In a disappointing move, the Supreme Court today denied the petition by Midland Funding to hear the case Madden v. Midland Funding.
But could the inaction by the Supreme Court be much ado about nothing?
The denial leaves in place the decision of the U.S. Court of Appeals for the Second Circuit that the National Bank Act (NBA) does not provide a shield against state law usury claims even though the loan, as originated by a national bank, was not usurious. Despite the strong objections of industry lobbying forces, the Supreme Court denied hearing the case, a move that was made less surprising when the Solicitor General failed to support the cert petition despite being openly critical of the decision on the merits. Although a case arising under a consumer loan transaction, plaintiffs will argue that there is nothing about the ruling that limits its impact to consumer loans. As a result, the ruling may have a materially adverse impact on commercial paper as well.
The Supreme Court, by not hearing the case, allows the precedent of the appeals court to stand. But it does not stand for a wider approval or precedent in any other circuit other than the Second Circuit (New York, Connecticut and Vermont). Moreover, the denial of certiorari does not mean that the Supreme Court has rejected Section 85 of the National Bank Act, Section 27 of the Federal Deposit Insurance Act, or the rights of banks to sell valid loans into the marketplace, or principles of federal preemption, generally. That said, within at least the Second Circuit, the denial of certiorari strikes a small but significant blow at the longstanding "valid when made" doctrine, under which courts have long concluded that a non-usurious loan remains non-usurious even if assigned or sold to another. See, e.g., FDIC v. Lattimore, 656 F.2d 139 (5th Cir. 1981). At least three other Circuits (the Fifth, Seventh and Eighth) have ruled to the contrary, and the denial preserves a split in the Circuits. As Judge Posner wrote for the Seventh Circuit, "once assignors were authorized to charge interest, the common law kicked in and gave the assignees the same right, because the common law puts the assignee in the assignor's shoes, whatever the shoe size." Olvera v. Blitt & Gaines, PC, 431 F.3d 285 (7th Cir. 2005).
In some respects this is a positive for marketplace lending platforms that might have faced the prospect of an eight-member Supreme Court accepting the case and siding with Madden. This would have effectively "nationalized" the case. By denying certiorari, the Court has localized the damage caused. Platforms will begin to mitigate the effects of Madden, but in the short term, credit availability in the affected areas to the affected borrowers will be relatively scarce. In fact, a recent study by professors at Columbia, Fordham and Stanford Universities has shown that the Madden case has had a chilling effect on credit availability.1
It is also important to remember that the preemption argument is only one part of a three-part argument by Midland Funding. The case is now remanded to the District Court to decide the two remaining claims relating to whether the "valid when made" doctrine applies under state law. As decribed above, "valid when made" means if the loan was valid when made, it does not matter in whose hands it is sold or assigned, as the borrower is still bound by the contract.
There are two arguments that could preserve "valid when made" and result in a Midland Funding victory. First, both parties elected Delaware as their choice of law. Delaware recognizes the "valid when made" doctrine and therefore Midland Funding would win despite the preemption ruling from the Second Circuit. Second, even if the District Court rejects Delaware as the mutual choice of law, which is plausible in a case involving a consumer's election in a fine-print credit card agreement, New York law would then govern. New York also recognizes the "valid when made" doctrine, although this is less clear than in Delaware.
The other big unanswered question is how the court will apply two competing state laws: valid when made vs. usury. The judge will play a critical role here. If choice of law is honored or if the home-state law honors "valid when made" as many, including the Solicitor General, expect, the preemption case we have been following all this time will become somewhat of a troubling academic exercise, like Dorothy waking up in Kansas and realizing it was all a dream. It is also possible legislation is passed in the interim to resolve this issue.
The refusal to hear the case will cause non-bank assignees to avoid purchasing certain loans made in the three states affected by the Second Circuit ruling to the extent that the loans would not have been valid if originated by such assignees. It will also cause national banks that originate loans largely to sell them to reposition their operations and strategies. Worse yet, those entities that have already purchased loans under the assumption that they would be valid in the affected states (and that may no longer be valid) may seek to undo these sales on the basis that the banks breached representations and warranties.
The decision may likewise expose some debt purchasers and others to liability under New York's criminal usury statute. If New York law is deemed to apply to Midland Funding (and that issue must be resolved on remand), then Midland Funding may find itself potentially liable under that statute because New York usury law restricts annual interest rate charges to 25%, and the annual interest charge is 27% in Madden. If on remand the court applies New York law, Midland Funding's debt collection attempts could render it liable under the New York criminal usury law, including for felonies if it were placed in the shoes of the lender.
Here are other key implications:
- Non-bank purchasers cannot buy loans from banks operating under the NBA in the Second Circuit that exceed applicable state usury caps. In New York, the largest state of the Second Circuit, the usury cap is 16% without a state lending license and 25% with a license.
- Such loans may be deemed uncollectible.
- This is a major problem for securitization of Second Circuit loans, as many securitization trusts purchase loan assets from national banks.
- The Court is passing up the opportunity to opine on whether the power to sell loans is a fundamental power under the NBA linked to the power to originate loans. This was a key argument by Midland and the amicus petitions filed by the Structured Finance Industry Group, the Clearing House Association, the American Bankers Association and ACA International, and their brief cosponsors.
- Marketplace lenders generally do not purchase loans from banks operating under the NBA, so Madden technically does not apply to them. Both Madden and Midland made this argument in their briefs to the Court. However, the factual analogy is compelling enough to spook investors and therefore platforms away from originating loans in the Second Circuit.
- Credit for the over-16% borrower in the Second Circuit will continue to be tight from originators that rely on loan sales or securitization. This includes subprime consumer and auto loans.
- Small business and real estate lending platforms that do not purchase loans from originating banks are not directly impacted by the decision.
- Platforms have already started reshaping their legal relationships with banks to be factually distinct from the facts in Madden. This may mean keeping more loans on bank balance sheets, appointing the bank as the master servicer, adding "skin in the game" by banks investing in loans or deferring compensation to banks until the borrower performs on the loan for some or all of the term.
- Platforms have also pursued the alternative or complementary strategy of becoming licensed in various states so as to not need to rely on a bank funding partner.
- Future challenges to the Madden case are likely to come out of the Second Circuit given the strong negative view of the Solicitor General and the significance of the case to the industry.
- We are keeping an eye on the Bethune v. LendingClub, WebBank et al. case and its implications on the "true lender" doctrine. Unlike Madden, which deals with the power of a bank to sell its assets, the plaintifs in true lender cases have the view that there never really was a bank involved. This case will also be a test of the platforms' mandatory arbitration clauses contained in every consumer loan agreement.