Few people following the crowdfunding space have been able to ignore the recent meteoric rise of online direct lending, often called “peer-to-peer” (P2P) lending. What started out as a simple one-to-multiple consumer lending solution has blossomed into a bona fide investment asset class that has attracted the attention of hedge funds, private equity funds, sovereign wealth funds, business development companies, family offices and other professional investment firms. Even banks are lending through peer-to-peer portals.
The borrower universe has diversified into secured and unsecured commercial loans, consumer loans, real estate financings, short-term receivables and other fields. The lending side has seen the development of creative investor structures that are tailored to meet the needs of both retail and institutional investors. Legally, many processes are well understood, but still more need additional guidance. In many cases, existing laws and regulations do not apply neatly to the online format, and new regulations from the U.S. Securities and Exchange Commission (SEC), the Financial Industry Regulatory Authority (FINRA) and states are being written on the fly, creating widespread confusion and misunderstanding (a prime example being the Oculus VR Kickstarter case).
With this in mind, and in order to commemorate David Letterman’s retirement, we have produced our own “top 5 list” that anyone intending to do business in this area should be mindful of before diving in. Our list is process-based, moving from origination to distribution and investment. From the home office of Pepper Hamilton LLP, we are proud to present “Top 5 Things You Should Know About Online Direct (P2P) Lending Law and Regulations — Before You Do Anything Else!”
1. I’m Not a Bank … And Don’t Want to Become One
P2P platforms may find it advantageous to enter into arrangements with banks pursuant to which the P2P can avoid being subject to state usury law limitations by taking advantage of the federal law preemption that allows banks to “export” their home-state interest rates and to not be subject to the borrower’s state usury laws. Such arrangements must be carefully constructed to ensure that the bank, and not the P2P entity, is deemed to be the “true lender” in such arrangements. A comprehensive program will ensure that the factors relevant to the true lender determination, including, among others, the control over underwriting criteria and credit decisions, the allocation of costs and expenses among the P2P business and the bank, and the purchase price of the loans, will weigh in favor of the bank as the true lender.
Keep in mind, however, that banks are more useful in the consumer context, which features much heavier regulation. In the commercial lending arena, platforms may be able to navigate the licensing and usury and servicing issues without engaging a bank. Which leads us to ...
2. Lender’s Licenses … Do I Really Need to Go Through All the Red Tape?
P2P businesses with commercial and small business lending platforms that do not wish to partner with banks will need to look to state licensing laws and relevant choice of law provisions to assist them in operating their business on a multi-state basis. Many states do not require lending licenses for commercial loans. For example, commercial loan providers are exempt from state licensing requirements in Delaware and Indiana. In other states – for example, New Jersey – licensing laws do not apply to commercial loans that are not backed by real property.
P2P commercial lenders may find it advantageous to rely on a single state’s lending license in order to lend in multiple states. For instance, some lenders have applied for a California Finance Lenders License and have subsequently relied on this license to lend in other states. The California Finance Lenders License application requires the applicant to provide financial statements showing that the applicant maintains a minimum net worth of $25,000, to obtain a $25,000 surety bond, and to allow the California Commissioner of Corporations to conduct background investigations of the applicant’s officers, directors, and shareholders. In addition, certain entities wishing to make commercial loans in California, such as licensed real estate brokers and licensed real estate mortgage lenders, are exempt from the California finance lenders license mandate. However, to the extent that a P2P commercial lender may wish to rely on the California finance lenders license in order to lend in other states, it may choose to apply for a California finance lenders license even if it is exempt from the requirement in California.
3. Securities Laws: Public Registration versus Exempt Offerings
The federal securities laws and regulations largely set the contours for investment in both entities engaged in peer-to-peer lending and the loans they extend to borrowers. The available strategies for obtaining investor capital which ultimately will fund peer-to-peer loans fall into two main avenues: (1) publicly tradable notes (SEC-registered) versus (2) exempt or unregistered investments by “accredited investors.”
Many of the largest players in P2P have taken the first route and have registered with the SEC, including Prosper and Lending Club. Much as described in Part 1, the Prosper and Lending Club approach entails the P2P platform pairing with a traditional bank that issues a loan to a borrower. The platform then buys the loan and issues its own promissory notes, in a back-to-back fashion, that pay out to investors (lenders) only if the borrower makes payments. The broadly marketed nature of the investment opportunity – among other things – has meant that the SEC interprets becoming a lender (i.e., purchasing a Prosper or Lending Club promissory note) as a securities transaction. In fact, Prosper was required to go on hiatus for the better part of a year while it registered its notes in 2008 on a Form S-1.
