United States: Will The Real Marketplace Lender Please Stand Up?

Understanding The Hidden Consumer Regulatory Risk For Hedge Funds
Last Updated: February 1 2016
Article by Michael D. Mann and Margot Laporte

The recent growth of marketplace lending platforms has resulted in non-bank entities, such as hedge funds, engaging in activities that could conceivably be construed as consumer lending transactions. The Consumer Financial Protection Bureau (the "CFPB") was established by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act") as an independent agency within the Board of Governors of the Federal Reserve System (the "Federal Reserve") to regulate the offering and provision of consumer financial products and services and to enforce federal consumer financial laws against banks and other covered entities.1 Currently, the CFPB does not have authority over nonbank entities engaging in activities such as marketplace lending that do not constitute the offering or provision of financial products or services directly to consumers. However, as marketplace lending becomes more sophisticated, the line will continue to blur between the regulated consumer lending activities of banks and other covered entities, which include the origination, brokerage and servicing of mortgage, student and payday loans, and the unregulated marketplace lending activities of non-bank entities, which include the provision of liquidity to online lending platforms that originate loans to consumers.

In this memorandum, we outline the potential risks and theories of regulation for non-bank entities engaged in marketplace lending and suggest several areas where proactive policies and procedures implementing best practices in advance of specific regulatory guidance would benefit non-banks engaged, directly or indirectly, in the fast evolving marketplace lending industry.

As marketplace lending migrates towards activities that more closely resemble consumer lending, non-bank entities should anticipate that their activities will draw the scrutiny of the CFPB and other regulators in connection with consumer protection laws, even if those activities do not directly touch consumers. These marketplace lending activities could include financing loans to consumers, purchasing and servicing loans to consumers originated by banks or online lending platforms, taking a controlling position in a chain of payday lenders, or engaging in other structured financial transactions that indirectly touch consumers. While non-bank entities may view their marketplace lending activities as removed from consumers, Congress, as well as federal and state regulators, have signaled a heightened focus on consumer protection, particularly in transactions involving sophisticated financial institutions.

On September 30, 2015, for instance, Lael Brainard, a member of the Board of Governors of the Federal Reserve, advised an audience assembled at the Third Annual Community Banking Research and Policy Conference that banks should consider regulatory compliance when purchasing consumer loans originated by online lenders, including whether the online lenders' origination, underwriting, credit and other practices raise any consumer protection risks. Governor Brainard noted that "some have suggested a need for regulators to take a more active role in defining and enforcing standards that apply more broadly to [the online lending] sector."2 While the Federal Reserve, the CFPB and other regulators supervise the banks to which Governor Brainard directed her remarks, non-bank entities engaged in marketplace lending should proactively monitor the increased regulatory focus on the duty of banks that purchase loans originated by online lenders to comply with consumer protection regulations.3

Because the CFPB has not, as of yet, regulated non-bank entities engaged in marketplace lending, there is an absence of market-wide consumer protection-related best practices in this industry. This void leaves the industry open to significant regulatory and reputational risk, both because it increases the likelihood that the CFPB and other regulators will turn their focus to these marketplace lending practices, and because it may leave non-bank entities unprepared to address the regulators' expectations in the event that their practices are subject to scrutiny. Accordingly, we recommend that non-bank entities should, first, implement internal risk-based best practices with respect to consumer protection laws and regulations in connection with their marketplace lending programs; and second, be cognizant of the risk that regulators might regard their involvement in the marketplace lending space—whether as a loan purchaser or as a financing party to, or investor in, marketplace lending platforms—as having crossed the line from disinterested investing to consumer lending.

