WLF Legal Backgrounder
Peer-To-Peer Lending: Innovative Access To Credit And The Consequences Of Dodd-Frank
By Alex Brill
December 3, 2010 (Vol. 25 No. 35)
Lending funds between neighbors, among friends, or between members of a community is perhaps the oldest and most basic type of financial transaction. Peer-to-peer (P2P) lending, as this activity is now known, has recently taken on new and much larger dimensions as a result of the connections people can establish through organized networks on the Internet. The recent financial crisis, credit crunch, and associated tightening of bank lending standards, along with the record number of bank failures in the United States since the fall of 2008, have served to further boost this budding, non-bank lending industry, as many people in need of alternative sources of credit have turned to P2P lending. The two largest U.S. P2P companies, Prosper and Lending Club, have funded over $390 million in loans combined.1 While total lending in this industry remains small relative to the credit card industry or total unsecured loan volumes--U.S. consumer debt recently totaled $2.41 trillion2--it represents a rapidly expanding financial services product, one that competes directly with traditional bank lines of credit and credit cards. It is also one of the clearest examples of modern financial innovation, as entrepreneurs have harnessed the Internet and its associated economies of scale to exert competitive pressure on more traditional lending practices.
Rapid growth in the P2P industry, however, has given rise to concerns over appropriate regulation of this alternative form of lending. In 2008, the Securities and Exchange Commission (SEC) exercised its oversight authority of the P2P industry based on the agency's determination that P2P loans are securities. Now, the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act has left the future regulatory structure open to potential modification--a development that increases the industry's prominence among public policy analysts. Specifically, Dodd-Frank requires that by July 21, 2011, the Government Accountability Office (GAO) conduct a study of P2P lending and offer recommendations on how federal regulation of the industry should be structured in the future.
Following a brief overview of how modern P2P lending works, this LEGAL BACKGROUNDER will describe these recent regulatory and legislative developments. It will then conclude with a discussion of the relationship between regulation and innovation as it applies to this area. As evidenced by the industry's growth, recent innovations in P2P lending have proven to benefit investors and consumers alike. While regulation is intended to improve transparency and protect the parties involved, it can have the effect of stifling innovation by imposing costly compliance hurdles.
Modern Peer-to-Peer Lending.
P2P lending as a modern industry--first present in the United States in its web-based structure beginning around 2006--relies on online platforms that connect borrowers with lenders. The two major sites that facilitate P2P loans in the United States currently are Lending Club and Prosper, but P2P lending sites include Kiva, Loanio, VirginMoney, and Zopa, among others. In addition to enabling the initial connection between lenders and borrowers, these companies service the loans after they have been originated.
The draw of P2P lending for both borrowers and lenders is that the companies serving as intermediaries charge just a small fee for their services. (Lending Club and Prosper each have a service charge of 1 percent.3) This low fee, along with strategies to mitigate default risk from borrowers, means that interest rates are generally lower than rates on credit cards or bank loans (for those borrowing) and higher than rates on other investment products (for those lending). On a P2P lending site, lenders choose how much they want to loan and to whom, based typically on borrowers' credit scores and personal traits. The loans are generally funded by multiple lenders, each of whom receives a promissory note guaranteeing payment from the borrower and the interest rate on the loan. Lending Club and Prosper offer loans ranging from $1,000 to $25,000, with lenders contributing as little as $25 per loan.4 Most lenders diversify risk by having multiple loans in their portfolio.
It is difficult to generalize the way the industry works because the platforms do not necessarily resemble one another. For instance, Lending Club and Prosper both currently use WebBank,5 an FDIC-insured, Utah-chartered industrial bank, to originate loans, with both companies then immediately purchasing and assuming full responsibility for the loans from WebBank.5 However, while Lending Club presets interest rates, Prosper allows lenders to bid on interest rates based on what borrowers are willing to pay.6 Additionally, some P2P sites specialize in a certain type of borrower. For example, Kiva specifically deals in loans for entrepreneurs. Furthermore, the rapid growth and constant innovation in this space means that new practice patterns can emerge, and the industry may continue to evolve. Regardless of differences in platforms, however, the important similarity among P2P lending companies is their facilitation of non-bank lending, which results in a direct and mutually beneficial arrangement between lenders and borrowers.
