Managing Small Business Banking Regulatory and Class Action Risk. Scott M. Pearson Cory Kampfer Chief Legal Officer Ballard Spahr LLP OnDeck

Transcription

1 Managing Small Business Banking Regulatory and Class Action Risk Scott M. Pearson Cory Kampfer Partner Chief Legal Officer Ballard Spahr LLP OnDeck

2 Overview Regulation of traditional small business lending The alternative lending model (using OnDeck to illustrate) Current hot issues for small business lenders in the class action and regulatory arena 2

3 Regulation of Small Business Lending by Banks The traditional small business bank loan Focus typically is on the risk to the bank, not the borrower - Banks have federally insured deposits (safety and soundness) - Small business lending treated like commercial lending Business borrowers more sophisticated Business borrowers less in need of protection (corporate form, etc.) 3

4 Risk-Based Regulation Supervision by risk - Identify and measure risks facing the institution - Allocate greater resources to the areas with highest risk OCC Risk Categories - Credit, interest rate, liquidity, price, operational, compliance, strategic, and reputation - Borrower issues are embedded in compliance and reputation 4

5 Regulatory Assessment of Traditional Small Business Loans Institutions should: - understand the borrower s business - focus on the strength of a borrower s business plan (including plans for borrowed funds) - understand the competition and local market conditions 5

6 Regulatory Assessment of Traditional Small Business Loans Institutions should: - realistically evaluate current and expected cash flows - consider credit history and financial strength, together with judgmental factors, such as the strength of management - structure loans appropriately (e.g., time with expected timing of business s cash flow) - analyze secondary sources of repayment (guaranty, collateral, etc.) 6

7 Regulatory Assessment of Traditional Small Business Loans Institutions should: - have robust credit risk management practices - promote a credit culture in which lenders develop and maintain prudent lending relationships and knowledge of borrowers - encourage lending staff to use sound judgment during the underwriting process - avoid portfolio management models that rely primarily on general inputs, such as geographic location and industry, rather than individual creditworthiness 7

8 Class Actions and Regulatory Enforcement? 8

9 Small Business Lending Market is Massive and Underserved $80-120Bn Unmet Demand $80-120Bn for Small Business Unmet Lines Demand of Credit for Small Business Lines of Credit 28MM U.S. Small Businesses $186Bn Business Loan Balances Under $250,000 in the U.S. in Q2 ꞌ15 45K $0.8Bn OnDeck Unique Small Businesses Served OnDeck Loans Under Management 1 Sources: U.S. SBA, FDIC 06/30/15, Oliver Wyman, How New-Form Lending Will Shape Banks Small Business Strategies, As of 09/30/2015; Loans under management represents the unpaid principal balance plus the amount of principal outstanding for loans held for sale, excluding net deferred origination costs, plus the amount of principal outstanding of term loans the company serviced for others, each at the end of the period. 9

10 Diversity of Small Businesses Creates Challenges for Traditional Lenders Cash Flow Profile Restaurant CHALLENGES FOR TRADITIONAL LENDERS Credit Card Rev. Cash Rev. Monthly Exp. Inventory & Payroll Landscaping Company Diverse businesses require manual underwriting Technology and data limitations Landscaping Rev. Snow Removal Rev. Monthly Exp. Fuel & Payroll Plumbing Company Lack of standardized small business credit score Repair Rev. Subcontractor Rev. Monthly Exp. Supplies & Payroll Q1 Q2 Q3 Q4 10

11 The OnDeck Score Proprietary and Purpose Built for Small Business 5 th Generation proprietary credit scoring model Transactional Data Score 100+ external data sources Credit Data Public Records Proprietary Data Analysis Platform Probabilistic record linkage Dimensionality reduction A B Ensemble learning 10 Million+ small businesses in proprietary database Proprietary Data Social Data Exhaustive cross validation Feature engineering Adaptive learning C D Risk Grading 2,000+ data points per application Accounting Data E F 11

12 The OnDeck Solution for Small Business Lending Apply Approve Fund Online Minutes 1 Automated Review As Fast As Immediately 3 As Fast As Same Day Traditional Lending Offline 33 Hours 2 Manual Review Weeks or Months Several Days 1. Application time depends on customer having the required documentation available. 2. Source: Small business survey conducted by the Federal Reserve Bank of New York, Spring Approximately 1/3 of customers are subjected to secondary, manual review process. 12

13 Tailored Products for Small Businesses Term Loan (Launched in 2007) Line of Credit (Launched in 2013) Use Case Buying Inventory Hiring New Staff Marketing Managing Cash Flow Size $5,000 $500,000 $5,000 $100,000 Term 3 36 months 6 months Pricing Annual Interest Rate as low as 5.99% % 36% APR Payment Availability Automated daily or weekly payments Renewal opportunity at ~50% paid down Automated weekly payments Draw on-demand 1. For Select Customers 13

14 Established and Diverse Customer Base $600,000 Median Annual Revenue 7 Years Median Time in Business 700+ Industries 45,000+ Small Businesses Served in all 50 U.S. states 14

15 Integrated and Scalable Technology Platform Online Customer Experience Data Aggregation, Analytics and Scoring Technology Powered Servicing & Collections $3 Billion+ Total Originations 75,000+ Total Loans 8 Million+ Customer Payments 15

16 Diversified and Growing Distribution Channels 14,920 Channel Mix 3Q 2015 Direct 1,276 5, % 3,870 Strategic Partners 437 1, Funding Advisors 3,731 5,955 8,131 19% Direct and Strategic Partners Funding Advisors Numbers represent loan units. 16

