[Editor’s note: This is a guest post from Brian S. Korn, a Capital Markets Partner at the law firm Manatt, Phelps & Phillips, LLP in New York City. He has over 50 clients engaged in marketplace lending activities and has made multiple appearances on Fox Business Television, CNBC, Bloomberg, CCTV America and National Public Radio. He previously served as a summer clerk to the Honorable Stephen Reinhardt, U.S. Court of Appeals for the Ninth Circuit in Los Angeles. He is admitted to practice law in New York and California.]
Legendary NFL Coach John Madden probably has no idea that his last name now invokes shrugs, grunts and eye-rolling from the marketplace lending community. Marketplace lending platforms, funding banks and investors have been engaged over the past month and a half in an analysis of a new and potentially troubling court case coming out of the debt collection world. The case, Madden v. Midland Funding, LLC, has potentially far reaching consequences for the marketplace lending consumer model.
Madden v. Midland Funding, LLC
In 2005, New York resident Saliha Madden opened a credit card account with a national bank, Bank of America. One year later, the credit card program was consolidated into another national bank, FIA Card Services. In 2008, FIA sold Madden’s $5,000 debt on the account to Midland Funding, LLC, a debt purchaser. Affiliate Midland Credit Management handled collection efforts and sent Madden a letter in November 2010 seeking to collect payment on her debt and stating that an interest rate of 27 percent per year applied.
Madden (with the help of some crafty lawyers of course) filed a putative class action suit against the defendants, alleging they had engaged in abusive and unfair debt collection practices in violation of the Fair Debt Collection Practices Act (FDCPA) and charged a usurious rate of interest in violation of New York state law, which prohibits interest rates in excess of 25 percent per year.
The defendants responded with a motion for summary judgment, arguing that as an assignee of a national bank, the plaintiff’s claims against them were preempted by the National Bank Act (NBA), which permits banks to charge interest at the rate of the state where it is located and provides the exclusive cause of action for usury claims against national banks. Delaware—where FIA is incorporated—permits banks to charge interest above 25 percent, so the defendants’ rate was legal, they told the court.
Madden lost in the district court citing that the NBA would preempt any state law usury claims. A panel of the influential Second Circuit Court of Appeals, the federal appeals court below the U.S. Supreme Court that determines cases arising from New York, Connecticut and Vermont, then reversed.
“Because neither defendant is a national bank nor a subsidiary or agent of a national bank, or is otherwise acting on behalf of a national bank, and because application of the state law on which Madden’s claim relies would not significantly interfere with any national bank’s ability to exercise its powers under the NBA, we reverse the District Court’s holding that the NBA preempts Madden’s claims,” the court wrote. Although the U.S. Supreme Court has “suggested” that NBA preemption may extend to entities beyond a national bank itself—holding that operating subsidiaries and agents of national banks can benefit from NBA preemption—the Office of the Comptroller of the Currency has made clear that third-party debt buyers are distinct from agents or subsidiaries of a national bank, the court said.
“In most cases in which NBA preemption has been applied to a non-national bank entity, the entity has exercised the powers of a national bank—i.e., has acted on behalf of a national bank in carrying out the national bank’s business,” the panel wrote. “This is not the case here. The defendants did not act on behalf of [Bank of America] or FIA in attempting to collect on Madden’s debt. The defendants acted solely on their own behalves, as the owners of the debt.” Extension of NBA preemption to third-party debt buyers such as the defendants would be an “overly broad” application of the statute, the court added.
“Although national banks’ agents and subsidiaries exercise national banks’ powers and receive protection under the NBA when doing so, extending those protections to third parties would create an end-run around usury laws for non-national bank entities that are not acting on behalf of a national bank,” the panel said.
