Why Congress Needs to Act Now to Fix the “Madden Issue”

[Editor’s Note: This is a guest post from Scott Stewart, CEO of the Innovative Lending Platform Association. ]

Courts are distorting credit markets in a way that hurts Main Street small businesses, and Congress now has an opportunity to fix it.

Imagine you opened a salon two years ago with a chair for both you and your business partner.  Over the years, you built a small clientele and grew steady revenues.  Your business is profitable, and you want to add two more chairs to your shop.  You estimate that the expansion will cost $20,000 but will yield $40,000 annually in new revenue.

Together, you discuss taking out a small business loan with both large and small banks, but they turn you down citing your 640 personal credit score and the lack of two years of business tax returns as the reason for the decline.  So, you reach out to online lenders in the hopes of securing the capital you need to expand and grow your business.

After reviewing your application, an online lender offers your business a $20,000 loan that can be funded in a day and paid back in weekly installments over a six-month period.  The APR seems high – it’s about 40% – but the total cost of capital is only $2,115.  That means you’ll pay $2,115 to borrow $20,000 to fuel your expansion, and that expansion is expected to yield a $40,000 return on your investment.  You and your partner decide to seize the opportunity.

Unfortunately, a recent decision by the Second Circuit Court of Appeals in Madden vs. Midland Funding, is making it difficult for online lenders to offer businesses the funds they need to grow and succeed.  The Madden decision undermined the legal doctrine known as “valid when made,” which has been a cornerstone of banking law for over 100 years.  The principle is simple.  If a loan is legal with respect to its interest rate, then it does not become invalid or unenforceable when sold to another party.  Numerous bi-partisan and non-partisan groups have come out in opposition to the Madden decision, in part because of the dangerous uncertainty it has inserted into the financial markets that are critical to supplying credit to individuals and small businesses.

When states impose interest rate caps that effectively prevent banks from partnering with FinTechs, lending to non-prime borrowers dries up.  Banks depend on liquidity – the ability to sell and assign loans on the secondary market – but the Madden decision injected uncertainty into secondary markets.  After Madden, potential purchasers of loans and interests in loan securitizations face the risk that a loan that was valid at origination may be ruled invalid after sale or assignment.  Without certainty and liquidity, loans will not be resold and banks will be forced to reduce the amount (and variety) of credit they extend, and the price of credit that is extended will be increased to account for the uncertainty.)  In other words, it will become more difficult for American small businesses to get the capital they need to grow.

By introducing uncertainty into the secondary markets, the court’s decision is having a pronounced effect on the availability of credit to underserved small businesses.  In the months following the decision, credit for non-prime borrowers dried up in the affected states.  In fact, a joint study by professors from Columbia, Fordham and Stanford Law schools found that “after Madden, loans to borrowers with FICO® scores below 644 virtually disappeared.”

So, that means no expansion for your salon or other small business.

Rather than protecting small business borrowers with lower credit scores, the Madden decision is choking off their access to capital.  These small business owners deserve an opportunity to build the American Dream for themselves, their families, their employees and communities.  Why should a court rob them of their chance to succeed?

That brings us to the potential solution currently before Congress.

A bipartisan group in Congress led by Senators Toomey and Warner and Representatives McHenry and Meeks introduced a simple legislative fix to the problems created by the Madden decision.  Their bill, Protecting Consumers’ Access to Credit Act of 2017, codifies the “valid when made” doctrine.  While the “fix” itself is narrow and technical in nature, its potential impact on American consumers and small businesses is significant.  This bill would provide greater certainty and liquidity in commercial credit markets, close troubling gaps in access to credit, and allow the markets to fairly price risk profiles.  Most importantly, it would give our salon owners and hundreds of thousands of small businesses the chance to invest in their own abilities and grow their business.

And, not only would the bill expand access to credit, it would do so in a manner that complies with key consumer protections.  Partnerships between banking industry and FinTechs facilitate well-regulated lending in underserved communities.  The loans that are being sold and purchased on the secondary market are well-regulated at the point of origination, and this bill doesn’t change anything about the terms of the original loan.  Furthermore, nothing in the bill precludes the CFPB or any other regulator from enforcing consumer protection laws.  In fact, loans provided through bank-FinTech partnerships are subject to key federal lending laws, including fair lending, anti-discrimination and fair treatment of customers, laws governing the use of credit reports, economic sanctions requirements, guidance and rent and bank arrangements, and fair trade practices.

We urge Congress to swiftly pass this bill so that small business capital providers can get back to serving Main Street small businesses who need access to capital the most.