Just To Be Clear: It has to do with Security Regulations

Just to be Clear:

The current prohibition of Pennsylvanians from lending on Prosper does NOT have to do with Banking Regs.

It has to do with Securities Regulations and the Registration of Promissory Notes as Securities.

From The Official Prosper Blog, dated 9/22/08:

In response to inquiries regarding the origin of the decision to discontinue lending activity in Pennsylvania, we would like to clarify that this decision relates to the Pennsylvania Securities Commission’s interpretation of Pennsylvania securities regulations. Due to the confidential nature of our discussions with the Commission, we cannot disclose any further information about our discussions, other than to say we respectfully disagree with their interpretation and are attempting to work with them to address their concerns.

More on this here.


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What are the Securities?

Go here, and scroll down to page 9, or just read below:

Q: What are the Securities?

A: The Securities consist of the Notes and the Lender Participant Rights related to the Notes.

Q: What are the Notes?

A: Notes represent Loans made by Prosper to a Borrower, and are the unsecured credit obligations of the individual Borrowers. Loans to Borrowers are evidenced by as many Notes as there are winning bids for the Loan, with each Note in the amount of the winning bid. All Notes are initially made payable to Prosper, and Prosper then sells and assigns the Notes without recourse to each Lender who was a winning bidder on the listing.


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I Called the CA Department of Corporations

I made a couple of calls and sent an email or two last week that I have not had a chance to post on yet.

Here's one of them:

I figured since Prosper Marketplace Inc. is located in San Francisco that I would turn to the California Department of Corporations.

Their website states:

The Department licenses and regulates a variety of businesses that affect your life, including securities brokers and dealers, investment advisers and financial planners, and certain fiduciaries and lenders. We also regulate the offer and sale of securities, franchises and off-exchange commodities.

I called the San Francisco branch and spoke with an attorney there who said that Prosper has a pending Securies application on file, and that such applications are generally public documents.

So I called the department's document coordinator who could not locate the document, but was willing to give me the name and phone number of the attorney who was handling the file.

I called that attorney, and left a message. I received a return call from that attorney who via voice mail, provided me with the file #: 5063341

The file dated back to the end of last year. The attorney mentioned that he, Prosper, and the SEC had met, but that for one reason or another Prosper was not able to move forward with the application.

A little more poking around and I uncovered this.

This is an SEC S-1 application.

Form S-1 is an SEC filing used by public companies to register their securities with the U.S. Securities and Exchange Commission (SEC).

Interesting. But what I think this is, was and had to do with was Prosper's attempt at creating a secondary market for their notes. We know or should know that did not end up happening for one reason or another.

In red type on the form it states:

The information in this prospectus is not complete and may be changed. We may not sell these securities until the registration statement filed with the Securities and Exchange Commission is effective. This prospectus is not an offer to sell these securities and it is not soliciting an offer to buy these securities in any state where the offer or sale is not permitted.

SUBJECT TO COMPLETION, DATED OCTOBER 30, 2007

My next question is: are the Promissory Notes as we know them today, not considered securities, but would have been considered securities had they been able to be traded on secondary market?

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Securities Tests

This is not the first time that the designation of "Notes" as "Securities" have come in to question.

In fact, on quite a few occassions, such questions have gone as far as the Supreme Court in making a determination.

As a result of such cases, certain "Tests" have been developed and used to help determine if a particular note qualifies as a security.

Before I dive in, I just want to reiterate that in the past it has taken the Supreme Court to make a final determination. So my little analysis here is nothing more than that. -just my own little analysis. I'll tell you upfront that I can't say for sure if they're securities or not. It just really isn't all that clear to me. -But, I will say, that as I walk through the various tests it seems that they lean more towards being securities than not.

The best place to start in making a determination is Section 2(a)(1) of the Securities Act of 1933.

The basic, or default definition of a “security” in Section 2(a)(1) is the term “investment contract”.

If something is an "investment contract" it is a security".

From there, one should turn to the “investment contract test” set out by the Supreme Court in the case of SEC v. W.J. Howey Company, also know as the “Howey” test.

