In a blow to banks and the marketplace lending industry, on June 27, 2016, the U.S. Supreme Court denied the petition by Midland Funding to hear the case Midland Funding, LLC v. Madden (No. 15-610). That case involves a debt-collection firm that bought charged-off credit card debt from a national bank. The borrower’s legal team argued that a buyer of the debt was subject to New York interest rate caps even though the seller of the debt, a national bank, was exempt from those state law rate caps due to preemption under Section 85 the National Bank Act. The borrower won on this startling argument and the debt collector appealed to the Supreme Court. The Office of the Comptroller of the Currency (the regulator for national banks), the U.S. Solicitor General and various stakeholders in the banking and lending industries vigorously argued that the 2nd Circuit’s decision contravened established law. The fear was that, if preemption strips loans of their usury-exempt status when the loans are sold, then banks’ ability to sell consumer loans, including the common practice of banks originating and quickly selling those loans to investors and marketplace lenders, would be significantly limited, if not curtailed.
The Supreme Court denied the debt collector’s appeal without explanation, which means the 2nd Circuit’s ruling is binding law in that Circuit, which includes New York, Connecticut and Vermont. However, the 2nd Circuit’s ruling is not the law outside of the 2nd Circuit.
As of today, these are some of the key takeaways for banks and the lending industry:
- For the immediate future, consumer loans originated to consumer borrowers in states other than New York, Connecticut and Vermont are not affected.
- Conceivably, the implications of the case could largely disappear, depending on what happens upon remand to the District Court. If the District Court decides that the loans were “valid when made” notwithstanding usury caps that only apply to a subsequent buyer of the loan, then the practical effect would be to return jurisprudence to its pre-Madden norm. It is likely that the OCC and the banking industry will vigorously pursue every opportunity to reach that result.
- Many marketplace lenders originate loans through state-chartered banks, which rely on interest rate and fee exportation under Section 27 of the Federal Deposit Insurance Act, not preemption under the National Bank Act. However, most industry observers are very concerned that future court challenges will not distinguish between exportation and preemption and will also discard exportation with respect to state interest rate caps.
- The Supreme Court’s ruling makes New York, already a difficult state for a non-bank lender to make consumer loans, even less hospitable. An investor or marketplace lender that wants to buy New York consumer loans from a bank must have a lender license to charge up to 25% or be subject to the 16% rate for unlicensed lenders. This will make unsecured personal loans unprofitable for a large segment of consumers and accelerate the trend of many marketplace lenders avoiding New York altogether. Connecticut rate caps for unsecured loans range between 11% and 17%, which makes that state even less profitable than New York. Vermont has a similarly restrictive rate environment. All three states will likely see a substantial withdrawal from the market by a variety of consumer lenders. In addition to the withdrawal by non-banks, banks will see a steep increase in their costs to make or hold consumer credit in these three states. Banks will need to sharply discount consumer debt if they wish to sell it to a non-bank or, if the discount is too steep to be palatable, simply hold the debt on their own books. Either way, the increased costs and reduced profitability will make consumer lending less available and more expensive to the consumer.
- Securitization of consumer debt originated in the 2nd Circuit states is much more difficult (and probably impossible if the stated rates on the debt exceed state law usury caps for non-banks). The current practice is to use a national bank as the trustee of the securitized debt to rely on the traditional preemptive power of a national bank. If securitization is limited or stopped, this will also increase the costs of making these loans.
- Business purpose lending is not affected at all because state law usury caps only apply to consumers. In the future, we may see sole proprietor businesses attempting to assert consumer defenses, but so far this has not succeeded in a meaningful way. Similarly, real estate lending (including consumer mortgages), is generally not affected as such lending is generally excluded from state law usury caps.
- Some marketplace lenders are strategically pursuing their own lender licensing to give themselves the option of originating loans without a bank and to take advantage of the higher rate caps available to licensed lenders. Lending under one’s own license also avoids a “true lender” lawsuit in which the consumer argues that the originating bank should be ignored and that consumer compliance should be evaluated solely based on the purchasing investor / marketplace lender.
So, while marketplace lenders and banks have taken a blow in the Supreme Court’s refusal to hear Madden v. Midland, the blow is not as bad as it could have been because the effects are limited to the 2nd Circuit. And, even those effects may be muted depending on future developments in the case. Business practices can be adjusted. But, as is usually the case with bad law, consumers will pay the price in terms of more expensive and less available credit.