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View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Yale Law School Legal Scholarship Repository The Misregulation of Person-to- Person Lending Andrew Verstein* Amid a financial crisis and credit crunch, retail investors are lending a billion dollars over the Internet, on an unsecured basis, to total strangers. Technological and financial innovation allows person-to-person (“P2P”) lending to connect lenders and borrowers in inspiring ways never before imagined. However, all is not well with P2P lending. The SEC threatens the entire industry by asserting jurisdiction with a fundamental misunderstanding of P2P lending. This Article illustrates how the SEC has transformed this industry, making P2P lending less safe and more costly, threatening its very existence. The SEC’s misregulation of P2P lending provides an opportunity to theorize about regulation in a rapidly disintermediating world. The Article then proposes a preferable regulatory scheme designed to preserve and discipline P2P lending’s innovative mix of social finance, microlending, and disintermediation. This proposal consists of regulation by the new Consumer Financial Protection Bureau. TABLE OF CONTENTS INTRODUCTION ................................................................................... 447 I. PERSON-TO-PERSON LENDING .................................................. 451 A. The Heartland of Person-to-Person Lending ....................... 451 B. Core Benefits and Efficiencies of P2P Lending .................... 457 C. Risks: Lender’s Money, Borrower’s Privacy ........................ 466 II. P2P LENDING AND PROBLEMS WITH THE SEC ........................... 475 A. Regulatory Overreach ........................................................ 478 * Copyright © 2011 Andrew Verstein. Associate Research Scholar in Law and John R. Raben/Sullivan & Cromwell Executive Director, Yale Law School Center for the Study of Corporate Law, Yale Law School. I would like to thank Ian Ayres, Steven Bradford, Eric Chaffee, Steven M. Davidoff, Kevin Davis, Anna Gelpern, Matthew Grieder, Mitzi Huang, Jonathan Macey, John Morley, Adam C. Pritchard, Larry Ribstein, Roberta Romano, Lanny Schwartz, Natalya Shnitser, Norman Silber, Robert C. Strong, II, Geoffrey Rapp, Gabriel Rauterberg, Lynn Wang, Anthony Weaver, and Ralph Winter for extensive comments. I am also grateful to my numerous interview subjects. 445 446 University of California, Davis [Vol. 45:445 B. Perverse Consequences of SEC Regulation ......................... 488 1. Formalistic Registration ............................................. 488 2. Mandatory Disclosures ............................................... 500 3. Difficulty of Private Enforcement .............................. 504 4. No Mandate to Help Borrowers .................................. 506 5. The Cliff Effect: Disperate Treatment for Similar Risks ........................................................................... 509 C. Understanding Misregulation ............................................ 517 III. REFORM PROPOSAL: P2P LENDING UNDER THE CONSUMER FINANCIAL PROTECTION BUREAU ............................................. 522 CONCLUSION....................................................................................... 529 2011] The Misregulation of Person-to-Person Lending 447 INTRODUCTION Amid a financial crisis and credit crunch, retail investors have lent over $1.5 billion through the Internet, on an unsecured basis, to complete strangers.1 Technological and financial innovation allows person-to-person (“P2P”) lending to connect lenders and borrowers in inspiring ways never before imagined. Industry analysts project that P2P lending could exceed $5 billion annually by 2013,2 with some even suggesting figures of greater than $30 billion.3 This blossoming of P2P lending brings with it both new risks and new regulatory concerns. For example, lenders may not be repaid in full, borrowers risk their privacy, and Internet platforms extend questionable 1 Rachel Gotbaum, Avoiding the Pitfalls of Family Borrowing, NAT’L PUB. RADIO (Oct. 6, 2006), available at http://www.npr.org/templates/story/story.php?storyId= 6208227 (stating that Circle Lending, later Virgin Money USA, lended over $100,000,000); About Us: Statistics, KIVA, http://www.kiva.org/about/facts (last visited Sept. 24, 2011) ($244,323,625); Lending Club Statistics, LENDING CLUB, https://www.lendingclub.com/info/statistics.action (last visited Sept. 24, 2011) ($366,103,025); Performance Data, PROSPER, http://www.prosper.com/invest/ performance.aspx (last visited Sept. 24, 2011) ($258,229,901); The Largest P2P Lending Service Is . ., P2P-BANKING.COM (Feb. 20, 2011, 6:30 AM), http://www.wiseclerk.com/ group-news/countries/china-the-largest-p2p-lending-service-is/ (CreditEase: about $300,000,000 annually); Zopa Sees Surge in Demand as Banks Fail to Meet Consumer Interests, FINEXTRA (Mar. 9, 2011, 10:09 AM), http://www.finextra.com/ News/Fullstory.aspx?newsitemid=22342 (£125,000,000, or about $200,000,000). 