The Howey test basically says that an “investment contract” is "any contract, transaction or scheme whereby a person invests money, in a “common enterprise” and is led to expect profits from the efforts of others."

In the Supreme Court case of United Housing Foundation v. Forman, the Howey Test was determined as the “essential” test to all securities.

If any instrument, no matter what it is called, meets the Howey test, it is a security.

But don't get too comfy, because it also say, "if it does not meet the Howey test it may still be a security, but will have to justify its status as a security in some other definitional manner."

United Housing Foundation v. Foreman added that just because something is called “stock” doesn’t necessarily mean it is a security, despite the language of Section 2(a)(1) that specifically includes “stock” as a “security”. This has come to be known as the “economic reality test”, also known as the "basic common sense test".

>what does common sense tell you? -I know I'm investing to make a profit, and I know Prosper is selling to make a profit. So, yes, I would say the "economic reality" lands Prosper Notes in the realm of securities.

> so count it, that's: 1 YES, and 0 NO's.

(Yes, it's a security vs. No, it's not a security)

Next, in the first Howey test an investment contract requires an “investment of money”. That means the intention that the money is given over with the expectation that profit or return will follow.

>Are Prosper "Lenders" investing money? Yes they are. They are definitely not "loaning" money. That's WebBank's job, and if Prosper Lenders were "loaning" money, then we would all be dealing with a whole other can of Banking Regulation worms.

An “investment of money” under Howey means "the investor must have committed his assets to the enterprise in such a manner as to subject himself to financial loss." SEC v. Pinckney, 923 F. Supp. 76, 80 (E.D. NC 1996).

> so count that one as well, that's: 2 YES's, and 0 NO's.

Next, and I warn you, read slowly here, the second Howey test is that there must be a “common enterprise.” What is a common enterprise?

"Common Enterprise" is established by "commonality" which can be either, "Horizontal Commonality", "Vertical Commonality", or both.

Vertical commonality is "the dependence of the investors’ fortunes on the success or expertise of the promoter". See Long v. Shultz Cattle Co., Inc., 881 F.2d 129, 140-41 (5th Cir.1989

>(Not the case with Prosper. That's assuming Prosper is the Promoter of the Notes, and even if WebBank was considered the Promoter, which I wouldn't, it still doesn't apply.)

Horizontal commonality is the pooling of investor funds and interests.

>(This could be the case for Prosper, unless one bidder covers the whole "loan", or we should say, buys 100% of the Promissory Note)

The courts have further identified two kinds of vertical commonality: "broad vertical commonality", and "strict vertical commonality".

To establish “broad vertical commonality,” "the fortunes of the investors need be linked only to the efforts of the promoter". See Long v. Shultz Cattle Co., Inc., 881 F.2d 129, 140-41 (5th Cir.1989).

>(Not the case with Prosper)

“Strict vertical commonality” "requires the fortunes of investors be tied to the fortunes of the promoter". Brodt v. Bache & Co.

>(Not the case with Prosper)

The easier definition, the so-called “horizontal” commonality test requires there to be at least two investors who have a similar relationship in the business enterprise, that is, they all pool their investments and share in the profits.

>It doesn't occur to me often, but it's wrapping of my mind around these concepts of commonality, where I really feel the brunt of NOT BEING AN ATTORNEY.

However, I found a statement that says:

"The courts generally recognize that “horizontal” commonality (for example, the pooling of an investment by two or more investors) is a common enterprise."

Either way, my tally of "YES's" and "NO's" within the 2nd leg of the Howey Test looks like this:
Broad vertical commonality = NO
Strict vertical commonality = NO
Horizontal commonality = YES & NO

> So, that leaves us with: 2.25 YES's and .75 NO's

The third leg of the Howey test is “efforts” of others. "The investor must rely strongly on the efforts of others. The "others" in this test are talking about the efforts of the Promotors."

>(Again, can we assume that Prosper is the promotor of the Notes?)

