This special edition of the Financial Services Law Newsletter includes a series of blog posts written by Peer-to-Peer Lending and Crowdfunding partner Brian S. Korn for the LendItUSA 2015 conference to be held April 13-15 in New York, NY. For more information on Manatt’s Peer-to-Peer Lending and Crowdfunding Practice, click here.
Top 5 Issues in Consumer P2P Law and Regulation
Though now several years old, peer-to-peer lending (P2P) has rapidly come of age in the past two years as loan volumes and investment accounts have spiked significantly. This past year saw the first few IPOs in the space along with eye-popping loan purchase and equity commitments for public and nonpublic platforms alike. LendIT 2015 finds the industry at an important crossroads—startups and established companies compete for loan volume, specialty platforms are emerging to capture niche borrower pockets in the large-purchase space, and technology and innovation are highly valued by investors, platforms and service providers. Origination and quality underwriting—two “old world” concepts—can make the difference between success and failure. In the background, enhanced regulatory scrutiny and a possible change in the way regulators view the industry threaten to stop the music.
With this in mind, here are the top five things I think will be the most important issues in the consumer P2P space in 2015. This is not an exhaustive list or legal review, and certainly reasonable minds may differ on my inclusion/exclusion and prognoses:
Most consumer platforms opt to use a funding bank in lieu of obtaining a consumer lending license or bank charter. Unlike traditional banks, funding banks in practice leave much of the underwriting criteria, credit decisions and even funding to the platform. Borrowers are onboarded by the platforms and, within seconds of applying for a loan, receive a tentative decision which is seldom, if ever, changed. The bank’s role is to make the official credit decision and fund the loan with money advanced by the platform. The bank then holds the loan for at least 24 hours and then sells the loan to the platform, where it is either held by the platform or fractionalized through the issuance of “payment dependent notes,” which are recourse only to payments from the underlying borrower. Many refer to this as the “rent-a-charter” model.
Rent-a-charter is perhaps the oddest feature of P2P to one who discovers P2P for the first time. The cost structure of running a bank and restrictions on obtaining bank charters make hiring a bank a cost-effective way of originating a consumer loan. Besides licensing, rent-a-charter also allows for interest rate exportation of the funding bank to other states under the Full Faith and Credit Clause of the U.S. Constitution. What this means is that a rate that might be usurious in State A can be charged to a borrower in State A if the rate is legal in State B, the state issuing the funding bank its charter.
Challenges to rent-a-charter have come from outside the P2P world, most notably in the point-of-sale deferred finance world. Thus far, the model has defeated challenges. But new facts brought about in P2P or otherwise may change this important dynamic.
2. Payment Dependent Notes Part I: Debt or Equity?
Keen tax lawyers have elevated a point recently that calls into question whether the borrower payment dependent notes issued by platforms in order to fractionalize consumer loans are really debt or equity. A platform that is very thinly capitalized or with a limited track record may issue notes with a face amount aggregating hundreds of millions of dollars. Putting aside the purported nonrecourse aspect of a payment dependent note, a question has been raised that debt issued by platforms with thin or no capital may really be issuing equity, since a significant aspect of the collectability of the note involves platform business and sustainability risk. This matters to investors who are recording the assets as debt on their balance sheets. It also matters to platforms that are deducting interest payments from top-line income. Moreover, for overseas investors, characterizing notes as equity may give rise to pass-through income, which might subject them to U.S. tax or U.S. tax reporting requirements. As always, check with your tax advisor.
