This article also appeared in the February 8, 2016 issue of Westlaw Journal - Bank & Lender Liability
As online consumer marketplace and peer-to-peer lending (Marketplace Lending) continues to grow into the mainstream, Marketplace Lending platform operators (Operators), lenders, and their service providers will come under greater scrutiny from federal and state regulators and policymakers. This pressure will likely increase as small dollar lenders, banks, credit unions, and institutional investors shift from traditional lending to Marketplace Lending in search of new markets and the potential for higher (or safer) returns. And, as is usually the case, additional scrutiny will lead to questions of whether there are adequate consumer protections for Marketplace Lending.
This article summarizes the complex and evolving regulatory framework for Marketplace Lending and provides suggested best practices for mitigating potential risk. In particular, we see three broad trends that will drive operational and regulatory risk for the industry moving forward:
- Increased operational costs driven by regulatory pressure;
- Increased regulatory and examination risks, most likely pushed by the Consumer Financial Protection Bureau (CFPB) and Securities and Exchange Commission (SEC); and
- Increased emphasis on compliance with consumer protection laws and regulations, in particular the need to implement an effective, efficient compliance management system (CMS).
We address these challenges below, along with suggestions for how Operators, lenders, and others in the industry can minimize potential regulatory risk and set up their businesses for long-term success.
What is Marketplace Lending?
With origins in crowdfunding, Marketplace Lending involves the use of online and other financial technology (FinTech) to allow direct lending between individuals (e.g., peers) in the consumer lending marketplaces. A traditional Marketplace Lending Operator, for example, manages an online platform that connects consumers seeking to obtain loans with other consumers interested in lending their own money to borrowers. The Operator does not lend its own funds; rather, the Operator makes money by charging fees and interest for each loan originated through the platform. In recent years, Operators have begun to expand operations by partnering with banks and institutional investors to fund lending platforms. A hedge or private equity fund, for example, might fund loans through a platform or purchase loans that have been bundled and securitized.
Although Marketplace Lending has received considerable attention in recent years as a disruptive force, the business model, at a basic level, involves many of the same steps as traditional lending – the marketing, underwriting, closing, servicing, securitization (in some cases), and collection of loans (if defaulted). All of these activities, as outlined below, have traditionally been subject to significant state and federal regulation and oversight. The fact that these activities take place through a different mechanism may not always protect Operators, lenders, and their service providers from federal and state regulatory scrutiny.
What Federal and State Laws and Regulations Govern Consumer Marketplace Lending?
Marketplace Lending—like other forms of lending—is subject to a host of federal and state consumer protection laws and regulations. So much so, in fact, that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank) directed the U.S. Government Accounting Office (GAO) to issue a report exploring potential future approaches for regulating Marketplace Lending. The GAO report, issued in 2011, identified two approaches: The first, an SEC-centered approach, would focus on protecting investors in connection with the purchase of federally regulated securities. The second, a CFPB-centered approach, would place the CFPB in charge of regulating Marketplace Lending loans as "consumer financial products."
Although the GAO did not recommend a particular approach, the CFPB is well positioned to take the lead in supervising and regulating Marketplace Lending. The CFPB, after all, has broad supervisory and examination, rulemaking, and enforcement authority over traditional lenders and a broad consumer protection mandate. Until a lead regulator emerges, however, the Marketplace Lending industry must be cognizant of the overlapping roles of the various federal (and even state) regulators. These regulators include, among others:
- Consumer Financial Protection Bureau. The CFPB is an independent federal agency responsible for enforcing "Federal consumer financial law," including Dodd-Frank's prohibition on unfair, deceptive, or abusive acts or practices (UDAAP) in consumer financial products and services. The CFPB's supervisory and enforcement authority extends to certain banks and nonbank entities that offer or provide financial products or services, including any "larger participants" in markets for consumer financial products and services that the CFPB defines by rule.
- Federal Trade Commission (FTC). The FTC is responsible for enforcing many federal consumer protection laws. In addition, the FTC investigates nonbank financial services providers that may be engaged in unfair or deceptive acts or practices. The FTC, for example, recently brought an enforcement action against an individual who engaged in deceptive acts and practices in raising funds for a crowdfunding campaign.
- Banking Regulators. Depository institutions are subject to comprehensive federal regulation and examination to ensure their safety and soundness. These regulators include the Office of the Comptroller of the Currency; Board of Governors of the Federal Reserve System; Federal Deposit Insurance Corporation; National Credit Union Administration; and the Office of Thrift Supervision for federal thrifts.
- Securities and Exchange Commission. The SEC enforces federal securities regulation to protect investors through disclosure requirements and antifraud provisions that can be used to hold companies liable for providing false or misleading information to investors. Several Marketplace Lending platforms have registered with the SEC in connection with selling securities in the form of loan promissory notes to the public.
- State Regulation. State regulators often supervise nonbank financial services providers; however, the scope of state-level powers and levels of supervision vary by state. In addition, most states have usury, collection, and advertising laws that are enforced by state attorneys general. In addition, many states have licensing requirements that extend to lenders, brokers, and debt collectors that potentially apply to Marketplace Lending.
