What the P2P lending industry doesn’t want you to know: of Lending Club and Prosper
Last week, Four Pillars emailed me on my business trip to inform me that Lending Club stopped accepting new loans while it registered with the Securities and Exchange Commission (SEC), the regulatory body that governs all aspects of selling securities in the U.S. This set off wide speculation in the blogging world ranging from Lending Club is dead or this is a good thing for Lending Club to what will happen to Lending Club in interim. I am going to try to put some legal context to this move and attempt to explain what happened and its impact on p2p users.
In essence, there are a wide variety of larger structural/regulatory issues of the p2p industry that, for obvious reasons, are not highlighted and should give pause to anyone who wants to use p2p lending as an alternative source of income. As a caveat, I am not a securities lawyer by training (but I know how to read securities regulations) and some of the below is speculation on my part given the documents I could retrieve. I also have no affiliation with either Prosper or Lending Club as lender, advertising source etc.
P2P in a Nutshell
Here’s p2p lending in a nut-shell from the lender side (the longer explanation can be found in a previous post about Prosper’s legal documents; incidentally, I emailed the post to them and got no response…):
- You pick the borrower you want at the rate you want;
- Assuming you win the bid, the p2p company, issues the loan to the borrower (i.e. they are the lender) and then assigns the loan to you. In other words, the lender of first instance is not you but the p2p company.
- However, the p2p company “services” the loan (collects money, updates records, chases defaulted payments)
Here’s the regulatory issue- IF A PERSON INVESTS MONEY AND HER EXPECTATION OF PROFIT IS DERIVED SUBSTANTIALLY THROUGH THE ENTREPRENEURIAL AND MANAGERIAL EFFORTS OF OTHERS, IT IS DEFINED AS A SECURITY. These are known as “investment contracts” (another example of this is an investment club that hands over their trading to someone not belonging to the club; that advisor has to be registered to make trades). Since the p2p companies are “selling” the loan that you bid on and then managing it, it is trading in a “security” and subject to SEC jurisdiction. I am speculating that the p2p industry is caught under this provision of securities law but the larger point is that the p2p companies have to become SEC “registrants” (there is some speculation as a broker-dealer) in order to sell the loans. Thus, they fall under SEC regulatory scrutiny.
HOW DOES THIS AFFECT ME?
You are probably asking yourself- what does this have to do with me? SECURITIES COMPLIANCE IS EXPENSIVE. A SEC registrant can spend anywhere from $250,000-$500,000 for a small registrant to $1 million plus a year in compliance (filing fees, new staff, legal fees etc). In all likelihood, the costs will be passed down to the users of the p2p system which, in turn, will cut into the return on investment. With the government beating the drums of increased regulation, it appears that the p2p industry will be subject to greater and greater compliance costs.
WHY IS LENDING CLUB BEING TREATED DIFFERENTLY?
The $64,000 question is why did Lending Club stop taking new lenders while Propser continues on business as usual?
Simply put, Prosper filed in October 30, 2007 paperwork to become a registrant of the SEC. Lending Club filed SEC documents on three separate occasions for their transactions to be exempt from SEC jurisdiction (section 4 and Reg. D are sections exempting a persons from registration requirements); the last filing on February 13, 2008. Obviously, something happened between February and last week between Lending Club and the regulators in which the latter disagreed that Lending Club could be exempt from the registration requirements of the SEC (the fact that Prosper filed to become a registrant probably made the SEC start looking at Lending Club’s operations closely- but I am speculating. However, I note that Propser has a lawyer in their listed management ranks and Lending Club does not).
To be clear, as far as I can tell on the SEC’s website, Lending Club is not publicly under investigation or a party to an administrative proceeding. It is just filing the proper paperwork.
And, yes, this also applies to Canada as well- so CommunityLend will have to file with in jurisdictions where it operates as well if it works on a similar business model.
I disagree with Four Pillars that Lending Club is done. More likely, their law firm is done.
However, the Lending Club saga brings to light the fact that p2p lending will be subject to the same rules as a “traditional” banks when it comes to regulation. It will not be free to operate as it wishes.
The industry’s implicit branding of free-market swashbuckling DIY capitalist has crashed with a resounding thud against the regulatory wall. More to the point, this regulatory issue has highlighted the fact that the p2p lending industry is a intermediary just like a bank or credit union. It is just subject to different rules and a different set of over-heads. You can’t run a business with some type of overhead so buying into the industry’s claim of “sticking it to the man” by undertaking p2p lending ignores business realty. P2p is a viable alternative investment. However, as with all investments, just understand what you are getting yourself into beyond the sales and marketing pitch.