17 Diversified Funding Strategy Hybrid Funding Model Focused on Diversity, Flexibility, and Resiliency Funding Mix 3Q 2015 Securitization / Warehouse Marketplace OnDeck Securitization Target Mix 60-65% of Term Loan Originations 35-40% of Term Loan Originations Marketplace Diversity Investors Seeking Fixed Returns Investors Seeking Variable Returns Flexibility Scalable as Originations Grow Greater Product and Investor Flexibility Cost Low Cost Execution Profitable Revenue Stream Resiliency Capital-Light Structure, Equity Contribution Aligns Interests Diversified Risk Exposure, Servicing Fee Aligns Interests Warehouse Lines Funding mix is shown as of September 30, 2015 based on the outstanding debt by funding source and Marketplace unpaid principal balance. 17

18 Consistent Portfolio Performance Over Time Net Charge-offs by Cohort 1 9.0% 5.5% 6.4% 4.4% 5.5% 6.9% 6.8% 6.2% 3.3% 0.9% 0.1% Q' 15 2Q' 15 3Q' Percentage of dollars loaned that are charged off. 2. As of 09/30/15, principal balance still outstanding was 0% for all cohorts except the 2013, 2014, Q1 15, Q2 15, Q3 15 cohorts, which had principal outstanding of 0.2%, 5.1%, 27.3%, 55.1% and 87.2%, respectively. 18

19 Growth Strategy Brand and direct marketing Product expansion Strategic partnerships Extend customer lifetime value Data and analytics International expansion 19

20 LEGAL Regulatory Environment for OnDeck OnDeck is not a bank As a non-bank commercial lender, OnDeck does not have a specific supervisory regulator, however OnDeck does not take deposits OnDeck engages in commercial lending only Non-bank commercial lenders do not have a specific regulator 20 Copyright 2014 OnDeck. All rights reserved. Confidential & Proprietary

21 LEGAL Regulatory Environment for SMB Lending as an SMB lender, OnDeck is subject to robust set of laws. Office of Foreign Assets Control (OFAC) Commercial state lending laws Servicemember s Civil Relief Act Telephone Consumer Protection Act (TCPA) CAN-SPAM Unfair, Deceptive, or Abusive Acts or Practices (UDAAP) USC Title 11 Bankruptcy Rules Know Your Customer (KYC) Fair Credit Reporting Act (FCRA) Anti-Money Laundering (AML) Rules FACTA, ID Theft Prevention The Equal Credit Opportunity Act, Regulation B Fair Lending Privacy Protection of Customer PII 21 Copyright 2014 OnDeck. All rights reserved. Confidential & Proprietary

22 Regulatory and Litigation Risk for Alternative Lenders Lending Structures - Bank (or Tribal) Partner Model - Choice of Law Model - Direct Lender Model Key Class Action Issues 22

23 The Bank Partner Model (and some more) Market the Bank Apply via Agent Mr. Needscash Investors Credit facility Securitization Sell whole loans HappyLoans.com Sell Marketing/Servicing Payments (via agent) Loan Sell participation interests Bank 23

24 Bank Partner Model Rewards and Risks Exportation of Interest Rates Does it work? - True Lender - Madden v. Midland Funding - State licensing issues 24

25 The True Lender Issue Market the Bank HappyLoans.com Apply via Agent Sell Mr. Needscash Payments (via agent) Loan Marketing/Servicing Bank 25

26 Madden Background Second Circuit Decision (NY/CT/VT) Sale of credit card debt by national bank to non-bank Issue was whether non-bank could charge interest above the state usury limit (post-assignment only) 26

27 Second Circuit Decision Applying state law to non-bank assignee would not significantly interfere with any national bank s ability to exercise its powers under the NBA - Post-assignment, only non-bank assignee is affected - No bank involvement post-assignment - No affiliation between bank and non-bank assignee Extending NBA protections to non-banks would create an end-run around usury laws for non-national bank entities that are not acting on behalf of a national bank. Serious policy implications beyond the bank model 27

28 Madden Viability Arguably conflicts with 8th Circuit cases - Krispin v. May Dep t Stores, 218 F.3d 919 (8th Cir. 2000); Phipps v. FDIC, 417 F.3d 1006 (8th Cir. 2005) Usury determined when loans are made, not later Common law of assignment Power to sell loans under NBA In the meantime, proper structuring is essential 28

29 Choice of Law Model OnDeck utilizes a hybrid origination model - The significant majority of OnDeck loans are originated directly under Virginia law Establishing proper nexus is critical to enforcing choice of law - OnDeck also utilizes a bank partner where the choice of law model may not be enforceable - The result of the hybrid approach is a belt and suspenders origination model 29

30 Direct Lending Model Make loans directly as a non-bank, complying with state law - Comply with usury limits - Comply with lender licensing requirements Bank models do not eliminate all licensing requirements 30

31 Arbitration 10/7/15 CFPB field hearing: - Proposed ban on class action waivers in arbitration contracts - Report individual arbitration demands and results to CFPB - Late 2016 or 2017 for rulemaking - Not retroactive (won t apply to existing agreements) 31

32 Class Action & Litigation Risks TCPA - July 2015 FCC Opinion FCRA - Direct dispute responses - Reasonable investigation - Adverse action notices 32

33 Class Action & Litigation Risks ECOA - Use of social media data - Adverse action notices Data breach 33

34 Class Action & Litigation Risks Electronic payments - EFTA: Cannot require ACH payments Recurring ACHs must be authorized in writing Provides for certain disclosures and dispute process requirements 34

35 Questions? Scott M. Pearson Cory Kampfer Ballard Spahr LLP OnDeck