Prosper announced Q2 earnings this week. We summarize key statistics below, and focus this week’s newsletter on the components of the Loan Purchase Agreement.
Anatomy of a Loan Purchase Agreement
Purchasing raw whole loans involves substantial legal and administrative investment. Originating platforms (“Sellers”) and whole loan investors (“Buyers”) enter into multiple negotiated contracts to purchase loans. These include the Loan Purchase Agreement, Loan Servicing Agreement, Loan Representation and Indemnity Agreement.
An LPA sets forth the economic terms, obligations, and representations for both the seller and buyer of loans. A sample LPA can be found on the SEC website although agreements may vary from platform to platform.
Below we outline key sections of a typical LPA agreement for a marketplace lending platform.
Purchase and Sale Commitment
The LPA defines the procedure for the whole loan investor to make an offer to buy and fund loans. The LPA agreement:
- Specifies the volume commitment (if any) of the purchaser.
- Sets forth the procedure and timeline for the loan purchase.
- Requires the investor to keep necessary funds in an account.
- Gives rights to the buyers to collect or custody loan documentation.
- Prohibits the originator from modifying loan terms and conditions after an investor has made an irrevocable commitment to purchase loans.
Upon a loan sale, the loan seller will sell, transfer, and assign all of its rights, title and interest in the loans to the buyer except for servicing rights. MPL originators generally seek to retain servicing rights and associated servicing fees as they are a material driver of revenue. The servicing fees also create an on-going economic interest in loan performance.
Representations and Warranties
Reps and warranties focus on lender’s underwriting policies, servicing practices, regulatory status, and loan performance information and are highly negotiated.
Seller and Purchaser Representation and Warranties
In this portion of the LPA, the Seller represents among other items that:
- The Seller is solvent.
- There are no judicial proceedings or investigations by regulatory authorities which could have a material effect on the agreement.
- The seller is in good standing, has the authority to execute the agreement, and has all licenses to carry on its business.
Purchased Loan Representations and Warranties
Here the originating platform provides a representation with respect to each loan that:
- No loan selection procedures were used by the Seller that identify the purchased loan as less desirable than other originated loans.
- The loan satisfies eligible collateral criteria and is enforceable by law.
- The loan is not delinquent.
- The Seller has sole title and beneficial ownership of the loan.
- The loan does not have any other outstanding liens.
- The loan is free of any defense, offset, counterclaim or recoupment that could be asserted by the applicable borrower.
- The Seller represents that the collection and servicing practices are compliant with law.
A negotiated issue here is whether the seller makes such representations as of the purchase date or on a continuing basis.
Indemnifications are also highly negotiated between the originating platform and Buyer. Seller’s generally agree to indemnify purchaser’s from damages related to:
- A breach of any covenant, or inaccuracy of any rep and warrant provided.
- Seller fraud, theft, or misappropriation of funds.
Similarly, Buyers agree to indemnify sellers for any breach of covenant or rep and warranty provided by the Buyer in the LPA.
Indemnity and Repurchase
The Seller will buy the loan back at a pre-defined repurchase price if the loan is not enforceable due to non-compliance of law or identity theft.
Originators therefore recognize a potential liability for repurchase and indemnification when loans are issued. The amount of future payments associated under this repurchase obligation are the outstanding balances of borrower loans issued (and associated regulatory fines).
Ironically, although platform provided reps and warrants are required to motivate a loan purchase, financing, or ABS transaction the platform’s ability to backstop the reps and warrants diminishes as platforms scale originations. Marketplace lending platforms are “capital light”. By virtue of the business model, outstanding balances are multiples of platform’s capacity to repurchase loans.
For instance, Prosper’s 10-Q notes its maximum repurchase liability is ~$4 Bn. This number is 50x the amount of available cash and other assets Prosper has on balance sheet to repurchase loans.
Since the balance sheet of the originator is a small fraction of issued loans, investors along the funding chain critically evaluate the i) the rigor and discipline of internal controls, ii) 3rd party vaulting and verification, and iii) 3rd party chain-of-title, credit validation, and data integrity checks such as those offered by PeerIQ. Platforms that invest in the above infrastructure see benefits in reduced financing costs for their whole loan buyers.
True Sale and Grant of Security Interest
In the True Sale section, the platform and Buyer acknowledge that the loan purchase is a true sale (as opposed to a financing) for tax, accounting, and all other purposes. A True Sale of loans into a bankruptcy-remote trust is critical to separating the credit risk of the collateral from the originator in a securitization.
