Silicon Valley entrepreneur Chris Larsen started Prosper Marketplace Inc. as an alternative lender for small loans -- an online community where borrowers seeking up to $25,000 are matched with lenders who bid for their business.
The Securities and Exchange Commission saw it differently, contending that Prosper is an investment firm in disguise.
The distinction isn’t academic. When the SEC won the debate and assumed jurisdiction over the company, the consequences for Prosper were significant. The start-up shut down for nine months and spent $4 million to get into compliance with SEC rules, Larsen said.
“This is as simple a version of banking as you can get,” said Larsen. The SEC “is putting a round peg into a square hole.”
The San Francisco-based company has turned to Congress, where its battle to be regulated more like a bank is being played out as a small part of the financial-regulation overhaul. Larsen characterizes it as a clash between the innovative Internet economy and outdated Washington attitudes.
“The worst kind of regulation is regulation that puts up huge barriers, kills the technology promise and at the end of the day didn’t protect either side,” Larsen said.
The stakes in how to regulate the business known as peer- to-peer lending could be high as it continues to grow. Gartner Inc., a research firm based in Stamford, Connecticut, predicted in January that the amount of outstanding peer-to-peer loans will jump at least 66 percent to $5 billion by 2013 as consumers who lose their jobs or businesses that lose lines of credit turn to the alternative marketplace.
$197 Million in Loans
Growth “will be driven by investors seeking higher returns and borrowers shunning (or being shunned by) banks,” Gartner said in a Jan. 5 report.
Prosper, which is privately held, employs about 30 people and has raised $57.7 million in venture capital. Since its February 2006 launch, the firm has originated $197 million in loans.
Think of the company as a cross between Facebook Inc. and EBay Inc. Borrowers make a request for loans of up to $25,000 and set the maximum interest rate they are willing to pay. Lenders set the minimum interest rate they want and then bid in increments of $25 to $25,000 on loans they want to fund. At the end of the auction, Prosper takes the bids with the lowest rates and combines them into one loan.
Along with viewing credit scores and histories, Prosper lenders can read and consider non-traditional criteria such as borrowers’ personal stories or endorsements from friends and families. Loans made on the site average about $5,000.
Prosper makes money from origination fees on the loans that range from 0.5 percent to 3 percent depending on the borrower’s credit rating. It also charges an annual servicing fee to lenders of 1 percent of the outstanding principal balance.
The SEC contends Prosper is not akin to a bank, because customers rely on the efforts of Prosper to make money and citations on the company’s website refer to peer-to-peer lending as an investment strategy. The SEC’s actions are driven by its duty to protect the public, said agency spokesman John Nester.
“Regardless of the innovative way in which investments are solicited, investors are entitled to the full and fair disclosure that our securities laws require,” Nester said.
When Prosper set up shop, it asked the SEC for guidance on whether it would be violating the agency’s rules. The SEC declined to give guidance, but did nothing to block the start- up.
The SEC’s scrutiny increased in 2008. Larsen, who said he was a bit surprised by the attention to his small firm at a time when the financial crisis was in full bloom, decided to stop facilitating new loans and register with the SEC in October 2008. Even though the company was closed, the regulator imposed a cease-and-desist order on Nov. 24, 2008.
Plaintiffs’ lawyers sued Prosper two days after the SEC order, arguing that lenders who lost money through the company’s website should be repaid because it wasn’t disclosed they were buying securities.
Prosper restarted the business last year and the company began to grow again. Borrowers included Priscilla Edwards, 62, who wanted to publish a children’s book about a tugboat on San Francisco Bay.
Edwards, who wrote her book under the pseudonym Una King, “spent every last dime” of her $80,000 in savings before a printing error almost derailed the effort. She found the Prosper website and borrowed $10,000 from 141 people at a 13.9 percent interest rate.
“Tiny Tug: Adventures on San Francisco Bay” is selling well, Edwards said. The book is carried at local gift shops near the Golden Gate Bridge and used in a Florida school district as part of its anti-bullying curriculum.
“Never in a million years” could she have gotten a loan from a traditional bank, Edwards said, noting that she had no collateral. “Banks don’t make loans on intellectual property.”
While what Prosper does may look like lending, the SEC is right to call it investing, securities lawyers said.
The agency has a responsibility to step in because many of the lenders lack the financial acumen to fend for themselves, said Donald Langevoort, a former SEC attorney who teaches securities law at Georgetown University in Washington.
1946 Supreme Court Ruling
“When you’re talking about loans of hundreds of dollars, that’s when the antenna goes up because it means you are targeting very unsophisticated people,” Langevoort said. Someone borrowing cash could be trying to “make money off these people, and usually it’s by not quite telling the truth.”
The SEC can point to a 1946 Supreme Court decision that defined investments in an orange grove as a security, said Peter Romeo, a partner at Hogan Lovells LLP in Washington. The Prosper website is akin to an investment contract in which lenders are relying on the work of someone else to make a profit, he said.
“Whether it’s stock or an orange grove, or a series of notes, if you have those basic elements, you have a security,” said Romeo, a former attorney in the SEC’s corporation finance division.
Prosper’s main competitor, LendingClub Corp. of Redwood City, California, has issued about $121 million in loans, according to its website. LendingClub isn’t fighting the SEC’s jurisdiction; its outside lawyer throughout the registration process, Meredith Cross, currently runs the SEC’s corporation finance unit, which is in charge of regulating the companies.
Cross has not weighed in on the issue of peer lending since she joined the agency last year, Nester said.
Failing to persuade the SEC, Prosper turned to Washington lobbyist Israel Klein of the Podesta Group. He got a provision into the House-passed version of the financial-overhaul legislation that would place the peer-to-peer lending industry under the jurisdiction of the new consumer financial protection agency. The SEC, after getting wind of the campaign, urged lawmakers to block a similar measure in the Senate.
Representative Jackie Speier, a California Democrat who sponsored the peer-to-peer amendment, said government regulation should strive to encourage new lending models, rather than choke them off. “It is more important than ever to protect consumers and harness the power of technology in helping to shore up our recovering economy and financial industry,” she said.
While the issue is being sorted out during a House-Senate conference this month to reconcile the bills, the SEC continues to treat Prosper as it would any company issuing securities on a regular basis.
The lender says it files many of the same disclosures as public companies, including annual and quarterly reports, and must comply with other federal rules, including an audit of its internal controls.
One disclosure Prosper makes twice a day provides details on each potential borrower, such as their state of residence, their credit scores and their comments on why they need money.
A filing posted on the SEC’s website yesterday included someone who got $2,000 to open an online Christian bookstore, a customer who received $5,000 “toward costs to adopt a baby,” and a fireman who borrowed $5,000 to purchase “beaters,” or old cars, that he planned to fix-up and resell.
Prosper points out that information, which is already available on its website for all its customers, is useless to outsiders because a lender can’t make a loan without being a registered member. Posting the disclosures on the SEC’s website also raises privacy concerns, the company said.
Such regulatory confusion, Larsen contends, is symptomatic of a deep divide between Washington regulators and Silicon Valley businesspeople. A lack of understanding of technology- related firms has discouraged innovation in the financial industry at a time when it may be needed most, he said.
“I’d really like to see Mary Schapiro out at Stanford, at Harvard, encouraging start-ups,” Larsen said, referring to the SEC chairman. “It’s not a welcome environment for entrepreneurs.”