If It's Not Broken, Don't Fix It: The SEC's Regulation of Peer-to-Peer Lending
| Author | Carl E. Smith |
| Position | Attorney |
| Pages | 03 |
Page 21
Online peer-to-peer lending, a lending practice in which a group of lenders bypasses traditional financial intermediaries to directly fund a borrower's loan, has proven to be one of the more successful financial innovations to utilize the connectivity of the internet over the past decade.1 On November 23, 2008 the Securities and Exchange Commission (SEC or Commission) issued a cease-and-desist order2 against Prosper Marketplace, Inc. (Prosper) then the largest online peer-to-peer lender in the United States,3 finding that loans originated on its website were unregistered securities the sale of which violated Section 5 of the Securities Act of 1933 (Securities Act). A month earlier, Prospers competitor, LendingClub Corporation (LendingClub), emerged from a six-month quiet period during which it registered its loans as securities with the SEC.4
This article examines the SEC's decision to regulate the online peer-to-peer lending market in the United States. The first part of this article briefly summarizes the recent regulatory history of online commercial peer-to-peer lending, briefly reviewing the operations of Prosper and LendingClub and the Commission's finding that the loans offered on the lenders' sites are securities. The second part of this article argues that the SEC's decision was an unwise policy decision at this time. By requiring peer-to-peer lenders to register their loans as securities, the SEC erected significant barriers to entry that new market entrants must overcome, which dampened the benefits to consumers that access to a broader marketplace would provide and stifled innovation in the peer-to-peer lending market. Even if peer-to-peer lenders were engaged in regulatory arbitrage, the SEC should have allowed the status quo to continue to permit the maturation of the both the peer-to-peer lending market and its products.
Both Prosper and LendingClub use their online platforms5 to offer investors the opportunity to fund a third party's unsecured,6 non-recourse loan.7 On both sites, lenders can view information about the borrower, including the borrower's stated purpose for the loan and his credit history, and are provided an opportunity to ask the borrower for more information.8 The companies are the sole servicers of the loans, managing payments and collections.9 Borrowers may ask for loans between $1,000 and $25,000,10 and lenders may fund loans in increments of as little as $25.11 The two sites differ in how they set the interest rate of a borrower's loan. On Prosper' s website, lenders bid competitively to set the interest rate for a individual loan, subject to a minimum rate set by Prosper based on (1) a borrower's credit history and (2) an "in-house custom score calculated using the historical performance of previous borrower loans with similar characteristics."12 LendingClub employs its own formula, which essentially uses the borrower's credit score to set a base interest rate and then adjusts it according to various criteria in order to set the final interest rate for a loan.13 Both generate revenues through origination and servicing fees.14
Both companies use WebBank, an FDIC-insured Utah chartered industrial bank, to facilitate their transactions.15 When a borrower's request for a loan is funded successfully, both companies move an amount equal to the principal amount of the loan from the individual lenders' prefunded accounts into an account maintained at WebBank.16 A promissory note is then endorsed to WebBank by the borrower.17 WebBank then disburses the loan proceeds to the borrower and receives a loan agreement in favor of WebBank from the borrower.18 WebBank then endorses the promissory note to either LendingClub or Prosper, as the case may be, and assigns the borrower's loan agreement to thePage 22company.19 In effect, WebBank acts as a conduit for the funds in order to allow the peer-to-peer lenders to offer services on a uniform basis to borrowers and lenders throughout the United States.
In short, the peer-to-peer lenders operate essentially in the same manner, with the exception of how the interest rate for a particular loan is set.
The Commission concluded that the notes offered on Prospers site were securities under the Supreme Court's precedents in SEC v. W.J. Howey Co.,20 and Reves v. Ernst & Young.21 Due to the similarity of Prospers and LendingClub's operations, it is safe to assume that the SEC's conclusions regarding the loans will apply equally to LendingClub.
Under Howey22 an investment contract is present where "the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others."23 Investment contracts are securities regulated under Section 2(1) of the Securities Act, and subject to registration requirements of Section 5(a) of the Securities Act.24
The Commission determined that the notes were investment contracts as defined in Howey25 The Commission dispensed rather easily with the requirement that an investment of money was involved26 and concluded that a common enterprise existed on the grounds that lenders and borrowers:
• relied on Prosper to be able to initiate new loans and to service existing loans;
• relied on Prosper to continue to operate the lending platform; and
• paid fees to Prosper.27
In addition, it concluded a common enterprise existed because "the vast majority of Prosper loans are funded by more than one lender and because the majority of lenders fund more than one loan."28
With regard to the requirement that the investment's potential profits come from the efforts of others, the Commission concluded that since borrowers and lenders were unable to transact business directly with one another, they were wholly dependent on Prospers efforts to make a profit.29
The Commission also determined that the notes offered on Prospers site were securities under the Supreme Court's ruling in Reves30 In Reves, the Court adopted the "family resemblance" test to determine if a note of longer than nine month's duration is a security.31 Such notes are presumed to be securities unless they bear a "strong resemblance" to a list of non-security notes listed in the opinion.32 Analysis of whether a family resemblance exists involves applying a four-factor test that examines (1) the motivations of the buyer and seller,33 (2) the note's "plan of distribution,"34 (3) "the reasonable expectations of the investing public,"35 and (4) the existence of a risk-reducing factor, such as an adequate alternative regulatory regime.36
The note is likely a security when a seller's motivation is to raise capital for "general use of a business enterprise or to finance substantial investments" and where the buyer's primary motivation is an expectation of profit.37 In contrast, the exchange of a note "to advance some...commercial or consumer purpose" is less likely to involve the sale of a security.38 The Commission concluded that Prosper lenders were largely motivated by profit.39 It did not address the buyer's motivation.
The note is also more likely a security if it is "offered and sold to a broad segment of the public"40. On the basis of this language, the Commission concluded that offering the notes on the internet—regardless of buyers' financial sophistication— constituted an adequately broad offering to find that the Prosper loans were securities.41
The reasonable expectations of the public can be determinative in analyzing whether a given note is a security.42 Marketing a note as an "investment," in particular, can create the public impression that a given note is a security.43 In concluding that a member of the public would reasonably expect that they were buying a security on Prospers website, the Commission pointedPage 23to a number of statements on Prospers website that compared its notes to other common securities and investing strategies.44
Regarding whether a sufficient risk-reducing factor existed to determine that Prospers loans were not securities, the Commission found that there "are currently no appropriate regulatory safeguards for Prosper lenders, such as those against misleading statements by a borrower... or against misleading statements by Pros-per."45
Thus, the Commission concluded, "the Prosper notes are securities under Reves because: (i) Prosper lenders are motivated by an expected return on their funds; (ii) the Prosper loans are offered to the general public; (iii) a reasonable investor would likely expect that the Prosper loans are investments; and (iv) there is no alternate regulatory scheme that reduces the risks to investors presented by the platform."46
Finding that Prospers loans were securities offered and sold without an effective registration statement in violation of Section 5 of the Securities Act, the Commission ordered Prosper to cease and desist in any future violations.47 Prosper complied with the Commission's order and did not offer lenders the opportunity to purchase notes on its site from October 16, 2008 until July 13, 2009, when it filed a registration statement with the SEC.48 Similarly, LendingClub shut down its lending operations from April 7, 2008 until October 13, 2008 in order to file a registration statement.49
So, both Prosper and LendingClub have now filed registration statements with the SEC. The individual loans sold on their sites are associated with...
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