Death by Regulation: Is Peer-to-Peer Lending Next?

One of the more promising alternatives for accessing capital by small business owners has been the growth of “peer-to-peer lending” – arrangements where borrowers and lenders transact without the traditional intermediaries (such as banks). These networks are also known as social lending networks.

As an Inc.com article describes them: “Through peer-to-peer lending websites, small-business owners or other people seeking a loan can borrow directly from individual lenders, eliminating banks from the process. On some sites, like Prosper.com, lenders bid on the interest rate they are willing to give a borrower. On others, like LendingClub.com, interest rates are based solely on the borrower's credit history and set by the company itself.” (Read the full Inc.com article here: “Getting a Loan Just Got Harder.”)

Around 2005, this type of lending began getting traction. As credit and capital got tighter in 2007 and 2008, peer-to-peer loans really took-off. By some estimates, outstanding loans in 2007 amounted to $647 million.

Quite possibly, due to their success, as well as the positive media coverage that such lending received, the Securities and Exchange Commission (SEC) became very interested in peer-to-peer lending sites. The following October 15, 2008 New York Times piece, “Lending Alternative Hits Hurdle” by Brad Stone, goes into detail about the SEC's involvement and inquiries into peer-to-peer loans.

Of course, Mr. Madoff escaped the eyes of regulators and the media while working his ponzi scheme. Same goes regarding the misdeeds of the financial industry. But really, what watchdog couldn’t have predicted what was about to unfold in the mortgage marketplace? Individuals were qualifying for mortgages and terms they couldn’t afford. (I do feel very bad for these homeowners, and former homeowners. Yes, while they should have been aware of the “if it’s too good to be true” rule, everyone involved in peddling these loans knew better.)

Anyway, it looks like peer-to-peer lending has been ensnared within the SEC’s bureaucracy.

As Inc.com reports: “In November, the SEC filed a cease-and-desist order against San Francisco-based Prosper Marketplace, which runs Prosper.com, ruling that the loan notes being offered on the site were securities and needed to be registered with the commission. Prosper had stopped facilitating new loans the previous month in anticipation of the ruling, and to start the registration process to set up a secondary marketplace where lenders could package and sell loans to each other. Prosper also reached a $1 million settlement with the North American Securities Administrators Association, the membership organization for state securities commissioners. As a result, another peer-to-peer startup, New York-based Loanio, decided to do the same in November, only a month after launching. London-based Zopa.com also closed its U.S. peer-to-peer lending site in October.”

The SEC says it protecting the lender-investor, and that they don’t want to harm innovative new practices in the marketplace. "Generally, we are always cognizant of new companies trying to do something innovative," said Laura Josephs (as quoted by Inc.com), an assistant director with the commission's enforcement arm who led the case against Prosper. "It's in nobody's interest to stomp out innovative products," she added.

Well, the bottom line is that Lending Club is the only peer-to-peer site “left standing.” The sad story here, of course, is that functioning, transparent and upright entities that are providing small business owners and new entrepreneurs with alternative tools for financing (and perhaps other innovative services to come) are getting caught up in outdated SEC rules and laws. No doubt, the frenzy to preemptively go after bad actors like Madoff is playing a big role in this crack down as well.

The current situation just goes to show how dysfunctional and archaic the financial regulatory system has become. Similar to Washington’s response in the wake of the Enron and MCI scandals, Congress ushered in Sarbanes-Oxley (SOX). Entrepreneurs and small public companies got hurt by SOX (and look how well it performed in making big public companies more accountable and transparent to shareholders!), and now entrepreneurs are getting the hit again.

The SEC may be doing its job, but isn’t there a faster, flexible way they can do it without hurting entrepreneurs and innovation in the financial system industry?

Karen Kerrigan, President & CEO