United Kingdom & the United States See Incredible Growth in Peer to Peer Lending Industry.
With all of the hype around equity crowdfunding the silent counterpart of peer-to-peer lending has been quietly growing into a significant and disruptive industry. In fact, some industry followers expect the Peer-to-Peer lending to grow to $1 trillion by 2025. In the United Kingdom, the industry achieved over £480 million in loans for 2013. In the United States, companies like Lending Club, Prosper, Funding Circle (a UK transplant) and DealStruck have quickly established their platforms as viable alternatives to traditional banks.
So why has the UK moved so quickly – in a considerably smaller market – and what can we expect on this side of the Atlantic? The potential is certainly palpable, but much of the success and strategies of these companies is driven by the regulatory environment in which they operate.
After review of the regulatory framework surrounding peer-to-peer lending in both the UK and the US the most dramatic distinction is the fundamental nature of the regulations themselves. The Financial Conduct Authority (the UK regulatory body) has gone to great lengths following a public comment process to develop and implement a body of rules specific to the peer-to-peer lending industry, which address the specific risks and operational features characteristic to the industry. In the US however, peer-to-peer platforms remain subject to a hodge-podge quilt work of state and federal regulation, none of which ever envisioned the nascent yet robust industry.
Peer-to-peer or P2P lending means lending from an ordinary person to another ordinary person (non-entity). Additionally, people have also adopted the term to include lending from an ordinary person to a business or real estate project. This is also referred to as P2B or peer-to-business lending. Whatever you want to call it, it is a £1.2 billion industry in the UK alone, and despite what I am about to tell you, a multi billion industry in the US. The difference is a function of market size and an ironic testament to the potential of P2P, despite a complicated and inapt regulatory regime in the US.
Rather than the tailored and measured approach taken by the FCA in the UK, the US has been content to allow multiple layers of inapplicable laws potentially apply to P2P platforms without providing industry specific guidance. Moreover, the lack of a workable and knowable regulatory regime has stifled new entrants to the market and reduced competition and access to capital. Notably, Peer-to-Business lending is almost non-existent in the US, but is taking off in the UK. P2B provides an important financing alternative to small and startup businesses facing the funding gap. P2B may be a lower risk alternative to new capital raising means provided by the JOBS Act, but due to the hostile regulatory regime, P2B platforms have found it difficult to ensure legal compliance and to operate with any scale.
Just for elucidation, below I have listed the different regulation and/or regulatory bodies that have a hand in regulating P2P in the US.
- Securities Act of 1933 – loans or loan participations sold to investors are deemed “securities” which must be registered or exempted from registration.
- Securities Exchange Act of 1934 – platforms may be deemed “brokers” or “dealers” and be subject to a particular regulatory regime, platforms may face reporting obligations due to numbers of securityholders.
- Investment Company Act of 1940 – platforms or entities they create to hold loans or pool investors may be deemed “investment companies” subject to registration and compliance.
- Investment Advisers Act of 1940 – platforms may be deemed “investment advisors” subject to registration and compliance.
- States have their own regulatory regimes for all of the above and platforms may have to comply with such regulations on a state-by-state basis depending on their status under the above regimes.
- Risk Retention Requirements – requires SEC, the Federal Reserve Board, the FDIC, the Federal Housing Finance Agency and the Office of the Comptroller of the Currency to jointly come up with regulations that mandate the originator of a loan which is then securitized to 1) maintain a certain portion of that loan on its balance sheet and 2) not hedge or otherwise synthetically remove the risk of such asset from its balance sheet. Dodd-Frank was passed in 2010 and set forth a revised set of proposed rules in August 2013, such regulations have yet to be enacted and are not clear without further guidance as to whether or not they would apply to P2P platforms.
- Consumer Financial Protection Bureau (CFPB) – authorized to adopt rules preventing deceptive practices within the consumer finance markets, has not issued regulations but has articulated standards.
- Government Accountability Office – instructed to conduct study to determine the best federal regulatory body for the P2P industry (SEC or CFPB), study was inconclusive.
- There are a myriad of state and federal laws applying to lending and the registration of lenders such as usury laws, use of bank charters, bank secrecy regulations, state licensing and debt collection.
Consumer Protection Laws
- Truth in Lending Act – requires certain disclosures be provided to borrowers.
- Federal Trade Commission Act – loan documents must not contain any “abusive” terms.
