With the hope of finally addressing the uncertainty created by the U.S. Second Circuit Court of Appeal’s holding in Madden v. Midland Funding,1 the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) recently proposed regulations to clarify that collecting interest on a loan that is legally permissible at the time of origination by a bank will continue to be permissible for a non-bank assignee or purchaser of such loan after the sale or assignment by the bank. The OCC proposal would apply to loans originated by national banks and federal savings and loan associations; the FDIC proposal would apply to loans originated by state chartered banks. If adopted, the proposed rules would have the effect of overriding Madden, a decision that has resulted in substantial uncertainty and reduced credit in the consumer credit markets, due to concerns about the enforceability of loans that were originated by a bank and sold or assigned to a non-bank entity.
The proposals are welcome news for marketplace and other tech-enabled lenders, as well as other financing providers and investors in consumer loans or consumer loan-backed securities. The Madden case has raised questions about the viability of the bank partnership model utilized by many marketplace lending platforms because, under that model, the marketplace lending platform typically purchases loans from the originating bank shortly after origination. The case also has created uncertainty for third-party debt purchasers that may have sought to enforce the loan agreement made by the originating bank against the obligor on the contract. The proposal does not eliminate all of the uncertainty in the market, however, because if adopted, the rules are likely to be challenged in court by any mix of consumers, state regulators and consumer advocacy groups.
Comments on the OCC proposal are due by January 21, 2020. Comments on the FDIC proposal are due by February 4, 2020.
The Madden Decision
In Madden, a national bank located in Delaware charged off a credit card account that was opened by a New York resident. The bank sold the account to Midland Funding, a non-bank debt buyer, which then sought to collect the full amount outstanding on the account. The account carried an interest rate in excess of the usury limit of the State of 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 (since a national bank may “export” the interest rate on a loan to borrowers in other states if the rate is permissible in the bank’s home state), once the account had been sold to a non-bank entity such as Midland Funding, preemption is 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. The holding has been widely criticized as inconsistent with the longstanding “valid when made” doctrine, which stands for the proposition that a loan, if not usurious by the party making the loan at the time of its origination, does not become usurious following a sale to a third party.2
The Madden decision has affected a variety of transactions involving non-bank entities that purchase loans from a bank – including hedge funds, debt collectors, marketplace lenders and securitization vehicles. For example, various rating agencies, securities purchasers and support providers have required that securitization vehicles exclude loans to borrowers in the Second Circuit states of New York, Connecticut and Vermont (which loans have interest rates above those states’ civil usury limits), because of the risk that the interest payable by the borrowers on those loans might not be enforceable. The reasoning in Madden, particularly if adopted in other jurisdictions, also would limit the ability of banks to sell loans to marketplace lenders, financing providers and other investors, which would significantly limit the availability of credit and a bank’s liquidity options.
The Proposed Rules
The OCC and FDIC proposals are intended to address the uncertainty in the consumer credit markets as a result of the Madden decision, which is consistent with Administration policy as reflected in a July 2018 report on financial innovation from the U.S. Treasury Department. In that report, Treasury recommended that “the federal banking regulators ... use their available authorities to address the challenges posed by Madden.”3 More recently, in a September 19, 2019 letter, Republican members of the House Financial Services Committee urged the OCC to update its interpretation of “interest” under the National Bank Act to mitigate the consequences of the Madden decision, which the letter asserts “threatens bank-fintech partnerships that can often provide small businesses and consumers better access to capital and financing alternatives.”4
The OCC proposed rule clarifies that when a bank assigns a loan, interest permissible prior to the assignment will continue to be permissible after the assignment.5 The OCC explained that this interpretation is consistent with a national bank’s authority under 12 U.S.C. 85 to “charge on any loan ... interest at the rate allowed by the laws of the State ... where the bank is located” and to export that rate to borrowers in other states, regardless of any other state law purporting to limit the interest rate on bank loans. Further, the OCC cited to a bank’s well-established authority to assign loans, in which case the third-party assignee steps into the shoes of the bank and receives the benefit of the loan, and may enforce the permissible interest rate thereon. The OCC also noted that its interpretation is supported by the longstanding “valid when made” doctrine, recognized by the Supreme Court as a “cardinal [rule] in the doctrine of usury.”6
The FDIC proposal applies similar reasoning based on the statutory scheme governing the interest rate authority of state banks,7 which was patterned after, and has been interpreted consistently with, 12 U.S.C. 85, to provide competitive equality among federally and state chartered banks.8
The proposals have already generated opposition from consumer advocacy groups, which assert that the rules would allow online predatory lenders to evade state interest rate caps, to the detriment of consumers.9 In addition, in a November 21, 2019 letter to the Comptroller of the Currency and the Chairman of the FDIC, just days after the proposals were issued, six Democratic senators urged the regulators to reverse course, alleging that the proposals would gut state consumer protection laws by encouraging payday and other non-bank lenders to evade state usury limits by funneling their loans through federally regulated banks in so-called “rent-a-bank” arrangements.10 The letter asserts that it is the role of Congress, not the executive branch, to address any disagreements with the Madden decision. These arguments presumably will be reiterated during the comment process, which is likely to generate strong views from those on both sides of the Madden debate.
True Lender Considerations
The agency proposals do not address “true lender” risks, which is a concept that has been considered by courts in the context of loans marketed by non-banks through bank partnership arrangements. In these true lender cases, a court may determine that the non-bank is the real party in interest and/or has the predominant economic interest in the loans originated by a bank. Such a holding has resulted in the re-characterization of the non-bank as the true lender of the loans and, therefore, the court evaluates the loan as if the non-bank lender made the loan, which could subject the loan to state licensing and usury laws. While the OCC and FDIC proposals are tailored to refute the holding in Madden and do not take a position on the true lender line of cases, the FDIC does state in the preamble to its proposal that it “views unfavorably a state bank’s partnership with a non-bank entity for the sole purpose of evading a lower interest rate established under the law of the entity’s licensing state.”11 The OCC previously expressed a similar view.12
Therefore, even if the OCC and FDIC proposals are adopted and effectively override the holding in Madden, market participants should continue to take steps to ensure that bank partnership arrangements are structured so that the bank, rather than the non-bank service provider, is reasonably viewed to be the true lender of the loans under prevailing judicial precedent and regulatory guidance.