Scholar calls for regulatory protections for small businesses facing abusive lending practices.
Small businesses are a mainstay of the U.S. economy, making up over 99 percent of all U.S. businesses. But when small businesses seek financing to expand or make themselves less vulnerable to market downturns, they could be subject to “rapacious market practices”—including interest rates reaching over 2,200 percent.
In a recent article, Adam J. Levitin, a professor of law and finance at Georgetown University Law Center, argues that small businesses struggle to acquire financing because it is difficult for lenders to evaluate small-business borrowers’ ability to repay loans. Levitin notes that, although many small businesses are owner-operated ventures with the same level of financial sophistication as ordinary consumers, the absence of sufficient small-business financing regulation leaves these businesses vulnerable to abusive lending practices. He advocates new regulatory protections geared toward small businesses, modeled after consumer credit regulations.
Levitin explains that, because almost half of all small businesses fail within their first five years, access to financing is essential to bolstering a small business’s resilience. Many small businesses, however, struggle to receive the financing they need for both operations and expansion.
Levitin describes two key informational problems that often prevent lenders from gauging credit risk for small-business loans, leaving small businesses without access to financing offers.
The first problem is that lenders often lack access to information about a small business’s income, expenses, and liabilities. Levitin attributes this information gap to several factors, including a lack of standardized small-business credit reporting, the inability of many small businesses to generate reliable financial information about themselves, and small businesses’ tendency to be newer and without an established credit history. The finances of many small businesses are also “completely intertwined with that of their owners,” Levitin notes—which means that a small business’s success could be derailed by its owner’s personal life.
A second informational problem stems from the heterogeneity of small businesses. Their wide variety of business models, structures, and products and services creates challenges for predicting the expected performance of small-business loans, Levitin argues. Small businesses also have diverse “assets, cashflows, and risks,” making it challenging for lenders to model their expected economic performance because reliable modeling requires “large numbers of similar borrowers.”
Levitin notes that these two informational problems “frustrate quick and efficient evaluation and pricing of credit risk” and cause many small businesses—especially smaller, newer, or riskier small businesses—to “struggle to get any financing offers.” When a small-business borrower does receive a financing offer, “it rarely has an alternative,” despite the large number of small-business lenders in the market.
This scarcity forces small-business borrowers into a “situational monopoly” that leaves them vulnerable to predatory lending practices, Levitin explains. He argues that the “most critical problem in small-business financing” stems from “supracompetitive pricing”—or excessively high prices arising from a lack of competition between lenders.
In addition, lenders can make misleading price disclosures that leave small-business borrowers unable to understand the full cost of loans or to be able to make accurate comparisons between different financing options. Lenders can also use abusive collection practices, such as requiring electronic payments, which makes it challenging for borrowers to withhold funds in the event of a dispute. In some states, lenders can even include contractual provisions that allow them to seek a court order to freeze a borrower’s assets prior to proving “whether funds are in fact owed by the borrower” or to obtain a default judgment against a borrower “without notice or a hearing.”
Levitin contends that these predatory practices are compounded by a lack of regulatory protections in the small-business lending market. He explains that, in contrast to the “extensive federal and state regimes” regulating consumer credit, only “scant protections” exist for small-business borrowers. State laws that regulate consumer credit terms do not typically apply to business lending. The Small Business Administration (SBA) does impose interest rate caps and other requirements for the loans that it guarantees, but many small-business loans do not fall within the SBA’s scope. This means that, in general, small businesses “have neither the protection of competition nor of regulation,” Levitin argues.
Levitin describes what he sees as a common belief that small-business borrowers need fewer regulatory protections because they are more financially sophisticated than ordinary consumers. He contends that this assumption is often untrue because “most small businesses are merely incorporated versions of their owner-operator,” meaning that they are no more financially sophisticated than a consumer would be.
Changes in the small-business lending market have also rendered the SBA’s regulatory protections for small-business borrowers less effective, according to Levitin. He explains that small-business lending has historically been dominated by small community banks that are subject to SBA requirements and need to maintain positive local reputations, which helped prevent abusive practices without the need for extensive regulation. In the last 20 years, however, the small-business lending landscape has changed significantly with the emergence of online, non-bank “fintech” small-business lenders, which are not subject to SBA regulations and do not have the same reputational constraints as community banks.
This trend underscores the need for “a comprehensive federal small-business financing regulatory regime,” Levitin argues. His proposed regulatory framework would require standardized disclosures about the cost of financing, modeled after the Truth in Lending Act’s disclosure requirements for consumer credit agreements. Levitin also suggests treating certain small-business financing as consumer credit under state law, which would allow state usury laws, which impose limits on the price of credit, to apply to owner-operator businesses’ loans.
In addition, Levitin advocates the adoption of licensing requirements for small-business lenders and prohibitions against predatory contract terms that mandate electronic payment arrangements or allow lenders to prematurely freeze borrowers’ accounts.
Although Levitin acknowledges that these reforms would “add some level of compliance costs” that could be passed to borrowers through higher prices or lower credit availability, he contends that small-business financing is similar enough to consumer financing that it “should be regulated in a substantially similar fashion.” He urges regulatory action to address the abusive practices evident in small-business lending and empower more small businesses to obtain the “fair, transparent credit” that they need to succeed.