3. Payment Dependent Notes Part II: IPO Preemption?
As more platforms engage in equity IPOs, a question has been raised as to whether payment dependent notes issued by the issuer or its wholly owned subsidiary would preempt state blue sky laws, possibly opening up public debt crowdfunding to all 50 states and DC. Under the Securities Act of 1933, as amended, state securities laws are preempted by federal law for securities listed on a national securities exchange and those securities pari passu or senior to the listed securities. The big question is whether companies listing common stock will be able to obtain preemption on their payment dependent notes. The issue is still unclear and several states have expressed doubt that a payment dependent note is truly pari passu or senior to common stock, notwithstanding the notion that debt is senior to equity. For instance, assuming the nonrecourse aspect of the payment dependent note is respected, a holder would not recover assets in a bankruptcy of the platform ahead of creditors or even common stockholders of the platform. If the borrower does not pay, the holder receives nothing. The mechanic of payment dependent notes is to make them separate and distinct from platform risk. This cuts both ways, however, and if they are treated as truly separate, they should not be able to be combined back for purposes of federal preemption.
Of course, there are 51 different opinions on this matter, and the state securities regulators are already fighting anti-preemption battles in the crowdfunding and Regulation A+ worlds (Titles III and IV of the Jumpstart Our Business Startups Act of 2012, or JOBS Act, respectively). So do not expect them to give up without a fight.
4. The IPO On-Ramp and P2P
Title I of the JOBS Act is informally referred to as the “IPO on-ramp.” The IPO on-ramp allows companies that have less than $1 billion in revenue to qualify as “emerging growth companies” (EGC) and take advantage of some reduced compliance and disclosure regulations in connection with going public, including:
- Confidential registration statement filing and review by the SEC
- “Testing the Waters” meetings with prospective investors pre-SEC filing
- Ability to opt out of Sarbanes-Oxley Section 404(b)—the costly auditor attestation requirement
- Reduced financial and compensation disclosures
- Research can be published prior to and during the offering
As platforms consider an IPO, it is important to think through the process carefully and understand the recent reforms and changes to what it means to be a public company. Platforms that are current public debt filers, such as public payment dependent note issuers, can still elect EGC status in connection with their IPO, even if their debt went public prior to the December 8, 2011, EGC cutoff.
Speaking more broadly, IPOs in P2P mean more disclosure and added research analyst and public investor scrutiny of platform P&L. This added dynamic and pivot—from managing to scale to managing for profitability—will add an important dimension to the industry, which is still largely in private hands. It will be interesting to see if public P2P companies show markedly different behavior from their private company counterparts.
5. Regulatory Collaboration Will Continue to Rule the Day
Regulators of the U.S. P2P industry are somewhat fragmented among banking, securities, investment funds, trade and consumer protection agencies and groups—federal, state and local. Many platforms and platform advisers have done a masterful job “threading the needle” between and among various regulatory controls—all in ways that are perfectly legal. The challenge for P2P regulators is to be able to effectively apply old law and cases to new technological developments and ways investors will invest. Many regulators have a view that investor protection, above all, must be achieved, and that substance over form will rule the day. Regulators also need to maintain flexibility to pounce on situations where investors are harmed by unsavory tactics or put at undue risk. We have already seen an enforcement case in the crowdfunding world against a platform that clearly crossed several double-yellow lines in the road (see In the matter of Eureeca Capital SPC). The P2P industry would be well-advised to continue to work and collaborate with regulators in order to manage expectations on both sides. In addition, legal counsel should be sought to guide platforms and investors in navigating difficult judgment calls and potential gaps of interpretation that might exist in the P2P world.
One reason P2P has been spared the harshest enforcement cases and indictments is that borrowers, platforms and investors are (up to now) coexisting in an environment of noncoercion and disclosed outcomes. P2P serves a great purpose in rebuilding our economy, especially with credit-worthy borrowers who cannot get adequate credit from traditional lending sources. Platforms are bona fide financial services technology disruptors. At the same time, investors are managing to “as advertised” returns and default rates. Collaboration is key to continuing to make things work smoothly, and to be fair the largest platforms are shouldering the most work in this regard. Payday lending and mortgage reform have offered the industry a nice regulatory diversion for now. But as rates creep up and borrower FICO scores get lower, whether that buffer holds remains to be seen. The other big unknown is the Consumer Financial Protection Bureau, which has yet to flex its muscle in P2P. Participants in the market should feel good about the progress that has been made to date, but the true test of market permanence will come from how it manages through the next market cycle.
