Peer-to-Peer Lending: Problems and Promise

Sites like Prosper and Lending Club must adjust to SEC oversight. For some people, the communities of small borrowers and lenders extend a credit lifeline

By David Bogoslaw

Just when it might have proved most useful, peer-to-peer lending has been severely hamstrung by the U.S. Securities & Exchange Commission's efforts to get a regulatory handle on the fledgling industry. With the credit crisis making it harder and harder for cash-strapped households and small businesses to get bank loans, the opportunity for creditworthy applicants to borrow up to $25,000 from strangers at slightly higher interest rates was seen as something of a godsend.

In a cease-and-desist order to Prosper.com on Nov. 24, 2008, the SEC labeled the loan notes that Prosper issued to investors as securities and said the company violated sections of the Securities Act between January 2006 and mid-October 2008, by selling securities without an effective registration statement or valid exemption from registration. The order cited the definition of a security under two Supreme Court cases as the basis of its judgment that Prosper's notes qualify as securities.

That judgment could potentially sink Prosper, ultimately costing it up to $10 million, Jim Bruene, editor and founder of Netbanker.com, an online banking resource site, wrote in an open letter to the SEC posted on his Web site. The ruling also exposes Prosper to potential class-action suits from investors who may try to recoup losses on loans by arguing the platform was selling unregistered securities, he said.

Prosper, the leader in the peer-to-peer lending business with about 80% of total loan volume in 2008, stopped accepting new loan applications in mid-October, pending the SEC's review of its registration paperwork. Another P2P lender, Loania, is also registering with the SEC, while British import Zopa, an industry pioneer, retreated from the U.S. market very soon after entering it, probably to avoid onerous regulations and the resulting added expenses.

SEC Registration Lends Credibility

That leaves Lending Club and startup Pertuity Direct as the only social lending networks still operating. Lending Club was shuttered for six months last year while it awaited the SEC's approval of its registration. It emerged in November with tougher qualifications for investors: minimum household income of $70,000 a year and net worth of at least $70,000, excluding a person's primary residence. Pertuity's hybrid structure, where lenders don't choose individual loans to invest in but are automatically invested in the entire loan portfolio through a mutual fund, the National Retail Fund, already subjects it to SEC oversight.

Renaud Laplanche, founder and chief executive of Lending Club, sees registration with the SEC as giving more credibility to the business, as well as ensuring transparency. "There's a general sense of maturity in the space that comes out of [the process]," he says. "It made it possible for us to establish a secondary market for the loans to give lenders the ability to sell a loan if they need liquidity for any reason."

Some lenders, such as Jim Hoffman, who joined Lending Club in January 2007, are using the secondary market not to sell loans but to buy additional ones at a slight discount and with essentially less risk. That's because by the time they hit the secondary market, loans are partly paid off and have established a payment history.