[Editor’s Note: This is a guest post by Brian Korn. He is the Co-Head of the Crowdfunding and Peer-to-Peer Lending Group at Pepper Hamilton LLP. Brian has become one of the leading legal experts in the country on p2p lending and he is a regular speaker at industry conferences. We asked him to write about the Lending Club IPO from a legal perspective, commenting on some of the lesser known issues, including whether Lending Club will become available to investors in all 50 states post-IPO.]
The upcoming initial public offering of LendingClub Corporation will be a true “coming of age” event in the peer-to-peer lending industry. Though Lending Club and its chief rival, Prosper Marketplace, have been in business for about eight years, the industry has seen tremendous momentum in the past two years. Lending Club passed $5 billion in loans originated in June and Prosper crossed $2 billion just last week.
Industry executives often describe the potential of the industry as being vast and virtually limitless. “We are in the first inning,” Ron Suber, President of Prosper often says.
Lending Club and Prosper originate loans through a funding bank, purchase the loans and then either sell whole loans to institutions or issue “borrower payment dependent notes” (or member payment dependent notes depending on the platform) to the investing public. But because the notes are not listed on a national securities exchange such as NYSE or Nasdaq, Lending Club and Prosper must apply for permission from each state in which it wants to distribute notes. About 20 states have refused to allow sales of notes, meaning investors in those states cannot invest in payment-dependent notes. Some very large states are included on this list – Texas, Pennsylvania, New Jersey and Ohio to name a few.
Several emerging peer-to-peer platforms such as Peerform and Patch of Land sell payment-dependent notes to accredited investors in “private placements” that are exempt from SEC registration under Rule 506 of the Securities Act of 1933 (also known as Regulation D). By offering notes to accredited investors, sales can be made in all states without state approval. This concept is known as “federal preemption.”
Preemption for Payment-Dependent Notes?
Federal preemption applies, in addition to Rule 506, to securities listed on a national securities exchange or any securities issued by the same issuer that are “pari passu” or senior to listed securities. So when General Electric sells bonds, they are preempted from state securities laws (also known as “blue sky laws”) because those securities are senior to GE common stock. When Lending Club lists common stock on the NYSE in connection with its upcoming IPO, payment-dependent notes will also be preempted, opening the door to sales to the public in all 50 states and DC. Notes are debt instruments of the company and under the rules of corporate liquidation, debt is senior to equity.
Some states have quietly voiced concern over the prospect of preemption for payment-dependent notes, likely because such milestone will remove state authority to regulate peer-to-peer note offerings in the state. States that currently do not allow payment-dependent notes to be sold may attempt to continue to restrict sales following the IPO. State legal arguments are that since no liquidation of Lending Club would have a payment-dependent noteholder paid ahead of a common stockholder, how can notes tied to a single loan with no recourse to any other assets of the company be senior to common stock, which has an ultimate liquidation claim to the assets of the company?
States rarely get involved in fighting preemption issues, but payment-dependent notes represent a new battlefront. State securities regulators are fighting preemption (and ultimate disintermediation) on multiple levels besides payment-dependent notes, including Regulation A+ (the small offering exemption) and crowdfunding – all of which allow the SEC to grant state law preemption under the JOBS Act of 2012. State regulators have a powerful lobbying force and may be able to successfully fight federal preemption efforts. Moreover, states are forming a national registration system to counter claims that the state-by-state approval process is too cumbersome.
Will Lending Club Become Available to Investors in All 50 States?
So will Lending Club’s payment-dependent notes become available to investors in all 50 states after the IPO? Lending Club has written a risk factor in its IPO prospectus that preemption from state law is not a certainty. As a result, we could see some new states accept federal preemption and begin to offer payment-dependent notes while others may fight, causing a delay. If multiple states take different views of the same language of federal law (“pari passu or senior”) then the decision will be decided by the SEC and ultimately the courts, which will have far-reaching implications beyond peer-to-peer.
Thus, it is not clear on whether Lending Club’s payment-dependent notes will become available to investors in states that currently do not permit the sale of notes. If a few states decide to fight the preemption issue, then it could force this issue into the court systems and meaningfully delay any action. If the states decide not to fight the preemption issue, then Lending Club’s notes could be rolled out if all 50 states sooner rather than later. In the meantime, many industry observers are watching this legal drama with great interest.
