A recent decision from a federal district court in Colorado, Colorado ex rel. Meade v. Avant, strikes another blow against many of the financial technology firms that are revolutionizing the way consumers and businesses access credit. Joining what is now a line of decisions, the court limited the valid-when-made doctrine, which provides that a loan that is valid when it is made does not become invalid (i.e., usurious) when it is sold or assigned to a third party. The court also embraced the plaintiff’s argument that the economic and operational realities of the underlying loan program, rather than traditional contract principles, should determine who was the “true lender” of the loans. 

For fintech firms — and, especially, platform lenders — the court’s decision is another reminder that judges have not yet embraced the fintech revolution.

Background Marketplace lenders often partner with banks to offer credit to consumers and businesses. This model — “platform lending” — creates substantial benefits.[1] By leveraging technology, platform lenders reduce operating costs for their bank partners, and some of those savings are passed on to borrowers. By relying on alternative data sources, platform lenders expand access to credit and promote financial inclusion, even while ensuring the performance of their bank partners’ loan portfolios. And by offering an online lending platform, platform lenders allow borrowers of all stripes to shop for loan products without stepping into a brick-and-mortar bank — which, of course, matters a great deal to tech-savvy consumers (e.g., millennials). But platform lending depends on several core legal principles. Section 85 of the National Bank Act, or NBA, permits a federally chartered bank to “export” its home state’s interest rate cap — that is, to make loans in every state at any interest rate permitted by the laws of the bank’s home state, even if the rate charged would otherwise be unlawful in the state where the loans are made. And Section 27 of the Federal Deposit Insurance Act, or FDIA, provides state-chartered banks with the same privilege. Thus, when a platform lender partners with a bank, it can avoid the costs and complexities of complying with a web of complicated and conflicting state usury laws.

At least, a platform lender can avoid those costs and complexities if two core legal principles hold. As noted above, the valid-when-made doctrine provides that a loan that is valid when it is made does not become invalid (i.e., usurious) when sold or assigned to a third party. Thus, when the validity of a loan made by a bank is challenged, the relevant legal inquiry is only whether the loan was lawfully made. Moreover, under traditional contract principles, the parties to a loan are the parties identified in the contract. Thus, when the validity of a loan is challenged, a court can, and should, identify the “true lender” by referencing the contract.

But both the valid-when-made doctrine and traditional contract principles are under assault, with regulators and class action attorneys leading the charge.

The Decision

The Avant decision in Colorado illustrates the trend. In Avant, the federal district court held that Section 27 of the FDIA does not completely preempt state law claims challenging the validity of loans made by a state-chartered bank if the loans are later assigned to a nonbank entity.

The defendant, Avant, had entered into a lending program agreement with WebBank, a state-chartered bank. Under the terms of the agreement, WebBank used Avant’s online lending platform to make loans to consumers and then, after holding the loans for a few days, sold the loans to third-party purchasers, including Avant.

The Administrator of Colorado’s Uniform Consumer Credit Code, Julie Meade, sued Avant — but not WebBank — in state court. Avant then removed the case to federal court, arguing that the federal court had jurisdiction over the state law claims because Section 27 of the FDIA completely preempts state law claims challenging the validity of loans made by a state-chartered bank.

In her motion to remand the case to state court, Meade did not dispute that Section 27 completely preempts state law claims challenging the validity of loans made by a state-chartered bank. Nor did she dispute that Section 27 permits a state-chartered bank, like WebBank, to “export” its home state’s interest rate cap.

Meade instead argued that Section 27 does not preempt state law claims against nonbank assignees, even if the claims challenge the validity of loans made by a state-charted bank. She urged the court to read Section 27 narrowly, noting that it expressly references only “state banks” and not their subsidiaries, affiliates, agents or assignees.

Meade also argued that Colorado law should apply despite Section 27 because WebBank was not the “true lender” of the loans. Meade conceded that WebBank was identified in the loan contracts as the lender. But she argued that Avant was the “true lender” because it performed the functions essential to the lending program and held the “predominant economic interest” in the loans. Indeed, according to Meade, the lending program agreement between WebBank and Avant was a sham intended to permit Avant to circumvent state laws, including Colorado’s laws, that limit the interest rates and other finance charges that nonbanks may charge.

