In a case closely watched by the lending industry, on August 12, 2015, the U.S. Second Circuit Court of Appeals denied a request by Midland Funding, LLC (Midland Funding) to rehear a case decided in May (Madden v. Midland Funding, LLC) in which the court ruled that a non-bank assignee of a national bank could not rely on federal preemption under the National Bank Act to override New York state’s usury laws. Midland Funding is expected to appeal to the U.S. Supreme Court, particularly given the apparent conflict with decisions in other circuits.
The case potentially has far reaching implications for the secondary loan and securitization markets. InMadden, a national bank located in Delaware charged off a credit card loan to a New York resident and sold it to Midland Funding, a debt buyer. Midland Funding then sought to collect on the loan that carried an interest rate (27 percent) in excess of the usury limit in New York. The Second Circuit found that, although federal law would preempt state usury limits while the loan remained in the hands of the national bank, once sold to a non-bank entity such as Midland Funding, preemption was no longer available. The court reasoned that applying New York’s usury law to Midland Funding would not “significantly interfere” with the powers of the originating national bank, particularly since the bank did not retain any continuing interest in the loan. The holding is inconsistent with the principle endorsed by other courts – as well as established market practice – that a loan, if not usurious at the time of its origination, does not become usurious following a sale to a third party.
If not overturned, the decision could significantly impact the pricing, marketing and sale of loans originated by banks (both national banks and state chartered banks), at least those made to borrowers in the Second Circuit states of New York, Connecticut and Vermont. Transactions involving non-bank entities that purchase loans – including hedge funds, debt collectors, online marketplace lenders and securitization trusts – could all be impacted. The ruling also could have the impact of reducing the liquidity of assets held by a national bank – a result directly at odds with the objectives of the National Bank Act.
Market participants should consider how deals may be structured consistent with Madden to avoid running afoul of state usury laws. Penalties for usury violations can be severe and, in some states, can result in the note being deemed void and the lender forfeiting the entire loan balance. While the U.S. Supreme Court may yet hear the case (if asked) and overturn it, there is no assurance that this will occur. Indeed, the Supreme Court grants certiorari in less than one percent of all cases appealed.
Some items to consider in a post-Madden world include the following:
- A key fact for the Madden court was that the bank did not retain a continuing interest in the loan sold to the debt buyer. Therefore, a case can be made that a loan in which the selling bank retains a continuing interest – such as through risk retention, servicing or an account relationship with the customer – should continue to enjoy the benefits of federal preemption from state usury laws.
- In some states, licensed lenders (which can include loan purchasers) are exempt from usury limits or are subject to substantially higher limits than non-licensed lenders. Therefore, obtaining a lenders license (at least in some states) may be a strategy for some non-bank loan purchasers, particularly those engaged in recurring loan purchases such as sponsors of online lending marketplaces.
- An effective choice of law provision in a state with a favorable usury statute (such as Delaware) could insulate a loan from a usury claim in another state, regardless of whether federal preemption is available. The Second Circuit did not consider the choice of law question in Madden and remanded to the district court the issue as to whether New York or Delaware law should apply. However, even a carefully constructed choice of law provision may not be respected in some states to the extent it purports to override the state’s usury laws.
- Business loans are far less likely to be impacted by Madden than consumer loans. Usury ceilings in many states either do not apply to business loans or only apply to small business loans below a specified dollar threshold.
- Some non-bank loan purchasers may decide, at least for the time being, to avoid purchasing loans to borrowers in Second Circuit states or to purchase only loans that would not violate applicable usury ceilings. Such actions, in turn, could impact the willingness of banks to originate loans in those states or the terms on which such loans are made.
While it is difficult to predict the ultimate impact of Madden on the consumer lending market, that impact will be magnified to the extent other courts follow its holding and adopt the reasoning of the case.