Marketplace loan investors may want to "gather ye discounted Madden loans while ye may," as the Robert Herrick poem reads (taking some fintech license, of course).
In the strongest rebuke yet of the U.S. Court of Appeals for the Second Circuit's opinion in Madden v. Midland Funding, LLC, the Solicitor General of the United States (SG) has filed its requested brief with the United States Supreme Court (Court). The Court is currently considering whether to accept the case for review. The SG, which is a unit of the Department of Justice, represents the interests of the United States before the Court. The brief includes input from counsel at the Office of Comptroller of the Currency.
Quick refresher—New York resident Saliha Madden was issued a credit card by Bank of America and later FIA Card Services, each national banks. Madden defaulted on her approximately $5,300 balance, and FIA wrote off the debt as uncollectible and sold the debt to Midland Funding. Midland sought payment from Madden and continued to charge the 27% interest rate that she was previously charged. Madden brought suit that charging such a rate was unlawful, as it exceeded New York's civil usury cap of 16%, or 25% if Midland was licensed by the New York Department of Financial Services. In the original card agreement, both parties stipulated to Delaware law governing the agreement. Under Delaware law, the 27% interest rate is allowed. The question before the Court was whether the Second Circuit was correct in claiming that the preemption granted national banks over state law under the National Banking Act (NBA) applied to purchasers of loans originated but no longer held by banks. The case threatens the cardinal rule of usury that a loan contract that is valid when made can never be invalidated by any subsequent transaction (quoting the 1833 case of Nichols v. Fearson). For more information on the case, see http://www.lendacademy.com/madden-2015-has-nothing-to-do-with-football/. The Second Circuit did turn the case back to the District Court for determination of (i) whether the Delaware choice of law should be honored (and therefore, according to the SG, Midland wins) and (ii) if not, whether New York law would nonetheless honor the "valid when made" doctrine (which the SG asserts it does, and therefore Midland still wins).
In its brief, the SG notes that the powers of a national bank granted by the NBA (specifically Sections 85 and 24(Seventh)) specifically allow for loans to be originated and sold without modification:
"The court of appeals' decision is incorrect. Properly understood, a national bank's Section 85 authority to charge interest up to the maximum permitted by its home State encompasses the power to convey to an assignee the right to enforce the interest-rate term of the agreement. That understanding is reinforced by 12 U.S.C. 24(Seventh), which identifies the power to sell loans as an additional power of national banks. The court of appeals appeared to conclude that, so long as application of New York usury law to petitioners' collection activities would not entirely prevent national banks from selling consumer debt, state law is not preempted. That analysis reflects a misunderstanding of Section 85 and of this Court's precedents."
This is surprisingly definitive language siding with Midland and almost reflects incredulity by the SG directed towards the well-respected Second Circuit in a very public forum. It is clear, the SG concludes, that Midland, a nonbank collection company, may charge the same rate of interest that was charged by FIA. The SG determines that the Second Circuit erred in three respects:
- The Second Circuit failed to recognize that a national bank's power to charge certain rates carries with it the power to assign to others the right to charge the same rates (per Section 85 of the NBA);
- The Second Circuit provided "misconceived" analysis that by limiting the activities of Midland, they were not limiting the activities of the national bank. The SG notes that imposition of this rule unduly restricts the bank from being able to sell loans; and
- The Second Circuit too narrowly draws the line of conflict preemption between the NBA and state law. "When a federal law explicitly grants a national bank an authorization, permission or power and does not explicitly state that the exercise of that power is subject to state law, state law is preempted to the extent that it restricts that power." (SG citing the 1996 Barnett Bank of Marion Cnty v. Nelson case.)
Okay, so the SG recommends that the Court hear the case and fix the error, right?
No. The SG's recommendation is that the Court turn down the case so that it may properly be played out in the district court, which is the federal trial court that first heard the case. The SG is mindful of the Court's extremely demanding docket and limited capacity to decide every case. Therefore, because the SG believes that Midland will win on either the Delaware choice of law argument or the New York state law recognizing "valid when made," the SG recommends the Court deny the petition for hearing the case. The problem with this result is that it leaves the "erroneous" Second Circuit opinion on NBA preemption, which has now been discredited. But that is not really Midland's problem.
The SG also cites a few other reasons why this case is a poor forum for the Court to weigh in on preemption:
- There is no split among the circuits; the Second Circuit did not properly apply its own precedents (an argument Midland's attorneys made in their brief).
- The parties were deficient in making the preemption argument and addressing whether the application of state usury law would interfere with the national bank's exercise of powers; in other words, the lawyers for both sides did not present the correct analysis and the Second Circuit limited its ruling to the arguments presented.
- Midland will likely win anyway under Delaware choice of law or the application of New York law itself.
- No analysis has been made of how many states do not incorporate "valid when made," and therefore the decision of the Court might be inapplicable in the presumed majority of states that recognize valid when made.
So where does that leave marketplace lenders?
This case represents the strongest proclamation yet against the Second Circuit's Madden opinion. Regular readers of Manatt client alerts and our Financial Services biweekly newsletter will recall that there are several other points of distinction between a typical consumer marketplace lending model and the facts in Madden:
- First, marketplace lenders (MPLs) do not operate under the NBA, but rather the Federal Deposit Insurance Act and the full faith and credit/parity principle. Technically, although the facts seem similar to an MPL bank partner structure, only the NBA is being challenged here, which none of the MPLs currently use.
- Second, marketplace lenders utilize the underwriting principles of a funding bank and work in very close collaboration with the funding bank. The funding bank is involved in the origination process and does not "sell and go away," as is the case in the debt collections context. Funding banks use their own capital to originate loans, not the funds from the platform.
- Third, many MPLs are tightening the relationships with their banks in part to counter the argument that a bank is not involved in the process post-origination. This may take the form of appointing banks to service the debt (with possible subservicing to professional servicing firms) or holding loans on bank balance sheets with a sale of the economic interests of each loan to the platform and onto investors.
What are some other key takeaways for MPLs?
As for Madden, the Court is likely to accept the recommendation of the SG and pass on hearing the case. The district court will now determine the choice of law and, if necessary, the state law issues.
It remains to be seen whether a plaintiff will attempt to create a case out of the distinction that marketplace lenders have in that they operate through state law and therefore the NBA would not be applicable. In April, we saw the filing of the Bethune v. LendingClub and WebBank case in which a plaintiff is asserting violations of the "true lender" doctrine—that WebBank is not in effect acting as the true lender in a LendingClub loan and is a "sham" bank. This argument is different from Madden in that instead of litigating the transferability of banked loans to a nonbank, the plaintiffs are asserting that there was never any bank to begin with. We believe this argument faces several challenges, given the reality of the relationship that WebBank and other funding banks have to loans that are originated by MPLs. This case will also test the mandatory arbitration clauses written into most loan agreements and currently under fire by CFPB proposed rulemaking.
It will be interesting to see whether loans from the Second Circuit that exceed state usury caps (so-called Madden loans) will make a comeback on the origination and investment side. In a recent joint study by Columbia and Fordham Universities, a decline in available credit was observed in Madden jurisdictions because of the uncertainty of being able to sell the loans and of investors being able to enforce them through their term. One of the Department of Treasury's observations under its recent white paper was the lack of available credit to higher-risk consumers. It is possible that the ultimate resolution of Madden in the district court results in the increase in available credit to the underserved consumer borrowing base to whom a loan at the state usury caps would not be economically feasible.