Raising Capital

Can a Borrowers’ Bill of Rights Tame The Wild West of Online Lending?

Amy Cortese | August 6, 2015

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Online lending has offered a lifeline to many small business owners that can’t get a bank loan. For others, it’s been a murky gateway into an escalating cycle of debt.

The problem is, it can be hard to tell good online lenders from the bad. To a busy entrepreneur, the web sites look similar and dangle the same come-ons of fast cash, even for entrepreneurs with battered credit. And loan terms can be hard to decipher. That hurts responsible lenders as well as small business borrowers.

To remedy that situation, a coalition of small business lenders and advocates plan to unveil today a set of voluntary guidelines they hope will bring transparency and accountability to the online lending world—and get out ahead of regulators.

Called the Small Business Borrowers’ Bill of Rights, it outlines six key “rights” that every small business borrower should expect from lenders.

Members of the so-called Responsible Lenders Coalition include Accion, Aspen Institute, Fundera, Funding Circle, Lending Club, MultiFunding, Opportunity Fund and Small Business Majority. Other lenders will be able to sign on if their CEO is willing to sign and attest to the pledge.

“While there’s a real market need for additional sources of small business financing, it’s imperative that lenders treat small businesses more fairly and that small business owners understand the terms of the loans they are agreeing to,” said John Arensmeyer, founder and CEO of Small Business Majority, an advocacy group and key participant in the effort.

Unfettered Lending

Online lending has been called the Wild West for good reason—the market is booming, but there’s been nary a sheriff in sight. The fast-growing market encompasses a range of nonbank lenders, from Merchant Cash Advance providers that process payments to peer-to-peer marketplace lending platforms, such as Lending Club—and lots of permutations in between.

“While this is a good thing in terms of increasing access to capital, borrower protections have not caught up,” Karen Mills, the former head of the U.S. Small Business Administration, said in a statement. Mills is scheduled to speak at the coalition announcement today in Washington.

Because online lenders are not regulated like banks, they have operated largely unfettered and under the radar. In contrast to consumer loans, there is no federal cap on small business lending rates or law that governs their disclosure. And state regulations, when they exist, can be easily skirted.

Small-Business-Bill-of-Rights

That makes it easy to obscure rates and fees. Small business borrows can end up paying the equivalent annualized interest rate of more than 50% or even 100% without realizing it. Many end up taking out new loans to pay off the old ones, incurring more fees. And because many online lenders deduct repayments daily or weekly from a business’s bank account, that can wreak havoc on cash flow.

So far, regulators have been hesitant to intervene in a market that is seen as innovative and expanding access to credit for job-creating small firms.

The online lenders have embraced technology and creative approaches to improve lending. They mine unconventional data sources to assess risk, such as Yelp reviews and sales patterns, allowing them to approve loans in hours or even minutes, compared to weeks for a bank.

Their innovative underwriting helps them lend to businesses that banks, which focus on FICO scores, would find too risky. Big banks approve roughly 21% of small business loan requests, compared to 60% approval rates for online lenders, according to Biz2Credit.

In addition to technology, the lack of regulation has given online lenders a clear edge over banks, which have had fresh restrictions heaped upon them since the financial crisis.

“Even toasters have basic safety regulations, so why shouldn’t a small business loan?”

Still, as the online lending industry grows and small business horror stories pile up, such as this one, scrutiny has been growing. Regulators are also keeping an eye on online lenders’ moves into subprime markets and the increase in securitizations. Most online lenders acknowledge that regulation is inevitable—some even say desirable.

The Treasury Department has been holding roundtables and meetings to better understand the issues around online lending, including an event on held on Wednesday attended by Treasury Secretary Jack Lew. So far, Treasury seems to view the online lenders as mostly beneficial, and is looking for ways to support, not stifle, the nascent industry.

Of more concern is potential action by the Consumer Financial Protection Bureau, which has taken a strong stance against consumer payday lenders but to date has declined to take on small business lenders.

Troubling Practices

A loan is typically characterized by a term of a year or more and an Annual Percentage Rate (APR), but the Small Business Borrowers’ Bill of Rights is intended to apply to lines of credit, merchant cash advances, short term loans and other products that may not meet the strict definition of a “loan.”

Notably absent from the coalition is OnDeck Capital, one of only two publicly traded online lenders (the other is Lending Club). Since it was founded in 2007, OnDeck has delivered more than $2 billion in loans, in partnership with financial backers Goldman Sachs. (Goldman now plans to launch its own online lending platform). OnDeck has been criticized for its short loan terms, high rates that are often hard to calculate and its reliance on high-fee brokers, although it has recently added longer term loans expressed in APRs.

“In our twenty years in business, we’ve never seen it this bad”

Some community-focused lenders have made an effort to reach out to small businesses that have been fallen prey to high-interest online lenders. Opportunity Fund, a large nonprofit microlender based in San Francisco whose loans typically do not exceed 12%, launched a direct mail campaign last year targeting 24,000 California businesses that have used online lenders in the past alerting them to its EasyPay program.

“In our twenty years in business, we’ve never seen it this bad,” said Opportunity Fund founder and CEO Eric Weaver. “There are some very troubling practices in the small business credit market that we need to contain without stifling innovation.”

Efforts to coordinate a voluntary code of ethics have been underway for at least a year. Dealstruck, an online lender in San Diego, is credited by some with initiating the coordinated effort. And in February, Fundera, an online marketplace that connects businesses with multiple lenders, laid out a Borrowers’ Bill of Rights plan in an op-ed piece on Forbes. Paraphrasing Elizabeth Warren, Brayden McCarthy, head of Policy & Advocacy at Fundera, wrote: “Even toasters have basic safety regulations, so why shouldn’t a small business loan?”

More recently, Lending Club, the consumer and small business marketplace leader that handled close to $5 billion in loans last year, has asserted its influence over the initiative.

Big banks approve roughly 21% of small business loan requests, compared to 60% approval rates for online lenders

The concept of a Borrowers’ Bill of Rights has precedent. A student loan borrowers’ bill of rights has been floated in the Senate, the most recent attempt by Elizabeth Warren, as well as Senators Dick Durbin and Jack Reed, earlier this spring. And the Mortgage Bankers Association has a Bill of Rights for mortgage borrowers.

A key question for the Responsible Lending Coalition is whether voluntary guidelines and CEO attestations will be enough to reign in abusive online lending practices. An FAQ on the coalition site reads: “We believe that a chief executive will refrain from making a public record of his or her organization’s compliance with these practices if his or her organization does not actually do so. We view this attestation process as a first step. We intend to continue to create transparency and accountability for small business lending practices.”

After all, the west was not won overnight.

Don’t know a cashflow lender from an MCA? Learn more about Online Lenders—and explore other funding options—in our Small Business Capital Raising Guide

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Comments

  1. Glad that you mentioned the absence of major lenders signing this Bill of Rights. We were shocked that only 2 of the 40+ signatories are national, for-profit lenders (that provide loans over 50K). When my company (Able) signed, that made 3.

    It’s time to get the other major lenders on board – where is OnDeck? Kabbage? CAN Capital? Think you’ll appreciate this follow-up post we just published- http://ablelend.co/1J3DMXS.

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