To paraphrase Albert Einstein, the way to get out of a crisis is not to employ the same thinking that got you into the mess.  Lawyers tend to be a sully lot because they help clients get out of messes, whether self-inflicted or not, so they spend their days in crisis management and problem solving; it may not look like it, spouting random latin phrases in our conversations, but lawyers are (supposed) to use the law to help their clients get out of messes. That is really our job description.

Are you in a mess (financial or otherwise)? I never thought about it until I wrote this blog but there is a very easy to replicate set of steps to get out of a mess:

1.  Ask someone if you are actually in a mess. This sounds very simple but are you actually in a mess. Being in debt $15,000 where the carrying costs are low and you are making $60,000/year is relatively “unmessy” compared to being in debt for $150,000 where the carrying costs are high and you are making $100,000/year (I would argue that you aren’t really in a mess in the former situation). Since we only know our own experiences, it is always helpful to ask someone you trust whether, relatively speaking, you are in a small, medium or large hole.  You could be panicking over nothing or willfully blind to imminent danger but unless you quantify the issue contextually, you’ll never know. In other words, don’t wait until the barbarians are at the gate to assess your situation. Depending on situation, a good financial planner, money coach, accountant or lawyer can help you wrap your mind around whether you are actually in a mess. That is why you have free consultations with professional advisors- sometimes you think you are in a mess and an advisor may tell you that you have over-blown the issue.
2. If you are in a mess, how big is it? Can this be fixed in months, weeks or years? For example, if you owe a lot of people money, how long would it take you to repay it and would the repayment impair your ability to live a normal life?  Notice I didn’t write can your mess be fixed in days. There is no silver bullet in life- no one waves a magic wand and the mess goes away. It takes some time to extract yourself out of a mess. Since a certain type of thinking got you into a mess consult with someone who thinks and acts differently than you to help you figure out the size of the issue.
3. What are your options given the size of the mess? There are always options. Get another job. Dump him. Ask your parents for help. There’s no such thing as a hopeless situation. Even in personal finance, there is always bankruptcy. Sit down and map out all your options. If you don’t know what your options are, get help and a second set of eyes to help you. Being in a mess is no time to be vain and not ask for help. In fact, I have often found people who are humble, willing to make changes and open to suggestion get a lot of help from strangers.
4. Weigh your options, pick one and don’t look back. The primary reason why people can’t dig themselves out of messes is that they change strategies mid-stream, have bad/negative thoughts and attitudes and they don’t work hard to get out of a mess. I thought the best definition of good leadership I read lately was a good leaders listen, weighs all of their options and then pursues a course of action decisively.
5. Track your way out of a mess. Track, track, track. A pillar of good goal setting which also applies to getting out of the mess. How are you doing? Make sure that the intervals that you use to track your progress are sufficiently wide to show progress. Tracking progress in days and weeks may not be too helpful since progress in the beginning can be slow and can discourage you.

Above all, stay positive throughout. Good luck.

I am on rather extensive business travel this week. It is one of those weeks where I have to remind myself where I am when I wake up in the morning (and, unfortunately, I am asking the question in a context different than the college days). Thus, this is the last post of the week. As you may know, I write a monthly column for Geezeo: a free online management software and budgeting tool. This month, I answered the question of what happens when financial goals are impacted by an economic downturn. Hope you enjoy the article.

Back to regular programming next week. Have a good weekend.

When you get to a certain age, doctors recommend that you starting seeing them for an annual physical to assess your personal health. This is a very good suggestion but when was the last time you did a check-up on your personal finances? I am not talking about an annual visit with your investment advisor or your accountant to look at your portfolio or file your taxes but a true contextual look at your financial life. Doctors run a typical battery of tests at a physical: blood pressure, resting heart beat, blood tests etc. Here’s my equivalent of an annual physical on your personal finances. The key is to do it all at once so you can formulate a plan to make the appropriate adjustments if you are not financially healthy.

