Marketplace lenders and investors that purchase interests in loans originated by banks should pay close attention as it could spawn a host of class action lawsuits if left standing.

In a controversial opinion decided on May 22, the U.S. Court of Appeals for the Second Circuit (the Court) held that the National Bank Act does not preempt the application of state usury laws to third-party, non-bank assignees, in this case a debt buyer. The Court’s decision in Madden v. Midland Funding, LLC, No. 14-2131-cv, 2015 WL 2435657 (2d Cir. May 22, 2015) — which is inconsistent with long-standing circuit court precedent if allowed to stand — will complicate interest rate exportation authority for any non-bank party that purchases loans from a bank, including those involved in peer-to-peer or marketplace lending platforms. Third-party, non-bank entities risk losing the exportation advantage that a Federal Deposit Insurance Corporation (FDIC)-insured bank has and may be subject to substantial penalties, including voiding of loans, for violating a borrower’s state usury laws.

Madden v. Midland Funding, LLC

In Madden, the plaintiff brought a putative class action against two non-bank defendants for violations of the Fair Debt Collection Practices Act and New York usury law. The plaintiff, a New York resident, opened a credit card account with Bank of America in 2005. The account was subsequently consolidated with the accounts of FIA Card Services, N.A. (FIA), a national bank headquartered in Delaware. Delaware does not have an interest rate cap for banks, so, under the National Bank Act (NBA), 12 U.S.C. § 85, FIA could collect interest at the rate set forth in the terms and conditions provided to the plaintiff, notwithstanding the usury limits in New York. The plaintiff owed a large balance on the credit card account, which was deemed uncollectable, so FIA sold it to the defendants, Midland Funding, LLC and Midland Credit Management, Inc. (collectively, Midland), which are non-bank debt purchasers. In 2010, Midland sent a letter to the plaintiff seeking collection of the debt owed by the plaintiff, which carried an interest rate of 27 percent per year. This interest rate exceeds the 25 percent per year criminal usury rate in New York.

The U.S. District Court for the Southern District of New York held that the plaintiff’s claims were preempted by the NBA, denied class certification and granted summary judgment in favor of the defendants. On appeal, the Court held that the NBA does not preempt state usury laws when loans are assigned to non-bank assignees. Although the Court correctly noted that section 85 of the NBA preempts state law limitations on interest rates, it found that such preemption does not apply when a third-party, non-bank assignee acts on its own behalf (as opposed to on behalf of the originating bank) in assessing interest after the account has been sold to it by the national bank.

The Court distinguished two contrary Eighth Circuit cases, which essentially reflect black letter law that a loan that is valid at inception retains that distinction when assigned to a third party, whether a bank or non-bank. In Krispin v. May Department Stores Co., 218 F.3d 919 (8th Cir. 2000), the Eighth Circuit held that the NBA preempted usury claims against a defendant that purchased accounts from a national bank and emphasized that a court should look to the originating entity and not the third-party assignee when determining whether the loan is valid based on the preemption available to the originating bank. The Court distinguished Krispin by explaining that, in Krispin, the national bank maintained a substantial interest in the accounts to warrant the application of preemption under the NBA.

In Phipps v. FDIC, 417 F.3d 1006 (8th Cir. 2005), where the plaintiffs brought an action against a non-bank entity for charging allegedly unlawful fees relating to mortgage loans, the Eighth Circuit held that the court should look to the originating bank to determine whether the NBA applies. The Court distinguished Phipps and explained that, in Phipps, the national bank charged the allegedly unlawful interest rate while, in Madden, the interest rate was charged after the loan was transferred to the defendants. In overturning the district court’s decision in Madden, the Court explained that, since Midland is neither “a national bank nor a subsidiary or agent of a national bank, or . . . otherwise acting on behalf of a national bank, and because application of the state law on which [the plaintiff’s] claims rely would not significantly interfere with any national bank’s ability to exercise its powers under the NBA,” the NBA did not act to preempt the plaintiff’s claims.

The Court did not take up Midland’s other argument that the Delaware choice of law in the credit agreement should be applicable to validate the loan. That issue was left to the district court to decide on remand.

The defendants have filed a petition for a rehearing en banc in the Second Circuit.

Pepper Points

• Unless reversed by the Court in an en banc review or by the U.S. Supreme Court, Madden creates a disturbing precedent with respect to whether non-bank assignees can enforce national or state banks’ rights under loan agreements and may create a catastrophe, as the rehearing petition notes, in the secondary lending markets, including securitizations, where loans are sold into a trust or other entity to be held for the benefit of investors who purchase beneficial interests in the pool of loans.
• Madden stands contrary to a long line of cases that establish the “valid at inception” doctrine, which says that the loan retains the same legality it had when originated by a national or state-chartered bank, even when the loan is assigned to a non-bank party. See FDIC v. Lattimore Land Corp., 656 F.2d 139 (5th Cir. 1981). The FDIC, which relies on the power that the originating bank had when it made the loan, will be in a difficult position as a receiver if it cannot rely on this doctrine in the future.
• Marketplace lenders and investors that purchase interests in loans originated by banks should pay close attention to this case since, if left standing, it could spawn a host of class action lawsuits challenging the rights of holders of such loans to collect interest at the rates made by the originating bank.