how risky these notes are………………even if we set aside the whole worst case p2p BK scenario. I think that p2p itself is to blame for this. For example consider that p2p has gone full throttle on insisting & marketing these investments as a whole as “Prime” Consumer Notes, with the no properly diversified lender has lost money in x amount of years or pitches of that nature . However, while it is certainly easy to argue that most A & B notes are indeed Prime consumers, the insistence that most E, F & Gs are even remotely Prime consumers is just silly & perhaps even fraudulent. I’d bet that there will be some legal challenge down the road on this whole characterization. Further exacerbating this problem are gems like this one that are prominently displayed on LC & Folio………….”The Notes are highly risky and speculative. They are suitable only for investors whose investment objective is speculation”. So is it any wonder that there is confusion? Call me crazy but I don’t see how “Prime consumers” & “highly risky & speculative” go well together. The possibilities to illustrate how silly all this is are numerous. Consider that a lender can actually buy an A rated Prime Consumer note & then minutes later put that same note up for sale……………….but that now it has somehow become a “highly risky & speculative” note. What a joke.

NealS
NealS
Nov. 6, 2014 8:48 am
Reply to  Brian Korn

You can put Oregon in the “never ending paperwork” category mentioned by Brian. I think the official denial letter said something like “since you didn’t provide x by the requested date, blah blah blah.”

B. Mason
Nov. 3, 2014 10:27 pm

A unique and informative post. I never understood why going public might allow the exemption, and I am now totally sympathetic to the argument for why some states think it should not. The idea that a borrower dependent note has no seniority over equity is a strong one. Thank you very much for your legal opinion. I feel like I should get a bill or something.

B. Mason
Nov. 3, 2014 10:30 pm
Reply to  B. Mason

However, in the event of a LC BK, I suppose if the borrowers continued to pay their debt, perhaps it would be senior, passing through to the note holders over equity claims. The borrower dependency doesn’t really have anything to do with the hierarchy of claims on the company. It merely determines whether the note is a claim or not.

B. Mason
Nov. 3, 2014 10:36 pm
Reply to  B. Mason

Meaning that a BK would take a very long time to sort out! A judge wouldn’t be able to determine the claims until all borrowers’ behavior is revealed. Or perhaps they’d predict the outcomes based on historical charge off rates.. What a mess.

Brian Korn
Nov. 3, 2014 11:31 pm
Reply to  B. Mason

Remember in a LC bankruptcy, the underlying loans are assets of the company. Since the loans themselves do not allow the platform to accelerate them, a judge would likely appoint an administrator to run them out and capture the servicing fee income owed to LC for the benefit of LC creditors (trade, administrative and senior creditors). The BPDN holders are not in that chain of creditors since they are receiving the loan runoffs in connection with their investments. It’s hard to imagine the holder of a performing loan also getting a senior claim on the servicing fee that would go to the company.

Bryce Mason
Nov. 4, 2014 8:15 am
Reply to  Brian Korn

Right, the fee income would go to the creditors, but the remainder of the payments would go toward the BPDN holders, yes? I can’t imagine a judge voiding that relationship, preferencing creditors who are taking a risk on the viability of the company (traditional bond holders, equity) and retail investors for whom the company is merely acting as a pass through. Recall that the original framework was for the note to reflect a relationship directly between borrower and lender before the SEC got involved.

Brian Korn
Nov. 4, 2014 9:56 am
Reply to  Bryce Mason

Correct, with a caveat that if fraud or misconduct of some kind is found, a judge has the authority to grant “equitable relief” – which is essentially the ability to throw out the rules and “do the right thing.” But respecting the structures in place, a holder of payment-dependent notes would not have a claim on the general assets of the platform, only on the payment stream actually received by the platform from the underlying borrower.