Top 5 Issues in Real Estate P2P Law and Regulation
The P2P land grab is on. Traditional sources of credit are being replaced with new platforms and credit providers. Offline lenders are developing an online presence. New platforms have seemingly been around for years. Above all, competition for borrowers and investors is fierce. On the horizon are battles over leverage and the need to scale, scale, scale. In the midst of this frenzy is a potential legal and regulatory powder keg. Here are my top five legal and regulatory issues in the P2P real estate sector:
1. Don’t IRRitate Investors
Often real estate transactions quote investors a projected internal rate of return. These IRRs are based on the developer or borrower executing on a business plan in accordance with a budget. Budgets are usually created by the developer and might have embedded assumptions. Assumptions should be realistic and grounded in the borrower’s and platform’s reasonable expectations. If no improvements are made to the property, why do we think the lease rate will go from 50% to 95% in year one? There might be a good explanation for it, but make sure there is. I believe quoting an IRR—and leading sales discussions with projected IRRs—that are highly dependent on far-flung assumptions are quite likely to draw regulatory heat. Disclosure and transparency are of prime importance as the industry continues to develop. You are better off selling a deal a day or two later than luring in investors with return claims that you know cannot be achieved. IRR is more often used in equity deals, but be careful whenever you quote someone a projected return.
2. LTV vs. ARV? Let’s Call the Whole Thing Off!
Loan-to-value ratio (LTV) is a critical metric in evaluating whether to invest in a loan. As the name would suggest, it is the ratio of the amount of the loan to the value of the underlying secured property. LTV is usually based on a property appraisal or some other objective valuation of the property. Most platforms post loans with an LTV of 70% or less. What this means is that there is a 30% cushion on property devaluation where the lender is theoretically still fully secured.
Many P2P real estate platforms, however, publish an ARV(after-repair value). ARV is the ratio of the loan amount to the value of the property after the developer applies the proceeds of the loan and spruces it up. ARV asks one to project into the future and assign a value to the developer’s completed vision. It assumes the project can be completed on time and on budget, and that the market for the property in the future will be somewhat healthy with no macroeconomic downturns that affect value. There are good arguments for posting ARV—one might say that once the renovations are complete, the borrower should be given credit for the value of the property being sold, not the value today.
LTV, on the other hand, is more cynical- it assigns no value to repairs and assumes the property will not have appreciable gain. Essentially, in the worst case scenario, if the borrower uses the cash for something else, sits on the money, or the project cannot be completed at the projected level or on the projected timetable, this is the ratio of the loan to the property as-is. The point is that investors should be aware of the use of these ratios and be able to distinguish one from the other through clear and transparent platform disclosure. Regulators will not be kind to sharp or deceptive practices.
3. BPDNs Are Not Secured
Some platforms and investors ask me to clarify that borrower payment dependent notes (BPDNs) are secured. BPDNs are issued by platforms and track the payments received by the underlying loan. The loan from the borrower to the platform generally has a first lien security interest in the underlying property. The corresponding BPDN is an unsecured promissory note issued by the platform. The BPDN does not have a secured interest in the property. In addition, the BPDN holder does not have the right to exercise on the collateral in the event the borrower defaults on the loan. In fact, the BPDN purchaser actually takes two credit risks: first, that the borrower pays on the underlying loan; and second, that the platform (i) accurately records its lien position and enforces its interests on behalf of BPDN holders, and (ii) promptly and accurately tracks and distributes payments to noteholders. Also, many forms of BPDN do not allow for any noteholder recovery for three years after the first default, even if the platform is eventually made whole.
4. Finder, LeadGen and Promoter Issues
Many platforms employ or pay an external team to source transactions. This group is sometimes called “lead generators.” The legality of compensating a finder for sourcing transactions needs to be examined very carefully.
The biggest potential issues are whether the finder needs a real estate brokerage or lending license, and whether the finder is engaging in securities broker-dealer activities.
