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On April 17, 2024, the CFPB filed an order again BloomTech, Inc. (known more commonly as the Lambda School) banning the school from the consumer lending business and personally banning the CEO, Austen Allred, from any consumer lending activities for ten years.

A CFPB action is hardly news these days. But a personal, ten year ban against a CEO? Ouch.

The CFPB’s claim is that Lambda’s core financial product, the Income Share Agreement (ISA), was deceptively marketed because it didn’t follow all the disclosure requirements of a loan such as providing APR and finance charge through a Truth in Lending disclosure.

Lambda’s rebuttal is that they have no problems following the rules for a loan but the ISA is not a loan, and therefore, not subject to the disclosure and marketing requirements.

The ISA is not a new concept. It differs from a traditional student loan in that it seeks repayment as a percentage of future income. And here’s the trick: if there is no future income, there should be no required repayment.

Potential scenarios:

Scenario 1:

Student borrows $10,000 to finance education

ISA says student will owe 1% of all future income until $20,000 is repaid

Student gets a job, makes $100,000 a year, works for 20 years and repays the ISA over 20 years (principal plus a whopping 100% extra)

Scenario 2:

Student borrows $10,000 to finance education

ISA says student will 1% of all future income until $20,000 is repaid

Student get a job, makes $100,000 a year for 5 years, quits job, and then decides become a nomadic writer bag packing through the Amazon rainforest while reading and re-reading 100 Years of Solitude and never works again.

Student repays $5,000 and doesn’t owe the rest.

Scenario 3:

Student borrows $10,000 to finance education

ISA says student will 1% of all future income until $20,000 is repaid

Student get a job, makes $100,000 a year for 10 years, gets another job making $50,000 until retirement.

Student repays $20,000 over 30 years.

So, Lambda’s motto, and is the case with most of ISA’s when structured properly is, “we don’t make money until you make money.” The truth, the CFPB claimed, is more nuanced.

First, Lambda collected an upfront fee. Now, that might be legitimate fee for administrative costs of originating the ISA, or it might be a back-door way to compensate for the downside risk.

Second, the effective APR on a loan may be 2–8% but the repayment cost on an ISA is much higher to compensate for the downside risk. So, query whether the student is really better off with an ISA versus a student loan.

All of these structural considerations led the CFPB’s claim that the Lambda school was duping students. In the end, the CFPB argued, the ISA always gets the school its money back and then some, and students are led to believe that the product is better than a loan because repayment is contingent.

MCA, Merchant Cash Advance, and the analog in commercial land.

Merchant Cash Advance’s have become popular in the last few years and quite a few successful B2B financing companies have built huge books of business on these products.

MCAs work similarly to ISAs except the borrower is a business. A “lender” will underwrite your future growth and cash flow, give you money, and then take a percentage of future revenue to get repaid.

In theory, this sounds wonderful: financing based on expected future value — ideal for high growth companies.

As with an ISA, if the company fails, the provider of the financial product shouldn’t get its money back. It is not a creditor in the debt stack, and so it doesn’t get to stand in line with the secure and unsecured debt in bankruptcy court.

At best, it has claims as a contractual counter-party, like a vendor, and to those vendors expecting to get repaid from the assets of an insolvent company: good luck.

But MSAs have come under scrutiny from regulators because of the way they are structured and marketed. If there’s even a hint of requiring repayment, the regulators are all over it and will declare it is a loan becuase it is waddles and quacks like a loan. This is often referred to by lawyers as recharacterization risk.

What makes a loan a loan?

(Also, what makes soup soup?)

The general principle is that a loan becomes a loan the second you require repayment. “Require” is a nuanced word in this case.

For example, even if the contract says the company doesn’t need to repay the MCA if it doesn’t meet X% of revenue threshold, if the company is constantly getting letters and calls asking for money, the MCA might be creeping into the loan territory.

And, if instead of charging interest, if the MCA provider is charging an “administrative fee” that is tied to the principal, that is likely a finance charge.

While the fee itself doesn’t necessarily make it a loan, the fee does begin to look like an interest rate that needs to be disclosed (recently, both NY and CA enacted disclosure laws that cover a broad array of financial products — including MCAs — and require disclosures that include APR and interest rates).

What’s wrong with loans?

So, why all this hullabaloo about try to be everything but a loan?

For one, loans are regulated by disclosure requirements, specifically Regulation Z at the federal level. The disclosure has some overhead — you need to provide it, and it limits creatively what you can do with interest rates and fees.

Second, and more importantly, loans require either a license or bank to be issued. So, if you are offering an MCA or an ISA, you don’t need to go through the pain of setting up a bank partnership or getting burdensome state licenses.

You can go straight to the customer, find product market fit, and grow your business from there.

RICs, and the proliferation of the “pay in four” model.

A few years ago, a savvy BNPL provider made a century old financial product — the Retail Installment Contract — popular again.

Retail Installment Sales statutes allow retailers to offer credit without licenses or partnering with a bank.

So, when GE started selling refrigerators at the turn of the century, GE could use a retail installment contract to help the customer finance the hefty purchase without involving the bank.

A RIC is special because it’s not a loan. And so it doesn’t carry the same disclosure requirements as a loan. It also, with a few exceptions, doesn’t require state licenses.

So the BNPL industry saw this opportunity and structured a credit product around it. It worked as follows:

BNPL PayBack partners with Holy Shirts and Pants (HS&P)

During the customer UX/UI, the customer is presented with a Retail Installment Contract to finance a $100 t-shirt. The contract is with HS&P.

Customer purchases shirt, and owes HS&P $100.

HS&P immediately sells the Retail Installment Contract to PayBack for $102

HS&P nets a $2 fee, PayBack now collects $100 from the customer as the assignee of the contract. The $2 fee, you could assume, was a toll of sorts to compensate the retailer for the privilege of originating the RIC in the first place, something that the BNPL couldn’t have done on its own.

Because the RIC is a RIC and not a loan, the agreements are simpler, the disclosures are fewer, and this suited the market for small dollar purchases.

(Sidebar: The reason for “pay in four” and not “pay in six” was because Regulation Z doesn’t require a disclosure if the payments are less than four installments. Even though the RIC is not a loan, the thinking was that keeping the installments below the Regulation Z threshold offers a second layer of defense from loan regulation)

Eventually, regulators caught up. They argued the BNPLs were leveraging retailers to offer a credit product that was really just designed only for the retail industry, and in doing so, sidestepping lending regulations with a product that started to look and feel like a loan in everything but name.

While they were very popular circa 2018–2022, RICs have, with some exceptions, fallen out of favor.

Words Matter.

There will undoubtedly be creative lawyering to find other financial products that sidestep the true definition of a loan in order to avoid state regulation, partnering with a bank, and/or cumbersome disclosure requirements that don’t suit the fast-paced digital world.

In the beginning, these products all start with the right intent. A bunch of lawyers gather everyone in the same room and chant:

“Repeat after me. This is not a loan. We can not call it a loan or require repayment.”

Eventually, something gets lost in translation and, as with most games with telephone, the end message to the marketing and credit risk department is different.

And that’s how you end up in the position of Lambda and its CEO. At some point, someone forgot that this was not a traditional financing credit product but started marketing it as such.

As with learned with our last post, “Superlatives are for High School Yearbooks,” in fintech, the words, one way or another, always come back to matter.

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While we hope you found this post helpful, please note that the information in this post is not intended to be legal or regulatory advice.

Fintech Law and Compliance 101 is affiliated with https://www.itsaffinity.com/ a compliance learning management platform built specifically for banks, bank sponsors, and fintechs

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