Most notably, except for the mandated study by the GAO in Dodd-Frank, none of the above regulations were drafted with P2P specifically in mind. Thus, none of the current regulatory regime was intended to regulate the P2P industry and is simply an add-hoc collection of semi-relevant laws.
Financial Conduct Authority Regulation in the UK
A completely different strategy was employed by the FCA in the UK when it came to the P2P industry. Rather than rely on 80-year-old regulations that never contemplated the internet let alone P2P, the FCA reviewed the nascent industry and proposed regulations balancing the need for investor protection and economic health and growth. Some highlights of the rules are below.
Minimum Capital Requirements – the FCA requires platforms to maintain a certain amount of capital to ensure it can withstand financial shocks. The volume-based financial resources requirement that each P2P platform is required to maintain is the sum of:
- 0.2% of the first 50 million pounds of total loans issued and outstanding;
- 0.15% of the next 200 million pounds of total loans issued and outstanding;
- 0.1% of the next 250 million pounds of total loans issued and outstanding; and
- 0.05% an any remaining balance of loans issued and outstanding.
Client Money Rules – platforms must abide by certain rules regarding client funds, to the extent they collect them including not comingling the funds and performing a reconciliation.
Arrangements for Successor Loan Servicing – platforms must ensure they have a robust back-up plan in place to service loans in the event they go out of business or otherwise cease to operate.
Provide Cancellation Rights – platforms must allow investors to cancel their investments under certain conditions and within certain timeframes. This basically conforms UK law to current EU regulations.
Disclosure Requirements – the rules require platforms to provide relevant and accurate information to their customers under a high level approach aimed at providing useful information and not overburdening consumers with too much detail. (This to me, is one of the most enlightened stances a regulator can take. The current state of US SEC disclosure, which provides 800 pages for fear of a material omission when 40 thoughtfully drafted pages will do, is vexing.) The disclosure must of course be fair, clear and not misleading – the UK standard, and websites and details of loans will be considered to be financial promotions subject to applicable rules.
Dispute Resolution Provisions – investors will have the right to complain first to the platform and then to the Financial Ombudsman Service and disputes are subject to a standards based process.
Ongoing Reporting – platforms will have regular reporting requirements such as disclosing their prudential and financial position, notification of a change in total value of loans outstanding of 25% or more, client money positions, investor complaints and information on loans arranged over the previous quarter, among other items.
How Do US Firms Operate?
After comparing the US and UK regulatory structures, you may wonder how US platforms could operate at all given the legal hurdles involved. The way the two leading platforms are currently operating is by filing full-blown registration statements with the SEC and registering the securities they offer to investors. Platforms have filed what is called a shelf registration statement, which allows for the issuance of a maximum amount of securities, then every time the platform arranges a new loan it files a prospectus supplement and takes down securities off the shelf to sell to investors. The loan is actually made by a bank that the platform partners with and then the platform purchases the loan from the bank. The platform issues notes to investors, which are dependent on the payment of the underlying loan. This structure is quite complex and actually leaves the investor subject to not only the credit risk of the borrower but to the credit risk of the platform itself, since that is the issuer of the notes. In addition, the costs involved with public registration and ongoing reporting are ultimately borne by the borrower, investor or both.
Based on the comparison between the spider web of US regulations and the streamlined UK approach and the convoluted offering structure US P2P platforms have had to adopt, it is clear that the US system is inferior and not competitive in the current global financial marketplace. Let us hope that US regulators (including Congress) can learn from their counterparts across the pond and embrace these new financial alternatives rather than pretend they don’t exist and rely on an antiquated set of laws.
Georgia P. Quinn, a senior associate in Seyfarth Shaw LLP’s Corporate department, has spent her career representing public and private companies and investment banks in a wide range of capital markets transactions, including registered offerings and private placements of debt, equity, and hybrid securities. Over the last year, Ms. Quinn has led Seyfarth’s Crowdfunding Initiative, helping clients stay at the forefront of the enacted and proposed SEC regulations. Georgia has conducted webinars, presented to the New York State Bar Association’s Securities Law Section and the Business Law and International Sections, has been featured on Crowdfund Insider and has been invited to chair a panel on Crowdfunding for the American Bar Association in April. All views and comments above are strictly her own views and do not reflect the opinion or position of Seyfarth Shaw.