The industry must take a leadership role in shaping legislation.
Private non-consumer lending has been largely ungoverned—anyone wanting to lend a friend enough money to flip a house should be able to, right?
The Game Has Changed
It’s no longer just a few local private money lenders making small loans on single-family homes. Big money is now attracted to the model because of the collateral-backed security and typically attractive returns. With more participants and more money involved, legislators are now considering regulation using more traditional financial sectors as comparable examples of how private lending could be governed.
The 2008 mortgage crash spurred regulators to ensure that banks could not write blank checks to unqualified borrowers. Dodd-Frank aimed to create more transparency in the financial system. Whistle-blowers and consumer-protection groups in many states are addressing payday lending laws too. Although private lending has been historically linked to mortgages, payday lending, crowdfunding and other technology-based lending platforms have legislators and regulators scurrying to find ways to keep lenders in line.
Not an Easy Comparison
Let’s set the stage. Countless funds, REITs and private lenders are making loans at terms ranging from prime bank rates to 100 percent or more per annum. Each raises money differently, and those trying to avoid trouble do so under state and federal regulation frameworks. How they place capital as loans and equity is also governed, typically by the state where the transaction is completed. Usury laws, lien-instrument types and foreclosure procedures vary greatly by state. Some private lenders stay in the single-family residence space and are licensed as mortgage companies Others are non-consumer commercial lenders and rely on the local commercial lending laws where they write checks. The lengths of terms fluctuate, but they are typically much shorter than what banks offer. Origination and other fees differ as well. By rule, private lenders usually price and structure loans based on risk. If risk were all there was to consider, however, the industry would be relatively easy to regulate.
For an example, let’s look at a short-term national private lender. Gauging local market indicators and many other risk factors, the lender underwrites with intense scrutiny and then prices its loans as an equity alternative. Borrowers with time constraints and challenging situations apply for capital that typically would be best structured as a partnership. Rather than taking 50 percent or more of a project’s equity (and thus half the profits), the lender makes loans at rates ranging from 12 percent to 18 percent annualized with terms of 18 months or less. When fees and required reserves are grossed into the loan amount, the rate can sometimes enter the twenties. Regulators comparing this structure to federally insured bank rates may see this cost of capital as exorbitant, even though this is a best-case scenario for project sponsors and borrowers when compared to equity.
How Did We Get Here?
Crowdfunding and technology-enabled capital-raising efforts drew attention when the kick-starters of the world were joined by platforms like Sharestates or AlphaFlow. These real estate crowdfunding platforms present investment opportunities to accredited investors. Rather than providing complementary gifts to startup sponsors, this model generates financial returns for investors. To the Securities and Exchange Commission (SEC) and other regulators, the model looks much like selling unlicensed securities in need of further protection measures. Crowdfunders have a well-defined quality standard for the loans it puts on its platform, but all crowdfunders are not created equal.
The quest to appropriately regulate an industry that takes so many new forms commenced with lightning speed in 2012 with passage of the JOBS (Jumpstart Our Business Startups) Act. This legislation was fiercely opposed by the SEC and many traditional transactional attorneys. The financial industry’s prevailing opinion was the JOBS Act was named to give politicians on both sides of the aisle reason to support it.
The legislation defined capital-raising efforts for developers, public and private companies, and funds. It allows deferment of registrations required under the SEC Act of 1954 and provides an on-ramp for emerging companies and those preparing to go public.
The Jobs Act has five major provisions. It:
- Directs the SEC to remove the conditions prohibiting marketing and general solicitation for those raising money under Rule 506-D.
- Creates legislation akin to Regulation D that contemplates cap amounts of $50 million instead of just $5 million.
- Allows intermediaries like online broker dealers or new categories of lightly-regulated crowdfunding platforms to raise money for small amounts from several investors for a single purpose.
- Establishes higher thresholds before companies are required to register under SEC Acts. (The amount of capital will stay the same, but the law increased the limit of record shareholders from 500 to 2000. No more than 500 of the record shareholders can be non-accredited. This doesn’t include employees who are paid in interest under exempt compensation plans.)