1. Check your credit score. You do this for a couple of reasons: (i) to check the accuracy of your creditors reporting on you; (ii) to assess if there are any mistakes (very possible if you have a common name); and (iii) to determine if you have been a victim of identity theft (i.e. is there a credit card account open that you didn’t authorize?). Credit reports are free by law. Obtaining your credit score in Canada or obtaining a credit score in the United States is simple and easy. As a side-note, you should never directly or indirectly pay for your own credit score. A lot of privacy products now sell your credit score as an added bonus to their privacy protection products. You can obtain your credit score for free by doing it yourself. The “added bonus” feature is not a bonus at all; they are relying on you being lazy to move product.
2. Track your budget or find out how much your fixed expenses are. The problem with budgets is that few people follow them. They are like new year’s resolutions. They are made and then forgotten about weeks later. Check how you are doing against your budget. If you are like me and hate budgeting then do what I do. I track what my fixed expenses are; I define fixed expenses as expenses you have to pay every month regardless of your circumstances which you need to survive. Thus, we are looking at items like rent/mortgage, car and life insurance, property taxes, day-care expenses, bank fees etc. If your fixed expenses are creeping up, find out why. It could be for perfectly legitimate reasons like you had another kid or not so legitimate reasons such as defining non-essential items as fixed expenses (your going out budget is not a fixed expenses; worse case scenario, you are broke, you stay home and watch t.v. or borrow a book from the library but seeing Iron Man is not a need in life).
3. Check how much cash or credit sources you have available. The key question being do you have enough cash or credit to get you through bad times? The only way to do this is to look at your fixed expenses. Ideally, you take your fixed expenses and multiply by 3. If you have this amount of cash or credit available, then you should be fine since you have 3 months of expenses covered in a worse-case scenario.
4. How is your portfolio doing? I am shocked when people don’t know approximately how much money they made or lost in their portfolio. You don’t have to be like us bloggers and know your net worth to the nanosecond. Pick a date every year, look at your portfolio from the same date last year and figure out how much you made. Can’t tell because you made contributions? Most institutions now do the math for you so request it (this also gives you an excuse to call your investment advisor and ask questions about what they did for you the previous year).
5. How is your asset allocation? Asset allocation refers what you hold in your portfolio whether it is cash, bonds or stock. Asset allocation is a whole discussion in and of itself but keep this fact in mind: studies show that 85% of your portfolio’s return is determined by asset mix (see Kirzner and Croft, Protecting Your Nest Egg). Middle Class Millionaire previously wrote a very concise summary on asset allocation. Again, if you have an investment advisor, this is the perfect time to call them up and have a discussion on where your portfolio is going.
6. Are you paying too much tax? The blogging world has a mantra that if you get a tax refund, you paid too much tax since a tax refund is really an interest-free loan to the government. I agree and disagree with this viewpoint (I didn’t have time to address this topic this year) but the larger question to me is do your tax returns show you are consistently receiving a refund of approximately the same amount? If you are, you would make better use of your time not complaining about the inherit unfairness of the tax system but doing sometime about your own situation (again, don’t file your taxes and put them away- look at them carefully and compare it against previous years). If you are receiving a refund year over year in the same amount, adjust your with-holding tax. Go to HR and tell them you want to with-hold less tax in the amount of your refund (for a more detailed how to in Canada, see comment 6 in Canadian Capitalist’s post about taxes refunds).
7. Update your resume. I am not sure I have to elaborate on this point but the more we do the less details we remember so update your resume even if you are not looking for a job. A resume is like a line of credit; have it ready before you need it.
8. Review how much passive income you are making annually. Tina Fey’s character in 30 Rock once said something funny to her boss (who, I gather, is super rich in the show) which sticks in my head even though I don’t watch the show- to paraphrase: “I need you to show me that thing that rich people do where they take money and make more money with it…” That’s how passive income is produced in a nut-shell. The more you have, the less you have to worry so start tracking how much interest, dividend, rental and other income you are making and then figure out ways to make money off your money.
9. Is it time to find new advisors? I have a post on this topic this week but too many people stick with advisors they don’t like/are not good fits because when they need an advisor, they don’t have any time to look for new ones. Take time to figure out whether your advisors are doing what they are supposed to well before you need to call them.
10. Are you getting where you want to go in life? If not, why not? The often quoted definition of insanity is doing the same thing and expecting different results. Are you getting closer to your goals? If not, what changes can you make to help you along because if you are going side-ways or backwards clearly what you are doing is not working.

I picked July 1 as my check-up date because my taxes are filed, half the year is over (meaning there’s enough time in the rest of year to make adjustments) and things begin to slow down come summer.

Did I miss anything in the check-up? If so, please share. Thanks.

