A federal judge has ruled that New York law—not Delaware law as the parties agreed in the initial loan agreement—applies to the defaulted borrower's claims and has certified a class action against the debt collector.
On February 27, U.S. District Judge Cathy Seibel issued a long-awaited decision in Madden v Midland Funding, LLC. The District Court's order considered the following questions: (1) which state's law should apply to the defaulted borrower's claims, and (2) whether to certify a class action against the debt collector on behalf of similarly situated borrowers.
After a brief history of the case, we summarize both holdings and discuss their implications for marketplace lending. In short, Judge Seibel's decision compounds uncertainty surrounding debt collection practices and could have far-reaching implications for related industries, including marketplace lending.
In 2005, Saliha Madden, a New York resident, opened a credit card account with Bank of America. The account cardholder agreement ultimately included a Delaware choice-of-law clause, whereby both parties stipulated that Delaware law would govern the agreement. Madden defaulted on the loan and her account was later sold to debt purchaser Midland Funding, LLC. Midland's affiliate attempted to collect the debt with a default interest rate of 27%.
In 2011, Madden sued Midland and the affiliate, claiming abusive and unfair debt collection practices under federal law and excessive interest under New York law, which provides that rates exceeding 25% per year are criminally usurious. The District Court found that the National Bank Act (NBA) preempted state usury law, thereby defeating both claims. The Second Circuit reversed in a ruling that has been roundly criticized, concluding that preemption applies only where application of state law would hinder a national bank's exercise of its powers under the NBA. While Bank of America is a national bank, neither Midland nor its affiliate is. The current eight-member U.S. Supreme Court declined to hear a further appeal and the case was remanded to the District Court for additional proceedings that resulted in the February 27 decision.
Choice of Law
Although the cardholder agreement chose Delaware law to govern the contractual relationship between the parties, the District Court determined that New York law should be applied. Midland argued for Delaware law, which has no interest rate cap, while Madden argued for New York law, which does. The Court found there was no reasonable relationship between the parties or the transaction with the State of Delaware. Moreover, the Court noted that New York's usury prohibition "constitutes a fundamental public policy" against excessive interest rates. Application of Delaware law would frustrate that policy.
The District Court also granted Madden's motion to certify a class action on behalf of as many as 50,000 similarly situated borrowers. The class includes New York residents from whom Midland has attempted to collect interest exceeding 25% since November 2008, and whose cardholder agreements purported to be governed by state laws (such as Delaware's) that have no usury cap.
The District Court's decision could prevent enforcement of choice-of-law provisions in credit agreements against New York borrowers unless the counterparty is a national bank. This could be especially consequential for agreements that provide for payment of interest exceeding 25%, which is common among consumer loans and credit cards.
Moreover, the decision creates added uncertainty among lenders and debt purchasers who operate in the Second Circuit (New York, Vermont and Connecticut). Before Madden, it was widely understood that loans that are "valid when made" are not made invalid when assigned or sold to another party. The District Court's decision undermines this principle, rendering a valid-when-made loan potentially unenforceable to the extent it contravenes the law of the borrower's home state.
Choice of law was an alternative to the preemption argument raised in the appeal, since even if federal bank preemption does not run to non-banks as the Second Circuit held, (1) Delaware recognizes the "valid when made" doctrine, and (2) no usurious interest was charged if the loan agreement is governed by Delaware law. But as proceedings continue, it remains unclear whether the District Court will recognize the "valid when made" doctrine under New York law. Unless it does so, the Second Circuit's preemption finding, together with the District Court's choice of law finding, could prove fatal to Midland's position.
The reasoning employed in Madden could apply beyond the sale of delinquent loans to debt collectors including, perhaps, to any secondary sale of loans to non-national bank buyers. In particular, this decision could adversely impact marketplace lenders. Even if an originating bank could enforce the terms of high interest loan agreements, its third-party debt collectors may be unable to do so. This could cause banks to scale back their primary lending (particularly at higher interest rates), reducing the supply of loans available for purchase by marketplace lenders. Further, as enforceability of existing loans is made less certain, their value on the secondary market is diminished. Uncertainty also increases risk of loss, making investments through platforms that hold loans made to New York borrowers less attractive.
It should be noted that Madden has not yet been followed by any other court, nor has its reasoning been directly applied to marketplace lending. In fact, two other circuits have come to the opposite view. Nonetheless, we urge marketplace lenders and others to carefully consider the District Court's decision and to closely monitor the ongoing proceedings. The prospect of class action is especially concerning, as it could lead to additional litigation and larger recoveries. In the meantime, industry members should evaluate whether their lending activities could bring them within Madden's reach, especially in the Second Circuit states of Connecticut, New York and Vermont.
Madden v. Midland Funding, LLC, No. 11-CV-8149, (S.D.N.Y. Feb. 27, 2017), available at http://bit.ly/2lYeKQF.