By Chris Gillock
When a new, disruptive business model emerges, there is usually some blow-back from the parties suffering the disruption. With marketplace lending, existing lenders face the biggest impact. Regulators, litigators and the media also take note and can challenge the upstarts. The New York Times took a poke at the marketplace lending sector this morning and the courts and regulators are making noises, too. Zach Fox of SNL Financial wrote a great overview of the situation:
Monday, September 14, 2015 12:20 PM CT
Court rulings bring uncertainty to marketplace lenders
By Zach Fox
Regulatory uncertainty has cropped up around marketplace lenders, but some legal and equity analysts think much of the concern is overwrought and that these lenders will not be forced to change their business models anytime soon.
Marketplace lenders have exploded in popularity in the U.S. over the last couple years after launching just before the 2008 credit crisis. Sometimes known as peer-to-peer lenders, the online-based companies allow individuals and institutions to invest in loans to borrowers in need, often focusing on unsecured personal loans.
Many states set maximum interest rates that lenders can charge, a restriction that some marketplace lenders can avoid by relying on certain legal theories. Under the National Bank Act, a federally chartered bank can charge as much as allowed by law in its home state. Marketplace lenders also rely on “choice-of-law” provisions in contracts that stipulate a certain state’s law is applicable.
A couple of the largest marketplace lenders, LendingClub Corp. and Prosper Marketplace Inc., have partnered withWebBank, based in Utah, which does not have a maximum interest rate for loans. This practice, sometimes referredto as “rent-a-charter,” has come under scrutiny following recent court rulings.
A May ruling in the case of Madden v. Midland Funding LLC undermined that tactic. The U.S. Court of Appeals for the Second Circuit found a nonbank debt collector that had purchased debt from a bank could not rely on that bank’s exemption from state-level usury laws. In a July 20 report, Moody’s called the decision a credit negative development for marketplace lenders. An Aug. 25 report from Bloomberg News noted that financial institutions have become more reluctant to partner with marketplace lenders following the ruling.
The Second Circuit on Aug. 12 denied a request to rehear the case, which means it will stand as precedent unless the Supreme Court takes up the issue, according to a report by lawyers at Orrick Herrington & Sutcliffe LLP.
LendingClub Chairman and CEO Renaud Laplanche told SNL that the ruling has had no impact on the company’s operations in the geographic area covered by the Second Circuit.
“We continue to do business the same way as we’ve done it before, and we’re having no trouble funding loans in New York, Connecticut and Vermont and continue to see plenty of investor interest,” Laplanche said.
Another unfavorable court ruling for the industry came Aug. 27 when a judge granted a preliminary injunction in the North Carolina Attorney General’s case against Western Sky Financial and CashCall Inc. A Sept. 2 report from analysts at Compass Point Research and Trading noted that the judge rejected the defendants’ argument that they enjoyed a “choice-of-law” provision by Western Sky’s affiliation with the Cheyenne River Sioux Tribe.
The Treasury Department has an outstanding request for information on marketplace lending business models, a process that often precedes new regulatory oversight.
Despite the unfavorable rulings and looming potential of regulatory oversight from the Consumer Financial Protection Bureau, analysts think the backlash has been oversold. In the Sept. 2 note from Compass Point, analysts said the North Carolina Attorney General’s injunction creates “another wave of uncertainty” while cautioning investors to not interpret the findings “too broadly,” especially considering the involvement of a Native American reservation, which does not apply to the largest marketplace lenders.
The Madden v. Midland ruling is far from settled law. While the ruling has triggered some consternation around marketplace lending, the implications are just as significant for the deep-pocketed credit card industry, said Julianna Balicka, an analyst with Keefe Bruyette & Woods.
“Before it hits LendingClub, we have to consider what the Visas of the world are going to do about it,” said Balicka, adding that the banking industry will take a look as well. “There are going to be a lot of challenges to that ruling.”
Scott Pearson, a partner at Ballard Spahr and leader of the firm’s new marketplace lending task force, agreed that the Madden v. Midland ruling’s impacts stretch far beyond marketplace lenders. If the ruling stands, it could affect banks’ ability to sell loans across state lines, an integral part of retail banking, as well as the ability to issue securitizations. Because the ruling could cause trouble for so many industries, Pearson said it will take up to a year to see any operational impacts and that it is possible the Supreme Court could take up the case.
“In the views of a lot of people, it was pretty crazy because it really disturbs decades and decades of well-settled law,” Pearson told SNL.
The Madden v. Midland ruling would appear to have a limited impact on the leading marketplace lenders. According to a Sept. 4 report from research firm IBISWorld, just three companies account for 55.3% of all marketplace lending — LendingClub, Prosper and Social Finance Inc.
A couple of analysts forecast very limited impact to LendingClub, by far the largest player with 34.5% market share. Even under a worst-case scenario in which all loans with interest rates in excess of state usury laws are declared null and void, it would affect just 12.5% of the institution’s loans, the amount Laplanche said came in above state usury laws.
Laplanche told SNL that the Madden v. Midland ruling was irrelevant since LendingClub relies on choice-of-law provisions. And he said the North Carolina Attorney General’s win against Western Sky was inapplicable since the lender in that case charged exorbitant rates and relied on Native American tribal law, whereas LendingClub lowers interest rates and relies on Utah state law.
“For any choice-of-law provision, it’s a matter of fact and circumstances,” Laplanche said.
Analysts said On Deck Capital Inc., the only other publicly traded top marketplace lender, should be similarly insulated from the Madden v. Midland ruling since it largely lends to small businesses, as opposed to individuals.
“Given our specific commercial lending model, we believe we have limited exposure to Madden vs. Midland,” OnDeck CFO Howard Katzenberg said in a statement provided to SNL. “Several funding transactions involving sophisticated financial institutions have closed since the ruling, and we do not anticipate any imminent changes to our financing strategy.”
Rob Lavet, general counsel for Social Finance Inc., told SNL that the company does not rely on choice-of-law provisions at all and instead secures its own charter in each state. As such, SoFi, which primarily focuses on refinancing student debt at lower rates, already abides by state-level usury laws.
“We prefer to have control of our own destiny through the state licensing route,” Lavet said.
Prosper Marketplace declined to comment.
As for Treasury’s request for information, which could be the start of supervision under the aggressive CFPB, analysts think the very nature of marketplace lenders provides protection. Much of the origination volume so far has been in the form of debt consolidation or refinancing, which lowers the interest rates consumers pay.
“The regulators whom I’ve spoken with about this, I think, are a little bit torn because they realize that marketplace lenders are filling a void in the market that is very important,” Ballard Spahr’s Pearson said.
In a recent interview with The Associated Press, CFPB Director Richard Cordray offered a fairly benign assessment of the industry: “We have been monitoring it and have had some of the companies in to talk to them. So far it has been a pretty consumer friendly industry. We will see how it develops.”
Marketplace lenders tend to offer loans to consumers who cannot access credit from retail banks. That could make tough regulatory oversight improbable in a political environment marked by concerns over credit accessibility.
“OnDeck is a small business lender, so from [regulators’] perspective, they would have to be coming down on credit availability for small businesses, and it would not necessarily be politically realistic,” KBW’s Balicka told SNL. “And from LendingClub’s perspective, they offer much better rates than credit cards.”