Peer-to-peer lending platforms, as their name suggests, allow borrowers to use a web-based platform to borrow money funded by other platform users rather than using the more traditional route of borrowing directly from a bank or other traditional lending institution. Peer-to-peer lending platforms have proliferated in the past few years, with some operating in the public markets,[1] and one going public itself.[2] This Alert provides an overview of the basic model used by many peer-to-peer lending platforms and some of the key peer lending regulatory and structuring considerations under the federal securities laws.[3]

The Basic Peer Lending Model
Generally, peer lending platforms (1) either originate loans to borrowers themselves or acquire loans, and (2) issue “borrower-dependent notes” to investors based on those loans. Both of these roles are discussed further below.

To facilitate lending, a peer lending platform typically provides a mechanism for potential borrowers to apply for loans, determines whether the proposed borrower and the proposed loan meet the platform’s lending standards, and preliminarily approves the loans. Information about each potential loan is then made available to potential investors, or “peer lenders,” who can then determine whether to, in effect, fund all or part of the loan. If there is sufficient interest by peer lenders to fund a loan, the sponsor of the platform then either originates the loans itself or passes the application along to a bank, which originates the loan and sells it to the sponsor. As a third alternative, a sponsor may purchase loans from a third party without providing origination services through the platform.

Once a platform sponsor acquires loans, it usually holds the loans on its balance sheet or through a special-purpose vehicle, trust or similar entity. The sponsor issues notes whose payments are solely dependent on payments on the underlying loan (“borrower-dependent notes” or “BDNs”). A purchaser of a BDN may have the right, for example, to receive payments equal to the principal (or par amount) of the BDN, plus a stated interest rate; all such payments to the purchaser, however, would be solely funded from and to the extent of the proceeds the sponsor receives from the loan related to that BDN. If the borrower on the related loan defaults, the purchaser of the BDN, and not the sponsor, bears the associated losses (other than any anticipated fees payable to the sponsor).

Typically, peer lending platforms do not issue notes backed by a pool of loans. It they do, they may be viewed as a sponsor of a securitization or as a fund manager; either of these results would subject a sponsor to a separate set of regulatory considerations not discussed in this Alert.

Offering the BDNs
BDNs may be offered in private placements under Regulation D under the Securities Act of 1933 (“Regulation D” and the “Securities Act”), or less commonly through public offerings under the Securities Act.

Private Placements
If BDNs are offered through a private placement, the sponsor must decide whether to offer them in compliance with Rule 506(b) under Regulation D, which prohibits the use of general solicitations and advertising, or Rule 506(c) under Regulation D, which does not. If a sponsor relies on Rule 506(b), it generally must have a reasonable belief that all investors who view potential offerings of BDNs are “accredited investors” as defined in Rule 501(a) under Regulation D; the sponsor therefore generally must screen investors for their accredited investor status prior to allowing potential investors to access the platform and view any offerings. If a sponsor relies on Rule 506(c), it must take “reasonable steps to verify” that no purchasers of BDNs are not accredited investors, but it may allow potential investors to view offerings of BDNs prior to verifying their accredited status. Rule 506(c) provides that certain methods of verification provide a safe harbor to issuers. However, in practice, based on guidance from the staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively), the verification standards under Rule 506(b) and Rule 506(c) are not materially different.

In any Regulation D offering (Rule 506(b) or (c)), a potentially significant cost consideration is the need to file Forms D in each of the states in which offerings are made. As a result, for smaller offerings, some sponsors try to limit each offering to purchasers in a relatively small number of states.

Registered Offerings
BDNs offered through public offerings must be registered with the SEC, most frequently on a Form S-1. There are significant regulatory and other issues associated with a registered offering of BDNs, including significant limitations on the sponsor’s ability to offer multiple series of BDNs off of a single base prospectus, rather than having to use a new prospectus for each offering. As a result, the registration process may be lengthy and costly.

Compensation and Broker-Dealer Registration
Companies engaged in peer lending may not charge commissions or other transaction-based compensation upon the sale of the BDNs without potentially triggering a requirement that they register as broker-dealers under the Securities Exchange Act of 1934 (“Exchange Act”).[4] As a result, compensation paid to peer lending sponsors often is based on a spread between payments made by borrowers on the loans and payments made to investors on the associated BDNs and/or potential origination and servicing fees related to the underlying loans.

