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 as an independent agency within the Board of Governors of the Federal Reserve System 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. Currently, the CFPB does not have authority over non-bank entities that engage 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 includes the provision of liquidity to online lending platforms that originate loans to consumers.
While marketplace lenders historically have partnered with originating banks that are subject to regulation by the CFPB and other banking regulators, as the marketplace lending space expands, we expect that the sources of funding will expand as well. In this article, we outline the potential risks and theories of regulation for non-bank entities engaged in funding and other activities related to 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.
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 non-bank 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 non-bank 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 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 non-bank entities could be held responsible for aiding and abetting a wide range of prohibited conduct under the broad UDAAP standard.
In particular, the CFPB’s February 24, 2014 Consent Order in the Matter of 1st Alliance Lending, LLC 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 had time 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 federal and state court decisions finding that non-bank entities and third-party service providers, rather than the originating banks, 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 one day consider whether entities that engage in marketplace lending could be subject to consumer protection laws.
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 whether the bank or the third party had the “predominant economic interest” in the lending transaction, 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.
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. 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 guidance from the CFPB, FDIC, OCC, and other banking regulators, 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.