On June 27, 2016, the Supreme Court of the United States denied the petition for certiorari in Madden v. Midland Funding, a case closely watched by the financial industry. With the Second Circuit’s decision remaining good law, existing transactions with exposure to bank-originated debt transferred to nonbanking entities are at risk. Transaction parties depend on contracted interest rates to determine the purchase price of debt in the secondary market and to model cash flow for asset-backed transactions which rely on interest proceeds to cover debt service. Hedge funds, securitization vehicles and other purchasers of bank-originated debt should evaluate their existing facilities and portfolios, as Madden poses a potential threat of litigation and a decrease in cash flow (and thus an increase in defaults) for these transactions.
In Madden v. Midland Funding, the plaintiff, Saliha Madden, a resident of the state of New York, opened a credit card account with Bank of America N.A., a national bank, in 2005. Bank of America transferred the account the following year to FIA Card Services N.A. (“FIA”), an affiliated national bank headquartered in Delaware. At the time of transfer to FIA, Madden received a “Change in Terms” document which contained a Delaware choice of law clause. In 2008, Madden failed to make payments in accordance with the terms of her account, and FIA “charged off” the account and sold the debt to Midland Funding LLC (“Midland Funding”), one of the defendants. Midland Credit Management Inc., the other defendant, is an affiliate of Midland Funding and services Midland Funding’s consumer debt accounts. Neither defendant is a national bank. In 2010, Midland sought to collect payment from Madden, applying an interest rate of 27% per year, a rate which was permitted under Delaware law but usurious under New York law.
The Arguments and the Court’s Analysis
Madden brought a putative class action alleging violations of the Fair Debt Collection Practices Act (“FDCPA”) and New York’s usury law.
The defendants contended that the claims failed as a matter of law because (1) state-law usury claims and FDCPA claims predicated on state-law violations against a national bank’s assignees, such as the defendants, are preempted by the National Bank Act (“NBA”), and (2) the agreement governing Madden’s debt requires the application of Delaware law, under which the interest charged is permissible. The District Court for the Southern District of New York entered judgment for the defendants.
However, the United States Court of Appeals for the Second Circuit reversed the District Court’s holding as to NBA preemption, vacated the District Court’s judgment and denial of class certification, and remanded the case to address whether the Delaware choice of law clause precludes Madden’s claims. The Second Circuit held that a loan originated by a national bank ceased to have preemptive effect under the NBA once it was assigned to a nonbank debt collector because the assignee was not a nationally chartered bank and it was collecting on behalf of itself and not on behalf of a national bank. 786 F.3d 246 (2d Cir. 2015).
On June 27, 2016, the Supreme Court of the United States denied the petition for certiorari.
What wasn’t included in the Second Circuit’s reasoning was the long-standing “valid when made” principle. In 1833, the Supreme Court of the United States held “that a contract, which, in its inception, is unaffected by usury, can never be invalidated by any subsequent usurious transaction.” Nichols v. Fearson, 32 U.S. 103, 109 (1833). The Fifth Circuit and the Eighth Circuit have also rendered decisions supporting the “valid when made” principle, providing that a loan does not become invalid upon assignment. See Krispin v. May Department Stores, 218 F.3d 919 (8th Cir. 2000); see also FDIC v. Lattimore Land Corp., 656 F.2d 139 (5th Cir. 1981). This fundamental principle of contract law is the basis for marketplace lending, which relies on the transferability of loans originated by national banks with their original interest rate term, among others. By ignoring this principle in its analysis, the Second Circuit has created uncertainty for the marketplace lending sector, which could have a chilling effect on the volume of transactions in that space.
The parties will go back to the District Court and determine whether the Delaware choice of law clause precludes Madden’s claims. If the District Court holds that the choice of law clause precludes Madden’s claims, then market participants can proceed with certainty if the debt has a proper choice of law clause.
The impact of Madden can be far-reaching for all participants in transactions involving the transfer of debt originated by a national bank, particularly for investors acquiring loans originated by the growing number of marketplace lenders. While Madden is technically controlling only in the Second Circuit (New York, Connecticut and Vermont), the case could in the future be followed in other jurisdictions. Until there is more certainty, market participants should be aware that the permissible interest rate charged by a national bank might not preempt state usury laws once the debt is transferred to a non-national bank and should model and price their transactions accordingly.