WASHINGTON – Congressional legislation that would deregulate the peer-to-peer lending market may result in a rapid expansion of the already booming industry.
The peer-to-peer market is based on a model of crowdfunding – the idea that borrowers can raise money through multiple small investments made by a large number of parties without the involvement of a financial institution.
But until now laws have allowed only “accredited investors” and the companies have had to register with the Securities and Exchange Commission, a requirement that many in the peer-to-peer lending market have seen as an obstacle to growth.
Sen. Scott Brown, R-M.A., wants to change that.
Brown testified Thursday before the Senate Committee on Banking, Housing and Urban Affairs during a hearing on crowdfunding legislation. Brown is the lead sponsor of the Democratizing Access to Capital Act – Senate legislation aimed at exempting crowdfunding websites from the legal regulations that Brown called obsolete.
“It’s called “crowdfunding” – that’s what happens when many investors make smaller-dollar investments in a project or company,” Brown said during his testimony. “It’s an innovative way to open up capital markets to new businesses and existing small businesses.”
The act would exempt small investments of $1,000 each, with the total amount of the investment limited to $1,000,000 from current SEC regulations.
“And because we all know you need a trustworthy market system before people will invest, my bill provides strong investor protections,” Brown said. “I know that other efforts have set different caps, some lower, some higher. I believe my bill is a good place to start, giving a fair shake to all market participants.”
Rep. Patrick McHenry, R-N.C., is behind another one of those efforts, only his plan – the Entrepreneurs Access to Capital Act, which passed the House in November – would let investors put up to $10,000 – or 10 percent of an investor’s annual income, whichever is the lesser value – in businesses not registered with the SEC.
“It’s clear that we need new ways to help small businesses and entrepreneurs take their ideas from the dinner table to the production line. The first step is to modernize outdated regulations that stand as barriers to American innovation,” McHenry said in a press release. “Crowdfunding can help give them the means to create jobs for hard-working individuals here at home.”
The McHenry plan would allow a crowdfunding exemption from SEC filing registration for firms that raise $5 million.
The White House has announced its support of efforts to establish a crowdfunding exemption for firms raising less than $1 million, less than the limit proposed in McHenry’s plan. “This will make it easier for entrepreneurs to raise capital and create jobs,” according to a White House press release.
Current registration regulation
Currently, crowdfunding sites that offer peer-to-peer lending services with the payment of interest are considered to be offering a “security” as the term is defined under federal securities laws. These sites are thus required to register all securities as the law outlines in the Securities Act of 1933.
To register each note bought and sold in each state the transaction takes place is an extremely expensive process. LendingClub.com and Propser.com are the only peer-to-peer sites that file daily with the SEC in all 50 states and are therefore able to operate nation-wide.
SoMoLend.com is peer-to-peer lending site that was recently launched only in the state of Ohio. Because of the current registration regulations, the site’s founder, Candace Klein, said it’s too expensive to operate in multiple states. If this regulatory exemption were passed, though, Klein said her site could go from operating in just Ohio to registering all 50 states over night.
While there are some exemptions to registration, such as intrastate offerings, these exemptions “restrict the very vitality of corwdfunding that makes it such a powerful force,” Klein said. “For example, limiting offerings to taking place within a single state does little to prevent fraud.”
More regulations in place
The Securities Exchange Act of 1934 specifies “any person engaged in the business of effecting transactions in securities for the account of others” as a broker. Under this definition, crowdfunding sites are interpreted to be acting as a broker and therefore must adhere to broker-dealer regulations as outlined by the act.
The Investments Advisor Act of 1940 defines an investment advisor as a party that provides investment advice for a fee. Under this act, crowdfunding sites are considered investment advisors, largely in part due to the regulatory efforts these sites take to protect investors.
“Obviously, there is a line that needs to be drawn so that actual investment advisers are regulated as such,” Klein said. “However, confirming debt to income ratios, years in business and other metrics, and using that information in an algorithm to produce an interest rate or other basic evaluation of risk, should not subject a crowdfunding site to investment adviser laws.”
What experts say
While the government takes steps towards deregulating the peer-to-peer lending market, some economists say that this industry actually needs more regulations, specifically in the role as investment advisors, to sustain its growth.
Borrowers are attracted to peer-to-peer lending options because they can often qualify for loans even if they have unbankable credit scores.
At SoMoLend.com, about 20 percent of borrowers do not qualify for loans from banks, according to Klein. Those borrowers would only qualify for a personal credit card.
Eventually, though peer-to-peer lending sites such as SoMoLend.com may have to “rely more havily on credit scores and apply some of the same kind of lending standards that traditional brick and mortar kinds of lending institutions have done,” Vanessa G. Perry, chair and associate professor of marketing at The George Washington University School of Business said.
And increased regulations may result in these alternative-lending platforms operating more like traditional lending institutions.
“If things continue in this way, this market will essentially be merged into the traditional lending market, and lending may become more accessible for borrowers who traditionally have not been able to get loans from traditional lending institutions,” Perry said.
But as alternative lending forums shift into higher regulatory standards, they will also likely face higher administrative costs. These potential costs are just another reason peer-to-peer sites could end up functioning more like traditional lending institutions.
Yet Klein says SoMoLend.com was developed with high regulatory standards in mind. “We set up for a high regulatory environment from day one,” she explained. “We anticipated we would be regulated like banks from day one. And the borrowers that come to our site mirror the borrowers who go to banks.”
Klein said that she foresees SoMoLend.com’s ability to remain successful in a potentially higher regulatory market as a product of the transparency the site provides its lenders. In addition to the five-star point system the site uses to assess potential borrowers, lenders are offered the opportunity to have direct communication with a potential borrower and even meet him or her in person.
The future of crowdfunding
Even with the high cost of regulations, the largest peer-to-peer lending in the U.S., Prosper.com foresees “fantastic growth for the industry,” according to Joseph Toms, the chief investment officer at Prosper.com.
It’s a market that offers borrowers an opportunity to achieve credit at lower interest rates and is a tremendously powerful opportunity for investors to earn yield, he added. And “there is a regulatory movement towards a more friendly crowdfunding approach.”
Prosper.com reported 12 consecutive months of growth in October. The growth was attributed in part to how “Prosper’s strong credit engine and risk scoring system continues to deliver the industry’s highest and most consistent seasoned lender returns, which in turn are driving Prosper’s exceptional growth,” Chris Larsen, Prosper’s chief executive officer and co-founder, said in a press release.
Experts such as Perry say that with so much volume these peer-to-peer lenders such as Propser.com will eventually have to put some sort of infrastructure into place, and that infrastructure will likely mirror that of a traditional lender. It is this that protects consumers and protects competition.
But Klein said it’s not accurate to peg banks and peer-to-peer lending sites as competitors.
“I see banks using these platforms as a new investment tool for their own money,” Klein explained. “Banks would tell you they have no interest in these small loans. It’s less an issue of credit worthiness and more an issue of small loans. If we do some of their due diligence for them I see banks utilizing sites like ours to bundle these small loans.”
Klein said that she thinks the alliance between banks and peer-to-peer lending forums will really start to take shape by the close of 2012.
“This is only good for small businesses,” Klein said. “Small businesses will have more options.”
The banking industry does very well, Toms added. Consumer lending is one area that banks did not need a bailout for.
“Banks want to protect their margin so it is not likely they will react soon,” Toms said. And the question is, Toms asked, “if and when they do this, can they do this successfully?”