What Happened To LendingClub? Bank Industry’s Big Disrupter Stumbles

Marketplace lending was supposed to be the bank industry’s next great disrupter. But on Monday the burgeoning sector faced another in a string of humbling setbacks as LendingClub CEO Renaud Laplanche resigned after revelations of impropriety by top managers at the company.

In an announcement alongside its first-quarter earnings Monday, the nation’s largest peer-to-peer lender said that an internal investigation revealed sales to a single investor of $22 million in near-prime loans that failed to meet that investor’s terms.

Hans Morris, LendingClub’s executive chairman, tried to reassure investors in a statement. “A key principle of the company is maintaining the highest levels of trust with borrowers, investors, regulators, stockholders and employees,” Morris said.

Investment bank Jefferies Group had offered to buy up a bundle of consumer debt, yet what top managers sold them came “in contravention of the investor’s express instructions,” LendingClub said. The company’s stock (NYSE:LC) opened down by more than a quarter Monday.

“The market will focus on it over the next few days pretty closely,” Jahan Sharifi, partner at Richards Kibbe & Orbe, said of LendingClub’s admission.

The news only confirmed a growing sense among stakeholders in the online lending sphere that the ascent of digital, peer-to-peer technologies in consumer lending may not be a fait accompli. LendingClub — together with rivals SoFi, Prosper and many others — are feeling sharp growing pains as they brace for increased attention from bank regulators and investors.

Investor caution has caused venture capital firms to tap the breaks on equity funding for the platforms, while lenders have found fewer buyers for debt. “They are finding that institutional sources of capital are not as plentiful as they were before,” Sharifi said. “It may be that the rate of growth will slow.”

It would be the first time the industry has paused since it got seriously underway in the late 2000s. Morgan Stanley estimated last year that the online lending sector is growing at a global rate of 23 percent annually.

The business operates by matching individual borrowers with investors willing to lend at a competitive rate. Rather than originating loans themselves, companies like Prosper and LendingClub partner with Utah-based WebBank, which subsequently sells the loans to investors. Most transactions involve consolidating or refinancing existing consumer loans and student debt.

Despite its troubles, the model has proved a worthy challenge to the traditional lending model, in which banks unilaterally determine creditworthiness and rates. By using nonstandard credit metrics and pursuing sometimes neglected corners of the loan market — particularly younger borrowers with little credit history — online lenders have been able to penetrate the $3.3 trillion consumer lending space, originating some $18 billion in loans last year, according to a report by Prime Meridian Capital Management.

But the industry faces some steep hurdles. As loan issuance has increased, so has regulatory attention. In March, the Consumer Financial Protection Bureau issued new guidance around using marketplace lenders to refinance government-backed student loans, warning that borrowers might lose consumer protections by doing so.

The first foray by the young regulatory body into the online lending space was seen by investors as a warning shot across the industry's bow. The Treasury Department, meanwhile, is expected to release a report this week summarizing its own evolving understanding of the space.

Because the model is so new, different regulators are trying to work out their own approaches to the online space, which could mean a shifting landscape. “There’s a stream of regulation that flows throughout the entire process,” said Marc Franson, a partner at Chapman and Cutler LLP. “There’s no one entity saying, ‘I’m looking at all of these people.’”

But the biggest active threat to the industry is currently lurking in the Supreme Court. The high court is considering Madden vs. Midland Funding, a case that tests whether state-level usury laws apply nationally to nonbanks. In question is whether a loan issued in Utah, which has no interest rate limit, at 25 percent, can be sold to an investor in, for example, Colorado, where interest is capped at 12 percent.

National banks are exempted from state usury laws. But if online lenders aren’t banks, let alone national banks, can they still make an end run around interest rate caps? “Some of the loans could in fact be seen to be violating usury laws,” Scott Budlong, also of Richards Kibbe & Orbe, said.

As the court mulls those questions, a group of aggrieved borrowers have filed a lawsuit against LendingClub, accusing it of breaking usury laws by issuing loans that exceed state-level maximum rates. That case, which the plaintiffs are seeking to be certified as a class-action lawsuit, isn't just a legal headache; Moody's has said it presents a credit risk to the securities made up of packaged loans that LendingClub sells investors.

But courts and federal agencies aren't the only risks investors are eyeing. LendingClub, which went public in 2014, has yet to see a market contraction anywhere near the scale of 2008’s financial crisis — or even a more modest pullback. How online lenders would keep their doors open during such a widespread credit event remains unknown.

In a survey released last month, 85 percent of investors in the peer-to-peer market said they were somewhat or very concerned about a marketwide credit event.

Moreover, investors worry that with an increasingly crowded market lenders may try to maintain their phenomenal pace of growth by chasing yield. “Will there be a drift toward lower quality borrowers as companies try to keep the volume machine cranking?” Budlong said.

Clients of Budlong’s, which include institutional investors interested in buying up marketplace loans, see the companies dialing back. “Platforms are proactively trying to slow growth in a way that preserves the quality of the underwriting process,” Budlong said.

However LendingClub adjusts in the coming months and years, it has a long road ahead. On Monday shares in Lending Club plunged more than 27 percent to $5.16 a share. That's nearly 80 percent down from its first-day closing price in December 2014.