In general, if the finder does nothing more than relationship brokering, the activity would not need to be licensed and the finder and platform would not be subject to enhanced securities liability. This activity would be similar to an email introducing two people who do not know each other. Once the activity extends beyond pure relationship brokering, the concern is twofold. First, platforms and borrower finders should be careful that sourcing the loan does not require a real estate license. In some states, such as California, either the finder or the platform should have a real estate license or a finance lender license (if you have a CFLL, you do not need a CRE license).
Second, if the finder is used to recruit investors to platforms, care should be taken that he or she is not engaged in active sales and does not receive “transaction-based compensation” (TBC). The receipt of TBC has legal significance that may trigger the need to be a registered broker-dealer. In addition to broker-dealer issues, the promoter him/herself may have securities liability with respect to disclosures he or she makes or fails to make with respect to the investment.
5. States Are Focusing on Blue Sky Compliance
Recently states have come to realize that crowdfunding and P2P platforms are great sources of filing revenues. Reports of private placements that qualify under the safe harbor afforded by Rule 506 of Regulation D, which virtually every platform issuing BPDNs to accredited investors (as opposed to public offering platforms such as LendingClub and Prosper) uses, must be filed with the SEC on a Form D within 15 days following the closing. As an aside, the SEC has proposed but not adopted a mandatory “advance Form D” requirement in which a Form D filing would be required at least 15 days before the commencement of any solicited Rule 506 transaction.
Many states require a “notice filing” whenever a Form D is filed with the SEC which indicates that purchasers from that state participated in the transaction. These are required by state securities laws, or blue sky laws, for securities not listed on a national securities exchange. Filing fees for a transaction can run over several thousand dollars. For the small company that raises capital episodically through a Reg. D transaction once or twice a year, no big deal. But P2P platforms are essentially professional private placement companies that can complete several transactions per week. This creates a real drag on platform P&L.
There are a few ways platforms can save money on blue sky filings, such as by combining multiple transactions on the same forms, and by taking advantage of states that allow “issuer” filings rather than transaction filings. I expect states to become more aggressive in enforcing these filings, since states are losing ways to regulate other types of securities offerings as a result of recent and upcoming changes in federal law.
Top 5 Issues in Small Business P2P Law and Regulation
Probably the fastest-growing segment of the P2P universe is loans to small businesses. Whether it’s a term, revolver, interest-only bullet, merchant cash advance or factor, borrowers are flocking to online platforms in droves with the hope of landing a new credit product. Most experts agree that stricter bank regulations resulting from the credit crisis, Dodd-Frank and Basel III capital adequacy requirements have tightened bank lending to all but the largest clients. Banks want to lend to clients where they can obtain the greatest “share of wallet” by cross-selling other credit, trading and underwriting products. A market opportunity has therefore opened for small business lending that few can remember. Many believe regulators are prone to be more lax for small business lending than they are for consumer products. But proceed with caution; there are still plenty of ways to misstep. Here are my top five legal and regulatory issues in the P2P small business sector:
1. License? We Don’t Need No Stinkin’ License!
The licensing protocols for small business lenders are very different from consumer or even real estate lenders. Consumer platforms generally need to engage a bank to make loans to consumer borrowers. WebBank and Cross River Bank are examples of these funding banks (see my “Consumer Top 5” piece for more information). Small business platforms have more choices in their licensing approach than their consumer brethren. Only five states categorically require licenses for business lending: California, Nevada, North Dakota, South Dakota and Vermont. The process of obtaining a California Finance Lender License takes about nine months and can be a somewhat painful process.
All other states allow loans to business entities for a business purpose so long as loans are made for a minimum principal amount and/or a maximum interest rate. Some states do not have interest rate maximums for loans to small businesses. Some platforms have attempted to locate their underwriting, lending and collection efforts in lender-friendly states, most notably Virginia. States, however, will generally take the view that loans extended to borrowers are being made in the borrower’s state, absent physical travel to the lender’s state or other extraordinary acts to be present in the lender’s state. There are two main risks here: that an unhappy borrower will seek to enforce their home state’s laws in a dispute and that regulators will take a hard stance against out-of-state lenders.