THEORIES OF POTENTIAL RISK AND REGULATION FOR NON-BANK ENTITIES ENGAGED IN MARKETPLACE LENDING

Recent developments suggest several lenses through which the CFPB and other regulators might one day view non-bank entities engaged in marketplace lending as subject to enforcement jurisdiction. The CFPB and other regulators could, for instance, seek to hold nonbank entities that engage in activities that directly or indirectly affect loans to consumers responsible for violations of consumer protection laws under a theory akin to aiding and abetting. Regulators also could seek to enforce consumer protection laws against non-bank entities that finance or purchase and service consumer loans under the theory that the non-bank entity, and not the originating bank, was the "true lender" in the lending transaction. These theories are discussed in greater detail below, but they are not the only ways in which the CFPB and other regulators may seek to broadly enforce consumer protection laws in the future.

Under an "aiding and abetting" theory of liability, the CFPB may seek to assert enforcement jurisdiction over hedge funds and other non-bank entities that engage in marketplace lending activities by alleging that the nonbank entity aided and abetted a covered entity, such as a loan originator, in violations of consumer protection laws. The CFPB's broad enforcement authority to prevent covered entities and "service providers"4 from committing or engaging in unfair, deceptive or abusive acts or practices ("UDAAPs") under federal law in connection with any transaction offering or providing a consumer financial product or service means that nonbank entities could be held responsible for aiding and abetting a wide range of prohibited conduct under the broad UDAAP standard.5

In particular, the CFPB's February 24, 2014 Consent Order in the Matter of 1st Alliance Lending, LLC6 raises questions about the types of activities that could subject non-bank entities engaged in marketplace lending to scrutiny by the CFPB. In this case, following a self-report by a mortgage lender, the CFPB imposed a civil monetary penalty on the lender for having paid unearned settlement fees to a hedge fund that at one time had financed its mortgage loans, in violation of the Real Estate Settlement Procedures Act. While the CFPB did not charge the hedge fund in this case, it is possible that the CFPB could, in the future, seek to hold hedge funds and other non-bank entities that finance problematic consumer transactions responsible for aiding and abetting violations of consumer protection laws.

With respect to the "true lender" theory, recent developments in litigation regarding whether non-bank entities or third-party service providers were the "true lenders" in the context of state usury and other consumer protection laws could provide another lens through which the CFPB and other regulators might consider whether entities that engage in marketplace lending could be subject to consumer protection laws. In CashCall, Inc. v. Morrisey7, for instance, the Supreme Court of Appeals of West Virginia affirmed a circuit court decision finding that CashCall, Inc., a California-based consumer finance company that purchased, marketed and serviced high-interest loans from First Bank and Trust ("FB&T"), was the "true lender" for purposes of state usury and consumer protection laws. FB&T, a South Dakota-chartered bank supervised and insured by the Federal Deposit Insurance Corporation, made small, unsecured loans at high interest rates to consumers in various states. Pursuant to marketing agreements with FB&T, CashCall purchased FB&T's loans within three days of the loans' origination dates. FB&T retained the origination fees and all interest accrued prior to CashCall's purchase of the loans.

Focusing on an examination of which entity had the "predominant economic interest" in the transactions, the appeals court affirmed the circuit court's conclusion that CashCall, and not FB&T, was the "true lender" in this case. The appeals court cited the circuit court's findings that: (1) CashCall's agreements with FB&T placed the entire monetary burden and risk of the loan program on CashCall; (2) CashCall paid FB&T more for each loan than the amount financed by FB&T; (3) CashCall's sole owner and stockholder personally guaranteed all of CashCall's financial obligations to FB&T, including the amounts of the loans prior to CashCall's purchase; (4) CashCall agreed to indemnify FB&T against all losses arising out of their agreement, including any claims asserted by borrowers; (5) CashCall was under a contractual obligation to purchase the loans originated and funded by FB&T only if the loans were approved pursuant to CashCall's underwriting guidelines; and (6) CashCall treated the loans as if it had funded them for purposes of financial reporting.

