P2P Borrower and Investor Legal Restrictions
Below is a revised excerpt from "Crowding Out Banks..." with Woongsun Yoo. The original version is Appendix B in the paper. Bear in mind there are two separate sets of regulatory issues here. The first deal with who can borrow on the platform. The second deal with who can invest on the platform. Below we try to shed some light on both sets of regulatory restrictions.
Borrower (Origination) Restrictions
To allow individuals to borrow through the platform, peer-to-peer (P2P) platforms must meet state-level banking and consumer financing standards. New banks entering a state would be subject to the same scrutiny. Banking regulators require a variety of licenses from the P2P platforms including lending, loan brokering/supervising, money transferring, and collection licenses. Indiana, for example, requires the platforms to seek a collection agency license. Mississippi requires platforms to hold a loan brokering license. Other states have no license requirements at all for the platforms and only regulate the issuing bank (Web Bank in Utah). The regulatory restrictions and degree of monitoring vary widely from state to state. In some cases, the licensing process simply requires disclosure on the part of the P2P platform, while in other cases a more thorough review of the firm is conducted. As might be expected of an innovative industry, in some instances the platforms’ lending process does not fit within the regulatory structure of a state and can draw additional scrutiny from the banking regulator or attorney general’s office. We find at least two instances when the P2P platforms have been subject to specific enforcement actions that have prevented lending activities, both of which we can connect to gaps in the aggregate lending data.[1] In other cases, like the state of Pennsylvania, we can verify that a platform is restricted from originating loans, but regulators will not confirm the details around origination restrictions for a particular platform.
While licensing is the most common regulatory barrier to entry, states can erect additional hurdles by making the financial intermediation model of peer-to-peer lending less profitable. For example, the state of Iowa makes originate-to-distribute (OTD) models of financial intermediation difficult for any lender to execute due to a statute that rebates origination fees in the event of loan prepayment.[2] Thus, peer-to-peer lenders are technically able to operate in Iowa, but the state has created barriers to entry through this set of fee rebates. As a result, essentially no borrowers in the state of Iowa have received loans from either platform over the 25 quarters we examine.
Above Figure - Panel A depicts the lending process for peer-to-peer lending during our sample period of 2009–2015. The borrower submits a loan application to the platform, and upon funding commitment from investors, the issuing bank originates a loan with the borrower. The loan is sold to the lending platform within a few days, and then the lending platform creates a new security called a borrower dependent note (BDN) that is sold to the investors that commit to funding the loan. Panel B depicts the lending process for peer-to-peer lending before our sample period in 2006–2009. The borrower submits a loan application to the platform, and upon funding commitment from investors, the platform originates a set of mini-loans with the borrower. The total principal of the mini-loans is equivalent to the aggregate loan amount funded by investors. The mini-loans are sold to the investors that fund the loan. Each mini-loan has a principal amount equivalent to the capital pledged by the individual investor.
Investment Restrictions
In this section, we briefly review how this regulation developed to demonstrate how the security registration process used by the lending platforms has been binding for investment. Before the restructuring in 2008, peer-to-peer platform investors directly funded a loan as opposed to indirectly through the BDN process depicted in Panel A above. The full amount requested by borrowers was fractioned to allow each investor to fund a “mini-loan” for the borrower. Panel B of the above figure depicts this early peer-to-peer lending process. The drawback of this format was that the lending platforms were subject to the local usury interest rate caps established in the borrower’s state of residence. As Rigbi (2013) discusses, the usury caps restricted loan origination volume and drove the platforms to adopt the process depicted in Panel A. When an issuing bank was brought into the lending process, a nationally chartered bank could export the interest rate cap of its home state when originating out-of-state loans (Jackson et al., 2016).[5] Borrowers entering into a loan contract with an issuing bank thus could be issued loans with an interest rate up to the cap of the issuing bank’s state rather than the borrower’s state.[6]
While the format shift resolved the interest rate cap for the lending platforms, the new strategy required the platforms to hold loans on their balance sheet and create new securities for each funded loan. This new process attracted the attention of federal regulators, who forced one of the platforms (Prosper) to begin to register its BDNs federally.[7] The other platform (LendingClub) preemptively selected a similar approach. At the time of the change in 2008, the majority of platform investors were non-accredited investors. By allowing non-accredited investors to participate in the security creation process depicted in Figure 1, Panel A, the platforms could not qualify for a federal registration exemption.[8] Thus, all BDNs needed to be registered at the federal level. Similar to firms undergoing the process to create equity securities, the lending platforms went through a “quiet period” and ceased origination operations in 2008.[9] Because the platforms did not qualify for federal registration exemptions, they issued a continuous security offering,[10] which allows the platforms to file a single federal security registration that acts as an umbrella under which BDNs can be created or “taken off the shelf.” As BDNs are offered (listed) to investors, the federal security registration prospectus is updated through a Form 424(b)(3) filing. When the BDNs are funded, a second, separate 424(b)(3) is filed for the final creation (sale) of the BDN. The lending platforms file multiple 424(b)(3) forms a day containing this information. This makes the peer-to-peer lending firms among the most active filers with the Securities and Exchange Commission (SEC). As of the end of 2017, LendingClub was the 10th largest filer of all time and Prosper Marketplace was the 25th largest filer.