2 Press Release, Gartner Newsroom, Gartner Says 50 Per Cent of Banks Will Still Lack an Innovation Programme and Budget by 2013 (Jan. 5, 2010), available at http://www.gartner.com/it/page.jsp?id=1272313 (“By 2013, P2P lending will soar at least 66 per cent to $5 billion of outstanding loans.”). 3 $30 billion would represent a modest 1% of the U.S. consumer credit market. BD. OF GOVERNORS OF THE FED. RESERVE SYS., FLOW OF FUNDS ACCOUNTS OF THE UNITED STATES: FLOWS AND OUTSTANDINGS, SECOND QUARTER 2011, at 100 tbl.L.222 ( 2011), available at http://www.federalreserve.gov/releases/z1/current/z1.pdf (indicating total consumer credit liabilities of households and nonprofit organizations is about $2.4 trillion); see David. G. Blanchflower & David S. Evans, The Role of Credit Cards in Providing Financing for Small Businesses, 2 PAYMENT CARD ECON. REV. 77, 79 n.4 (2004) (“Other estimates place the amount of [consumer] credit available at over $4 trillion.”); see also Alan Farnham, New Ways to Get a Loan Without Going to a Bank, ABC NEWS, (Jan. 6, 2011), http://abcnews.go.com/Business/online-peer-peer-loans- benefit-borrowers-lenders/story?id=12547398 (quoting LendingClub CEO and co- founder Renaud Laplanche’s explanation that “[i]f you compound [Lending Club’s] growth rate, [they]’ll be the size of Citibank in three years”); Press Release, Zopa, Zopa Lending Passes £100 Million Milestone (Sept. 30, 2010) (available at http://uk.zopa.com/ApplicationResources/press/2010/Zopa%20lending%20passes%201 00%20million%20milestone.pdf) (stating that one UK P2P firm currently accounts for more than 1% of all UK consumer credit transactions). 448 University of California, Davis [Vol. 45:445 promises to transacting parties.4 Who will police this burgeoning market and under what regulatory scheme? The U.S. Securities and Exchange Commission (“SEC”) currently asserts itself as the chief regulator over P2P lending and requires P2P lending firms to register as issuers under the Securities Acts.5 This Article argues that the SEC fundamentally misunderstands this innovative industry of P2P lending. As a result of the SEC’s inability to grasp the true nature of P2P finance, the SEC overreaches its authority and threatens the very existence of P2P marketplaces. Thus, SEC oversight increases both risk for P2P lenders and cost for P2P borrowers.6 This Article begins in Part I by introducing P2P lending and demonstrating that P2P transactions provide a core economic function worth preserving. Consumers, and the financial system, as a whole, benefit from P2P lending. Part I also presents risks associated with P2P lending, such as fraud and identity theft, that require sensible regulation.7 Part II traces the SEC’s involvement in the P2P lending market. The SEC approached P2P regulation under the ill-fit vocabulary and logic of the traditional investor and issuer.8 This misapplication led the SEC to conclude that P2P transactions must register under the Securities Acts.9 Operating under the wrong assumptions and the wrong regime, the SEC forced P2P online lending firms to offer even riskier assets. Imposing the securities regime on the P2P lending market also discourages competition by raising costs, and leaves consumer complaints unanswered.10 Part II also analyzes the SEC’s response to P2P lending,11 assesses the SEC’s role in the twenty-first century, and questions why the SEC was unable or unwilling to fashion a nuanced response to P2P lending. The analysis suggests that the SEC’s failure 4 By “platform,” I refer to the various internet sites providing access to P2P lending services. 5 The securities laws require issuers of securities to disclose certain information to investors through the prospectus, a legal offering document, and through periodic filing with the SEC. Securities Act of 1933 §§ 6, 7, 10, 15 U.S.C. § 77(f)-(g), (j) (2006); Securities Exchange Act of 1934 §§ 12-13, 15 U.S.C. § 78(l)-(m) (2006). 6 See infra Part II.B. 7 See infra Part I. 8 It is not wrong to refer to P2P lenders as “investors,” a term this article, too, uses. Rather, the language of investment led the SEC to apply the wrong regulatory framework to the putative issuer. See infra Part II. 9 See infra Part II.A. 10 See infra Part II.B. 11 See infra Part II.C. 2011] The Misregulation of Person-to-Person Lending 449 may be part of a general trend of regulatory discomfort with a rising trend of disintermediation.12 Part III recommends naming the Consumer Financial Protection Bureau as the
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