The Regulation of Marketplace Lending: A Summary of the Principal Issues (May 2022 Update)
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Notes? And second, in securitizations of marketplace loans (to which the Retention Rules
unquestionably apply), who will be deemed the “sponsor” required to retain the credit risk?
As to the first of these questions, technical arguments can be made that Platform Notes constitute
“asset-backed securities” to which the retention requirement applies.
If that were the case, the
Funding Bank would likely be deemed the party required to retain the risk.
At the same time,
technical arguments also can be made that the Retention Rules do not extend to Platform Notes.
It
is unnecessary for us to debate the relative merits of these opposing arguments as the Agencies
(although they have made no formal pronouncement) have not applied risk retention to Platform Notes
nor have they indicated any intention to do so. In this regard, the industry may consider itself fortunate
Although numerous securitizations of marketplace loans have been completed, to date there have been no securitizations
of Platform Notes. Securitizing Platform Notes (as opposed to marketplace loans) offers no advantages to either the sponsor
or investors and would create additional expense and complexity.
As previously discussed, Platform Notes do not constitute “asset-backed securities” for purposes of Regulation AB under
the Securities Act because (i) each Platform Note is backed by a single Borrower Loan and does not represent an investment
in a “pool” of assets, and (ii) the Operator is not a “passive” issuer as contemplated by Regulation AB. The risk retention
requirements therefore would not apply to Platform Notes if Congress had incorporated the Regulation AB definition of
“asset-backed security” in the Dodd-Frank Act. In fact, however, the Dodd-Frank Act amended the Exchange Act to include
a new (and broader) definition of “asset-backed security” that will govern the retention requirements. Under this definition,
an “asset-backed security” will include any “fixed-income … security collateralized by any type of self-liquidating asset
(including a loan … or other secured or unsecured receivable) that allows the holder of the security to receive payments
that depend primarily on cash flow from the asset.” It follows that a Platform Note will constitute an “asset-backed security”
for purposes of the risk retention requirements if (i) it is “collateralized” by a loan, and (ii) the holder’s right to receive
payments depends primarily on the cash flow from such loan. Platform Notes appear to satisfy both clauses of this test. In
regard to the first clause, the Retention Rules state that an asset “collateralizes“ a security (whether or not the issuer grants
the investors a security interest over the asset) if the asset provides the cash flow that the issuer will use to make payments
on the securities. The Borrower Loans do of course provide the cash flow that the Operator will use to make payments on
the Platform Notes. In regard to the second clause, payments on the Platform Notes will depend not only ”primarily” but
in fact solely on such Borrower Loan cash flow. In contrast to Regulation AB, the Exchange Act definition does not require
the “asset-backed security” to be backed by the cash flow from a “pool” of financial assets.
If Platform Notes are “asset-backed securities” subject to risk retention, the Funding Bank arguably is the “sponsor” subject
to the retention requirement since it transfers assets (i.e., the Borrower Loans) to the issuing entity. If this is the case, the
Funding Bank would be required to retain credit risk and would not be permitted to transfer 100% of the credit risk on any
Borrower Loan to the Operator. Regulators might also be inclined to deem the Operator to be a ”sponsor” (whether in
addition to, or in place of, the Funding Bank) since the Operator manages the overall program and helps to select the
“securitized” assets by determining the loan underwriting criteria in conjunction with the Funding Bank. However, a court
decision strongly suggests that the regulators do not have authority under the Retention Rules to treat the Operator as a
“sponsor” in this situation because the Operator, assuming that it does not acquire the Borrower Loans from the Funding
Bank and then transfer them to a special-purpose company that issues the Platform Notes, has not transferred any Borrower
Loans to the issuing entity (i.e., to itself). See footnote 550 below.
Under the Retention Rules the retention requirement applies only if assets are transferred to an “issuing entity” and the
asset-backed securities are issued in a “securitization transaction” (which similarly requires that the asset-backed securities
be issued by an “issuing entity”). Although the Operator (or an Affiliated Issuer or a Trust, as further discussed under
“Bankruptcy Considerations” below) unquestionably is the issuer of the Platform Notes, it may not be an “issuing entity.”
The Retention Rules define “issuing entity” as the entity that (i) owns or holds the pool of assets to be securitized, and
(ii) issues the asset-backed securities in its name (emphasis supplied). Each Platform Note is backed not by a pool of
underlying assets but by a single Borrower Loan. It therefore may be reasonable to conclude that, although Platform Notes
are “asset-backed securities” for purposes of the Retention Rules, they are not issued by an “issuing entity” in a
“securitization transaction” and therefore are not subject to risk retention requirements. Although in certain circumstances
the SEC has deemed pass-through securities backed by a single asset to constitute “asset-backed securities” within the
meaning of Regulation AB (notwithstanding the pooling requirement in Regulation AB), there are reasons to differentiate
those securities from Platform Notes and to view them as not controlling. See footnote 511 above.