What the P2P lending industry doesn’t want you to know: of Lending Club and Prosper

Posted by on April 15, 2008 in Misc.

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…):

  1. You pick the borrower you want at the rate you want;
  2. 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.
  3. However, the p2p company “services” the loan (collects money, updates records, chases defaulted payments)

REGULATORY ISSUES

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.

FINAL THOUGHTS

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.

15 Comments on What the P2P lending industry doesn’t want you to know: of Lending Club and Prosper

By Four Pillars on April 15, 2008 at 8:26 am

Very interesting post.

It sounds like the odds are pretty good that they will be back in business (at least I hope they do) – but a shutdown like this is never good for business.

Mike

By Traciatim on April 15, 2008 at 8:26 am

I wonder if this is why ioucentral.ca has ceased taking new loans and communitylend.com hasn’t launched yet, because the regulators are taking their sweet old time.

By FinancialJungle.Com on April 15, 2008 at 12:30 pm

What would we do without ThickenMyWallet to keep us straight? Good post.

By Colin on April 15, 2008 at 6:36 pm

Terrific post and summary of the underlying issue. As parties to the issue you will undersand we are limited in what we can speak about, however you have done a good job here in summarising what you see.

We too are curious about Prosper.

@Traciatim I cannot speak on behalf of others, but your assessment regarding CommunityLend is accurate with one exception. We would commend the regulators in Canada for their pro-active stance after we approached them about our new model last year. Its not easy fitting a pile of square peg online processes into a regulatory round hole.
@FinanceJungle … hear hear
Colin

By Terrific post from a lawyer summarising the securities issues on social lending / p2p lending « CommunityLend blog on April 15, 2008 at 6:46 pm

[...] Thicken My Wallet » Blog Archive » What the P2P lending industry doesn’t want you to know: of Le… 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.…. [...]

By admin on April 15, 2008 at 8:26 pm

Thanks for the comments and the kind words!

By Nancy (aka money coach) on April 16, 2008 at 1:01 am

This is off topic (but props for a great post, chiming in with other commenters): you alluded to investment clubs. I joined one years ago, and we easily set up a bank account (3 signers) and a trading account (same signers). Last year, in a volunteer capacity, I got another one off the ground. This group didn’t have it nearly so easy! (things have changed in the 10 years). They had to register with the provincial gov’t as a not-for-profit (even though obviously they hope to make money, but the primary intent is education), all members had to become joints on the account, plus the gov’t doc’s had to be submitted for the trading account etc. I’d love a post from you on the legalities of investment clubs. More than that – if you created an e-book, I’m sure I could sell a number of them (depending on the price).
sorry for such a long off-topic comment!

By Intermediary on The Finance World For News and Information Around The World On Finance » What the P2P lending industry doesn’t want you to know: of Lending… on April 16, 2008 at 6:10 am

[...] What the P2P lending industry doesn’t want you to know: of Lending… 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… [...]

By Lending Club's Future on April 16, 2008 at 9:50 am

[...] My Wallet – What the P2P lending industry doesn’t want you to know: of Lending Club and Prosper addthis_url = [...]

By Julien on April 16, 2008 at 3:50 pm

It was obvious that Colin would find this post “terrific”. Even if it was quite a nice sum up (probably the best so far), you’ve just briefly touched the issue we got here in Canada (I’m pretty sure it’s the same in the USA). I think he doesn’t want people to know what are the secrets to start a successful P2P lending platform in accordance with securities authorities.. I deeply understand him. On our side, we are working with securities lawyers for many months (actually more than one year). I think it’s essential to be pro-active and work jointly with provincial authorities. IOU Central have done exactly the opposite by trying to start their platform before talking with l’Autorité des Marchés Financiers (AMF). It’s quite surprising that venture capital firms have invested in this company without the certainty that the project would be feasible on the regulatory side. In my opinion, IOU will never comme back again..

I honestly whish the best to Communitylend, they seem to have done a great work so far.

Julien
Colektivo

By Tom on April 18, 2008 at 7:37 am

“…inform me that Lending Club stopped accepting new loans while it registered with the Securities and Exchange Commission.”

They are actually accepting new loans, they are just not accepting new lenders or commitments from existing lenders.

Thanks for putting this post together. There is lots of speculation about what is going on and it’s good to hear from a lawyer on the issue.

By admin on April 18, 2008 at 9:55 am

Thanks to all the industry players for their comments. I hope all of you engage the community further going forward.

By Carnival of P2P Lending | rocket finance on April 18, 2008 at 5:01 pm

[...] My Wallet further dissects the Lending Club conundrum by surmising that Lending Club will return, but with greater regulation and overhead. I just hope [...]

By Color on RegD on April 23, 2008 at 12:06 pm

The RegD 506 filings by Lending Club have little to do with their “marketplace”. All these relate to the money they raised. The one from Feb 13th relates to just over $1MM that the company raised from investors.

By Thicken My Wallet » Blog Archive » Inside the World of Peer to Peer (p2p) Lending on June 4, 2008 at 5:01 am

[...] Let’s wade into issues raised by Lending Club announcing: “[We have] started a process to register, with the appropriate securities authorities, promissory notes that may be offered and sold to lenders through their site in the future. Until they complete the registration process, they will not accept new lender registrations or allow new commitments from existing lenders.” The issue arose because the original loans facilitated by Lending Club were not actually between the individual borrower and lender but the borrower and Lending Club who assign/transfer the loan to the lender (acknowledging in reality that the lender picks the borrower that Lending Club is lending to) and the loan created through the Lending Club service can be classified as a “security” and regulated by the appropriate regulators. [...]

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