Microfinance Focus, August 13, 2011: The U.S. Government Accountability Office (GAO) has recently proposed two regulatory approaches to P2P lending platforms - the current "bifurcated" SEC-centric approach and a "consolidated" Consumer Financial Protection Bureau (CFPB) centric approach and discussed their advantages and disadvantages in providing more efficient and effective oversight of the industry.

According to Orrick’s Social Sector Finance Update as the GAO proposal relates to the Social Sector Finance space, any adoption of a consolidated regulatory approach at the federal level could subject P2P platforms like Kiva to oversight by the CFPB, which could create additional burdens and costs on the organizations.

The two main for-profit lending platforms studied in the report are Prosper and LendingClub which offer P2P investors a return on investment. The primary non-profit in the report, Kiva, offers investors only a return of principal.  This difference results in the securities offered by the for-profits requiring registration with the SEC, while the non-profit's offering to investors is viewed more as a donation and deemed not to be a security.

On the borrower side of the platforms, Prosper and LendingClub extend credit directly to individuals, an activity regulated by the Consumer Financial Protection Bureau, whereas Kiva aggregates investor funds and lends them to microfinance organizations, which in turn provide loans or lines of credit to individual borrowers.  Business-to-business lending activities like Kiva's are not currently regulated by the CFPB.

The current SEC-centric approach provides broad, non-industry-specific protection to investor-lenders and borrowers in the P2P space.  The SEC staff asserted that these broad protections afforded to investor-lenders under federal securities laws as well as the disclosure and attendant liability for false disclosure provided by these laws are key to safeguarding investors.

However, some industry observers noted the downside in relying primarily on disclosures required under securities registration requirements: namely the lack of uniformity in disclosing loan performance and returns on investment and the lack of investor protection if a P2P company enters bankruptcy. Others questioned the ability of securities regulators to adapt and respond to a burgeoning and evolving P2P industry without stifling growth and cited concerns about the cost and burdens of the securities registration process on existing P2P platforms and new companies attempting to enter the market.

The GAO report cites an SEC no-action letter, Poplogix, confirming that notes like those offered by Kiva, with no cash return on investment, are exempt from registration because they are not considered to be securities.  Kiva has not registered its investments as it does not consider them to be securities, while Prosper and LendingClub, whose P2P investor-lenders receive interest on their P2P notes, have been required to register the notes they issue as securities with the SEC.

The Poplogix letter affirms Kiva's position, explaining that the SEC considers a security to be present only where the investor expects to earn a profit as a result of a third party's efforts.

The GAO's second analysis is of a potential consolidated regulatory approach that would combine oversight of both the investor-lender and borrower relationships under one federal regulator, most likely the CFPB.  The GAO suggests that under a consolidated approach, existing borrower protections would continue but investor-lenders would receive expanded protection.  A fundamental change that would occur under this CFPB-centric approach is that P2P investments would be treated as consumer financial products instead of securities at the federal level.  The CFPB would regulate the relationships between the P2P platforms and the investor-lenders instead of the SEC.

Kiva and similar platforms would be viewed as marketing consumer finance products regardless of the securities characterization of the products.  Consolidation of authority at the federal level, however, would not necessarily lead to corresponding reforms at the state level.  P2P platforms otherwise exempted from SEC oversight could still be required to register investment offerings with state securities regulators.

Some industry observers suggested that a CFPB-centric approach would be more appropriate for balancing the often conflicting interests of investors seeking credit-risk information and borrowers' privacy interests.  Others cited the opportunity to oversee non-profit platforms as an advantage.  However, the GAO makes clear that the flexibility, efficiency and effectiveness of the CFPB-centric approach are uncertain.

Federal and state regulators and industry observers raised concerns as to how the CFPB-centric approach would be defined in statute and how it would actually be implemented.  Others questioned the effectiveness of the CFPB in protecting investors when the purpose and scope of the CFPB in the Dodd-Frank Act is focused on the protection of consumers of financial products and services, rather than the protection of investors.

Officials from Prosper and LendingClub also noted concerns regarding the costs involved in shifting to a new regulatory approach, considering the cost and time already invested in complying with SEC mandates.  Finally, reductions in the regulatory burden on P2P lending platforms would generally be limited if state securities regulations continued to apply.