Legal Corner: The Legal Basis of How Prosper and P2P Lending Works

by Jonathan Wilson, securities attorney at Taylor English Duma

[Again, my comments will be in the braces otherwise this is all from our legal expert. None of this is personal legal advice but you should reach out to him or comment here if you have a question or need for Jonathan's expertise. This post is more technical than usual but if the how and why of peer to peer lending platforms interests you then please enjoy. I think it's cool to see how it is set up so we can invest and be the bank.]

In my last few posts I’ve written about what securities are and how securities can be either registered or exempt from registration. With this background behind us, we can now dig into the heart of the matter: how P2P lending works from a legal point of view.

How Prosper Stays Legal

On the Prosper site, lender members of the site (called “Lenders”) [that's us investors] have the ability to see the loan applications of borrowers (each, a “Borrower”).  Each Borrower is an individual person.  There are no corporations, partnerships or LLCs.  Each Borrower is seeking an unsecured loan in a specified amount.  If the loan is made, it will bear interest at a fixed rate and will amortize in equal monthly amounts over a specified period of time. [We have discussed this before that these loans are fully amortizing over the term, just like a mortgage loan but without the property as collateral]

Importantly, none of the Lenders knows the actual identity of any Borrower.  Borrowers are anonymous to the Lenders (although Prosper has their actual identity and contact details).

Lenders have the ability to decide which Borrowers can receive a portion of their cash.  If enough Lenders elect to fund a particular Borrower’s loan request, the loan is initiated by Prosper and appears in each Lender’s online dashboard as if it was an individual loan.

In reality, however, none of the Lenders is actually making a loan to any individual Borrower.  Rather, each Lender is electing to purchase a participation in a promissory note (called a “Borrower Dependent Promissory Note” or “BDPN”) that is issued by Prosper Funding, Inc.  (Before February 1, 2013 the Borrower Dependent Promissory Notes were issued by an affiliate, Prosper Marketplace, Inc.)

The BDPNs are specially structured.  Although Prosper Funding, Inc. is the obligor (or the party who is obligated to pay), the obligor’s duty to pay is limited to passing along amounts received by the individual Borrower.  If the individual Borrower fails to pay, Prosper Funding, Inc. does not pay anything and the participating Lenders also suffer the loss.

So how does this work legally?  The story tells you a lot about how P2P lending has grown as an industry.

Prosper and the SEC

Prior to November 2008, Prosper Marketplace structured and sold its BDPNs without registering the notes.  Eventually, the SEC opened an investigation and accused Prosper Marketplace of selling unregistered securities without an applicable exemption.  As often happens, Prosper Marketplace conceded and consented to the issuance of a Cease and Desist Order against it on November 24, 2008.  (SEC Release No. 8984).  The Cease and Desist Order makes for interesting reading because of the way the SEC describes the Prosper Marketplace P2P platform and the procedure used for initiating and selling BDPNs.

As you might expect from the way I teed up this discussion, the SEC found that Prosper Markplace’s Borrower Dependent Promissory Notes were actually securities that had been sold without either registration or an applicable exemption.  The November 24, 2008 cease and desist order effectively halted Prosper’s lending marketplace and required Prosper to completely re-launch its business.

In retrospect, the SEC’s conclusion should not have been surprising.  Each BDPN is an investment contract between the Lender and Prosper Marketplace.  The Lender [again that's us investors] relies on Prosper Marketplace’s ability to manage the underlying loans to Borrowers in order to collect those loans and thereby fund payments to the Investor.  Looking at it from that point of view, you can see how the arrangement was, in the words of the Howey case cited in my first post on this site, “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”

Once the SEC focused on the Prosper note arrangement, it quickly came to the view that the Borrower Dependent Promissory Notes were securities that were being sold within an effective registration statement.

Prosper had already filed an S-1 registration statement in order to be able to issue registered securities back in October 2007.  (Initial S-1 registration statement.)  In part because of the pending controversy over its unregistered BDPNs, the registration statement had to be amended six times between October 2007 and July 10, 2009, when the SEC finally issued a notice of effectiveness for that S-1 registration statement, marking the beginning of Prosper’s method of issuing registered notes.

As a result, Prosper now registers its notes in $500 million increments.  Several times each day, it updates the prospectus for the applicable registration statement to include the key details of each individual Borrower whose loan is being funded through the note offering.  When participating investors (who are Lender members in the Prosper system) purchase a BDPN from Prosper, they are purchasing a registered security whose ultimate value is dependent on the success of the underlying Borrowers to repay their individual loans.

One of the successes of the Prosper system is being able to present each Lender’s information through the website as if the Lender were actually making individual loans to each Borrower.  The website uses the language of “Lenders” and “Borrowers” while the actual mechanics of the BDPNs is deep in the background.

[There is some really interesting reading in this S-1 statement and it's not all legal, technical and financial jargon. In fact, the first page talks about Prosper operating a 'double blind' system where neither borrower or investor knows the identity of the other AND describes in detail all of the platform participants, including how it handles defaults and collections. All interested investors should read the first couple pages of this statement as everything in here, and importantly NOT in here, affects us and our investments directly]

About the author

Stu Stu Lustman, the author of this post, is a Credit Analyst by trade trying to bring Commercial Credit Analysis techniques to the world of Peer to Peer Lending. Check me out on Twitter, LinkedIn and Google+

10 thoughts on “Legal Corner: The Legal Basis of How Prosper and P2P Lending Works

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    • AngieOctober 21, 2010 at 4:15 pmLending money is always a risk. The more money, the reiksir. You need to write up an agreement with this person. Include the amount, the length of the loan, interest rate and when payments are due (monthly, annually, lump sum). Both of you need to sign this. If he/she doesn’t not pay you back, then you need to file with small claims court and present this document. It still doesn’t guarantee payment, but it’s the best that you will be able to do.References :

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