Business & Economics

Making Small Business Investment Easier

Congress should reduce the oppressive regulatory burden on peer-to-peer lending

Image Credit: Boonchai Wedmakawand, Getty Images

Peer-to-peer, or P2P, lending enables individuals to make small loans to many borrowers via an internet platform. Thus, an individual might invest $10,000 to acquire a portfolio of one hundred $100 loans to borrowers within a specified range of credit ratings. The internet platform handles the allocation of the $10,000 to 100 different borrowers and services the loan payments. The large number of small loans enables the lender to diversify risk even though he or she is loaning a modest amount overall. Usually, these platforms enable small lenders to obtain better rates of return than they would by placing the money in a bank or buying a bond, and typically the borrowers obtain better rates than they would at a bank.

Yet because of onerous Securities and Exchange Commission (SEC) rules that dramatically increase regulatory costs, this form of lending is rare in the United States. In fact, Lending Club, one of the two major firms in the P2P lending business, stopped offering retail notes on October 8. P2P lending is largely unavailable to small businesses. In contrast, P2P lending is relatively common in most other developed countries. It is time to remove regulatory impediments that prevent P2P lending to both small businesses and consumers.

The key point here is that a loan is a loan, not a security. Whether that loan is from a bank, a credit union, a nonbank lender or an individual via a P2P lending portal should not matter. But under the current regulatory regime, the SEC adopts the position that virtually anything that earns a return on investment is a security unless there is a specific statutory exemption. Because of various statutory exemptions, loans to small businesses or consumers by banks, credit unions, finance companies or individuals in private transactions not using a P2P lending platform are almost always treated as exempt from the legal requirements that apply to securities. Loans via P2P lending platforms are not.

This fundamentally irrational disparity in treatment creates a major regulatory impediment to both consumers and small businesses using P2P lending platforms, harming both. And, of course, small investors seeking a better return also suffer. In addition, this disparity shields banks from competition from nonbank lenders.

The SEC rules dramatically impede financial innovation. The complexity and cost of current rules also protect the established consumer P2P lending platforms from competition from new entrants. Although the incumbent firms have now learned how to deal with the current SEC requirements and are large enough to absorb the regulatory costs, even they are finding that the regulatory costs associated with the P2P model are too high compared with other means of raising capital and making loans. Under current SEC rules, they must, for example, typically make weekly and sometimes daily filings with the SEC.

There are three possible ways of eliminating, or reducing, the regulatory obstacles to P2P lending generally, and P2P small business lending in particular.

First, Congress should exempt P2P lending from federal and state securities laws. Perhaps surprisingly, the House-passed version of the Dodd-Frank bill in 2010 would have taken this approach. The provision, which was not included in the bill that was ultimately enacted into law, provided “primary” jurisdiction to the Consumer Financial Protection Bureau (CFPB). It exempted “any consumer loan, and any note representing a whole or fractional interest in any such loan, funded or sold through a person-to-person lending platform.” It defined a consumer loan as a “loan made to a natural person, the proceeds of which are intended primarily for personal, family, educational, household, or business use.” This provision should be adopted and expanded to explicitly exempt small business loans (as opposed to only those made to natural persons).

The House-passed version of Dodd-Frank did not explicitly preempt state securities laws, usually known as “blue sky laws.” The preemption of blue sky registration and qualification provisions is critical to success because state laws substantially increase costs and introduce major regulatory delays. This is particularly true in the two-fifths of states that are “merit review” states. In these states, state officials decide whether an investment is fair or good rather than simply ensuring that the terms of the deal are adequately disclosed. Any preemption of state blue sky laws should not, however, preempt state antifraud provisions.

This is the preferred approach. To the extent that Congress wishes to have a regulator overseeing this market, lawmakers could assign that task to one of the bank regulators, the CFPB, or the SEC. But involving a federal regulator is probably unnecessary since fraudulent transactions would be a violation of countless existing laws, including state blue sky laws, state consumer protection laws, state banking laws and the common law of fraud.

