An Online Lender Takes on the SEC

In 2006, Chris Larsen started Prosper Marketplace, an online service where borrowers apply for loans of up to $25,000 and individual investors bid to lend as little as $25. Soon he was at war with the Securities & Exchange Commission, which insists that Prosper is an investment firm offering bonds, and not a lender.

Larsen disagrees, arguing that the SEC "is putting a round peg into a square hole" as it applies securities laws dating from the 1930s to the Silicon Valley startup and other so-called peer-to-peer lenders. By the middle of 2009, Prosper had spent $4 million, even shutting down for nine months, to comply with SEC rules. Larsen claims the company now spends more than $1 million annually on legal fees and audits, and makes more public disclosures—about two a day—than almost any other company. The filings include details on each potential borrower's credit score and why they need the money.

Prosper isn't arguing against all regulation, just regulation by the SEC. The company wants to be overseen by the consumer financial protection agency Congress may soon create. Larsen, 49, argues that by trying to twist the industry into something it's not, the SEC is harming innovation and shutting off a source of credit for small businesses as the economy struggles and traditional banks lend less.

Israel Klein of the Podesta Group, Prosper's lobbyist, last year persuaded the House to place the nascent industry under the jurisdiction of the new consumer agency, part of the financial regulation bill. The SEC, after getting wind of the move, blocked a similar provision in the Senate measure. John Nester, an SEC spokesman, says the agency had a duty to protect investors. "Regardless of the innovative way in which investments are solicited, investors are entitled to the full and fair disclosure that our securities laws require," he says.

Based in San Francisco, Prosper is one of two major U.S. peer-lenders; it employs about 30 people. Since its launch, the service has originated $197 million in loans. Its main competitor, Lending Club, which isn't fighting with the SEC, has issued $121 million in loans. Research firm Gartner (IT) predicted in January that peer-to-peer lending will jump at least 66 percent, to $5 billion, in outstanding loans by 2013.

Priscilla Edwards turned to Prosper last year to help her publish a children's book about a tugboat on San Francisco Bay. Edwards, 62, read about Prosper in the local paper, then went online and borrowed $10,000 at a 13.9 percent interest rate from 141 people, having attracted bids from 391 potential lenders. "Never in a million years" would a bank loan her money, Edwards says, noting she had no collateral.

Some securities lawyers agree with the SEC. "When you're talking about loans of hundreds of dollars...the antenna goes up," says Donald Langevoort, who teaches securities law at Georgetown University. "It means you are targeting very unsophisticated people."

To Larsen, the disagreement is symptomatic of a deep divide between Washington and Silicon Valley. "I'd really like to see Mary Schapiro out at Stanford, at Harvard, encouraging startups," Larsen says, referring to the SEC chairman. "It's not a welcome environment for entrepreneurs."

The bottom line: The SEC's insistence that securities laws should apply to online lending services has set off a fight about innovation and regulation.

    Before it's here, it's on the Bloomberg Terminal.