RK&O RICHARDS KIBBE&ORBE LLP
December 9, 2015
J/ As marketplace lending migrates towards activities that more closely resemble
non-bank entities should anticipate that their activities will draw the scrutiny of the CFPB and other regulators ..."
New York Washington London
WILL THE REAL MARKETPLACE LENDER PLEASE STAND UP?
Understanding the Hidden Consumer Regulatory Risk for Hedge Funds
By Michael D. Mann and Margot Laporte
he recent growth of marketplace lending platforms has resulted in non-bank entities, such as hedge funds, engaging in activities that could conceivably be construed as consumer lending transactions. The Consumer Financial
Protection Bureau (the "CFPB") was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act") as an independent agency within the Board of Governors of the Federal Reserve System (the "Federal Reserve ") to regulate the offering and provision of consumer financial products and services and to enforce federal consumer financial laws against banks and other covered entities. 1 Currently, the CFPB does not have authority over non bank entities engaging in activities such as marketplace lending that do not constitute the offering or provision of financial products or services directly to consumers. However, as marketplace lending becomes more sophisticated, the line will continue to blur between the regulated consumer lending activities of banks and other covered entities, which include the origination, brokerage and servicing of mortgage, student and payday loans, and the unregulated marketplace lending activities of non-bank entities, which include the provision of liquidity to online lending platforms that originate loans to consumers.
In this memorandum, we outline the potential risks and theories of regulation for non-bank entities engaged in marketplace lending and suggest several areas where proactive policies and procedures implementing best practices in advance of specific regulatory guidance would benefit non-banks engaged, directly or indirectly, in the fast evolving marketplace lending industry.
As marketplace lending migrates towards activities that more closely resemble consume r lending, non-bank entities should anticipate that their activities will draw the scrutiny of the CFPB and other regulators in connection with consumer protection laws, even if those activities do not directly touch consumers. These marketplace lending activities could include financing loans to consumers,
Covered entities over which the CFPB has enforcement authority include: (1) any entity , and any service prov ider to that entity, that engages in offering or providing the following consumer financial products or serv ices: (a) "origination, brokerage, or servicing of loans secu red by real estate for use by consumers primarily f or personal, family, or househo ld purposes, or loan modific ation orforedosure relief services in connection with such
loans," (b) private student loans, or (c) consume r payday loans, Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 ("Dodd-Frank Act"), 12 USC§§ 5481(6). 5514(a)(1). 5514(c); (2) large insured depos itory institutions , large insured credit unions, and their affiliates and service providers that engage in offering or providing a consumer financia l product or service,id §§ 5481 (6), 5515(a). 5515(c),5515(d); and (3) servtce providers to a "substantial numbe r" of small insured depository institutions or small credit unions that engage in offering or providing a consumer financial product or service, Jd. §§ 5481(6), 5516(e).
R O I RICHARDS KIBBE&ORBELLP
purchasing and servicing loans to consumers originated by banks or online lending platforms, taking a controlling position in a chain of payday lenders, or engaging in other structured financial transactions that indirectly touch consumers. While non-bank entities may view their marketplace lending activities as removed from consumers, Congress, as well as federal and state regulators, have signaled a heightened focus on consumer protection, particularly in transa ctions involving sophisticated financial institutions.
On September 30, 2015, for instance, Lael Brainard, a member of the Board of Governor s of the Federal Reserve, advised an audience assembled at the Th ird Annual Community Banking Research and Policy Conference that banks should consider regulatory
compliance whe n purchasing consumer loans originated by online lenders, including whether the online lenders' origination, underwriting, credit and other practices raise any consumer protection risks. Governor Brainard noted that "some have suggested a need for regulators to ta ke a more active role in defining and enforcing standards that apply more broadly to [the online lending] sector."2 While the Federal Reserve, the CFPB and other regulators supervise the banks to which Governor
Bra inard directed her remarks, non-ba nk entities engaged in marketplace lending should proactively monitor the increased regu latory focus on the duty of banks that purchase loans originated by online lenders to comply with consumer protection regulations3
Because the CFPB has not, as of yet, regulated non-bank entities engaged in marketplace lending, there is an absence of market-wide consumer protection-related best practices in this industry. This void leaves the industry open to significant regulatory and reputational risk, both because it increases the likelihood that the CFPB and other regulators w ill turn their focus to these marketplace lending practices, and because it may leave
non-bank entities unprepared to address the regulators' expectat ions in the event that their practices are subject to scrutiny. Accordingl y, we recommend that non-bank entities should, first, implement interna l risk-based best practices with respect to consumer protection laws and regulations in connect ion w ith their marketplace lending programs; and second, be cognizant of the risk that regulators might regard their involvement in the
marketplace lending space-whether as a loan purchaser or as a financing party to, or investor in, marketp lace lending platforms-as having crossed the line from disinterest ed investing to consume r lending.
