ONPOINT / A legal update from Dechert
The Evolution of Marketplace Lending
Marketplace lending in the U.S. continues to evolve at a rapid pace as a result of legal and regulatory developments and market forces. In particular:
The Consumer Financial Protection Bureau recently ramped up its focus on marketplace lending, increasing the likelihood of future regulatory and enforcement actions.
One of the largest marketplace lenders recently restructured its relationship with its issuing bank out of concern that the Second Circuit’s decision in the Madden v. Midland Funding case could be construed to prohibit marketplace lenders from preempting state usury laws.
The funding model for marketplace lending continues to evolve, as evidenced by one lender’s establishment of an affiliated hedge fund to purchase marketplace loans it originates.
Earlier this month, the Department of Treasury (the “Treasury”) issued its white paper on online marketplace lending, after issuing a request for input from the public last summer. See Dechert OnPoint, US Treasury Eyes Online Marketplace Lending.
These developments come on the heels of other recent judicial and regulatory developments at the state level, further evidencing the growing pains in the emerging marketplace lending industry. See Dechert OnPoint, Marketplace Lending Developments in Maryland, California, and Pennsylvania. The announcement by Lending Club earlier this month that its CEO had resigned amidst various concerns of the board, including weaknesses in the company’s internal controls, only exacerbates the sense that the industry is at a crossroads and may undergo a variety of changes in the coming months and years. Lending Club also disclosed that it has received a grand jury subpoena from the U.S. Department of Justice and has experienced a slowdown in investor demand for loans through its platform.1
1. Marketplace Lending Under the Looking Glass of the Consumer Financial Protection Bureau
On March 7, 2016, the Consumer Financial Protection Bureau (the “CFPB”) announced that it is now accepting complaints from consumers encountering problems with loans from online marketplace lenders.2 The CFPB also released a consumer bulletin to provide an overview of marketplace lending and outline important information that consumers should consider before taking out a loan.
The CFPB, according to CFPB Director Richard Cordray, hopes to give borrowers a “greater voice in these markets and a place to turn to when they encounter problems.”3 Since all consumer lenders are required to comply with consumer financial protection laws, the CFPB’s increased focus on marketplace lending could have significant consequences for the industry. The CFPB often uses complaints from consumers as the first step in identifying issues amongst specific groups of consumers before undertaking an enforcement program or initiating a rulemaking proceeding.
One area of focus for the CFPB is likely to be whether the online lending platforms of marketplace lenders raise fair lending concerns by incorporating potentially discriminatory factors into their underwriting practices such as geographic data points when assessing the likelihood of a borrower’s ability to repay its loan. These concerns were echoed by the Treasury in its recently released white paper on online marketplace lending. While some marketplace lenders have taken steps to avoid issues of “redlining” or potentially discriminatory lending practices by, for example, choosing to include only the first three digits of the borrower’s zip code when disclosing information that may be accessed by loan buyers, the fair lending laws were written long before financial products were offered online and it remains to be seen how those laws will be interpreted and applied by the regulators to the marketplace lending model.
2. Lending Club Enters into New Relationship with WebBank
Earlier this year, Lending Club announced a restructuring of its relationship with WebBank, an FDIC-insured institution through which most of the loans on its platform are issued, in order to provide WebBank with a continuing interest in the loans.4 The new arrangement is intended to eliminate or minimize the impact of the Second Circuit’s decision in the Madden case that the purchaser of a loan from a national bank is not entitled to federal preemption of New York’s usury laws. That holding could significantly impair the marketplace lending model of Lending Club and others, which utilizes an issuing bank to originate loans in order to preempt state usury laws on a nationwide basis.
The new arrangement, as outlined in a Form 8-K filed with the U.S. Securities and Exchange Commission, consists of WebBank maintaining an-ongoing economic interest in all loans after they are sold to Lending Club via a “loan trailing fee,” which is paid on a monthly basis until the loan is paid back in full.5 If the borrower fails to pay back the loan, then WebBank will not receive the loan trailing fee from Lending Club. Under this arrangement, the bank’s revenue is tied to the terms and economic performance of the loans. The bank also maintains an on-going contractual relationship with the borrowers, who may later seek additional credit through the Lending Club program.6 These changes are designed to ensure that WebBank maintains “skin in the game” with respect to the loans it originates that are sold to Lending Club. Indeed, the Madden court indicated that its decision was based, at least in part, on the fact that the national bank that originated the loan did not maintain any continuing interest in the loan after it was sold.
