SEC to startups, don't you dare innovate

Prosper were just sent a cease and decist by the SEC for offering investments without registration. Prosper is/was one of a small handful of P2P lending markets offering an innovative approach to lending, allowing normal people to lend money to each other.

Not that I am a lawyer, but from reading the ruling, it appears that for Prosper to be allowed they would need to register each and every loan with the SEC as well as every investor would need to be an Accredited Investor. Either of these 2 would be impossible to do for them or anyone else trying to offer a similar service.

Using existing rules, I think the SEC were following clear rules. That does not stop them from being evil of course. Personally I can’t see either how the constitution even permits them to shut down Prosper without a trial. They are somehow allowed to both make the rules, execute them and judge them.

Reves ruling

The SEC metions the Reves ruling and lists the following rules from it:

(i) the motivations of the buyer and seller; (ii) the plan of distribution; (iii) the reasonable expectations of the investing public; and (iv) the existence of an alternate regulatory regime.

They argue that (i) is breached as:

… Prosper lenders are motivated by the desire to obtain a better return on their money than they otherwise could in another venue. While some Prosper lenders may be motivated, in part, by altruism, altruistic and profit motives are not mutually exclusive.

Oh, horror that someone would like better returns than in the bank.

(ii) is breached because as they say:

With respect to the plan of distribution, the Prosper notes are offered and sold on the internet to the public at large. There is no special level of financial sophistication or expertise that Prosper lenders must have.

Those are the rules, I know but just look at the current financial mess and read anything by Nassim Taleb to see what happens when “sophisticated” investors are let loose.

(iii) is breached because:

bla. bla. bla. … Prosper lenders reasonably expect a valuable return on loaned funds and would reasonably believe that the Prosper loans are investments.

Again they are right according to the rules. Obviously lenders believed they were making an investment.

(iv) is breached because there is no alternative regulatory scheme:

Finally, with regard to whether an alternate regulatory scheme exists to reduce risk to potential investors, there are currently no appropriate regulatory safeguards for Prosper lenders, such as those against misleading statements by a borrower about the purpose of a loan, the borrower’s employment and income, or even the borrower’s identity, or against misleading statements by Prosper.

This is where I believe they are wrong. Granted there is office anywhere in Washington DC called the “Person 2 Person Lending Exchange Regulatory Commision”. However in the US we do have these 3 great regulatory schemes called the free press, contract law and the judicial system.

Prospers.org and apparently a whole host of blogs are busy auditing and criticizing Prosper all the time. There is plenty of information available to anyone, which should make you think twice about investing in Prosper if they are risk averse.

E-Gold were under similar constant crowd sourced regulation via their mailing lists and online tools. Read more about E-Gold’s innovations.

While Prosper may claim they weren’t a bank or under the SEC, they were always under contract law (Both Common Law and UCC). The same can be said for their borrowers and lenders. They have apparently been pursuing law suits in the courts for some time. I have no idea if they have done enough here, but then it is the job of a crafty lawyer to come up with a class action lawsuit to keep them on the right path.

Innovation is needed, new rules are needed. The SEC followed their rules and protected the existing financial industry who have done such a bang up job in recent years protecting our wealth.

Updated: Just posted 3 ideas for innovating securities law where I talk about how the SEC could allow innovation.

Updated: Thanks to David for pointing out that they aren’t actually closed, but just not able to post new loans until they get registered