- Provides relief through offering activity and reduces ongoing disclosure. Any company with total revenue less than $1 billion can maintain EGC (Emerging Growth Company) exemptions for five years. Now, companies are free to test the waters with institutional (accredited investors) to determine the interest in their offering before filing.
The industry and regulators are still uncovering the JOB Act’s impacts. So far, the major effect seems to be the emergence of many more crowdfunding platforms and among emerging growth companies (EGCs). More companies will try to go public using this on-ramp because it saves costs and eases some of the Dodd-Frank and Sarbanes-Oxley requirements.
Another space affected by the JOBS Act is peer-to-peer activity. Although this sector is more a predecessor to crowdfunding than private bridge lending, regulators have a hard time defining peer-to-peer activity. The peer-to-peer model rightfully earned its billion-dollar annual market share. But, with no major recourse or security on peer-to-peer loans, potential problems will draw yet more regulatory scrutiny to the lending industry.
The fear of potential problems still plagues the crowdfunding sector. In the comfort of their own homes, accredited investors get regular emails from these platforms. Deals sometimes look too good to ignore—“Developer Seeking 2nd Mezzanine Equity to Complete High-Rise Condos in Staten Island With a Guaranteed 20% Return.”
The technology allows investors the freedom to quickly and conveniently make their own decisions. But, what happens when a deal goes south? Who is responsible to ensure that these financial platforms aren’t just enticing accredited (but unsophisticated) investors with high promised rates of return?
Shaping the Legislation
When (not if) a contingent of poorly executed crowdfunded loans or equity deals default, regulators will become more serious about buttoning things up. So far, it is all about sexy deals on sexy platforms with very little history or data to suggest anything other than success. But, when crowdfunding and other online capital-raising efforts eventually invite more scrutiny, the door to more regulation of private lending will get kicked open further.
So far, most legislative efforts have focused on the raising of money, whereas the placement of money seems to receive less scrutiny. Regulation of both components is probably inevitable—and there is a place for win-win regulation. The industry, however, needs to take a leadership role in proposing commonsense solutions.
Institutions tirelessly supporting legislation calling for less transparency are helping write a recipe for disaster, much like the one that culminated in 2008. Investors have a right to feel that someone beyond their adviser has their back. When investors lose hard-earned money because an alluring deal was bad to begin with, someone should have to answer, be it an inexperienced crowdfunder or a genuine bad actor.
The traditional approaches of impacting legislation by writing representatives or joining other lenders to hire a K Street lobbyist may work, but it has not in most nontraditional financial sectors since 2008. The damage to traditional sectors was so deep, and so rooted in greed and misconduct, that legislators are rightly wary. They do not want to be on the approving end of lax regulation that enables another type of crash.
Most politicians are not trained in finance—especially nontraditional finance. So, they form opinions based on the rare, negative experiences of some vocal constituents. Some politicians do understand there is a place in the industry for higher-risk/higher-reward financial models. They also realize technology has made these alternate models inevitable. They know that a healthy level of freedom combined with strict guidelines, where needed, will enhance the industry.
There are between 8 and 9 million accredited investors in America. They are the private lenders’ partners. Private lenders who ethically and responsibly manage that wealth for a return should earn market share and continued confidence. Earning confidence from financial allies makes them natural political partners. The best way to avoid over-regulation is through disciplined execution and industry-wide integrity. If private lenders want to continue to self-govern, they must lead an effort to expose errors that hurt those partners—the investors—and lead to reactionary and poorly crafted legislation tailored to failures in other finance sectors.
Private lenders who damage the industry’s reputation by gouging or intimidating borrowers increase the risk that all private lending will be regulated like its peer industries. Because of the complex nature of our industry, educating Congress would be only possible with the support—financial and political—of those we ethically serve. The best way to protect the industry is by making loans that protect investors and enable borrowers to succeed and by enlisting their help in maintaining our business models. ∞