The Madden decision is on appeal to the U.S. Supreme Court. In late March, the Court took the unusual, though not unprecedented, step of soliciting the views of the Solicitor General as to whether the Court should accept certiorari in the case. On May 24, the Solicitor General, in a joint brief filed with the Comptroller of the Currency, recommended that the Supreme Court not hear the case, noting that there was no split in the circuit courts and that the case was a poor vehicle for addressing the preemption question in view of deficiencies in the Second Circuit’s analysis. The brief also noted that any decision might not affect the outcome of the case, which remains on remand to the district court as to the effect of the choice-of-law clause in the applicable contract. Significantly, however, the agencies did express the view that the Second Circuit decision was wrongly decided and the assignee of a loan from a national bank should be entitled to charge the same interest rate as the national bank could charge. Although it generally follows the Solicitor General’s recommendations, the Court is not bound to do so and will allow both parties an opportunity to issue short responses before ultimately deciding whether or not it will grant certiorari. A decision by the Supreme Court appears likely by the fall of 2016 or early 2017.
3. Funding Issues Affecting Marketplace Lenders
One of the largest marketplace lenders recently set up an affiliated hedge fund whose purpose is to purchase the platform loans that it originates. Other marketplace lenders have taken similar steps. This underscores the longstanding concern of marketplace lenders that they may be vulnerable to a liquidity crunch during times when there is insufficient demand from buyers to purchase their loans. An affiliated hedge fund serves to diversify the funding sources available to a marketplace lender.
Unlike a bank, marketplace lenders do not have access to a steady stream of low-cost deposits to fund their lending operations. The ability of marketplace lenders to maintain access to funding during the ups and downs of a credit cycle is a critical factor in their ability to increase lending volumes and achieve the growth necessary to achieve and maintain profitability.
4. Marketplace Lenders Form Trade Group
In response to the increased regulatory scrutiny of the marketplace lending industry, Lending Club, Prosper Marketplace, and Funding Circle announced last month the formation of the Marketplace Lending Association, a new trade group that will represent the marketplace lending industry in Washington. The focus of the trade group is to have a forum for leaders in the industry to discuss and tackle the unique challenges, risks, and opportunities faced by participants in the sector. The Marketplace Lending Association will require its members to adhere to a specific set of operating standards that are designed to promote responsible lending, governance and controls and foster the industry’s growth. In light of recent developments, such efforts may be crucial in helping to regain the confidence of investors in marketplace loans as well as addressing the concerns of regulators.
5. The Treasury Releases White Paper on Online Marketplace Lending
On May 10, the Treasury issued a white paper on the online marketplace lending industry after soliciting input from the public in a Request for Information (“RFI”) issued last summer. The white paper acknowledges the benefits and risks of online marketplace lending and provides policy recommendations promoting the responsible growth of the industry.7 It was the goal of the Treasury to engage directly with the industry to foster discourse about how the industry could best serve the financial needs of the American public. Treasury received approximately 100 responses to its RFI from a wide range of stakeholders, including online marketplace lenders, trade associations, investors, academics and financial institutions. While commenters addressed a wide range of issues, several common themes emerged:
Use of Data and Modeling Techniques for Underwriting is an Innovation and a Risk – The use of data-driven algorithms for credit underwriting is one of the essential elements of online marketplace lending, which expedites credit assessments and reduces costs. However, there is concern that the use of such data could potentially have a disparate impact on certain groups of borrowers or present the potential for fair lending violations.
Marketplace Lending Expands Access to Credit – Marketplace lending has expanded access to credit for consumers and small businesses that ordinarily might not have had access to capital from a traditional lending institution.
New Credit Models and Operations Remain Untested – Marketplace lending models and underwriting tools have been deployed in an economic period of very low interest rates, declining unemployment, and strong credit conditions. There is concern that the industry remains untested through a complete credit cycle, particularly with respect to its servicing and collection capabilities.
Small Business Borrowers Will Likely Require Enhanced Safeguards – Small business loans are not currently subject to the same consumer protection regulations and safeguards as personal loans. There is a widespread view that small business borrowers need enhanced consumer protections when accessing credit either through a traditional financial institution or an online marketplace lender.
