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Talking Point

Tuesday 19 January 2016 12:42 London/ 07.42 New York/ 20.42 Tokyo

Category: ABS Regulation Secondary markets

Alignment of interest

Marketplace lending regulatory scrutiny discussed

Representatives from Kaye Scholer, Fundation Group and PeerIQ recently discussed the impact of heightened regulatory scrutiny on the US marketplace lending industry during a live webinar hosted by SCI (view the webinar here). This Q&A article highlights the main talking points from the session, including the fall-out from the Madden versus Midland Funding ruling and the US Treasury's request for information on the sector. For an in-depth exploration of the European marketplace and direct lending landscape, attend SCI's alternative lending and securitisation seminar on 10 February.

Q: The Madden vs Midland Funding case hit the headlines in May 2015, when the US Court of Appeals for the Second Circuit ruled that a non-bank debt collector that purchased written-off credit card accounts from a bank could not rely on the pre-emption of State usury laws. If interpreted broadly, the decision could affect a wide array of bank-originated loans that are subsequently sold to non-bank entities. How is the Madden case expected to impact the marketplace lending industry specifically?
Lawton Camp, partner at Kaye Scholer:
A typical marketplace lending structure involves a national bank or federally chartered institution originating loans based on criteria established by the bank and the marketplace lender. The bank transfers that loan to the marketplace lender or to investors that are funding the loan after a certain period of time has passed.

Pursuant to the National Bank Act and Section 27 of the Federal Deposit Insurance Act, a bank that is federally insured may impose fees in accordance with the usury laws of the State in which it is located. Web Bank, for example, is located in Utah; therefore, you would look to Utah's usury law - regardless of the location of the borrower. Before Madden, it was assumed by marketplace lenders and investors that if the loan was enforceable at the time of issuance, it would be enforceable by any subsequent assignee.

The Madden case involves a collection action with respect to a charged-off credit card account. The credit card was issued by a bank in Delaware related to Bank of America. The charged-off account was purchased by Midland Funding, who attempted to collect on the outstanding balance. Midland continued to charge interest on the outstanding balance after it purchased the charged-off account at the original default rate.

Madden sued in the District Court of New York, claiming - among other things - that as Midland isn't a bank, it may not rely on the federal pre-emption relied on by the Delaware bank. This pre-emption had allowed the Delaware usury laws to be exported to New York, where Madden resided.

The District Court upheld the exporting of the interest rate, but the Second Circuit subsequently overturned the ruling and stated that once the Delaware bank had sold the entire account to a non-bank, the non-bank holder of the account could not rely on the federal pre-emption relied on by the Delaware bank. However, the Second Circuit remanded the case to the District Court to determine whether the law of the State of the consumer or the governing law of the underlying contract would apply.

In the context of marketplace lending, the decision creates concerns by non-bank holders of marketplace loans that they may not be able to enforce collection on a loan if the interest rate on the loan is above the relevant State usury rate.

Henry Morriello, chair of the finance practice at Kaye Scholer: The Madden ruling has the greatest impact in the consumer sector, where civil usury limits come into play. The ruling has implications for everyone involved in marketplace lending, especially as loans move from platforms to investment vehicles to securitisation vehicles. It has precipitated a good deal of proactive structuring to allow issuers to get comfortable that the ruling won't interfere with cashflows, nor subject them to any sanctions.

LC: With respect to Madden, the district court will need to determine which State usury rate applies. Beyond the specific facts in Madden, the appropriate State usury limit may depend on the law of both the State where the loan was originated and the State in which the borrower resides. It will be interesting to see if the Supreme Court decides to review the decision.

Kevin Reed, coo and evp at PeerIQ: Most platforms and institutions appear to be adopting a 'business as usual' attitude, at least with respect to the primary market - in other words, purchasing loans from platforms. Most participants feel that the Madden ruling is a questionable decision and contrary to precedent.

Nevertheless, there is a sense that sponsors have a fiduciary duty to exclude Second Circuit loans from securitisations, given the potential risk of discharge. With respect to warehouse lines, some credit providers are asking for covenants that exclude loans originated within the Second Circuit - either full exclusions or only those loans that are in excess of the usury rate.

Marketplace lending securitisation is a non-standard, nascent industry. Representations and warranties aren't standardised and most sponsors don't have long histories, and Madden has brought the specter of unenforceability. But we haven't seen any movements on existing securitisations yet and there isn't a secondary market, so we can't tell how the potential legal risk of Madden is being priced in.

The impact could worsen if the decision is adopted by other States, but at the moment it is somewhat contained - assuming the attributes of warehouse lines and so on remain unchanged. We are yet to see a slow-down in originations; nor have we seen a specific move away from lower FICO originations.