Second, Congress should amend Title III of the JOBS Act to create a category of crowdfunding security called a “crowdfunding debt security” or “peer-to-peer debt security.” Title III of the JOBS Act, which provides an exception from registration for securities offerings, was intended to help small businesses raise capital from the securities markets in a cost-effective manner. Results have so far been disappointing. Part of the reason is likely that the disclosure requirements of the law—which can be very burdensome, particularly for small businesses—apply to both debt offerings and equity offerings. Many of these disclosure requirements make more sense for equity offerings because they provide an ownership interest in the company. The disclosure requirements make a lot less sense for debt offerings because, as is generally the case with loans, there is no ownership interest. This problem is magnified by the fact that small business are much more likely to raise money through debt than equity offerings.

Title III disclosures are designed to provide investors with the information they need to make an informed decision on whether to buy, as well as ongoing disclosures that allow investors to monitor the health of their investment. Herein lies the rub. The type of information an equity investor needs to monitor his or her investment is far more expansive than what a debt investor needs. The value of an equity investment frequently relies on the company becoming more successful, and therefore valuable, over time. If this happens, and subject to some limitation, original investors may be able to sell their ownership stake in a company that is more valuable than when the investors obtained it, with the increase in profit realized from the sale being the investors’ return.

Because of this, investors need to know how the company they partially own is doing. Title III addresses this concern by imposing initial and ongoing disclosure requirements on companies that use it to sell securities. These ongoing disclosure requirements can be quite fulsome and expensive to comply with. Many of these disclosures touch on questions important to an equity investor, such as what the plan to make the company more profitable is, and whether there are any plans for an opportunity for investors to sell their shares through acquisition or public offering.

The problem? Companies that make debt offerings are bound to the same disclosure requirements, even if much of the information is far less relevant to debt investors. What matters for debt offerings is whether the company can make good on repaying what is effectively a loan. The company doesn’t need to get massively more profitable or have a liquidity event for a debt investor to have a successful investment, and the securities are self-liquidating (i.e., the investor doesn’t need to sell them to get value; the debt payments provide the value until the debt is repaid and the bond retired).

The expense of initial and ongoing disclosure requirements that aren’t needed for debt offerings makes Title III a poor fit for companies who want to get loans via the public. However, Congress could fix this and create a more viable option.

What would the reform look like? First, a debt security would be defined “as any contract that (1) provides no ownership stake in the issuing company, (2) provides for the repayment of the principal amount over a definite period together with interest, and (3) provides no payments to the holder other than principal payments, interest payments and penalties for late payments.” The issuer offering these securities pursuant to Securities Act section 4(a)(6)—the Title III crowdfunding exemption—would be exempt from many of the continuing disclosure requirements.

The crowdfunding debt security exemption should include special-purpose entities created by a lead investor for the sole purpose of allowing individuals to invest in an entity that holds the debt securities of a single issuer. This will be attractive to issuers because they will not be required to deal with potentially hundreds of very small investors. Instead, they will simply have to deal with the manager of the special-purpose entity. This crowdfunding approach, along with exempting P2P lending from state securities laws, might give some vitality to lending via crowdfunding platforms. The statutory P2P debt security exemption should be self-effectuating rather than requiring the SEC to issue rules to become effective.

Third and finally, Congress could adopt an alternative regulatory regime for P2P lending. It would require some regulatory agency (usually the CFPB is suggested) to promulgate rules and create a division to regulate P2P lending. This is the least attractive approach because it will likely lead to even more bureaucratic complexity. It is, however, still better than the current regulatory situation, which simply makes P2P lending to small firms effectively impossible because of high regulatory costs.

This is the sixth in a series of articles that will examine ways to help entrepreneurs who are seeking to start small businesses in the wake of the pandemic to access the capital they need. The first article in this series provides an overview of the challenges facing would-be entrepreneurs in the coronavirus economy. The second article concerns offering small businesses guaranteed access to credit. The third article examines the rules governing investors in startups. The fourth article concerns easing restrictions on lending by small banks. The fifth article proposes easing restrictions on the sale of securities by small startups. The seventh article proposes several reforms to the Small Business Administration. The eighth and final article urges governments to create a better environment for small businesses by reducing uncertainty and reopening the economy.

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