A new way to do things opens up hazards that can be hard to navigate. We’ve all done it, jumped in to something we thought we understood only to realize that we should always look before we leap.
There are a number of complex questions that still loom over the burgeoning community of online private investing. Among these questions is the recurring misconception that exists regarding traditional securities regulations and their applications in a cloud based environment. While technology will greatly affect the order input, processing and execution pieces of private investing in the future, it is worthwhile to revisit the past, to familiarize ourselves with one of the industry’s more influential decisions regarding securities regulations and to examine how we may learn from these mistakes moving forward.
Several early pioneers of peer-to-peer lending models operated without proper registration, were subsequently found to be in violation of multiple securities laws. In a nascent space without any clear rules or regulations, these platforms chose to facilitate a market without using a properly registered entity. The SEC soon intervened with cease and desist letters, identifying these operations as sales of securities without effective registration statements or valid exemptions from registration.
Having violated Sections 5(a) and (c) of the Securities Act of 1933, these platforms’ ability to conduct business stalled until they fixed the structural and systemic deficiencies in their model, bringing the emerging industry to an abrupt halt. These findings were most notably demonstrated in the ceasing of Prosper Marketplace, Inc., who endured a subsequent period of inactivity lasting over six months.
As the online private investing movement continues to mature, it is important that both issuers and investors understand when loan notes must be treated as securities. So, how does one determine if a note qualifies as a security?
Just ask Reves.
The Reves Test:
The Reves Family Resemblance test is based on the following four principles:
I. The motivations of the buyer and seller.
II. The plan of distribution.
III. The reasonable expectations of the investing public.
IV. The existence of an alternate regulatory regime.
If a note’s characteristics deviate from those of the defined non-security notes, in respect to these four pillars, it is said to have failed the family resemblance test. Issuers of notes that fail the test are not exempt from security registration requirements, and their transactions must be pushed through a broker-dealer. The Supreme Court’s opinion in Reves v. Ernst & Young, 494 U.S. 56 (1990) established a select group of notes as “non-security notes.”
In Prosper’s case, their notes are securities under Reves, because in their nature: (i) Prosper buyers are motivated by an expected return on funds; (ii) Propser notes are offered to the general public; (iii) reasonable investors would likely expect that the Prosper notes are investments; and (iv) there is no alternate regulatory scheme that reduces the risks to investors presented by the platform.
Though the Reves ruling only applies to loan notes, one should expect the same rationale to apply to all classes of online investing. The JOBS Act has brought significant disruption, scrutiny, and opacity to the marketplace for online private investing. For the online private investing marketplace to flourish, it is essential that all parties involved understand and recognize the pre-JOBS Act guidelines in defining aspects of the marketplace and that they cannot bypass already existing rules and regulations – let a broker-dealer look so you can leap.
Disclaimer: WealthForge provides this information to our clients and other friends for educational purposes only. It should not be construed or relied upon as legal advice.