Delays and Difficulties for Fintech Start-Up Begin with Regulatory Questions About What a Security Is and What It Means to Facilitate Securities Transactions

The story in the May 30 New York Times, “Fintech Start-Up, Backed by Big Names, Finds Wall Street Entry Difficult,” has generated numerous inquiries. The story provides an overview of what appears to be portrayed as the over-regulation of the fledgling Orchard X auction-style trading platform for loans. Moreover, many details regarding the regulatory issues involved with launching such a platform are missing from this story, and it is worth noting that some of the issues are relatively settled within the SEC's existing regulatory framework.

According to the story, Orchard Platform was founded in 2013 and began its financial services business by offering institutional investors an automated service to analyze marketplace lending loans and buying them from different online lenders. From there, Orchard’s long-term plan was to create a “many-to-many” trading platform for these loans. But, apparently, the second step has been anything but easy. After a long process involving building the trading platform, enticing loan platforms to use it, recruiting financial industry veterans and engaging lawyers to pave the way through the SEC, Orchard “arranged” its first sale of about $30 million in loans from an ailing platform in January 2017, from which it received a fee of 0.5% of the sale price, presumably from the seller. More recently, Orchard has provided data for a smaller loan sale for another lender and signed up additional lenders to “broker” loan auctions. Importantly, in the end, “[a]lthough Orchard X would receive commissions for all such sales, it would not clear and settle the auctions like an exchange,” as reported.

The story raises several fundamental regulatory questions that are not entirely answered for readers: whether the transactions effected through the Orchard X platform involve a security that potentially requires registration under the Securities Act and whether Orchard’s platform or activities would constitute the facilitation of a securities transaction that potentially requires the platform itself to register with the SEC and FINRA as an exchange, an alternative trading system (ATS) or a broker-dealer. Accordingly, this article does not pretend to know what happened to Orchard but instead explores the existing regulatory framework to better understand the regulatory challenges that Orchard likely needed to address.

The threshold legal issue Orchard encountered, according to the story, was whether the marketplace loans (whether as a pool of loans or as a beneficial interest in that pool) are considered “securities” under the federal securities laws. The definition of “security” in Section 2(a)(1) of the Securities Act includes a “note,” “bond,” “debenture” and “evidence of indebtedness,” as well as “investment contract,” which, through enforcement actions, the SEC has broadly defined as any contract, transaction, or scheme involving (i) an investment of money, (ii) in a common enterprise, (iii) with the expectation that profits will be derived from the efforts of the promoter or a third party. By way of example, the story addresses the line between non-securities based loans made by banks, “which take deposits, make loans and hold capital to absorb loan losses,” and securities based loans made by marketplace lenders who “match investors and borrowers directly, with the investors taking the risk of losses in exchange for higher interest rates.” In addition to distinguishing these kinds of loans, the story points out that Orchard sought to standardize legal and data formats for loans among the largest loan platforms, so that the loans would be set up from the start in such a form that would expressly facilitate their trading for speculation and investment, a hallmark of a security under a U.S. Supreme Court decision known as the Howrey test.  

If the marketplace loans are deemed “securities,” a platform that facilitates purchases and sales of unregistered securities listed on the platform must take reasonable steps to ensure such transactions are affected in accordance with one or more exemptions under the Securities Act, such as (i) the intrastate offering exemption of Section 3(a)(11) of the Securities Act; (ii) the private offering exemption of Section 4(a)(2) of the Securities Act and Sections 3(b) and 3(b)(2) of the Securities Act (known as Regulation A and Regulation A+); (iii) the exemptions under Regulation D of the Securities Act - Rule 504 and Rule 506; (iv) the accredited investor exemption under Section 4(5) of the Securities Act; and (v) the other exemptions under Section 4 of the Securities Act.  Although not described in the story, presumably Orchard’s platform is limited to qualified institutional buyers under Rule 144A of the Securities Act and accredited investors under Rule 501 of Regulation D.

The next legal issue faced by an operator of a platform that facilitates trading in marketplace loans is whether it would be effecting securities transactions. Activities such as helping an issuer to identify multiple potential buyers of the loans and handling transaction funds or securities would likely trigger a number of rules and regulations that apply to persons who facilitate transactions in securities.

The Exchange Act is the primary federal legislation governing “brokers” and “dealers” in securities. With certain exceptions, Section 15 of the Exchange Act requires registration with the SEC of all broker-dealers using interstate commerce or the facilities of any national securities exchange to effect transactions in securities (other than exempted securities and certain short-term debt instruments). The SEC has promulgated rules requiring the registration of all broker-dealers involved in over-the-counter transactions, while regulation of transactions on national securities exchanges was primarily granted to registered exchanges. Section 15(a)(1) compels registration of most broker-dealers by prohibiting the use by any broker or dealer of the mails or any means or instrumentality of interstate commerce to effect any transactions in, or to induce or attempt to induce the purchase or sale of, any security (other than an exempted security or commercial paper, bankers’ acceptances, or commercial bills) unless such broker or dealer is registered with the SEC in accordance with the Exchange Act. In the case of Orchard, it appears to be an SEC registered broker-dealer.

However, the registration of broker-dealers as compared with their electronic trading platforms, or “exchanges,” has become less clear-cut in recent years. Section 3(a)(1) of the Exchange Act defines an exchange as “any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange . . . .”

Exchange Act Rule 3b-16(a) interprets the Section 3(a)(1) definition to mean any organization, association or group of persons that:

  • brings together the orders of multiple buyers and sellers; and
  • uses established, nondiscretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.

Absent an exemption, an exchange must register as a national securities exchange pursuant to Section 6 and Section 19(a) of the Exchange Act. Any platform that brings together buyers and sellers of securities must either register as an exchange or an alternative trading system.

Regulation ATS allows an ATS to choose whether to register as a national securities exchange or to register as a broker-dealer and comply with additional requirements of Regulation ATS. An “alternative trading system” is defined as any organization, association, person, group of persons, or system:

  • that constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange within the meaning of Rule 3b-16 under the Exchange Act, and
  • that does not set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such organization, association, person, group of persons, or system; or discipline subscribers other than by exclusion from trading. (Regulation ATS, Rule 300(a)).

A platform that operates a market or platform to bring together purchasers and sellers of loans that are deemed securities, and does not set rules governing the conduct of subscribers other than the conduct of such subscribers’ trading on such platform, may be required to register as an ATS, which Orchard X has also done.

The story does not say so, but it seems that Orchard’s counsel may have requested assurance from the SEC that it would not recommend enforcement action against Orchard concerning some aspect of these regulatory matters, but did not obtain a “no-action” position. Sometimes, this occurs when an incoming letter presents no “novel” facts in an area of the federal securities laws that is well settled by prior no-action correspondence, and such correspondence provides adequate interpretive guidance to companies and their counsel on what the Division’s position would be with respect to specific factual situations, including in the case of Orchard.

While it is impossible to know from the story exactly what happened with Orchard at the SEC, it appears that its business operations have been modified, presumably in response to its discussions with the SEC staff, to substantially comply with existing SEC guidance by (i) not clearing and settling the auctions like an exchange and (ii) dropping its goal of legal standardization among lending platforms.

Learning from the Orchard experience, it is worth noting existing compliance and registration requirements facing operators of trading platforms which wish to engage in the business of effecting securities transactions that may bring them under the definition of a broker, an exchange or an alternative trading system.

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