THEORIES OF POTENTIAL RISK AND REGULATION FOR NON-BANK ENTITIES ENGAGED IN MARKETPLACE LENDING
Recent developments suggest severa l lenses through which the CFPB a nd other regulators might one day view non-bank entities engaged in marketplace lending as subj ect to enforcement jurisdiction. The CFPB and other regulators could,for instance, seek to hold non bank entities that engage in activities that directly or indirectly affect loa ns to consumers responsible for violations of consumer protection laws under a theory akin to aiding and abetting. Regulators a lso could seek to enforce consumer protection laws against non-bank entities that finan ce or purchase and service consu mer
loans under the theory that the non-bank entity, and not the originat ing bank, was the "true lender " in the lending transaction. These theories are discussed in greater detail below, but they are not the only ways in which the CFPB and other regulators may seek to broadly enforce consumer protection laws in the fut ure.
Under a n "aiding and abetting" theory of liability, the CFPB may seek to assert enforcement ju risdiction over hedge funds a nd other non-bank entities that engage in marketp lace lending activities by alleging that the non bank entity aided and abetted a covered entity, such as
Lael Brainard, Member, Board of Governors of the Federal Reserve System, Community Banks, Small Business Credit, and Online Lending,Address at the Third Annu al Communi ty Banking Resea rc h a nd Policy Conference (Sept. 30, 2015).
Of particula r note, on October 29, 2015, Santander Consumer USA announced its intention to sell its entire personal lending portfolio. Press Release Santa nder Consumer USA, Santander Consumer USA Holdings Inc. Reports Third Quarter 2015 Results (Oct. 29, 2015). It has been reported that Santander Consumer USA had entered into an arrangement with Lending Club in March 2013 to purchase up to 25 percent of the loans it originated, but exited the arrangement aher receiving "regulatory pressure" from the Federal Reserve regarding the level of risk. See Ben McLannahan,Lending Club Delive rs Earnings Rebuke to Bears, Financial Times, Oct. 29, 2015; Sa ntander Halts Unsecured-Loan Initiative,Asset-Backed Alert (Nov. 6, 2015).
a loan originator, in violations of consumer protection laws. The CFPB's broad enforcement authority to prevent covered entities and "service providers"4 from committing or enga ging in unfair, deceptive or abusive acts or practices ("UDAAPs") under federal law in connection with any tr ansaction offering or providing a consumer financial product or service means that non bank entities could be held responsible for aiding and abetting a wide range of prohibit ed conduct under the broad UDAAP standard.5
In particular, the CFPB's February 24, 2014 Conse nt Order in the Matter of 1st Alliance Lending, LLC6 raises questions about the types of activities that could subject non-bank entities engaged in marketplace lending to scrutiny by the CFPB. In this case, followin g a self-report by a mortgage lender, the CFPB imposed a civil monetary penalty on the lender for having paid
unearned settlement fees to a hedge fund that at one time had financed its mortgage loans, in violation of the Real Estate Settlement Procedures Act. While the CFPB did not charge the hedge fund in this case, it is possible that the CFP B could, in the future, seek to hold hedge funds and other non-bank entities that finance problematic consumer tra nsactions responsible for
aiding and abetting violations of consumer protection
With respect to the "true lender" theory, recent developments in litigation regarding w hether non-bank entities or third-party service providers were the "true lenders" in the context of state usury and other consumer protection laws could provide a nother lens through which the CFPB a nd other regulators might consider whether entities that engage in marketplace
lending could be subject to consumer protection laws. In CashCa/1, In c. v. Morrisey?, for instance, the Supreme Court of A ppeals of West Virgini a affirmed a circuit court decision finding that CashCa ll, Inc., a California-based
consumer finance company that purchased, marketed and serviced high-interest loans from First Bank and Trust ("FB&T"), was the "true lender" for purposes of state usury and consumer protection laws. FB&T, a South Dakota-chartered bank supervised and insured by the Federa l Deposit Insurance Corporation, made sma ll, unsecured loans at high interest rates to consumers in various states. Pursuant to marketing agreeme nts with FB&T, CashCall purchased FB&T's loans within three
days of the loans' origination dates. FB&T retained the
or igination fees and all interest accrued prior to CashCall's purchase of the loans.