Public Registration / Form S-1
Under the Securities Act of 1933, as amended (the “1933 Act”), any offering of securities in the United States must be registered and issued with a specially regulated prospectus, unless an exemption applies. Public offerings (e.g., IPOs), including securities distributed to the investing public like P2P notes, must be registered. Not only is registration long and complex, “going public” imposes a costly obligation to make periodic disclosures and essentially live in the “glass house” of the public marketplace. Importantly, the issuer, its officers, directors and underwriters can be sued for any untrue statement of a material fact or an omission making the registration statement misleading (similar liability holds for the prospectus).
Whether for debt or equity, the process entails filing with the SEC of a lengthy registration statement (typically Form S-1)1 containing company disclosures including financial statements. The issuer also must respond to often extensive SEC comments to the S-1. Additionally, during the period of preparation of a registration statement, the company cannot publicly market its securities, requiring it to strictly curtail communications.
Fortunately, the Jumpstart Our Business Startups Act of 2012 (JOBS Act) has reduced some of these burdens for many – or most – P2P entities. “Emerging growth companies” (EGCs) with less than $1 billion annual revenue may pre-market their securities with institutional investors (“testing the waters”) and may submit their draft S-1 confidentially to avoid immediate public scrutiny. Likewise, only two years of audited financials are needed, among other advantages available to EGCs.
Another hurdle is that many securities – generally including P2P-type notes – which are not traded on a national securities exchange face not only federal but also state-level registration following the National Securities Markets Improvement Act of 1996 (NSMIA). Burdensome requirements in a number of jurisdictions all but prohibits the offering of P2P notes in such states.
In contrast, the long-awaited public crowdfunding provisions of the JOBS Act (Title III) are not yet available, as SEC rules have not been finalized. In sum, the maximum amount possible to be raised under equity crowdfunding in any 12-month period will be $1 million and the offering must be conducted through a broker or a regulated “crowdfunding portal.” We do not believe Title III crowdfunding will have a significant impact on the peer-to-peer marketplace, as the current market functions efficiently on one of three models: (i) public offerings (Lending Club, Prosper); (ii) private placements potentially using the new “advertised” private placement rules of the JOBS Act (Title II – see below); and (iii) whole loan sales that are exempt transactions, as they are generally not considered to be “securities,” and therefore neither subject to registration or exemption.
Exempt Offerings / Rule 506
Making the lending opportunity available to potential capital providers in an offering exempt from the registration requirement under the federal securities laws offers two major advantages over the registered avenue: (1) speed to market and (2) reduced ongoing legal compliance burdens and costs.
First, an exempt offering can proceed as soon as the banking and lending issues are tackled, without the delay of registering the offering with the SEC. Preparation of an SEC registration statement is typically far more time-consuming than the preparation of private placement materials in connection with an exempt offering, and the latter does not require input from the SEC and the corresponding numerous rounds of comments and revisions prior to effectiveness (which must be achieved before you can offer the platform to capital providers). An exempt offering can be put in place in as short a time period as one to two months. SEC-registered offerings can take six months to a year before going effective.
Second, once the lending platform is established and the funding is in place, an issuer in an exempt offering has minimal ongoing compliance requirements with regard to the offering materials. SEC-registered offerings require periodic updates for material events, and in any event require regular amendment and updating with the SEC. The requirements for exempt offerings are far less rigid and categorical.
However, the primary drawback to exempt offerings as compared to SEC-registered offerings is a limitation on the investors who can become capital providers and, in some cases, a limitation on the manner in which they may be solicited. An exempt offering can proceed in one of two ways: (1) the offering can be made to anyone and without any limit on the manner of solicitation (including advertising), as long as only “accredited investors”2 actually invest, and as long as the issuer takes reasonable steps to verify that each investor is indeed accredited, or (2) the offering can be made to persons with whom you have a bona fide pre-existing relationship and in a manner that does not give rise to a “general advertisement” or “general solicitation” (i.e., one-on-one with your contacts) and can be sold to an unlimited3 number of accredited investors and up to 35 investors who are not accredited (this is an offering under the “old” private placement rule, which remains in effect after the enactment of the general solicitation rule). Note that an offering that includes non-accredited investors would require substantially enhanced issuer disclosure (and corresponding time and expense). In any case, these two options stand in stark contrast to the options with an SEC-registered offering, where the offering can be made to anyone and by any means available. Exempt offerings are therefore quite restricted in terms of both who can invest and how the offering is marketed.
The SEC has taken the view that online campaigns are general solicitations, so most platforms opt to comply with the advertised private placement rules (what lawyers call 506(c)). However, limited-purpose Web sites may still pass muster under the “unadvertised” rule – 506(b).
