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.