Just an odds and ends Friday, where I clean out various items across my blogging desk:

1. As pointed out by one of the commentators, question 7 in yesterday’s Debt Management and Savings Test, asked about the size of retirement contributions which did not consider that those in their 20’s and 30’s may not have worked long enough to be eligible to contribute $50,000 to their retirement portfolio. Thus, in lieu of that question, give yourself one point if contribute 6.8% or more of your gross salary to your retirement portfolio annually (the 6.8% figure is from a 2001 study from the Employment Benefits Research Institute and the Investment Company Institute). I’ll try to come up with some new tests and quizzes in the future.
2. I am becoming a carnival junkie. This week I was privileged to be the Carnival of Personal Finance hosted by Lazy Man and Money. Thanks for hosting Lazy Man (although if you did work to host, are you really that lazy?)
3. I mentioned as a side-comment in a previous post that revealing your salary at work causes more problems than solves them. This article writes on this issue and how the Facebook generation has no issue revealing their salaries publicly. The comments are amusing since, after the writer talks about all the trouble caused about revealing salaries, various commentators post their salary (or at least their salary range).
4. Michael James on Money ran an informal poll on what interest rates people are paying on unsecured line of credits. How do you compare?
5. Dividends4life muses about questions you should ask before you invest in anything.

Have a good weekend. On business travel next week, expect a lighter than usual posting schedule.

Yep, I am giving all of you, dear readers, a quiz on your debt management and savings practices. The rules are easy; There’s 10 questions. For every question, you give yourself one point if you answer it “right.” A 10 is a perfect score. Some of the questions are based on conventional standards of debt management and savings and others are just personal rules for me. Here we go…

1. DEBT MANAGEMENT. When you apply for a loan, a financial institution looks at your debt-to-income ratio (in other words, how much of your gross income you use to pay debt). The first ratio is known as the front ratio and measures the cost of carrying a home (mortgage payment, home insurance, municipal taxes, mortgage insurance premiums and condo fees if applicable) as a percentage of your gross income. To calculate your front ratio, add up the cost of carrying shelter and divide by your gross income monthly. For example, if your shelter costs are $1,500 and your gross income monthly is $4,000, your front ratio is 37.5%. If your front ratio is 31 or less (the recommended ratio according to the Federal Housing Administration in the U.S.), score one point (good luck Vancouver-ites!).
2. DEBT MANAGEMENT.The second part of the debt-to-income rati0, the back ratio, measures your total debt load (the front ratio plus credit card payments, car loans, student loans, LOC payments etc) over your gross income. Using the above example, if your housing costs are $1, 500 and all other debt is an additional $500, your back ratio is 50% ($1500+$500/$4,000). If your back ratio is 43 or less (i.e. you spend 43% or less of your gross income on debt), score one point.
3. MORTGAGES. The Millionaire Next Door (one of my favorite personal finance books) recommends that to achieve financial success never purchase a home that requires a mortgage that is more than twice of your household’s realized annual income. In other words, if your household income is $75,000, never carry more than a $150,000 mortgage. Score one point if your mortgage is 2 times or less of your household income.
4. AUTO EXPENSE. The Bureau of Labor Statistics reported in 2005 that all households spent on average $8,344 in automobile expenses (gas, car loan, insurance, repairs, fuzzy dice etc.); that’s a lot of money on a depreciating asset. Score one point if you spent less than that (you may have to ball-park this).
5. CREDIT CARDS. The median (not average) amount of credit card debt in the U.S.A. is estimated to be $1,900. Score one point if you have credit card debt of less than $1,900.
6. CREDIT CARD BALANCE. A debt ratio on your credit card means how much of your credit limit has been used. For example, if you have a credit card limit of $5,000 and you use $3,000 of it, your debt ratio is 60%. A debt ratio of over 50% lowers your credit score. Score one point if your debt ratio on your credit card is less than 50%.
7. RETIREMENT CONTRIBUTION. In 2005, the CA Magazine (a magazine for accountants) estimated the average retirement portfolio was $50,000. Score one point if your retirement portfolio is over $50,000 (if you have a pension, lucky you, and score a point since the average pension for public sector worker is worth $500,000).
8. SAVINGS RATE. Score one point if you save 10% or more of after-tax income (and kudos to you if you make it automatic). For reference, most experts agree that a 15% savings rate makes you comfortable and anything over 20% savings will, over time, give you financial independence.
9. MINIMIZING TAXES. According to the Millionaire Next Door, the average American pays 11.6% of their net worth annually in income tax. In other words, if your net worth is $200,000, you are paying $23,200 annually in taxes. The best way to reduce this ratio is to put your money in appreciating assets and hold onto them (since you are only taxed upon sale), tax-free instruments (i.e. municipal bonds) or invest in assets that produce tax-friendly distributions (i.e. dividends). Score one point if you pay less than 11.6% of your net worth in taxes annually.
10. CASH ON HAND. Score one point if you have cash on hand or unused line of credit equal to three months of fixed expenses.

