[Editor’s note: This is another guest post from Brian Korn of Manatt, Phelps & Phillips, LLP. They will be in attendance at LendIt USA 2015 on April 13-15. You can view his first post, the top 5 issues in consumer p2p regulation and law here. In this post, he talks about the top 5 issues in real estate p2p law and regulation]
The P2P land grab is on. Traditional sources of credit are being replaced with new platforms and credit providers. Offline lenders are developing an online presence. New platforms have seemingly been around for years. Above all, competition for borrowers and investors is fierce. On the horizon are battles over leverage and the need to scale, scale, scale. In the midst of this frenzy is a potential legal and regulatory powder keg. Here are my top five legal and regulatory issues in the P2P real estate sector:
1. Don’t IRRitate Investors
Often real estate transactions quote investors a projected internal rate of return. These IRRs are based on the developer or borrower executing on a business plan in accordance with a budget. Budgets are usually created by the developer and might have embedded assumptions. Assumptions should be realistic and grounded in the borrower’s and platform’s reasonable expectations. If no improvements are made to the property, why do we think the lease rate will go from 50% to 95% in year one? There might be a good explanation for it, but make sure there is. I believe quoting an IRR—and leading sales discussions with projected IRRs—that are highly dependent on far-flung assumptions are quite likely to draw regulatory heat. Disclosure and transparency are of prime importance as the industry continues to develop. You are better off selling a deal a day or two later than luring in investors with return claims that you know cannot be achieved. IRR is more often used in equity deals, but be careful whenever you quote someone a projected return.
2. LTV vs. ARV? Let’s Call the Whole Thing Off!
Loan-to-value ratio (LTV) is a critical metric in evaluating whether to invest in a loan. As the name would suggest, it is the ratio of the amount of the loan to the value of the underlying secured property. LTV is usually based on a property appraisal or some other objective valuation of the property. Most platforms post loans with an LTV of 70% or less. What this means is that there is a 30% cushion on property devaluation where the lender is theoretically still fully secured.
Many P2P real estate platforms, however, publish an ARV(after-repair value). ARV is the ratio of the loan amount to the value of the property after the developer applies the proceeds of the loan and spruces it up. ARV asks one to project into the future and assign a value to the developer’s completed vision. It assumes the project can be completed on time and on budget, and that the market for the property in the future will be somewhat healthy with no macroeconomic downturns that affect value. There are good arguments for posting ARV—one might say that once the renovations are complete, the borrower should be given credit for the value of the property being sold, not the value today.
LTV, on the other hand, is more cynical- it assigns no value to repairs and assumes the property will not have appreciable gain. Essentially, in the worst case scenario, if the borrower uses the cash for something else, sits on the money, or the project cannot be completed at the projected level or on the projected timetable, this is the ratio of the loan to the property as-is. The point is that investors should be aware of the use of these ratios and be able to distinguish one from the other through clear and transparent platform disclosure. Regulators will not be kind to sharp or deceptive practices.
3. BPDNs Are Not Secured
Some platforms and investors ask me to clarify that borrower payment dependent notes (BPDNs) are secured. BPDNs are issued by platforms and track the payments received by the underlying loan. The loan from the borrower to the platform generally has a first lien security interest in the underlying property. The corresponding BPDN is an unsecured promissory note issued by the platform. The BPDN does not have a secured interest in the property. In addition, the BPDN holder does not have the right to exercise on the collateral in the event the borrower defaults on the loan. In fact, the BPDN purchaser actually takes two credit risks: first, that the borrower pays on the underlying loan; and second, that the platform (i) accurately records its lien position and enforces its interests on behalf of BPDN holders, and (ii) promptly and accurately tracks and distributes payments to noteholders. Also, many forms of BPDN do not allow for any noteholder recovery for three years after the first default, even if the platform is eventually made whole.
4. Finder, LeadGen and Promoter Issues
Many platforms employ or pay an external team to source transactions. This group is sometimes called “lead generators.” The legality of compensating a finder for sourcing transactions needs to be examined very carefully.
The biggest potential issues are whether the finder needs a real estate brokerage or lending license, and whether the finder is engaging in securities broker-dealer activities.
In general, if the finder does nothing more than relationship brokering, the activity would not need to be licensed and the finder and platform would not be subject to enhanced securities liability. This activity would be similar to an email introducing two people who do not know each other. Once the activity extends beyond pure relationship brokering, the concern is twofold. First, platforms and borrower finders should be careful that sourcing the loan does not require a real estate license. In some states, such as California, either the finder or the platform should have a real estate license or a finance lender license (if you have a CFLL, you do not need a CRE license).
Second, if the finder is used to recruit investors to platforms, care should be taken that he or she is not engaged in active sales and does not receive “transaction-based compensation” (TBC). The receipt of TBC has legal significance that may trigger the need to be a registered broker-dealer. In addition to broker-dealer issues, the promoter him/herself may have securities liability with respect to disclosures he or she makes or fails to make with respect to the investment.
5. States Are Focusing on Blue Sky Compliance
Recently states have come to realize that crowdfunding and P2P platforms are great sources of filing revenues. Reports of private placements that qualify under the safe harbor afforded by Rule 506 of Regulation D, which virtually every platform issuing BPDNs to accredited investors (as opposed to public offering platforms such as LendingClub and Prosper) uses, must be filed with the SEC on a Form D within 15 days following the closing. As an aside, the SEC has proposed but not adopted a mandatory “advance Form D” requirement in which a Form D filing would be required at least 15 days before the commencement of any solicited Rule 506 transaction.
Many states require a “notice filing” whenever a Form D is filed with the SEC which indicates that purchasers from that state participated in the transaction. These are required by state securities laws, or blue sky laws, for securities not listed on a national securities exchange. Filing fees for a transaction can run over several thousand dollars. For the small company that raises capital episodically through a Reg. D transaction once or twice a year, no big deal. But P2P platforms are essentially professional private placement companies that can complete several transactions per week. This creates a real drag on platform P&L.
There are a few ways platforms can save money on blue sky filings, such as by combining multiple transactions on the same forms, and by taking advantage of states that allow “issuer” filings rather than transaction filings. I expect states to become more aggressive in enforcing these filings, since states are losing ways to regulate other types of securities offerings as a result of recent and upcoming changes in federal law.
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Brian S. Korn is a Partner in the Capital Markets Group of Manatt, Phelps & Phillips, LLP, and focuses on P2P. This article is not to be construed as legal or tax advice.