The key determination is whether the promoters’ efforts, not that of the investors, form the “essential managerial efforts which affect the failure or success of the enterprise. -citing Unique Financial Concepts, 196 F.3d at 1201 (citing SEC v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir.1973)). See also SEC v. Rubera, 350 F.3d 1084 (9th Cir. 2003) (test is whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise).

>Blah, Blah, Blah. DOES NOT APPLY. (These Notes rely on Personal Loan repayments seperate from any "efforts" of the Promotor or Investor)

> This leaves us with: 2.25 YES's and 1.75 NO's

Nest, we have to look at Reves v. Ernst & Young because this is the case the SEC told me to look at, and um, unlike someone we all know, I'm going to listen to the SEC!

In Reves v. Ernst & Young the court tried to deal with the issue of separating an "investment note" (which is a security) from a "commercial note" (which is not a security).

To do this the court came up with the “family resemblance” test.

Essentially this test is a look at the motivations of the parties.

First, is the motivation an "investment" or a "commercial finance arrangement"?

>With Prosper, we are not talking about Commercial Finance arrangements. Prosper isn't selling Notes to finance inventory or liquidate Accounts Receivables, etc. Thus, it's clearly an investment.

So count'em: 3.25 YES's and 1.75 NO's

Next, is the instrument meant to be traded? (Investment notes often have the ability to be traded, commercial notes almost never do.)

>Prosper Note buyers can not trade their Notes like a stock on some financial exchange.

That's 1 for the NO's: 3.25 YES's and 2.75 NO's

Next, ask, "what are the reasonable expectations of the public?" (would the financial world consider the note an investment note or a commercial note).

>The public here being "Lenders" or "Bidders" or anyone viewing a Prosper add. The general perception is that Prosper is a place to invest.

That's 1 for the YES's: 4.25 YES's and 2.75 NO's

Finally, ask, "Is there any other regulatory scheme better suited to deal with the instrument" (banking laws for example).

>This one is tough to answer, and I think it could go either way. We are, after all, talking about the selling and buying of Promissory Notes that rely on and originate as personal loans. I could be wrong on that point, but WebBank is funding/providing/making loans to individuals, and then "assigning" ie. selling the notes to Prosper, who is then assigning ie. selling the notes to other individuals. The notes are not touching any sort of financial exchange like stocks, bonds, and commodities do, so maybe banking laws would be better than securities regulations.

>Even if we give this one 100% to the NO's, Prosper Notes still fall short, in my layman's analysis, of NOT being considered a security. But, I say we split it down the middle and give .5 to each.

So, here you have it: we end up with:

4.75 YES's and 3.25 NO's

Prosper notes look more like securities, than not.

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Did Prosper Not Register -OR- File for Exemption? I'm just wondering.

Are these Promissory Notes securities or are they not?

Prosper obviously believes they are not, or else we wouldn't be in this mess to begin with right? Because they would have taken steps to appropriately register them, right?

Pennsylvania says they are Securities.

The more I investigate, the more I can't help but think that PA has a good argument. Although, I'm not willing to commit to that yet.

What I am willing to commit to is the fact that I'm beginning to feel like a dog chasing it's tail. That much I know for sure.

I guess another thing we know for sure is that Prosper has not registered their Notes as securities.

As a logical exercise, let's just say they ARE exempt.

Shouldn't Prosper then have the appropriate Federal exemption as proof of such exemption?

Since Prosper doesn't seem to have anything like this to fling back in the PA Security Commission's face, can we assume then, that Prosper neither registered their Notes OR filed the appropriate exemption?

I don't know, but i can't help but wonder.

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The SEC called me back.

Since Prosper.com and the Pennsylvania Securities Commission can't seem to get on the same page I thought I would see what the SEC has to say.

In general, I want to know if Promissory Notes are considered securities by the SEC?

Specifically, I want to know if the Promissory Notes sold on Prosper are considered securities in the eye's of the SEC?

If you look at my previous post you will see that I don't expect a cut & dry answer. As we know, "Most Promissory Notes are considered securities" based on this SEC publication.