The actual impact of the ruling within the Second Circuit has been marginal. In terms of Lending Club and Prosper originations, only 3% of their loans within New York, Vermont and Connecticut have interest rates above State usury caps.

Q: What are the ramifications of the Madden decision being adopted by other States?
KR:
It would likely have the biggest impact on California, which is the largest market in terms of marketplace loan originations. While New York has a 16% usury rate, for instance, California's is 10% - meaning that three-quarters of consumer loans originated in the State would be affected by the ruling. However, there is a precedent in California that runs fairly contrary to Madden and so there is a bit of a 'wait and see' approach at present.

LC: A number of other States also have precedents that are the contrary to Madden. But there are cases in other States, such as West Virginia, that are not as favourable.

HM: Generally speaking, usury is a matter controlled by State law and, therefore, the outcome of situations like the Madden case will likely vary State-to-State. For States that have adopted the Uniform Consumer Credit Code (UCCC), the law of the State in which the consumer resides will generally control. However, in States that aren't subject to the UCCC, a further analysis must be made as to whether the controlling law will be the law in which the consumer resides or the governing law of the contract.

Against this backdrop, during the aggregation phase prior to tapping the capital markets, various provisions are being inserted in financing documents for loans to become ineligible if Madden spreads to jurisdictions beyond those located in the Second Circuit.

Q: How can the industry gain clarity around 'true lender' status of online lending platforms?
Samuel Hu, evp - head of legal, compliance and operations at Fundation Group:
There are three ways that the industry can potentially gain clarity around the issue that the Madden case has raised.

The first is for a platform to become the 'true' lender; in other words, the platform would actually originate the loans in the first place. This solution would typically require each platform to obtain licences in each State that they want to lend in and then abide by the applicable State laws, including any usury limits in those States. But sometimes the usury limits may be too low to be a viable option, based on the borrowers they are trying to attract, or the licencing requirements may be too difficult or costly to satisfy.

The second option is to simply do nothing and wait to see what choice of law the District Court ultimately applies in the Madden case. If the District Court determines that Delaware law applies, there may be less scrutiny around the issue since there is no criminal usury law in Delaware. Marketplace lending platforms may also just wait to see if a Supreme Court ruling brings more clarity, given the fact that there is substantial precedent that is contrary to the Second Circuit's decision in Madden.

The third approach could involve an industry response to develop a standardised set of policies and procedures that need to be adopted by an 'originating bank' (such as WebBank), so that it would be clear that the originating bank is in fact a 'true lender' and, as such, can rely on laws such as the National Bank Act and Section 27 of the Federal Deposit Insurance Act. Such policies and procedures could require the originating bank to conduct its own know-your-customer (KYC) due diligence on each borrower, a credit analysis of each borrower and/or require the originating bank to retain the risk of each loan that it originates for a certain length of time.

Q: The Madden case has focused attention on reps and warranties and enforceability in connection with marketplace lending securitisations. What should investors look for when assessing these features?
SH:
The Madden case focuses on one particular representation and warranty; that is, whether the underlying receivable is enforceable with respect to the borrower. If it is unclear as to whether or not the securitised receivables are enforceable, investors should focus on the remedies available to them if the enforceability representation turns out to be invalid.

The remedies available in a typical securitisation include a put-back right or an indemnity claim against the platform. However, remedies are only as good as the ability of platforms to honour them.

Many smaller or less capitalised platforms may not have the capital to remedy significant put-back claims or honour indemnity provisions. Consequently, investors need to analyse both a platform's practices to gauge whether there may be an issue regarding enforceability or the loans and a platform's ability to provide adequate remedies in the event that there is an issue.

Q: Regulatory scrutiny of the marketplace lending model increased in July 2015 when the US Treasury issued a request for information aimed at ensuring both that the industry grows in a safe manner and that Treasury officials fully understand it. How has this RFI been received by the industry?
KR:
The context in which the RFI was introduced was that the Treasury is gathering information and isn't contemplating any additional regulation. The primary focus is how marketplace lending can address underserved credit markets and how the technology can be leveraged for more efficient underwriting and better borrower penetration.

The slowest recovery has been in consumer and small business lending. The Treasury sees P2P lending as a great way of plugging the gap, but it wants to ensure that the sector grows in a responsible way.

A primary topic of the debate is how to create alignment of interest in a way that doesn't kill innovation. This has spurred a lot of discussion about risk retention and how it would affect platforms that don't have balance sheets.

There may be ways of partnering up with another institution to satisfy risk retention requirements, but it may also force many lightly capitalised platforms out of business. Such consolidation is probably premature, however.