Extrapolating from this analysis, the CFPB and other regulators could seek to hold non-bank entities engaged in marketplace lending responsible for problematic consumer lending transactions under the theory that the non-bank entity was the "true lender" in the transaction. Although not every court that has undertaken a "true lender" analysis in the context of state usury and other consumer protection laws has found the non-bank entity to be the true lender, these cases suggest that, in determining whether a third party that funds or purchases and services a loan was the "true lender," courts have examined the contractual and economic arrangements between the parties, focusing on factors such as: (1) the degree to which the non-bank entity assumes, or shares with the bank, the monetary burden and risk of loss arising from the loan transaction; (2) whether the non-bank entity agrees to indemnify the bank against any loss arising from the loan transaction; (3) the non-bank entity's right to impose underwriting and other credit risk guidelines with respect to the types of loans it will fund or purchase; and (4) the amount of time that elapses before the non-bank entity purchases the loan.8

Consequently, non-bank entities that participate in marketplace lending should consider these factors when negotiating and structuring arrangements with banks and other lending platforms in order to limit the risk that they might be considered the "true lender" should the lending relationship be subject to regulatory scrutiny in the future.

PRACTICAL RESPONSES TO POTENTIAL FUTURE REGULATION

While we cannot predict regulatory trends with certainty, we can predict that, as the marketplace lending activities of non-bank entities migrate closer to consumer lending, these activities increasingly will be subject to scrutiny by the CFPB and other regulators in connection with consumer protection laws. We have identified two potential theories under which the CFPB may seek to enforce consumer protection laws against non-bank entities over which it does not currently have jurisdiction, but these theories are not exhaustive.

As a result, we recommend that hedge funds and other non-bank entities engaged in marketplace lending take several steps today to mitigate the risk from this regulatory uncertainty. First, non-bank entities should develop consumer protection-related best practices akin to those that have been established for banks and other regulated entities engaged in consumer lending. Second, non-bank entities should be cognizant of the line between marketplace lending and consumer lending, in order to be in a better position to assess when their marketplace lending activities could subject them to consumer protection-related risk.

In the absence of established consumer protection-related best practices with respect to marketplace lending, current regulatory guidance addressed to financial institutions provides insight into regulators' expectations for entities that enter into arrangements with third parties, including online lending platforms, for the financing or purchase of loans. In view of recent regulatory guidance9, non-bank entities developing best practices with respect to marketplace lending should consider implementing policies and procedures that include the following:

  • Due diligence prior to entering into relationships with third parties, including with online lending platforms, that includes a review of the third party's business reputation and experience, as well as its policies, procedures and compliance with federal and state laws, rules and regulations, including consumer protection laws and regulations;
  • Due diligence on the terms of any consumer loans purchased through third-party relationships, including online lending platforms, to assess potential regulatory and other risks, including with respect to consumer protection laws and regulations;
  • A risk assessment of the structure of the proposed financial arrangement to understand the degree to which the arrangement directly or indirectly touches consumers and any consumer protection-related risk to which the non-bank entity may be subject as a result;
  • Based upon the results of this risk assessment, procedures to mitigate any consumer protection-related risk, which may include:

    • Structuring the transaction to reduce exposure to consumers, as appropriate, including in consideration of the "true lender" analysis discussed above, or
    • Negotiating the third party contract to include policies, procedures and controls that are designed to address compliance, including with respect to consumer protection laws and regulations. These contractual provisions should include appropriate consequences if the third party violates any compliance-related responsibilities, including by engaging in unfair, deceptive or abusive acts or practices;
  • Ongoing monitoring of the third party, including with respect to its compliance with consumer protection and other laws and regulations; and prompt action to address any issues that may arise, including termination of the relationship, if appropriate;
  • Effective and ongoing monitoring of any consumer loans financed or purchased, potentially including an appropriate investment in evolving technologies that can efficiently and periodically "re-underwrite" consumer loans in real time to detect deficiencies and predict problem loans, while evidencing to regulators that forward looking, risk-based controls were in place at the time the loan was acquired and have been continuously maintained; and
  • Appropriate documentation of the policies and procedures undertaken with respect to each transaction.

