Lending Club's CEO Has Left and Its Stock Has Plunged. Should Lenders Bail Out?

As recently as last year, peer-to-peer lending company Lending Club was one of the hottest companies in the hottest sectors of the stock market, a fintech unicorn that promised to disrupt the way millions of Americans borrowed and invested. Now its stock is plunging, the company is struggling to save its reputation, and the Lending Club's users are left to wonder whether peer-to-peer lending was such a good idea in the first place.

Here's what you need to understand about what went wrong at Lending Club -- and how it might affect you.

Shift in Focus

Lending Club launched in 2006 with a promise to "disrupt" banks by letting individuals make and apply for loans through an online lending platform. Both Lending Club and its rival, Prosper Marketplace, drew interest from investors seeking a fixed-income alternative with higher rates of return than what bonds were paying.

But as the industry has sought faster growth, it has also expanded the types of lenders it works with, inviting institutional investors like banks and hedge funds to make loans alongside individuals. In fact, during the first quarter of 2016, only about 15% of Lending Club's loans came from individuals investing on their own.

That shift has brought new scrutiny to the industry, and more trouble for Lending Club in particular.

Controversy & Resignations

In May, Lending Club founder and CEO Renaud Laplanche and several other executives resigned amid an ethics controversy. Although there were two separate issues cited, one in particular is pertinent to individual lenders. This spring Lending Club sold a number of loans to Jefferies, an investment bank, which planned to package them into bonds and sell them on to other investors. Like the individual lenders who use the site, Jefferies specified the types of loans it was willing to buy. But $22 million of the loans didn't meet the criteria Jefferies asked for, and the company has said at least some of its executives were aware of the flaws and let Jefferies buy them anyway. (In addition to forcing out Laplanche, Lending Club says it took back the loans and was able to resell them properly labeled at full value to a different investor.)

The events at Lending Club have raised some eyebrows. After all, if the company is willing to sell mislabeled goods to one its largest and most sophisticated clients, why should Joe Investor assume he'll be treated any better? “It brings up issues of trust,” says Michael Tarkan, a stock analyst that follows the company. “Small investors need to be sure they are receiving the loans they signed up for.”

Peer-to-peer lending has faced other problems as well. Two ratings companies raised questions this spring about the performance of peer-to-peer loans. In February, Moody's said investments backed by loans issued by Lending Club's rival Prosper weren't performing as well as expected and might have to be downgraded. And in April, Fitch said "pockets of recent credit underperformance" were prompting marketplace lenders (a larger group that includes peer-to-peer companies as well as other lenders) to tweak the computer models they used to evaluate loans -- suggesting that the companies may not be as good at vetting borrowers as they had suggested. In an emailed statement, Lending Club said it “monitors a variety of economic, credit and competitive indicators” on behalf of investors.

Bankruptcy Implications

Lending Club hasn’t put the controversy behind it yet. Last week the company delayed its annual shareholder meeting, saying it was "not yet in a position to provide its stockholders a complete report on the state of the company." Still, the company says it has more than $900 million in its coffers and posted a profit during the first quarter of the year.

Lending Club’s overall financial health is relevant to mom-and-pop lenders using its platform -- because a bankruptcy could put any money you've lent at risk. Investors who make loans through Lending Club are actually buying a "note" from the company -- not unlike a bond -- rather than from the borrowers themselves.

“You’ve got exposure not just to individual borrower but also to Lending Club,” says Peter Manbeck, an attorney who has worked with online lenders.

That's an important distinction. It means if Lending Club were to enter bankruptcy, you would become one of the company's unsecured creditors, the notes' prospectus makes clear. In other words, your legal claims are ultimately against Lending Club, not the person who borrowed money from you through Lending Club. (Prosper works slightly differently, with notes issued by a separate entity, which may provide lenders an extra layer of legal protection if Prosper Marketplace were to ever go bankrupt.)

While it's possible a bankruptcy judge would decide to let you collect on the loan, it's also possible he or she might decide to divert those payments to other Lending Club creditors.

Takeaways for Investors

So should you stay clear altogether? Not necessarily. For investors seeking higher returns outside their equity allocations, peer-to-peer lending seems to offer an alternative to traditional bonds. Historically, interest rates on Lending Club’s highest rated “A” loans have averaged 7.6% -- eclipsing the current 6% yield for corporate junk bonds -- although borrower defaults can bring your effective return down to 5.2%, Lending Club says.

“There are higher risks,” says Little Rock, Ark., financial planner Ryan Fuchs, who has experimented with peer-to-peer lending in order to advise clients who want to try it on their own. “That’s why you get the higher return.”

The company's problems appear to be isolated and shouldn't be a deal breaker, Fuchs argues.

What you should do, however, is approach peer-to-peer lending with the same caution you would any untested investment. Remember that individuals, even ones with high credit scores sometimes lie, lose their jobs or end up in the hospital. That makes peer-to-peer lending inherently riskier than lending to the government or a blue-chip corporation.

While the fixed payouts on peer-to-peer loans mean they fit naturally into the bond section of your portfolio, view them as akin to junk bonds, not Treasurys or investment-grade corporate debt. Fuchs recommends limiting the amount you loan out to 3% to 5% of your overall investments.

He also suggests you build a diversified portfolio of loans, rather than making just one or two big bets. (With a $25 minimum investment per loan, this should be easy to do, even with a few thousand dollars.) “If you put in $2,500, pick 100 loans at $25 each,” says Fuchs.

You'll also want to keep an eye on the company's overall financial health over time, Fuchs says, checking its SEC filings as you make ongoing investments. “Keep up with the news and their quarterly reports,” he says.