Not all FinTech platforms are subject to such scrutiny. Following the JOBS Act, the SEC revised Regulation D rules in September 2013 to allow “general solicitation” for securities exempted under Regulation D. This allowed other competing platforms to use the internet to “generally solicit” accredited investors (Manbeck et al., 2017). While we focus on two platforms, LendingClub and Prosper, other lending platforms such as Upstart fund borrower loans solely through accredited investors. Upstart’s subsidiary Upstart Networks files a federal exemption so that the BDNs created on Upstart’s platform do not have to be federally registered.[11]
Normally, when securities are federally registered, they are considered “covered,” i.e., exempt from additional state-level registration of the security. Thus, federal registration implies that the peer-to-peer platforms should be exempt from any additional state-level registration requirements. However, to be considered a federally covered security, peer-to-peer lending platforms must meet the requirements of section 18(b) of the Securities Act of 1933. According to that section, the security, or more junior security, must be listed by and trade on a national market system (a registered exchange). Because the BDNs are never listed on or traded on a national market system, the platforms are forced to register the BDNs again at the state level.
During the quiet periods and in the ensuing years, platforms have sought state security registration to allow investors to participate on the platform. We interviewed state security regulators to collect effective registration dates for both platforms and discovered that both platforms have applied to almost every state for security registration, but not all states have been willing to grant registration. There is a spectrum of rigor around financial suitability and disclosure required by state security regulators. At one end, disclosure states require the least amount of information, whereas merit states require a firm-level review before security registration approval (Warren, 1987; Colombo, 2013). Once a platform is approved to issue securities within a state, it has an effective security registration. In some states, effective registrations are perpetual and require no additional filings until the amount of security registered is issued in full. In other states, unissued security needs to be renewed annually. Thus, it is possible for an effective registration to lapse until the platform renews its original registration or files for an additional security registration. As a result of these state-level security registration changes, the evolution of investor participation on the platforms varies over time and by platform.
It is possible that lending platforms ignore state security regulators after federally registering their securities due to the cost of state-level compliance. However, we note two details that suggest state-level security registrations are at least partially binding for the platforms. First, both lending platforms acknowledge the lender restrictions in their Prospectus filings. Thus, they clearly are aware of the need for state-level registration and the risks of noncompliance. Second, in 2008, Prosper entered into a settlement with the North American Security Administrators Association, the industry organization for state security regulators, several of whom had brought forward investigations against the platform. Under that settlement, “Prosper agreed not to offer or sell any securities in any jurisdiction until it is in compliance with that jurisdiction’s securities registration laws.”
[1] The state of Mississippi issued a cease-and-desist order to LendingClub in 2009 after its loan broker license expired. This prevented any additional lending activity until the Mississippi Division of Banking and Consumer Finance was satisfied that LendingClub had sufficiently met the requirements of the order. LendingClub resumed lending activity within the state in 2014. The state of Kansas came to a consent judgement/settlement agreement with LendingClub in 2010. During the negotiation period, in the first three quarters of 2010, LendingClub ceased origination activities in Kansas.
[2] The state of Iowa entitles consumers to a finance charge rebate under statute 537.2510 if the consumer loan is prepaid.
[3] Prosper had originated loans in all states except South Dakota before its restructuring. LendingClub had issued loans to borrowers in every state except North Dakota and West Virginia prior to its restructuring.
[4] LendingClub fails to issue loans in Iowa, Idaho, Maine, North Dakota, and Nebraska for almost the entire sample period. The LendingClub platform initiates lending part way through the sample period in Indiana, Mississippi, North Carolina, and Tennessee. Prosper does not issue loans in Maine, North Dakota, and Iowa over the entire sample period. Prosper ceases to issue loans in the state of Pennsylvania part way through the sample.
[5] The interest rate exportation ability comes from Section 85 of National Banking Act of 1864 and Section 521 of the Depository Institution Deregulation and Monetary Control Act of 1980, in addition to multiple federal case laws.
[6] Over the course of most of their operations, both platforms have used a Utah bank as their issuing bank. According to Title 70C of the Utah Code, banks are not limited on the interest rate charged or the fees levied for the loan types issued on the platform.
[7] Securities and Exchange Commission Administrative Proceeding 33-8984 on November 24, 2008.
[8] Common exemptions include Regulation D Rule 506(b) or Rule 506(c) exemptions but are only available to securities offered to accredited investors. Later exemptions available to non-accredited investors as part of the JOBS Act were not available at the time.
[9] During an IPO, a firm must undergo a quiet period as directed by the SEC when the firm issues only clarifying statements concerning its prospectus and other federally filed information (Bradley et al., 2003). The intent is to confine all material information to the prospectus for potential investors to reference. Although the security being issued post–quiet period for the lending platforms were BDNs and supposedly not tied to the platform’s performance, the SEC directed the platforms to undergo a “quiet period” during the federal registration process of the BDN.
[10] Continuous security offerings are covered under Rule 415 of the Securities Act of 1933.
[11] Upstart Networks files a Regulation D Rule 506 exemption for its BDNs. Upstart Networks also files registration exemptions within the states where Upstart investors live to satisfy state-level registration laws.