Focusing on an examination of which entity had the "predominant economic interest" in the transactions, the appeals court affirmed the circuit court's conclusion that Cas hCall, and not FB&T, was the "true lender " in this case. The appeals court cited the circuit court's findings that: (1) CashCall 's agreements with FB&T placed the entire moneta ry burden and risk of the loan program on CashCall; (2) CashCall paid FB&T more for each loan than the amount fina nced by FB&T; (3) CashCall's sole owner and stockholder persona lly guaranteed all of CashCall's financia l obligations to FB&T, including the amounts of the loans prior to CashCall's purchase; (4) CashCa ll agreed to indemnify FB&T against a ll losses arising out oftheir agreement, including any cla ims asserted by borrowers; (5) CashCall
was under a contractual obligation to purchase the loans originated and funded by FB&T only if the loans were approved pursuant to CashCa ll's underwr iting guidelines; and (6) CashCall treated the loans as if it had funded them for purposes of fina ncial reporting.
Extrapolating from this analysis, the CFPB and other regulators could seek to ho ld non-bank entities engaged in marketplace lending responsib le for problematic consumer lending transact ions under the theory that the non-bank entity was the "tr ue lender" in
The Dodd-Frank Act defines a "service provider" as "any person that provides a material service to a covered person in connection wit h the offering or provision by such covered person of a consumer financial product or service." Dodd-Frank Act, 12 U.S.C. § 5481(26). Hedge funds and other non-bank entities that purchase and service consumer loans risk being rega rded by the CFPB as "service providers" to the covered loan originator, and thus potentially subject to CFPB supervisory and enforcement authority.
5. See id. § 5531(a).
Consent Order, In the Matter of 1st A lliance Lending, LLC, CFPB No. 2014-CFPB-0003 (Feb. 24,2014).
CashCall, Inc. v. Morrisey, No. 12-1274, 2013 W. Va. LEXIS 587 (W. Va. May 30, 2014), cert denied, 2015 U.S. LEXIS 2991 (May 4, 2015).
which the arrangement directly or indirectly touches consumers and any consumer protection related risk to which the non-bank entity may be subject as a result;
Based upon the results of this risk assessment,
procedures to mitigate any consumer protection
related risk, which may include:
understand and consider where their marketplace lending activities could one day subject them to scrutiny by the CFPB, will earn dividends in reduced regulatory and reputational risks and costs in the event that the CFPB and other regulators target their marketplace lending practices in the future.
0 Structuring the transaction to reduce exposure to consumers, as appropriat e, including in consideration of the "true lender" ana lysis
MORE TO COME...
discussed above, or
0 Negotiating the third party contract to include policies, procedures and controls that are designed to address compliance, including with respect to consumer protection laws and regulations. These contractual provisions
sho uld include appropriate consequences if
the third party violates any compliance-related responsibilities, including by engaging in unfair, deceptive or abusive acts or practices;
Ongoing monitoring of the third party, including
with respect to its compliance with consumer protection and other laws and regulations; and prompt action to address any issues that may arise, including termination of the relationship, if appropr iate;
Effective and ongoing monitoring of any
consumer loans financed or purchased, potentially including an appropriate investment in evolving technologies that can efficiently and periodically "re-underwrite" consumer loans in real time to detect deficiencies and predict problem loans,
whil e evidencing to regulators that forwa rd
looking, risk-based controls were in place at the time the loan was acquired and have been continuously maintained; and
Appropri ate documentation of the policies a nd
procedures undertaken with respect to each
We are currently working with many parti cipants in the
marketplace lending space, including helping investors form funds to invest in loans originated by marketplace lending platforms. In assisting these clients with their investment programs, we encounter many of the issues discussed above. In a fu ture article, we will discuss the practical implications of the issues discussed above in the context of funds mak ing investments in these assets.
If you have questions regarding the matters discussed in this memorandum, please call your usual contact at Richards Kibbe & Orbe LLP or one of the persons listed below.
Michael D. Mann Washington, D.C. 202.261.2990
Margot Laporte Washington, D.C. 202.261.2969
Non-bank entities, including hedge funds, that incorporate consumer protection-related best practices into their marketplace lending programs now, and that
This distribution may be considered advertising under
applicable state laws.
This distribution is provided by Richards Kibbe & Orbe LLP for educational and information purposes only and is not intended and should not be construed as legal advice.
©2015 Richards Kibbe & Orbe LLP, 200 Liberty Street, New York, NY 10281/212.530.1800 I www.rkollp. com All rights reserved. Quotation with attribution is permitted. If you would like to add a colleague to our mailing list or if you need to change or remove your name from our mailing list, please email publications@rkollp .com.
Any advice concerning United States Federal tax issues provided in this memorandum is not intended or written to be used, and cannot be used by any taxpayer, for the purpose of (i) avoiding penalties that may be imposed on the taxpayer or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.