Add up your score, if you scored…

0-2: Nowhere to go but up. Tackle things one step at a time. Most of all, stay positive.

3-5: Need work but you have a foundation to work on.

6-8: Great work, you are well on the way to financial success

9-10: what are you doing reading this blog? Don’t you have your own island to tend to?

I scored an 8. How did you do?

Million Dollar Journey posted in December of last year a comparison of the listed net worths of bloggers and it is still generating comments! If nothing else, it shows our natural curiosity (or our innate sense of nosiness) on how much people make or are worth. But, as is often commented on by others, net worth does not give a true indication of wealth in and of itself. It is merely a balance sheet value which is only really worth something if you liquidated all your assets. Many American found this out the hard way recently; as paper millionaires, their net worth was dependent largely on paper gains on their real estate holdings. Once that valuation collapsed so did their net worth (assuming they valued net worth of real estate at market value and not price of acquisition).

What, then, is a true determination of wealth? The “get rich quick” industry, for lack of a better term, certainly presents a viable measure of wealth: true wealth is determined by how long you can survive without any employment income. In other words, how long can you live on your investments? This concept of wealth has certainly been seized upon by Robert Kiyosaki, author of the Rich Dad Poor Dad series of books, as the true indicator of wealth and used as a selling tool into why people should invest in real estate (although one suspects he’s backed away from such naked support of real estate investing in this day and age).

It certainly makes sense to me from a business perspective. Business need assets to survive just like we do but businesses who do well generate the most of amount of cash from the money invested. This is typically business activities which require the least amount of effort. That is why businesses are moving away from labor intensive ventures (such as retail banking for financial institutions or traditional manufacturing for industrials) to ventures which can make money with smaller amount of employees or employs technology for operational efficiency (hence, explaining the rush for financial institutions be deal- making investment bankers). No one would argue that Bear Stearns was asset rich; its undoing was that it didn’t have enough short-term cash to get through the crisis.

On the personal finance level, and to extend this analogy, the business of “you inc.” requires more focus on activities that make you money with smaller effort than the traditional job. This would involve investing money into dividend yielding stocks, stocks that pay interest or return on capital, cash flow from real estate or returns on investments on private business.

Anyone have any other definitions of financial wealth?

There’s an inside joke among lawyers that you basically have to set your workplace on fire before your employer has cause to fire you - and, even then, there’s no certainty that may happen! The point being that, in this day and age, employment law for most white-collar workers is quite employee friendly. However, because of the feelings of inadequacy and rejection most terminated employees feel (regardless of whether such dismissal is with or without cause), this group of employees tends to feel they have no leverage when it comes to cutting a good deal upon dismissal (now I am taking about being dismissed as part of a larger slow-down in business). What’s the worse that happens if you negotiate your exit? They can fire you? They already did.

Most quasi-progressive to progressive employers want to appear to be humane in dismissing employees. There’s also a business rationale as well; if you land on your feet because of how your former employer treated you, you may have cause to refer them business sometime down the line. There’s always a few things you can do if you think you may be laid off or just been told you have been laid off:

Negotiate a deal before they swing the axe

If your employer is not doing great, and you have no reason to believe your job or department will be around as part of a down-sizing or you simply hate your job, negotiate your exit before they do it for you. Because a standard severance package has not been set yet, those who get to human resources first may be able to negotiate a customized severance package which is a little out of the box in its thinking (they pay for re-training as opposed to giving you conventional working notice, they give you a lump sum of money, they structure your exit to maximize tax savings etc).

I interned for the provincial government during the 1990’s when a third of the bureaucrats got axed. Those who voluntarily exited before they announced massive lay-offs tended to get better deals since you are not a number at that point but an individual who may be able to personalize their severance package.