Greater Transparency Can Benefit Borrowers and Investors – There is a need for greater transparency for all marketplace lending participants. Suggested areas for greater transparency include clear pricing terms and disclosures for borrowers and standardized loan-level disclosures for investors.
Secondary Market for Loans is Undeveloped – The secondary market for whole loans originated by marketplace lenders is limited. Smaller loan size and underdeveloped trade and portfolio management infrastructures are several impediments affecting the growth of the secondary market in marketplace loans. The prevailing view is that a well-functioning securitization market is needed. An established securitization market with significant repeat issuances would lower funding costs for marketplace lenders and borrowing costs for consumers.
Regulatory Clarity Can Benefit the Market – Although there were diverse views regarding the role the federal government should play in the growing marketplace lending industry, there was general consensus that some level of regulatory clarity would benefit the industry. Particular areas suggested for regulatory attention include cybersecurity and fraud, the lack of federal supervisory authority for certain nonbank lenders, compliance with anti-money laundering and Bank Secrecy Act requirements and whether risk retention requirements should apply to the online marketplace lending model. As to risk retention, Treasury expressed the view that such requirements should not apply to the sale by marketplace lenders of member payment dependent notes in public offerings. In those transactions, marketplace lenders are selling securities to investors in the form of member payment dependent notes and investment contracts, rather than interests in pools of loans. According to Treasury, the risk retention requirements only apply to the securitizer in the securitization of marketplace lending notes, not to the originator selling the notes.
Based on market research and the RFI responses, Treasury issued the following recommendations to facilitate the safe growth of online marketplace lending while fostering affordable access to credit for consumers and businesses:
Support More Robust Small Business Borrower Protections and Effective Oversight – Treasury expressed willingness to work with Congress to consider legislation that increases oversight of online marketplace lenders and enhances protections for small business borrowers. Treasury noted that effective oversight could result in greater transparency in small business online marketplace lending that could lead to better outcomes for borrowers.
Ensure Sound Borrower Experience and Back-End Operations – To best serve borrower needs, Treasury recommends that the industry (i) adopt standards designed to provide a sound borrower experience from the start of the customer relationship to collections in the event of delinquency, (ii) develop contractual or other mechanisms to align the interests of borrowers and investors and (iii) provide strong customer service from origination to repayment, even in cases where borrowers face financial difficulties. Treasury also noted that it is vital that platforms develop back-up servicing plans to ensure loans continue to be managed if the firm ceases operations or fails.
Promote a Transparent Marketplace for Investors and Borrowers - In order to improve transparency for investors and borrowers, and to facilitate the development of an active and stable secondary market, Treasury recommends the creation of a private sector driven registry for tracking data on transactions, including the issuance of notes and securitizations, and loan level performance.
Expand Access to Credit Through Partnerships that Ensure Safe and Affordable Credit – To expand access to underserved markets, Treasury recommends that online marketplace lenders partner with community development financial institutions (“CDFIs”) that have significant experience serving this market. Traditionally, CDFIs provide a wide range of products, flexible underwriting and technical assistance to educate and support individuals and business in low income areas.
Support the Expansion of Safe and Affordable Credit Through Access to Government Held Data – Consistent with the federal government’s open data policies, Treasury supports allowing online marketplace borrowers access to their government held data for the purpose of verifying financial capacity during the underwriting process. Having access to data in real time will enable marketplace lenders to make more accurate credit assessments and reduce the risk of default.
Facilitate Interagency Coordination through the Creation of a Standing Working Group for Online Marketplace Lending – Treasury recommends the creation of an interagency working group to address issues related to online marketplace lending. The working group would include Treasury, the federal banking agencies, the CFPB, the Small Business Administration, the Securities Exchange Commission and a representative of a state bank supervisor. The working group would enable the member agencies to coordinate efforts towards identifying areas where additional regulatory clarity could protect borrowers and investors and expand access to credit.
Publication of the white paper evidences the important role of online marketplace lending in the U.S. consumer and small business credit markets. While Treasury has no direct regulatory oversight over marketplace lenders, the white paper helps frame the terms of the debate as to the appropriate role of government as the industry develops. The white paper identifies the opportunities and challenges of online marketplace lending and is likely to be used as a blueprint by regulators and legislators as they consider how best to encourage the development of the industry while protecting consumers and small business borrowers.