4. Most Efficient Ways to On-Board Investors and Structure Your Vehicle
Once the manner of offering to capital providers is determined, assuming an exempt offering is chosen, another issue that will need to be addressed is how investors participate in the loans. Here, a lending platform has four options: (i) a traditional commingled investment fund, (ii) a more contemporary “series” fund, (iii) a separately managed account arrangement whereby there is no actual fund or commingling of investor capital, or (iv) a single investor fund (SIF) which combines the concepts of options (i) and (iii).
The traditional fund route involves collecting investment capital from a group of investors into a single bucket, and then funding loans out of that bucket. The fund’s manager selects which loans to fund. Each investor participates in income, gain, loss and expense in proportion to its percentage interest of the fund’s capital. This option is simpler than the series fund and affords investors with diversification. Investors are also able to take a more passive role with respect to their investing. However, the main drawback is that investors cannot select particular loans or groups of loans, or have input or much visibility into the selection or underwriting process. Also, without a valuation mechanism or active market for the portfolio loans, it is difficult to bring in additional investor capital once a period of time has passed since the fund began.
The series fund builds on the traditional fund by slicing up the single bucket of capital referred to above into tranches or sleeves of capital, known as “series.” Multiple series can be created within a single bucket for a variety of purposes, such as (i) offering a single series for a set period of time (i.e., six to 12 months) and each series is a limited duration fund (and then offering additional series in the future as the preceding series expires), or (ii) creating additional series for the purpose of making only certain types of loans out of particular series and/or offering certain series only to particular investors. In doing so, the series fund option can overcome the main drawbacks to the traditional fund structure, but is typically more cumbersome to set up and administer on an ongoing basis.
Separately Managed Accounts (SMAs)
A managed account arrangement involves the opening of an account for each individual investor and gives that investor the option or the right to pick out individual loans he or she wants to fund. It is up to the individual investor to achieve the desired level (if any) of diversification and they are limited in the ability to fund loans to the amount they can risk (rather than the economies of scale that can be achieved through a traditional fund or a series fund). Also, managed accounts can involve significant work and overhead burden in order to administer them properly. However, the managed account can leave the greatest amount of power in the hands of the investor, as compared to the traditional fund or the series fund models.
Finally, the single investor fund, or SIF, combines the fund model with the separately managed account. It is for the investor who desires to be passive, invest a large enough amount to gain diversity over the loan portfolio, and yet have the same flexibility as with a separately managed account. The SIF manager exercises all discretionary authority over which loans to fund, in accordance with detailed investment guidelines; provides customized reporting to the investor; and enjoys a performance fee that has capital gain character potential.
5. Broker/Dealer and Investment Adviser Regulation – Possible Exemptions to Protect Yourself from Regulatory Scrutiny
Ok, you knew it was coming. The cops are pounding at your door. What are the main issues you need to keep in mind with respect to broker-dealer and investment adviser regulation?
A P2P fund – whether it is relying on Section 3(c)(1), Section 3(c)(7) of the 1940 Act or on the fact that it may potentially be comfortable that the loans it is investing in are not “securities” even under the expansive standards of the 1940 Act -– still has to consider broker-related regulatory issues. As defined in the Securities Exchange Act of 1934, as amended (the “1934 Act”),4 a broker means, subject to certain exceptions, “any person (i) engaged in the business of (ii) effecting transactions in (iii) securities (iv) for the account of others” (numbering and emphasis added). If P2P investments are originated or acquired directly (with the fund’s general partner, manager, etc. acting in the fund’s name), such transactions need not involve a “broker” or broker-related concerns. However, if a fund is using a third party to “find” it P2P products to purchase (in particular if the fund is paying for the service in a “transaction based” manner based on the size of the “find”) and the P2P products are deemed to be 1934 Act “securities,” the “finder” is (at least potentially) an unlicensed “broker” – a fact that that could have negative implications for the “finder” as well as the fund. Relatively few exceptions to broker registration are available; these include very narrow exceptions for intrastate brokers and potentially for “chaperoned” brokers based outside the United States.
A secondary broker question for a P2P fund is often how to sell interests in the fund itself. Selling interests in a fund (no matter what the fund is invested in – securities, non-security loans, real estate, etc.) is the selling of securities. The SEC has traditionally considered the question of whether or not a party is “engaged in the business of effecting transactions for the account of others” to involve an analysis of the facts and circumstances of the transactions involved. With limited exceptions and on a practical basis, selling the securities of a fund in a regulatory compliant manner involves either (a) hiring a licensed broker, or (b) having parties who work for the fund or its controlling parties (i.e., as a partner, officer, director, or employee of the fund’s general partner) meet the conditions of 1934 Act Rule 3a4-1 (Associated Persons of an Issuer Deemed Not To Be Brokers). Bottom Line: Even for P2P transactions that would appear to be simple “loans” and not “securities” to a layman, broker issues remain in play.