Become a contractor

Related to the above point. To avoid the axe, volunteer to convert yourself from an employee to a contractor and save your ex-employer paying your employee benefits (a hidden costs employers obsess over). Again, do this before the axe comes down. Suitable more for industries where the labor market is very fluid (computer programmers comes to mind) rather than your traditional jobs (accountants, lawyers etc). This will allow you to make some income as a contractor while you try to figure out what to do next.

Do not sign a release until you see a lawyer- and ask them to pay for it

Most employers will present you a severance package and ask you to sign a legal release. Don’t sign it until you have reviewed it with a lawyer and ask your employer to pay for an hour of a lawyer’s time. Employer’s hate getting sued over employee grievances- lots of dirty laundry gets aired about the boss, the work-place and the powers that be. It becomes a public mud slinging contest. An employer would much rather pay a few hundred dollars to give you piece of mind than engage in tens of thousands of dollars in litigation. Typically given to middle management and up assuming you are not part of a massive layoff since a lawyer’s review basically consists of checking to see whether your severance is industry standard. If you are part of a massive layoff and are given the same package as everyone else, you don’t have that much leverage.

Ask what everyone else is getting

This is one of those socially awkward situations but if you are getting less than everyone else, there may be grounds to negotiate for more. If everyone got 2 weeks severance for 1 years of service and you only get 1, ask why you are being treated differently. Different in severance, where the different is less, is not good and grounds for some negotiations.

Employers get away with this because the natural human reaction is to isolate yourself once you have been rejected and not try to band together and compare notes. Think about being dumped; lot of people withdraw and lick their wounds. In this analogy, I am advocating calling all their old ex’s and comparing notes to make sure your dumping wasn’t worse than anyone else’s.

The little things to ask for to help you land on your feet

The goal after being laid off is to find a new job. If you are a real go-getter and want or need a new job immediately, there are a few things to ask for to help you with that goal:

• The obvious one is to obtain a letter of reference. Try to obtain 2 or 3. You never know if your boss is next in line. If your boss is lazy and asks you to write it for her, always remember to write the letter outlining a challenge at work, how you solved it and the result. Be specific and cite examples. It makes the letter sound less generic.
• Ask that they keep your voice-mail and email up for the length of your severance. It looks like you are still employed that way and employers like hiring employed people. Come to an agreement on what you can and cannot use those accounts for.
• Make sure that they extend your benefits for the length of the severance. Having access to health care or the gym (assuming it is not in your ex-employer’s premise) are always good things to have around during trying times.
• Ask human resources to give you a list of resuming writing centers and outplacement services if they don’t have one on hand.

These are tough concessions to negotiate because they are small in scope but a pain to administer so there’s a lot of resistance not from a legal/cost perspective but from a sheer laziness angle.

Hope that helps. Anyone care to share other tips?

Yesterday was the first anniversary of this blog. Kinda. I actually pre-wrote a bunch of posts and quietly posted them on blogger as a soft launch before an official unveiling on this site last year. Since I took down the blogger site, my recollection of the official launch date of this blog is hazy at best 225 plus posts later. This anniversary is equivalent to proposing to your spouse on public transit- everyone tries to forget it and substitutes a better story in its place (”it was a bus, honey, but on the way to the Eiffel Tower…”). Thanks for everyone who has read, linked, commented and provided suggestions over the year. Your support is greatly appreciated.

If I learned one thing in the year of blogging about personal finance, and at the risk of giving the owners of Seinfeld an idea to expand into financial publishing, it is to act like George Constanza.

I better explain.

My favorite Seinfeld episode of all time is the Opposite. George, at this point of the show unemployed and living at home with his crazed parents (”serenity now!”), comes to the realization that every instinct about his life is wrong and he decides, for the course of the episode, to do the opposite of what he would normally do. Of course, this all works out swimmingly for George, cumulating in the greatest pick-up line of all time: “My name is George. I am unemployed and I live with my parents.” He promptly gets a date out of that line/candid admission which leads indirectly to him getting a job with the New York Yankees.