Yesterday I called the SEC Office of Small Business Policy. I received a call back today, but I was away from my desk so I missed the call, however the representative did leave me a voice mail.

I was invited to give a call back, however the gentleman left a generous amount of information in regards to my "general" question. I would like to consider the information he left before giving him a call back.

In his voice mail, he pointed me towards a Supreme Court case that provides a test to determine if a Promissory Note is a security, or if it is exempt from registration.

He further mentioned that most exemptions meet Regulation D criteria.

If you would like to take a crack at the Supreme Court Case it is Reves v. Ernst & Young, 494 U.S. 56 (1990).

He said that if I email him he will send a copy of the case so I replied with the response copied below.

I intend to follow-up with him tomorrow once I've had a chance to review the case.

If nothing else, please pay special attention to my 2nd to last paragraph, because I point out a couple of things. Basically, if Prosper and the Pennsylvania Securities Commission are not going to take care of Pennsylvanians who have already invested on Prosper then I think it is more than appropriate that the SEC become aware of this situation.

"Thank you for returning my phone call from yesterday, 9-22-08. I really appreciate your sharing of expertise and I further appreciate your pointing me in the appropriate direction via Reves v. Ernst & Young. The "test" you described in your message, sounds like it is exactly what I am looking for. Please feel free to reply with a copy of the case at your convenience.

As I mentioned in my phone message, I am specifically attempting to understand if the Promissory Notes sold on the peer-to-peer lending site, Prosper.com are, or should be considered securities in the eyes of the SEC, and either appropriately exempted, or registered as such.

My query stems from a decision by Prosper.com on 9/15/08 to suspend members residing in the Commonwealth of Pennsylvania from purchasing notes on the site. This apparently is the result of an interpretive dispute between the Pennsylvania Securities Commission and Prosper.com.

In a conversation with the PA Securities Commission I was told that while no order has been issued against the company, that Prosper.com is in violation of Pennsylvania Statute 70, Section 1-201 Registration of Securities,(http://www.psc.state.pa.us/policy/Act2K502.pdf) Section 201 is on page 7. I was further directed to cross reference "(t)" on page 6 of the linked document, which states that a note is a security.

Long story short, Prosper says they are not securities, Pennsylvania says they are.

The result is that Pennsylvania investors in Prosper.com are left in a precarious situation. These are unsecured Notes with a three year term with no right to sell or transfer. Thus investors have been left without option or ability to liquidate, expand, diversify, or compound their portfolios. Because of the high default risk of these notes, portfolio expansion, diversification, and compounding of earnings are vital abilities and benefits that Pennsylvania investors are now deprived of.

Thank you for your time and thank you again for your help in this matter. I plan to follow up with you with any questions once I have had an opportunity to review the case. If in the mean time you are able to provide any other insight, please do not hesitate to email or reach me by phone."

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I Called the SEC

In my last post I asked, "Is a promissory note considered a security?"

I further asked, "What does the SEC have to say?"

I then cited some information found on the SEC website that makes the statement:

"Most promissory notes must be registered as securities with the SEC and the states in which they’re being sold."

This morning I called SEC Toll-Free Investor Information Service at 1-800-SEC-0330. I easily reached a representative and explained the reason for my call. She made a statement along the lines of,

"Unless a Promissory Note is sold on an exchange it does not need to be registered with the SEC."

She then suggested I call the SEC Office of Small Business Policy. I'm not 100% on whether this is the most appropriate direction, but I took her advice and called.

The automated answer states, "If you have an interpretive or policy question" to leave a message and a lawyer will call back. So that's what I did. My question being:

"I have purchased Promissory Notes through the website, Prosper.com, a peer-to-peer lending site. Do these Promissory Notes require registration as securities with the SEC?"

(I explained that loans are "made" by WebBank, then "assigned" to Prosper, and then "assigned/sold" to individual investors)

I further asked:

"Is Prosper.com considered a broker/dealer of the Notes, and are they required to register as such with the SEC"

I will follow up on this.

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