Investment Adviser Issues
Regardless of whether broker-dealer registration is required, operating a peer-to-peer lending platform raises the question of whether the sponsor needs to register as an investment adviser, which in turn depends on whether the activities involve investment advice related to securities. About the only way to avoid investment adviser registration is for investor access to take the form of a managed account (as opposed to a fund or series fund structure) where investors have 100-percent discretion over whether to fund loans (and a single investor is required to fund 100 percent of each loan). Once the loans are sliced up and parceled out amongst investors (regardless of whether the fund, series fund or SMA structure is utilized), those loan participations will almost certainly be viewed as securities.5 And if the traditional fund or series fund structured is utilized such that the platform sponsor is making investment or lending decisions for the capital providers, that is investment advice.
A lending platform with $100 million or more in capacity would result in the sponsor being deemed an investment adviser and (subject to the above discussion regarding whether securities investment advice is involved) would be required to register with the SEC as such. A lending platform with $25 million to $100 million in assets under management (AUM) would result in the sponsor registering with the SEC only if (i) the managed account structure is utilized, (ii) the state in which the sponsor operates does not permit registration or (iii) another federal exemption does not apply, such as exempt reporting adviser status (this voluntary reporting status affords exemption from registration up to, generally speaking, $150 million in AUM). If the fund structure is pursued, the sponsor would be subject to the investment adviser laws of the state where the platform conducts business activities. If the platform has less than $25 million in capacity, only state law would be in play and the sponsor generally would be prohibited from SEC investment adviser registration, regardless of structure. (We note that a narrow exemption also applies to investment advisers based outside the United States with minimal active clients in this country.)
Registration as an investment adviser with the SEC or a state typically entails substantially similar requirements, as many states’ investment adviser laws are primarily based on those of the SEC. Those requirements include:
a code of ethics
a detailed compliance program
internal reporting requirements with respect to investment/lending activities conducted by personnel/employees outside of the adviser business
preparing a detailed brochure that must be delivered to capital providers, prohibitions on principal transactions (where the sponsor sells loans to or buys them from the capital providers, the imposition of a fiduciary duty to act in the best interest of clients (i.e., capital providers, not borrowers)
public disclosure of the size of the lending platform/advisory business, and
most importantly, being subject to inspection by the SEC or the applicable state regulator.
The primary difference between the SEC and state oversight of registered investment advisers is that the SEC has a generally uniform approach to all investment adviser registrants that is typically perceived as being relatively benign. On the other hand, the states’ oversight of investment advisers can vary widely and be heavily dependent on the personalities involved and the applicable state’s budgetary and political climate. Painting in unreliably broad strokes (as a 50-state survey is beyond this article), the states in the Western and Southeastern portions of the United States can be characterized as generally being relatively proactive about investment adviser regulation and at times can regulate firms quite closely, whereas many of the other U.S. states have a more hands-off approach.
As you can see, the paths are many and the issues are complex. As the industry continues to grow, new issues will undoubtedly arise, and regulators’ ears will perk up even more, requiring thoughtful, trusted legal counsel who have a dedicated team of professionals focused on the important issues in this multi-disciplined field (hint-hint).
As a wise man once wrote:
“You're off to Great Places!
Today is your day!
Your mountain is waiting,
So ... get on your way!”
- Dr. Seuss, Oh, The Places You'll Go!
1 Qualified issuers may use Form S-3 and undertake a “shelf registration” that, in practical terms, allows the company to “take down” securities from the “shelf” and sell them at any time after registration.
2 Generally, “accredited investors” are (i) individuals with annual income of $200,000 or more, (ii) married couples with combined annual income of $300,000 or more, (iii) individuals with a net worth of $1 million or more or (iv) entities with total assets of $5 million or more. The Supreme Court’s same-sex marriage ruling in 2013 now allows married same-sex couples to aggregate their income and assets for meeting the accredited investor standard.
3 Unlimited if the loans are not deemed securities. If they are deemed securities, the Investment Company Act of 1940, as amended (the “1940 Act”), which governs funds investing in securities, would come into play, limiting the total number of investors to 100 (with certain exceptions) unless they are all (with limited exception) qualified purchasers as defined in Section 2(a)(51) of the 1940 Act. See Part 5 of this article for a discussion of whether peer-to-peer lending involves “securities” for purposes of the federal securities laws.
4 It should be noted that, based on past regulatory interpretations, the standards of what is seen to be a “security” under the 1934 Act are somewhat narrower than under the 1940 Act.
5 Whether whole loans would be viewed as securities for purposes of the investment adviser laws is a murkier question, and while courts have held that whole loans are not securities under certain circumstances (generally under the 1933 and 1934 Acts, which define “security” somewhat more narrowly), platform sponsors would be best advised to proceed with caution and assume they are dealing with securities.