How does this relate to personal finance? Through the course of blogging, I have learned or researched or been taught that almost every conventional truth about personal finance is wrong and the best way to get ahead in many instances is to do the opposite of what you are conditioned to do. The easy example is the often quoted mantra of “buy low, sell high” but think about all the other things we take as conventional wisdom that if we did the opposite we would be better off:

• You have to be fully invested- yet, most value mutual fund managers have upwards of 20% in cash
• You need a million dollars to retire- well, if I had Conrad Black’s life-style
• You can beat the market- really? Most professional can’t, what gives me the edge (yes, I am a new convert to passive investing- subject of a future post)?
• Be active in trading and invest in trends- sitting on your butt on blue-chip stocks would probably do you well over time
• Invest in mutual funds for a safe retirement- your mutual fund company will do well but, statistically speaking, you’ll do worse than the market and you are paying fees for that return
• real estate is the best investment- consider it shelter and no more; statistically speaking, less than 50% of real estate investors polled make money (this pool was taken before the real estate bubble burst)

… and, on and on and on.

I really think there should be a book called “Investing Advice by George Constanza” that applies George’s wisdom in the Opposite by listing all the major investing convention and tests them in a down to earth writing style and gives a verdict of “true” or “the opposite.” Donuts to dollars, I would suspect you see more “the opposite” than “true” verdicts. Just my pie in the sky idea.

Would you buy this book?

Here’s looking forward to another year of blogging. Thanks for reading.

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I am part of Rocket Finance’s carnival of P2P Lending with my post on the regulatory and compliance issues of the P2P lending industry. Thanks for Rocket Finance for hosting.

I noticed a lot of articles recently on finding a job, interviewing and doing more to make your job secure. Many of them are written from human resource consultants and offer great tips but does anyone ever ask what the boss thinks? I am currently a boss of three people. In the past, I have had employees who had a daughter 3 years younger than me (I would more accurately describe that working relationship as my assistant told me what to do and I obeyed), Generation Y employees, temps, my boss’ kid, employees who talked to much, employees who said nothing…in other words, I have been the boss of many types of employees.

…and you know what? I’ll let you in on a secret. I am still stunned people think I am in charge. Call it the impostor syndrome. But, outside questions of a technical nature, I get asked a lot of questions that completely stump me. If you ask your boss a question and they pause, they are probably thinking the same thing I am in a similar situation- how do I not sound stupid to a question I can’t answer? A lot of my friends who are bosses admit the same thing. There really is no “boss school.” A MBA teaches you great theory but being a boss require a lot of soft skills you develop through life experience- in other words, it can’t be taught and what you get promoted for (being good at some technical skill) is different than what you have to do after you are promoted (manage people): it is a really strange contradiction of business.

But, here’s what I learned about what makes a good employee:

• Be a work geek. You remember that Star Wars or Star Trek geek in high school? They knew EVERYTHING about the shows and would talk to everyone about it. Be the same thing at work. Know what you do better than anybody else. Its hard to replace someone who is that technically good at their job since a potential replacement would be that far of a step down.
• Make your boss’ life easy. Tell her the problem and how you intend to solve it. Make him look good in front of others. Figure out what your boss is terrible at and make that your strength (in other words, cover up for my weaknesses). Solutions, solutions, solutions instead of problems, problems, problems…If your boss has to solve all your problems, why does she need you? I will give you an example. My friend complains that his employee sees him every 10 minutes after an assignment is given to look over their work- why did he assign the work in the first place if he’s basically doing it for them?
• Reliability is sometimes worth more than talent. What drives boss’ insane are the employees with potential who coast at work; they are unreliable- which version will show up? The employee who delivers on potential or the one who coasts. If you are a sports fan, you know what I am taking about- the player who’s good enough to break your heart aka the “coach killer.” Bosses don’t necessarily need geniuses at work (cue the boss being stumped even more) but we like reliability. Doing what you say you are going to do goes very far in life and at work. Bosses like grinders (to use the sports analogy)- they know they will get into the trenches and work hard.
• Attitude counts. I sometimes hate corporate-speak. Being a “good team player” really means “people respect this person professionally and likes them personally.” Why can’t people write that? The issue is that an employee may be technically proficient but people hate them. This causes the boss a huge problem (you are not making my life easy- see above).  Bosses hate employees who complain what they don’t have (I don’t make enough, I don’t have enough responsibility, I want a promotion). I have seen employees with a good attitude who are reliable getting ahead faster than their more talented counterparts.

Anyone have any other tips?

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.