In a disappointing move, the U.S. Supreme Court has denied the petition for certiorari by Midland Funding to hear the case Madden v. Midland Funding. But could the inaction by the Supreme Court be much ado about nothing?

What happened

The denial leaves in place the decision of the Second Circuit Court of Appeals 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 Justices declined to hear 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.

The Supreme Court, by not hearing the case, allows the precedent of the appeals court to stand. The Justices passed 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.

But it does not stand for a wider approval or precedent in any other circuit other than the Second Circuit, which covers Connecticut, New York, and Vermont. Moreover, the denial of certiorari does not mean that the Supreme Court has rejected Section 85 of the NBA, 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 long-standing "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. At least three other circuits—the Fifth (in FDIC v. Lattimore, 656 F.2d 139 (5th Cir. 1981)), Seventh (Olvera v. Blitt & Gaines, PC, 431 F.3d 285 (7th Cir. 2005)) and Eighth—have ruled to the contrary, and the denial preserves the circuit split. 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."

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 already had a chilling effect on credit availability.

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.

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.

Outside of the courtroom, the refusal to hear the case will cause nonbank 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, then Midland Funding may find itself potentially liable as New York usury law restricts annual interest rate charges to 25 percent and the annual interest charge is 27 percent 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.

In addition, nonbank 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 in the Second Circuit, the usury cap is 16 percent without a state lending license and 25 percent with a license. Such loans may be deemed uncollectible and credit for the over-16 percent borrower in covered states will continue to be tight from originators that rely on loan sales or securitization, including subprime consumer and auto loans.

Other implications include serious challenges to the securitization of loans in the Second Circuit, as many securitization trusts purchase loan assets from national banks.

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 could scare platforms away from originating loans in the Second Circuit. 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. Alternative coping strategies include becoming licensed in various states to avoid the need to rely on a bank funding partner.

Other cases may also have an impact on how Madden continues to play out. A recent putative class action filed against LendingClub in New York federal court could have implications on the "true lender" doctrine. Unlike Madden, which deals with the power of a bank to sell its assets, the plaintiffs 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.

Why it matters

The full impact of the Madden decision remains to be seen, but lenders are already tweaking their relationships in the Second Circuit to survive in the wake of the opinion. Future challenges to the Madden case are likely to arise given the strong negative view of the Solicitor General and the significance of the case to the industry.

This article was originally published on on June 27, 2016. To read the full article, click here.