By: Diane Ring
Just a few years ago, Income Share Agreements, or ISAs, were garnering popular attention. ISAs are arrangements in which an individual receives upfront funding from investors, perhaps for education or a start-up business, in exchange for agreeing to pay a percentage of his or her future income for a period of time. Well-known examples included Fantex (which involved a stake in the future earnings of a professional athlete), as well as Upstart, Pave, and Lumni (which generally involved funding for education or business ventures). Although the structures and terms varied, the feature these ISAs had in common was the absence of a guaranteed return of principal and the degree to which the investor was investing in the personal, financial success of the funding recipient – a relationship some criticized as owning a piece of the funding recipient.
Ultimately, though, the market did not show tremendous interest in these instruments. Upstart and Pave shifted to traditional loan models, and Lumni reportedly has issued fewer than 30 ISAs in the United States. Fantex has remained active, but Fantex was always a little different, because it actually involved an issuance of stock in a corporation whose value effectively tracked the earnings performance of a pro athlete. Additionally, the Fantex investment had a novelty dimension, appealing to sports enthusiasts.
Why, though, was the market not that interested in ISAs? There are a few likely reasons:
First, the market had trouble pricing ISAs (on both the investor and funding recipient sides). Relatedly, the very students who might expect that they would have high incomes (based on their fields of study) might be disinclined to pursue an ISA, particularly when interest rates on loans are low, and where there are post-graduation refinancing options that can lower loan payments.
Second, there are significant regulatory uncertainties surroundings ISAs, including tax uncertainty. The regulatory challenges arise from questions regarding the proper classification of ISAs for various legal and regulatory purposes—for example, are they debt, equity, partnership, insurance, illegal contract of servitude, or something else? A possible response to the regulatory drag on ISAs was the introduction of legislation granting specified regulatory treatment and/or classification to ISAs in a variety of contexts. One such proposal (Rubio-Petri) was introduced in 2014 but ultimately was not passed (another bill was introduced in 2015 and has been referred to committee). In an article that my co-author Shu-Yi Oei and I wrote addressing the tax treatment of ISAs, we expressed significant reservations about the legislation because it was both under- and over-inclusive and failed to anticipate the range of forms ISAs could take. In contrast, we suggested the introduction of safe harbors to provide certainty for several forms of ISAs. Such safe harbors might lead the market to issue only ISAs that were within those bounds, but they would remove the regulatory uncertainty for both the investor and the funding recipient. Ultimately, none of these regulatory reforms have come to pass. A related funding possibility, with the potential to bypass some regulatory concerns, was proposed by a fellow Surly Subgroup blogger (Ben Leff) and his co-author–an income-based repayment swap (“IBR” swap) for funding legal education. Under such a swap (the contract is not actually an ISA), the student would first borrow to finance the education, and then enter a swap with a financial institution pursuant to which the institution would be responsible for making the loan payments and the student would pay the financial institution a percentage of future earnings for a period of time.
Third, it has been suggested that ISAs faced competition from similar ISA-like offerings made available by the government sector. For example, in 2009, the federal government introduced an income-based repayment program for certain education loans. Revisions to the plan have been made over the years, and in 2012 the Pay As You Earn (PAYE) plan was introduced for qualified new borrowers. These plans have competitive advantages over private sector ISAs. First, there is no need to “attract” investors; the government is providing the funding. Second, the government plans cap a student’s monthly payment and a student is eligible only if the income-contingent payment is less than what the student would pay under the standard student loan plan. Thus, under these plans there is no government/“investor” upside, which makes the government-sponsored alternatives more appealing to students than private sector ISAs.
Despite these impediments to the ISA market, two recent developments on the ISA landscape suggest that the ISA market may not be completely dead. As reported in the New York Times, Purdue University recently announced a pilot program (Back-a-Boiler) in which the Purdue Research Foundation will begin making ISAs available to Purdue juniors and seniors for the 2016-2017 school year. According to the University’s current description of the program, it appears that it operates more like a traditional ISA with the potential for investor upside, and that the percentage of income paid under the ISA may be based on the student’s college major. The Purdue program raises a number of questions: Does Purdue’s move indicate that it believes that the market is ready for ISAs? Can Purdue more effectively price the ISAs by focusing on its own graduates? Is there a donative dimension to the program, akin to scholarships? What about regulatory questions? How will the ISA be treated for tax purposes? These regulatory and tax questions will be important if the pilot succeeds and outside investors are sought to expand the program.
The Purdue program is not the only new ISA activity raising questions. A few weeks ago, Cumulus Funding raised $30 million to support its funding of ISAs to individuals (to date the company reports providing over 500 ISAs). It is not clear how Cumulus is viewing the ISAs for tax purposes. On its webpage discussing opportunities to be an investor (indirectly through the company, not on a peer-to-peer basis as with the earlier Upstart and Pave ISAs), Cumulus Funding does refer to the funding recipients as “borrowers” and the financing as its “lending capital”–but that could be casual speak and not regulatory classification. A determination that the Cumulus ISAs were debt for tax purposes could prove very interesting for the active and contested debt/equity line over which the IRS and taxpayers regularly battle.
In any event, we don’t know yet the extent to which the Purdue and Cumulus ISAs will take hold. What we can say for now is that the market for ISAs does seem to be heating up and with it likely interest in and pressure on their regulatory treatment.