Investment Adviser Registration
Sponsors of peer lending programs generally avoid providing any investment advice to BDN investors to avoid potential registration and regulation as an investment adviser under the Investment Advisers Act of 1940 or comparable state laws. This means that sponsors generally do not charge separate compensation for advice regarding, among other things, which BDNs to purchase, the advisability of investing in BDNs generally, or any other topic related to value of any BDNs or the advisability of investing in, purchasing, or selling them.

In certain cases, sponsors of peer lending platforms have created and registered affiliated investment advisers in order to provide investment advice to purchasers of the BDNs, as well as to manage private funds that hold certain loans, advise investors with respect to the purchase of whole loans, and/or provide other related advisory services. This model allows a sponsor’s advisory affiliate to receive compensation in return for the provision of any such investment advice.

The Investment Company Act
As previously discussed, sponsors typically hold loans acquired through their peer lending programs on their balance sheets, or in a subsidiary or other controlled entity. If those loans are deemed to be securities, a sponsor (or any affiliate holding the loans) could meet the definition of an investment company under the Investment Company Act of 1940 (“ICA”); this could cause the sponsor (or its affiliate) to be required to register as an investment company and be regulated under the ICA. This is because the ICA generally treats as an investment company any company that holds more than 40% of the value of its total assets in investment securities. For a host of reasons, most peer lending sponsors could not operate under the ICA. Among other things, the restrictions in the ICA on affiliated transactions might prohibit the sponsor from issuing and/or acquiring the loans that serve as the basis for the BDNs.

Depending on the precise model used for a peer lending program and the types of loans held by a sponsor, however, sponsors may be able to rely on one or more bases for the conclusion that they do not fall within the definition of an investment company, including the following:

• The sponsor does not hold more than 40% of the value of its total assets in investment securities, because the loans are not securities. 
• The sponsor may rely on Section 3(c)(4) of the ICA, which generally excepts from the definition of an investment company issuers that are engaged in a consumer financing business.
• The sponsor may rely on Section 3(c)(5)(A) or (B) of the ICA, which generally excepts from the definition of an investment company issuers primarily engaged in commercial finance and sales factoring, or Section 3(c)(5)(C) of the ICA, which generally excepts from the definition of an investment company issuers primarily engaged in holding mortgage loans and similar real estate-related assets.
• Under Section 3(b)(1) of the ICA, the sponsor is primarily engaged in a business other than that of investing, reinvesting, owning, holding, or trading in securities, because it is primarily engaged in the business of facilitating peer-to-peer lending.

The analysis applicable to a particular sponsor also depends in part on, among other things, whether the peer lending model in question primarily involves consumer or business loans.

Platform Issues
Peer lending platforms are also structured to take into account the laws and regulations that govern online transactions, consumer privacy, and other related issues. The users of online platforms typically consent to electronically sign all agreements presented to them on the platform, to be bound by their electronic signature, and to receive all documents and notices electronically. Platforms have generally adopted privacy policies and provide the privacy notices required under federal law. In addition, platforms will generally require users to sign or abide by terms of use, platform agreements, and other documents that lay out the terms of using of the platform. These documents typically describe the process of investing through the platform and generally include requirements that, among other things, users are truthful and complete in providing information to the platform sponsor, they indemnify the sponsor for any losses based on the user’s activities on the platform, and they abide by certain rules of conduct when interacting with other users. Platform agreements also provide disclosures related to investing through the platform. Sponsors typically retain the right to terminate use of the platform and/or void any agreements with a user (including investments made through the platform) if the user violates any agreements related to use of the platform.

Conclusions
We expect that peer-to-peer lending platforms will continue to mature and evolve, and we expect that the issues discussed in this Alert will continue to drive their structuring decisions, business models, and regulatory compliance under the federal securities laws.

Notes:
[1] See LendingClub Corporation and Prosper Marketplace, Inc., both of which offer borrower-dependent notes publicly through registered offerings.

[2] See, e.g., “Lending Club IPO: Finance Business Gets Tech-Stock Allure,” Wall Street Journal (Dec. 10, 2014).

[3] Peer-to-peer lending also raises significant consumer finance issues, which will be addressed in a separate peer lending alert. In addition, among other issues, we note that there are significant regulatory, tax, and other issues associated with permitting foreign investors to participate on any peer lending platform. We do not address these issues in this Alert.

[4] Under Section 15 of the Exchange Act and related guidance, transaction-based compensation is the “hallmark” of a broker-dealer. Brumberg, Mackey & Wall, P.L.C., SEC Staff No-Action Letter (May 17, 2010).