Legal Corner: Why I can invest with Lending Club but not with Circleback Lending

Our legal eagle, Jonathan Wilson, is back with some more great info for us on why we can invest in some lending platforms but not others. He's from Taylor English Duma and you can check out his profile here. He's also on Twitter @JBWilsonLaw.

Have you ever wondered why P2P sites like Prosper and Lending Club allow anyone to invest while other sites like CircleBack and Funding Circle limit participation to “accredited investors”?  The answer depends upon the way U.S. securities laws work.

In an earlier post here, I described how the Securities Act of 1933 required that all securities either be registered or subject to an exemption from registration.  The purpose of the Securities Act of 1933 is to discourage fraud in the market for securities by requiring the freely-traded shares be registered with the SEC.

Issuers of such registered securities are required by the Securities and Exchange Act of 1934 (the “1934 Act”) to file periodic reports (on Form 10-Q and 10-K) to keep investors informed of their financial status.  They are also required to file more frequent reports (on Form 8-K) when certain material events take place (like changes in officers and directors and other material events).  By requiring this kind of public reporting the 1934 Act is intended to promote transparency so that all investors have equal access to information.

Exempt Securities

In contrast, shares that are issued under one of the available exemptions under the 1933 are (nearly always) NOT required to issue ongoing public reports under the 1934 Act.  Issuers of these (private) exempt securities might provide periodic reports to their investors, but those reports are not regulated the way public companies (i.e. those covered by the 1934 Act) are.

It is this distinction that drives the different treatment between Prosper and Lending Club (which allow anyone to invest) and sites like CircleBack and Funding Circle (that are restricted to accredited investors).

How Prosper and LC do it

Prosper and Lending Club issue securities to investors that have been registered under the 1933 Act.  You can read my earlier post where we mention about Prosper's securities needing to be registered.

While your investments at Prosper and Lending Club are linked to individual consumers, you are not actually lending to those consumers.  (In fact, you don’t even know who they are.)  [As we know it's known as a double blind system as we don't know who they are and they don't know who we are either.]  Rather, you are investing in a publicly-traded security issued by Prosper or Lending Club that is linked to the underlying borrower.

What Lenders with Exemptions Do

In contrast, CircleBack and Funding Circle are selling unregistered securities.  There are several exemptions from registration under the 1933 Act, but the chief exemption used these days is called the “private exemption” under Section 4(2) of the 1933.  As implemented by the SEC through Regulation D, the private exemption allows an issuer to sell unregistered securities to accredited investors (subject to a few additional requirements).

The term “accredited investors” is defined in Rule 501 of Regulation D and (generally speaking) it includes individuals who either (a) have a net worth of $1 million or more (excluding personal residence) or (b) have income of $200,000 or more for each of the past two years and the expectation of having $200,000 or more in the current year ($300,000 if the person files their income taxes jointly with a spouse).  For reasons known only to Congress in 1933, the law permits persons meeting this definition to purchase unregistered securities under the private exemption but persons falling below these levels of wealth and income may not. [Stu here. It's believed that these people are more 'financially sophisticated' and are able to understand the risks before investing in these private securities that other lay people may not understand.]

So, while only accredited investors can purchase participations in loans funded by CircleBack and Funding Circle (because those participations are securities exempt from registration under the Section 4(2) of the 1933 Act) anyone can purchase notes from Prosper or Lending Club so long as those notes are covered by the 1933 Act registration statements maintained by those public issuers.

Conclusion

Thanks to Jonathan for more great info. I know I always wondered why I was eligible to lend on some platforms but not others. While this post is technical in nature, it really boils down to whether the SEC registration is subject to an exemption, and the less onerous paperwork requirements that go with it being exempt, or if they have to follow all of the paperwork requirements to register their securities the way Prosper and Lending Club do.

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+