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.