Non-bank entities, including hedge funds, that incorporate consumer protection-related best practices into their marketplace lending programs now, and that understand and consider where their marketplace lending activities could one day subject them to scrutiny by the CFPB, will earn dividends in reduced regulatory and reputational risks and costs in the event that the CFPB and other regulators target their marketplace lending practices in the future.

Footnotes

1. Covered entities over which the CFPB has enforcement authority include: (1) any entity, and any service provider to that entity, that engages in offering or providing the following consumer financial products or services: (a) "origination, brokerage, or servicing of loans secured by real estate for use by consumers primarily for personal, family, or household purposes, or loan modification or foreclosure relief services in connection with such loans," (b) private student loans, or (c) consumer payday loans, Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 ("Dodd-Frank Act"), 12 U.S.C. §§ 5481(6), 5514(a)(1), 5514(c); (2) large insured depository institutions, large insured credit unions, and their affiliates and service providers that engage in offering or providing a consumer financial product or service, id. §§ 5481(6), 5515(a), 5515(c), 5515(d); and (3) service providers to a "substantial number" of small insured depository institutions or small credit unions that engage in offering or providing a consumer financial product or service, id. §§ 5481(6), 5516(e).

2. Lael Brainard, Member, Board of Governors of the Federal Reserve System, Community Banks, Small Business Credit, and Online Lending, Address at the Third Annual Community Banking Research and Policy Conference (Sept. 30, 2015).

3. Of particular note, on October 29, 2015, Santander Consumer USA announced its intention to sell its entire personal lending portfolio. Press Release, Santander Consumer USA, Santander Consumer USA Holdings Inc. Reports Third Quarter 2015 Results (Oct. 29, 2015). It has been reported that Santander Consumer USA had entered into an arrangement with Lending Club in March 2013 to purchase up to 25 percent of the loans it originated, but exited the arrangement after receiving "regulatory pressure" from the Federal Reserve regarding the level of risk. See Ben McLannahan, Lending Club Delivers Earnings Rebuke to Bears, Financial Times, Oct. 29, 2015; Santander Halts Unsecured-Loan Initiative, Asset-Backed Alert (Nov. 6, 2015).

4. The Dodd-Frank Act defines a "service provider" as "any person that provides a material service to a covered person in connection with the offering or provision by such covered person of a consumer financial product or service." Dodd-Frank Act, 12 U.S.C. § 5481(26). Hedge funds and other non-bank entities that purchase and service consumer loans risk being regarded by the CFPB as "service providers" to the covered loan originator, and thus potentially subject to CFPB supervisory and enforcement authority.

5. See id. § 5531(a).

6. Consent Order, In the Matter of 1st Alliance Lending, LLC, CFPB No. 2014-CFPB-0003 (Feb. 24, 2014).

7. CashCall, Inc. v. Morrisey, No. 12-1274, 2013 W. Va. LEXIS 587 (W. Va. May 30, 2014), cert. denied, 2015 U.S. LEXIS 2991 (May 4, 2015).

8. See, e.g., id.; Sawyer v. Bill Me Later Inc., No. 2:11-cv-00988, 2014 U.S. Dist. LEXIS 71261 (D. Utah May 23, 2014); Spitzer v. County Bank of Rehoboth Beach, 846 N.Y.S.2d 436 (N.Y. App. Div. 2007).

9. See, e.g., Fed. Deposit Ins. Corp., Advisory on Effective Risk Management Practices for Purchased Loans and Purchased Loan Participations, FIL-49-2015 (Nov. 6, 2015); Off. of the Comptroller of the Currency, U.S. Dep't of the Treasury, Risk Management Guidance, Third-Party Relationships , OCC Bulletin 2013-29 (Oct. 30, 2013); Consumer Fin. Protection Bureau, Service Providers, CFPB Bulletin 2012-03 (Apr. 13, 2012); Fed. Deposit Ins. Corp., Guidance for Managing Third-Party Risk, FIL-44-2008 (June 6, 2008).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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