Our view is that there needs to be alignment of interest, but it doesn't have to be in the form of risk retention. Many alternative mechanisms could be used; for example, standardisation of data in a useable format is a great source of alignment of interest.

Q: In its RFI, the Treasury asked if marketplace lending platforms should be required to have skin in the game for the loans they originate. How is this issue likely to play out?
HM:
Our view is that there needs to be alignment of interest among participants in the market, but that the Dodd-Frank provisions are adequate to cover ABS investors that aren't 'at the table' to negotiate risk retention into their own contracts. Generally under these provisions, the sponsor in a securitisation is required to hold 5% of the risk associated with the ABS.

That 5% can be achieved in various formats - through a horizontal tranche, a vertical tranche or an L-shaped tranche, which is a combination of both the horizontal and vertical tranches. The idea is to encourage sponsors to issue responsibly because they're retaining 5% of the risk.

Marketplace lending securitisation participants generally include the originating bank, the platform, the aggregator (which buys the loans from platforms to then securitise) and the ABS issuer (which is normally an affiliate of the aggregator). The view of many trade organisations is that these parties are able to negotiate for themselves the appropriate level of risk that they should take and that regulation isn't necessary to protect them.

SH: The skin-in-the-game question primarily arises where the platform itself simply facilitates a loan, but never holds any part of the risk. It's debatable whether that kind of business model will ultimately be successful, given that it only allows platforms to earn fees from origination and servicing, but no interest income.

Based on the financial information that is publicly available, it is clear that in order to be profitable, platforms that rely only on origination and servicing fees for revenue need to operate on a large scale. On the other hand, platforms that originate and hold assets on their own balance sheet clearly have skin in the game. My view is that the skin-in-the-game question might be a little premature to ask from a regulatory perspective, as it could resolve itself in how the marketplace lending industry develops and what business models ultimately prevail.

Q: Given the heightened scrutiny of the sector, how should investors in marketplace loans and related securitisations assess the regulatory risks of holding these assets?
SH:
Apart from enforceability of the underlying assets and the related issues, other regulatory risks that could be concerning for investors include reputational risk - whether they want to be associated with an industry that typically charges high interest rates (albeit with the intent of providing credit to underserved borrowers) and offers products that may be in some people's view predatory. Another risk is information security: to the extent that investors obtain personal information on underlying borrowers, they need to ensure that they adequately protect this information, so that the data isn't leaked or accessed fraudulently. Investors also need to ensure that platforms are complying with KYC/AML requirements so that they are not inadvertently participating in any illegal activities.

Q: How can marketplace lending platforms differentiate themselves in light of heightened regulatory scrutiny?
KR:
While many larger incumbents are based on a P2P model, newer players are adopting a balance sheet model and obtaining funding for their loans from a number of large institutions. Increasingly platforms are embracing other methods too.

Many are trying to grow rapidly, so it's about how they can differentiate their capital markets strategy - especially in terms of securing long-term, stable and passive funding. There is a lot of retail interest in the sector at the moment, but that money can be fickle, so platforms are considering which mechanisms and products can allow institutions to hold marketplace investments through a credit cycle - whether that would be via risk transfer or owning particular parts of a security.

Capital markets strategies are driven by how platforms can achieve the lowest cost of capital. If they have a lower cost of capital than their competitors, they can offer better rates to the end-user and originate loans more efficiently.

SH: Platforms can also differentiate themselves by highlighting which steps they're taking to go above and beyond what's necessary from a regulatory perspective. For example, although there is no specific stipulation regarding data security, a marketplace lending platform can adopt guidelines published by the Federal Financial Institutions Examination Council and design their IT infrastructure accordingly. Other examples include employing specialised anti-money laundering officers to identify suspicious activity and adoption of robust compliance management systems to address issues such as fair lending and consumer complaints.

SCI's Marketplace, Direct Lending & Securitisation Seminar is being held on 10 February at The Royal College of Surgeons of England, 35-43 Lincoln's Inn Fields, London. The conference programme consists of panel debates covering the investor perspective, risk management and underwriting, bank partnerships, structuring and credit considerations, regulatory challenges, disintermediation and lending strategies.

Speakers include representatives from: Beechbrook Capital Partners, BNP Paribas Investment Partners, Bondora, Chenavari, Crowdnetic, East Lodge Capital Partners, ESF Capital, EuroCredit Exchange, 400 Capital Management Europe, GLI Finance, Godolphin Capital, Liberum, Proventus Capital Partners, Ratesetter, Venn Partners, Victory Park Capital, Whitehorse and Zopa.

Please email SCI for a conference registration code or click here and follow the link to register.

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