From the start, web-based P2P lending companies operating in a given state have had to abide by that state's laws and regulations governing lending. However, the growth of P2P lending in the United States attracted the attention of the SEC. The SEC is charged with enforcing the Securities Act of 1933, a statute intended to ensure that securities offered to the public are appropriately described to investors. This objective is achieved through the requirement that securities (generally) must be registered, which means that the registrant must describe the business, the security, and the management and that financial statements describing the business must be audited by independent accountants. According to the SEC, "Pursuant to SEC v. W. J. Howey Co., 328 U.S. 293 (1946), an investment contract exists if there is present ‘an investment of money in a common enterprise with profits to come solely from the efforts of others.' . . . An investment contract is a security under Section 2(a)(1) of the Securities Act, the offer or sale of which must be registered pursuant to Section 5 of the Securities Act."7
The SEC determined that the promissory notes issued to lenders by P2P companies facilitating the loans were securities, as defined by Section 2(a)(1) of the Securities Act and under the Supreme Court's decisions in both Howey and Reves v. Ernst & Young, Inc., 494 U.S. 56 (1990). On November 24, 2008, the SEC served Prosper with a cease-and-desist order, claiming that Prosper was engaging in the sale of securities without registering first with the agency.8 Anticipating the SEC's move, Prosper shut down in October 2008, reopening nine months later, in July 2009, after complying with securities registration requirements.9 Lending Club had voluntarily shut down in April 2008, six months before Prosper, to meet compliance obligations, and it reopened just days before Prosper shut down.10
In October 2009, a newly formed industry trade group, the Coalition for New Credit Models, declared its opposition to P2P lending's securities classification and consequent SEC regulation, advocating that P2P lending should be regulated instead as a consumer banking service.11 Prosper, a member of the coalition that complained of being "suffocated by rigid regulations," had costs in excess of $5 million related to compliance with SEC registration.12 Consumers also suffered from the sudden imposition of SEC oversight, as the cease-and-desist order against Prosper, as well as Lending Club's preemptive shut down, fell in the midst of the credit crunch, when P2P lending was offering critical access to capital for borrowers suffering from the financial crisis's impact on traditional lending.
Recent Legislation and Forthcoming GAO Report.
In response to the financial crisis and recession, Congress, at the behest of the Obama administration, undertook legislation to more strictly regulate financial markets, increase regulatory oversight, and increase transparency for consumers. A major component of the Dodd-Frank financial regulatory reform bill was the creation of a Consumer Financial Protection Bureau (CFPB). In anticipation of this new agency, the Coalition for New Credit Markets launched a campaign for the regulation of the P2P industry to be turned over to the CFPB, arguing that the SEC's regulating P2P lending sites was like "putting a round peg into a square hole."13
In response to the coalition's lobbying efforts, Representative Jackie Speier, a member of the Financial Services Committee, sponsored a provision in the House financial regulatory reform bill that would have transferred regulatory supervision of P2P lending from the SEC to the CFPB.14 However, there was no comparable provision in the Senate bill, and negotiators reconciling the two bills reached a compromise of sorts. The compromise is found in Section 989F(a)(1) of the final Dodd-Frank bill and mandates a GAO study that examines the current P2P lending regulatory structure; state and federal regulators' responsibility for oversight of P2P lending markets; existing studies of P2P lending; and consumer privacy, anti-laundering, and risk management issues.
The provision requires that GAO, in conducting its study, consult with federal banking agencies, the SEC, consumer groups, outside experts, and the P2P lending industry. It also requires GAO to present alternative regulatory options for P2P lending, including the involvement of other federal agencies and alternative approaches by the SEC, along with recommendations on whether the alternative options are effective. The results of this study as well as the associated policy options and recommendations must be presented to Congress by July 21, 2011.
Balancing Innovation and Regulation. P2P lending is an important innovation in the financial services marketplace because it broadens access to capital for borrowers and increases competition for lenders. And competition with established financial institutions and credit card companies is good for consumers. Consider the benefit to P2P borrowers who are looking for better ways to pay off credit card debt: the average interest rate these borrowers face on credit cards currently exceeds 14 percent,15 while interest rates on 36-month loans from Lending Club, for instance, currently average 11.9 percent.16 P2P loans also give borrowers alternatives to payday loans and home equity loans. And the benefits are not one-sided: for lenders, P2P lending offers higher returns than bank deposits or the returns seen recently in equity markets.
On a broader scale, financial innovation generally is essential to the health of the economy and the improvement of consumer welfare, as credit operates as the grease in our economic engine by facilitating everything from a small business's accounts payable to a startup's R&D costs to a homeowner's ability to repair a leaky roof. While government regulation may intend to serve the same goal of maximizing consumer welfare, there is always the risk that regulation will stifle innovative ideas by creating barriers too high for innovators to enter the market. Nowhere is that regulatory risk greater than when it is imposed on industries capable of new innovation.