Adopting a magistrate judge’s recommendation, the district court agreed with Meade’s argument that Section 27 does not completely preempt state law claims against nonbank assignees, like Avant. The court acknowledged that “under common law principles the assignee of a loan ‘steps into the shoes of the assignor.’” But it then read Section 27 as if that were not true, holding that Section 27 “does not on its face regulate interest or charges that may be imposed by a nonbank, including one which later acquires or is assigned a loan made or originated by a state bank.”

The court also embraced Meade’s “true lender” arguments. In response to Avant’s argument that Meade had sued the wrong party, the court quoted the allegations in Mead’s complaint supporting her argument that Avant was the “true lender,” and then found that Meade was not “manipulating the pleadings.” The court did not expressly find that Avant was the “true lender” of the loans, instead leaving that question open for the state court on remand. But the court found — at least implicitly — that Avant could be the “true lender” of the loans given its role in providing an online lending platform to WebBank. And just as important here, it also found that it did not need to decide whether Meade was challenging the validity of loans made by a state-chartered bank in determining whether her claims were completely preempted by Section 27.

While the court attempted to cabin the reach of its decision, its comments to that effect provide little comfort. By ignoring Avant’s status as an assignee and failing to reject Meade’s true-lender allegations, the court limited the scope of the valid-when-made doctrine and rejected traditional contract principles. For platform lenders and their bank partners, then, the decision is a loss. Indeed, several lending associations, including the Marketplace Lending Association, the Clearing House Association, the American Bankers Association, and the Loan Syndication and Trading Association, had urged the court to adopt a different tack.

Recent Congressional Action

There is some small chance, however, that Congress will make right what, from the fintech industry’s perspective, the district court in Colorado (and other federal and state courts) have gotten wrong.

Introduced in July 2017, the Protecting Consumers’ Access to Credit Act of 2017 (H.R. 3299) would overrule those federal and state courts decisions, including the Second Circuit’s decision in Madden v. Midland Funding, that have limited or rejected the valid-when-made doctrine. The congressional findings included in the bill note that the valid-when-made doctrine has been “a cornerstone of United States banking law for nearly 200 years.” They also assert that the doctrine, “by bringing certainty to the legal treatment of all valid loans that are transferred, greatly enhances liquidity in credit markets by widening the potential pool of loan buyers and reducing the cost of credit to borrowers at the time of origination.” The bill passed out of the House on Feb. 14, 2018, and is currently pending in the Senate’s Committee on Banking, Housing, and Urban Affairs. It was overwhelmingly opposed by House Democrats, however, which suggests that the bill may not obtain the votes necessary to pass out of the Senate.

Introduced in November 2017, the Modernizing Credit Opportunities Act (H.R. 4439) would overrule those federal and state court decisions that have rejected traditional contract principles in favor of a multi-factor “true lender” analysis. The congressional findings included in the bill note that some courts have employed “judicially crafted multifactor balancing tests” to decide the true-lender question. That approach, according to the findings, has led to inconsistent decisions about the “identity and location” of the true lender, with resulting harms to the efficiency and transparency of the lending process and to the otherwise “substantial benefits of third-party lending arrangements.” The bill is currently pending in the House Financial Services Committee, but no vote has yet been scheduled.

Takeaways

For platform lenders, the key takeaway from the district court’s decision in Avant is that government regulators and class action attorneys are challenging the core legal principles that support their business model, and judges have not yet caught on to (or have ignored) the risks inherent in the argument they are presenting. That being so, platform lenders should consider adopting structural arrangements that mitigate their risks of facing a “true lender” action. Moreover, if confronted with a “true lender” action, a platform lender should present a coherent narrative demonstrating the risks inherent in undermining the valid-when-made doctrine and traditional contract principles, even while integrating those legal principles into the plain language and congressional intent behind the National Bank Act and the Federal Deposit Insurance Act.

First published on Law360 https://www.law360.com/articles/1024269/foolishness-versus-fintech-foolishness-wins-again