Together, each of the regulators noted above exercises a degree of jurisdiction over the Marketplace Lending industry. In particular, the business of consumer lending has long been subject to a host of federal and state laws and regulations, including:
- Bank Secrecy Act—Requires financial institutions to adopt anti-money laundering policies and procedures;
- Electronic Fund Transfer Act—Protects consumers by establishing the rights, liabilities, and responsibilities of parties in electronic funds transfers (EFTs);
- Equal Credit Opportunity Act—Prohibits discrimination against credit applicants, establishes guidelines for evaluating credit information, and requires written notification when credit is denied;
- Fair Credit Reporting Act—Requires a permissible purpose to obtain a credit report, "furnishers" to report information to credit reporting agencies (i.e., credit bureaus) accurately, notice by creditors who take adverse action based on credit reports, and creditors to develop and maintain an identity theft prevention program;
- Fair Debt Collection Practices Act—Prohibits certain abusive and unfair acts and practices in connection with third-party debt collection of consumer debts;
- Gramm-Leach-Bliley Act—Restricts disclosure of nonpublic personal information to nonaffiliated third parties, and requires financial institutions to notify their consumers about their information-sharing practices and the consumers' right to "opt out" in certain circumstances if they do not want their information shared with certain nonaffiliated third parties;
- Securities Act of 1933—Requires an issuer engaged in the public offering of securities to register the securities with the SEC; and
- Truth in Lending Act—Establishes uniform methods for calculating the cost of credit, disclosing credit terms, and resolving errors on certain types of credit accounts.
Practical Considerations for Consumer Marketplace Lending
Within this increasingly aggressive regulatory environment, there are, fortunately, steps that Operators, lenders, and their service providers can take to limit potential scrutiny. The starting point is the implementation of a comprehensive CMS that covers the entity's business operations and compliance with applicable laws.
Development of a Compliance Management System. A CMS should be integrated into a company's operations at every level. The focus on compliance must be both top-down and bottom-up, with the board and senior management exercising appropriate oversight to ensure that employees have the right direction, training, resources, and support to carry out the compliance function.
- Provide appropriate training for board members, management, and staff that covers compliance with federal financial and consumer protection laws.
- Implement underwriting policies with an eye toward preventing potential consumer harm.
- Implement a process for regular internal and external audits to review operations for compliance with applicable legal requirements.
- Develop systems to monitor for, respond to, and resolve consumer complaints and inquiries.
- Develop third-party oversight, management, and training to ensure that service providers comply with applicable federal financial and consumer protection laws.
Prepare for and Cooperate with Examinations. While a regulator may lead with an investigation and not an examination, preparing in advance for a potential exam can help a company focus its compliance efforts and mitigate regulatory risk. In the event of a CFPB or other regulatory examination (or need for state licensure), the examinee should take steps to present its operations and compliance policies in the best possible light:
- Designate an employee (preferably within the legal or compliance department) to serve as the Point of Contact for the regulator examination team and the document collection and production process.
- Prepare and train staff who will likely interface with regulatory examiners.
- Set up an initial meeting with examiners to explain the company's business model and set appropriate expectations.
- Work with counsel to review all submissions to the regulator for responsiveness, privilege, and consistency.
- Respond in a timely manner to examiner requests—work with examiners to identify their key areas of interest and how the company can provide the requested information.
- Manage examiner expectations and maintain clear lines of communication.
- Review the draft examination report closely to identify any factual inaccuracies or areas of potential misunderstanding. If the regulator identifies any areas of potential concern, work with counsel to identify steps to "self-correct" or resolve the issues prior to the regulator's issuance of a final examination report (as appropriate).
Monitor Legal Developments and Be Aware of Lending Activities That May Attract Heightened Scrutiny. The Marketplace Lending industry should keep a close eye on federal and state legal developments. As the legal framework continues to evolve, the industry must keep pace or risk drawing the attention of regulators. On March 26, 2015, for example, the CFPB announced several proposals to regulate short-term and longer-term consumer lending (focused, primarily, on payday and related lending). As explained by Director Richard Cordray in announcing the proposals, the Bureau is concerned that some lending products may extend "credit to people in a way that sets them up to fail." In this regard, the Bureau's proposals are an example of its focus on holding financial institutions responsible under certain circumstances for confirming that individual consumers can afford the institution's products or services. Although the proposals do not apply to Marketplace Lending, they nevertheless provide insight into the types of lending practices that have drawn scrutiny.
* * * * * * * * * *
As small dollar lenders, banks, credit unions, and institutional investors shift into this new market, so too will the regulators that enforce these laws and regulations. And, with the creation of the CFPB, there is now a single regulator of consumer financial products and services that has rulemaking, enforcement, and examination authority, including, potentially, over Marketplace Lenders and their service providers. Although the CFPB has been on the scene for only a few years, the Bureau has shown a willingness to use its tools aggressively to address perceived weaknesses in markets for consumer products and services.
* * * * * * * * * *