Given the forthcoming GAO report, discussion of P2P lending regulation is not simply a theoretical exercise. It is critical that the regulatory structure GAO recommends does not impede the industry's growth. Already, existing P2P lending regulations have had negative effects in this regard. For example, Zopa, the British site that launched internet-based P2P lending, withdrew from the U.S. market because of worries over stringent regulations.17
The provision in the Dodd-Frank bill that mandates the GAO report is drafted in a manner that will likely draw GAO to find in favor of some regulatory or legislative change with regard to oversight of the P2P industry. In attempting to ensure that future regulation does not stifle innovation, GAO should be addressing two issues in its report. First, are P2P loans like other products (i.e., consumer products or securities) and should be regulated as such? Second, is the SEC doing a good job--are the compliance, regulatory, and legal burdens appropriate for the industry, and are those industry burdens exceeded by the consumer (borrower and lender) benefits from the information being provided?
Ideally, GAO's recommendations will foster a low-cost, streamlined regulatory structure, and the report will be interpreted by both the industry and policymakers as evidence that Washington can help this fledgling industry not by doing more to regulate it, but rather by working to minimize the barriers imposed by the current regulatory structure and seeking more efficient ways to ensure clear and adequate disclosure and transparency for investors.
Alex Brill is a research fellow at the American Enterprise Institute for Public Policy Research (AEI) and is a former senior advisor and chief economist to the House Committee on Ways and Means. Mr. Brill is also CEO of Matrix Global Advisors and an advisor to the law firm Buchanan Ingersoll & Rooney PC.
1. Prosper, "Company Overview," available at www.prosper.com/about (accessed Nov. 18, 2010); and Lending Club, "Latest Company Statistics," available at www.lendingclub.com/public/about-us.action (accessed Nov. 18, 2010).
2. Federal Reserve, G.19 report, "Consumer Credit," Nov. 5, 2010, available at www.federalreserve.gov/releases/g19/Current.
3. Lending Club prospectus, July 30, 2010, available at www.lendingclub.com/extdata/Clean_As_Filed_20100730.pdf; and Prosper prospectus, July 26, 2010, available at www.prosper.com/downloads/Legal/Prosper_Prospectus_2010-07-26.pdf.
4. Carl E. Smith, "If It's Not Broken, Don't Fix It: The SEC's Regulation of Peer-to-Peer Lending," American University Washington College of Law Business Law Brief, Fall/Winter 2009-2010, available at www.wcl.american.edu/blb/documents/AU_BLBFall09_Smith.pdf?rd=1.
5. Lending Club and Prosper prospectuses, supra note 3.
6. Ian J. Galloway, "Peer-to-Peer Lending and Community Development Finance," Federal Reserve Bank of San Francisco Working Paper 2009-06, Aug. 2009, available at www.frbsf.org/publications/community/wpapers/2009/wp2009-06.pdf.
7. Securities and Exchange Commission, Release No. 8984, Nov. 24, 2008, available at www.sec.gov/litigation/admin/2008/33-8984.pdf.
9. Carl E. Smith, "If It's Not Broken, Don't Fix It: The SEC's Regulation of Peer-to-Peer Lending," supra note 4.
11. Coalition for New Credit Models, "Financial Start-ups Form ‘Coalition for New Credit Models,'" news release, Oct. 20, 2009, available at www.newcreditmodels.com/news/2009/10/20/financial-start-ups-form-coalition-for-new-credit-models.html.
12. Ibid.; and Silla Brush, "Online Lender Lobbies Congress for Industry Consumer Regulator," The Hill, June 9, 2010, available at thehill.com/business-a-lobbying/102323-online-lender-lobbies-congress-for-industry-consumer-regulator.
13. Quoted in Robert Schmidt and Jesse Westbrook, "An Online Lender Takes on the SEC," BusinessWeek, June 10, 2010, available at www.businessweek.com/magazine/content/10_25/b4183025376406.htm.
14. Silla Brush, "Online Lender Lobbies Congress for Industry Consumer Regulator," supra note 12.
15. Federal Reserve, G.19 report, supra note 2.
16. See Unocal Settles Rights Suit in Myanmar, N.Y. Times, Dec. 14, 2004; Catherine Rampell, Yahoo Settles With Chinese Families, Wash. Post, Nov. 14, 2007, at D4; Jad Mouawad, Shell to Pay $15.5 Million to Settle Nigerian Case, N.Y. Times, Jun. 9, 2009, at B1.
17. Lending Club, "Lending Club Statistics: Summary (from 05/01/2007 to 11/18/2010)," available at www.lendingclub.com/info/statistics.action.
18. Giles Andrews, "The Tricky World of US Regulation," Zopa Blog, Nov. 28, 2008, available at blog.zopa.com/archives/2008/11/28/the-tricky-world-of-us-regulation.