However, in the event that that transfer of the payment stream from the originator to the investor fails to constitute a true sale (e.g., a court determines the loans to be assets of the platform or interprets the arrangement as a financing), then the originator grants to the Buyer a “present and continuing” security interest on purchased loans.
The security interest provides the Buyer with a first priority claim on any borrower loan proceeds. The investor is authorized to perfect their security interest under Article 9 of the Uniform Commercial Code (“UCC”). Steps to perfect the security interest include filing financing statements on form UCC-1 which name the purchaser as the secured party and the platform as the debtor. Investors will also take possession of the original loan note and related documents (or require the borrower to deliver the same to a lender custodian). Parties will arrange for an electronic custody provider to hold an authoritative electronic record in a dedicated electronic “vault”.
Similarly, downstream in the financing chain, any bank that provides a credit facility to a Buyer purchasing loans will also seek to reduce the risk of Buyer default by requiring the Buyer to grant a security interest in the purchased loans to the leverage provider.
Buyers are incented to negotiate for a robust rep and warrant package while also ensuring transactions satisfy true sale tests. However, there are trade-offs between certain reps and achieving the conditions of true sale. For instance, a Buyer may reasonably seek to have the platform rep to loan validity at time of sale and on an on-going basis. An on-going representation, while desirable, may arguably undercut the legal status of true sale.
Offshore investors may require true sale, arms-length pricing, 3rd party valuations, blocker structures, and other safe harbor exemptions to manage their Effectively Connected Income tax (“ECI”) liabilities. This makes negotiating a forward flow agreement between a platform and an offshore investor especially difficult–an offshore investor’s commitment to a funding schedule and a pre-defined loan purchase valuation may itself trigger incremental ECI tax.
Failure to secure up-front securitization friendly reps, warranties, and indemnifications may impede the ability of a Buyer to secure financing. For instance, unless agreed to by contract, the Buyer cannot require the lender to provide loan performance data for preparing offering materials, or repurchase ineligible loans from the ABS special purpose vehicle.
Buyer’s that seek term ABS as a source of financing may request the originating platform to:
- Indemnify the special purpose vehicle and underwriters against material inaccuracies in disclosures of lender’s loan performance.
- Seek a “negative assurance” letter from originator’s counsel in relation to these disclosures.
- Authorize the SPV to rely upon the reps and warranties and re-purchase rights in the LPA.
- Assist in the Buyer in responding to ratings agencies questions.
Specialized legal, tax counsel, and professional expertise is required to navigate these challenges. Additionally, PeerIQ and SFIG recommend that platforms move toward an industry standard rep and warrant package to reduce complexity and improve adoption for whole loan and ABS investors.
PeerIQ will speak at:
- ALTFI Global Summit 2016 in New York on September 14.
- IMN’s ABS East Conference in Miami on September 18-20.
- American Banker Marketplace Lending and Investing Conference on September 27-28 in New York.
- Context Summits 2016 Alternative Lending Summit on September 28 in Dana Point, CA.
- Meet Marcus, Goldman Sachs’s Online Lender for the Masses (NYT, 8/18/16) GS most likely to roll out an online lender in October.
- Fintech’s Answer for Chilly IPO Market? Debt (WSJ, 8/18/16) Fintech companies are delaying IPOs and raising money via debt markets.
- To Starve the Beast of Finance, Fintech Needs Regulatory Support: James Saft (Reuters, 8/16/16) The current regulatory regime will encourage new FinTech entrants.
- Two CEOs Tell Us Where Alternative Lending is Headed (BusinessInsider, 8/15/16) The CEO of Prosper and Kabbage share insights on their business models and the future of alternative lending.
- SocietyOne Chief Jason Yetton Says Lending Jumps Tenfold (SMH.com, 8/16/16) P2P Lending is growing rapidly in Australia.
- Online Lending Myth Now ’Debunked’, Investor of These Loans Says (Bloomberg, 8/19/16) There is a demand for new analytical tools to compare loans across originators to enable investors to do independent assessments.
- Marketplace Lending News Roundup (LendAcademy, 8/13/16) ABS-15G summary of marketplace lending deals.
- Usain Bolt and the Fastest Men in the World Since 1896 – on the Same Track (NYT, 8/15/16) A visual comparison of Bolt’s speed against every medalist since 1896.