On Aug. 12, 2015, the U.S. Court of Appeals for the Second Circuit denied a petition for rehearing in Madden v. Midland Funding, LLC,1 essentially re-affirming its troubling ruling in Madden that non-bank holders of bank-originated consumer loans cannot enforce such loans to the extent that they contain interest rates in excess of state law usury limits.
Banks are generally permitted to rely on their home state usury limits regardless of where the loan was made or where the borrower resides. Therefore, many bank consumer loans contain interest rates in excess of the limit applicable in the borrower’s home state. The ruling in Madden upset the presumed framework underlying the secondary market for debt: that a loan purchaser stands in the shoes of the originator and can enforce the loan according to its terms, so long as the loan was “valid when made.”2 While it is likely that Midland Funding will petition the U.S. Supreme Court for a writ of certiorari to review the decision, it is far from certain that the Supreme Court will take up the case.3 Thus, participants in the secondary market must be aware of the implications of Madden.
Midland Funding purchased the credit card debt of Saliha Madden from FIA Card Services, N.A. after FIA had “charged-off” her account as uncollectable. Midland Funding attempted to collect payment on Madden’s debt and informed her by letter that an interest rate of 27 percent per year applied. Madden then filed a suit against Midland Funding, alleging that Midland Funding was attempting to charge her a usurious rate of interest in violation of New York law.
The U.S. District Court for the Southern District of New York held that Midland Funding was entitled to the protection of the National Bank Act (“NBA”) if the originating bank, Bank of America, was entitled to the protection of the NBA, which allows national banks to charge any interest rate allowed by the state in which the bank is located.4
However, the Second Circuit reversed this decision, holding that the NBA did not bar state law usury claims because Midland Funding was not a national bank (nor a subsidiary or agent of a national bank) and application of the state usury law to Madden’s claims would not significantly interfere with any national bank’s ability to exercise its powers under the NBA.
The ruling in Madden, and the Second Circuit’s subsequent denial of Midland Funding’s petition for rehearing, could have significant consequences for participants in the consumer loan secondary market.5 Entities, including funds, that purchase and hold consumer loans, as well as those that trade in the securitization of such loans, should be aware that the interest rates charged in those loans may now be subject to the usury laws of various individual states, rather than the usury laws of the state in which the originating bank was located.
It is important to note that the Second Circuit’s holding is binding only in New York, Connecticut and Vermont. However, since Madden represents a departure from the assumed-settled “valid when made” doctrine, it is possible that the holding may lead to similar decisions in other circuits. Absent such further developments, however, parties must pay particular attention to the interest rates of any loan with a nexus to any of the three foregoing states sufficient to potentially render it subject to that state’s usury law (see the discussion below on choice of law).
Within the three states covered by the Second Circuit, the impact is potentially significant. Under New York law and Connecticut law, consumer loans with usurious interest rates are void in their entirety — negating the value of both the interest and the underlying principal.6 Vermont law allows for recovery of one-half of the principal of usurious loans.7
The absence of uniformity in interest rates that has been historically been available could also lead to changes both in the value and credit ratings of pre-existing loan securities as well as the need to re- evaluate the value of prospective loan purchases, as it is now possible that a non-bank purchaser of consumer loans will be unable to enforce the terms set by the originating bank. This lack of certainty may also change the metrics by which securitized pools of consumer loans are valued and the manner in which those pools are created, as well as increase diligence demands on the purchasers of consumer debt.8 The holding even has potentially troubling implications for originating banks in relation to “put-back” risk. Many existing credit agreements contain provisions by which the originating or selling party may be forced to re-purchase loans or compensate the buyer under certain circumstances, such as for loans that do not comply with applicable law, are unenforceable or suddenly decrease in value.
Choice-of-Law Provision Unsettled
The Second Circuit’s decision in Madden leaves unresolved the impact of the choice-of-law provisions contained in the terms of consumer loan agreements. The defendant was a resident of New York and filed suit under New York usury laws, but the terms of her cardholder agreement stated that the agreement was to be governed by Delaware law. The Second Circuit did not address the question of which state’s laws to apply, instead remanding the issue to the district court. However, it is unlikely that choice-of-law provisions in credit agreements will enable the holder of consumer loans to enforce usurious interest rates and should not be relied upon to avoid state-by-state usury law concerns.
New York law is somewhat unsettled on the question of the application of out-of-state choice-of-law clauses to usury law claims.9 While some courts have adhered to the general rule that choice-of-law provisions are valid and enforceable in New York,10 most have examined choice-of-law provisions under the “substantial relationship” test, which almost invariably results in the application of New York law.11 Because a consumer loan provided to a New York resident will typically be negotiated, signed and performed in New York, a New York court will likely conclude that New York has a greater interest in applying its own law than the law of another state named by the loan agreement.
Further, New York courts have stated that New York has a “strong public policy” against interest rates that violate its usury laws.12 This is likely to be an especially relevant concern to a court where the party raising a usury defense is an individual consumer rather than a corporation.13
As long as Madden remains good law, funds and other entities that participate in the secondary market for consumer loans must take steps to ensure that the loans they purchase do not involve interest rates that violate the home state usury laws of debtors residing within the three states covered by the Second Circuit. Failing to do so risks the purchaser’s ability not only to collect the contractual interest but also to retain even its rights to the underlying principal.