Applicability to Marketplace Lenders
Similar to debt buyers in other contexts, including collections similar to Midland’s practice, marketplace lending platforms to consumers generally use a funding bank to originate loans, then repurchase them and service them or use a third party servicing firm. If Madden stands for the principal that a loan purchaser cannot charge the same rate the funding bank can charge, the industry will likely have to undergo some structural changes in either how loans are funded, the rate charged borrowers or the amount of post-sale involvement a bank must retain. On the other hand, there are several points of difference between what marketplace lending platforms do and the facts in Madden. These include:
Because the case arose in the collections context, the process of a marketplace lending platform originating a loan and sending it to the bank to fund and sell back has not been properly considered by a court. One could argue that the facts and circumstances of a credit card account which gets sent to different servicing companies is different than a borrower who approaches a platform and that platform continues to service the loan until maturity.
The plaintiff in Madden could claim that she was surprised to learn that someone has purchased the account and was unaware such a practice was possible, whereas marketplace lenders are the originators in most cases and a platform purchasing a loan from a bank does not change the character of the original arrangement. Borrowers know before they sign the promissory note that the platform will be servicing the loan and expect to deal with the platform, not the bank.
Marketplace loans are generally amortizing three and five year loans, making it tougher to recruit a plaintiff, whereas there are no shortage of credit card accounts that last for decades with no reduction in balance.
The case challenges the authority of a non-bank to charge the interest a bank is entitled to charge under the NBA. Marketplace lenders operate under state banking authority and laws, not the NBA, thus making Madden harder to apply to marketplace lending since the same law is not at issue.
Next Steps and Strategy
Marketplace lending platforms are watching this case carefully to see if it is overturned or modified on appeal. Midland has appealed to have the case reheard en banc, meaning the entire Second Circuit would decide the case anew, not just the three judge panel. This process could take several months and there can be no assurances of a different outcome. Major legal heavyweights have weighed in and filed briefs in support of Midland because of the important precedent and change in application of the current law that would result if the case was allowed to stand. If unsuccessful, Midland could appeal to the U.S. Supreme Court, but again the ability to have the case heard and the ultimate outcome of the case is unclear. Moreover, the case would likely be heard in the Fall 2016 or 2017 term, resulting in a significant delay.
A collection agency, marketplace lender or other buyer of loans from banks can bring an action for declaratory relief in another court outside the Second Circuit hoping to get assurances from that court and possibly set up a split among the circuits. This is risky, however, since the court may agree with Madden or at least be unwilling to ignore the now persuasive authority of the Second Circuit’s decision. A litigant in such a case would find itself worse off than if it had done nothing. Conversely, plaintiffs’ lawyer might be emboldened by the Madden decision and begin to look for more fee generating opportunities by bringing similar cases in other jurisdictions (eg, spread the Madden doctrine nationally).
Regardless of the ultimate outcome in Madden, platforms needs to prepare now to overcome the worst case scenario for them- that Madden is affirmed and applied nationally. Here are ways to do that:
Banks can engage in risk retention whereby a percentage of the loans that are sold will stay on bank balance sheets;
Banks can wait until the case is applied to state banking laws, not just the NBA; each bank is governed by the laws of only their chartering state; states will be loath to have their banks’ powers curtailed in this manner since it will mean more risk on the balance sheet of the banks and create a greater public threat of future bailouts;
Banks can retain the loans on their balance sheets and sell participation interests in the loans to the platforms;
Platforms can curtail lending in the Second Circuit states;
Platforms can curtail their interest charges to the local usury limit in Second Circuit states; and
Platforms can apply for banking licenses in the states that prove to cause the most trouble and ask for exceptions from bank regulators to allow them to exceed the usury caps.
One thing is for sure- it will be a very interesting Fall season following this case and what follows.
To read the opinion in Madden v. Midland Funding, LLC, click here.
Peter Renton is the chairman and co-founder of LendIt Fintech, the world’s first and largest digital media and events company focused on fintech. Peter has been writing about fintech since 2010 and he is the author and creator of the Fintech One-on-One Podcast, the first and longest-running fintech interview series. Peter has been interviewed by the Wall Street Journal, Bloomberg, The New York Times, CNBC, CNN, Fortune, NPR, Fox Business News, the Financial Times, and dozens of other publications.