2. WWABCD? (What Will a Bankruptcy Court Do?)
Considerable attention has been paid to the legal entity structure of commercial lenders and whether investors are buying loans in a “bankruptcy remote” fashion. Bankruptcy courts have very broad discretion to grant equitable relief—essentially throwing out the rules and doing the right thing. Even the most straightforward loan purchase agreement results in a 20-page reasoned “should” opinion. The fact is that prediction of judicial action is a fool’s errand. These cases will be inherently bespoke and specific facts and circumstances will rule the day.
The good news is that loan sales by a platform can be structured in a way that will bolster an investor group’s argument that their loans are not assets of the platform’s bankruptcy estate. The following factors can benefit an investor’s argument in this regard:
- Loans should be originated out of a subsidiary or special-purpose entity in order to remove the platform’s investors from regulatory risk
- The subsidiary should have an independent director if possible
- Investor and platform should be unrelated entities
- Loan purchases should be done on an arm’s-length basis
- Sold loans should be custodied in an account in the purchaser’s name
3. Personal Guaranty—What Is It Really Worth?
Small business loans most often include a personal guaranty from a founder or chief executive officer. The guaranty provides that the entrepreneur will pay the loan in the event the business fails. The guaranty also usually grants a lien on the assets of the guarantor for the benefit of payment of the loan obligations. Unlike consumer loans, small business loans are underwritten on the basis of business financial statements and prospects.
The personal guaranty serves a few functions. First, and most importantly, it serves as a backup to the business loan. If cash flow is insufficient to support payments on the loan, the guaranty is the “stick” that ensures payments are made. Nobody knows what’s “really going on” like the entrepreneur. In the worst-case scenario, if the business falls flat on its face, the guaranty reverts the loan to an equivalent. Second, the guaranty is a line of defense against fraud. If the business is fictitious or grossly overvalues itself, the guaranty, properly executed, will keep the entrepreneur making payments.
A function of a proper guaranty is assessing what assets and financial resources the guarantor has, and what level of security interest the lender can obtain—are assets all encumbered by other obligations or can the lender obtain a first lien interest. Ease of collection should also be assessed. How portable are the guarantor’s assets? Finally, if the guarantor becomes the primary driver of the business loan—if the business loan could not be underwritten without the guaranty—consideration should be made as to whether the loan is really a consumer loan. If it is a consumer loan, bank licensing issues should be addressed.
4. Watch the Fees
A key aspect of small business lending regulation is the fees to be paid by the borrower. Typical fees are origination (paid by the borrower) and servicing (paid by the investor). Some platforms charge fees bordering on exorbitant when compounded or annualized. Special care should be taken that all fees are “reasonable,” and consistently and accurately charged with full upfront disclosure. When added with the interest, the origination fees should not exceed state usury caps of the borrower’s state. Also, if a platform charges other miscellaneous borrower fees, such as UCC filing fees, document, delivery, funding and loan maturity fees, these also need to be considered in the usury analysis. Again, disclosure is important.
5. What About the New Regulation A+—Can I Really Offer Investments to Non-Accredited Investors?
In mid-June, new Regulation A+ will take effect. Regulation A+ ushers in a new type of quasi-public offering that breaks the classic dichotomy of registered public offering or private placement. Regulation A+ is a novel opportunity for small business lending platforms to raise capital from both accredited and non-accredited investors without becoming fully registered public companies. Of note for platforms is the ability to register debt securities on a “delayed and continuous” basis, similar to registered shelf offerings under SEC Rule 415. Therefore, platforms will be able to file for the offering of payment-dependent notes under Regulation A+, even if such notes apply to different underlying loans and even if those loans are not yet originated.
Notes can be issued to accredited and non-accredited investors alike, with an investment maximum for non-accredited investors of 10% of annual income or net worth across all Regulation A+ transactions. Securities issued under Regulation A+ will be freely tradable. Regulation A+ looks to have potential to allow even more investors under the tent of marketplace lending and gives issuers more flexibility.