[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.]
As the Marketplace Lending (MPL) industry gears up for the upcoming conference trifecta – ABS Vegas, AltFi Europe and LendIt USA 2016, the effect of the Midland Funding, LLC et al. v. Saliha Madden case and its pending appeal before the U.S. Supreme Court is palpable. LendingClub, the largest MPL platform, recently announced a retooling of its Webbank relationship in an attempt to build a stronger case that their model differs strongly from the facts in Madden. But a funny thing has happened on the way to the Supreme Court . . .
Here’s a quick rewind in case you have not been following the case: Ms. Madden had defaulted on her bank credit card account and the account was sold to Midland Funding, a non-bank collection firm. Midland continued to charge the rate that had been charged by the national bank. Madden brought an action in federal court challenging the ability of Midland to charge the same rate that the bank had charged, which was higher than the legal rate otherwise allowed to be charged under the laws of her state (New York), even though Midland was not a bank. The U.S. District Court sided with Midland. Upon appeal to the U.S. Court of Appeals for the Second Circuit, the Court panel reversed by a 3-0 margin. A process to reverse the appeals court by the other Second Circuit judges, called an en banc review, was unsuccessful. Midland has now appealed the matter to the U.S. Supreme Court.
The case is not about marketplace lending. It is a credit card collection matter. But the essential facts of permitting a non-bank loan purchaser to charge that same rate of interest as the loan’s originator—what lawyers often refer to as the “200-year-old Cardinal Rule”—is being tested. MPL platforms in the consumer space and to some degree in other verticals leverage legal and regulatory compliance by using a bank partnership model under which a loan is typically purchased by an MPL platform soon after it is originated by the bank.
But MPL platforms and investors have an unlikely ally in their struggle to work through and distance themselves from the Madden case—Madden’s attorneys. In the original petition to the Court, Midland defined the issue as:
Whether the National Bank Act, which preempts state usury laws regulating the interest a national bank may charge on a loan, continues to have preemptive effect after the national bank has sold or otherwise assigned the loan to another entity.
In its brief, Midland’s attorneys, and several other amici curiae briefs filed in their support, make the argument that the case calls into question any loan sold from a bank to a non-bank. MPL platforms and the securitization market should be very afraid, they would have you believe.
However, in Madden’s brief in opposition, her attorneys define the question presented to the Court much more narrowly:
Whether the National Bank Act permits a debt collector—which is neither a national bank nor affiliated with a national bank—to charge interest that is criminally usurious under New York law on defaulted consumer debt that the debt collector purchased from a national bank.
In its brief, Madden’s attorneys refute the impact on MPL platforms head-on:
Amici argue the decision below is “working mischief on the national credit and securitization markets,” but offer scant support for their claims. Instead, amici rely almost exclusively on out-of-context statements drawn from Internet commentary about “marketplace lending,” which is a new and narrow segment of the lending industry that has nothing to do with this case. Wholly distinct from traditional financial institutions, marketplace lenders operate virtually unregulated Internet platforms that enable private investors to lend to private borrowers, often at usurious rates.
Nothing to do with this case? I don’t understand. Why all the hype, fear and loathing over Madden these past nine months?
Well, obviously it’s not that simple. In their desire to defend their positions, both sides will vigorously argue that the case has either far-reaching or very narrow impact on American life, depending on what side they are on. But the proclamation of Madden to the highest court in the land that the case has nothing to do with marketplace lending is a breath of fresh air.
Here are some other reasons why I believe the only thing we have to fear regarding Madden is, well, fear itself:
Although not binding precedent, I believe many judges would find the argument that expressly removes MPL platforms from Madden made by Madden’s attorneys to be highly compelling.
Both sides stipulate (that’s a fancy legal term for “agree”) that the case turns on an interpretation of the National Bank Act. It is an important detail that no MPL platform partners with a national bank. Therefore the National Bank Act and court interpretations of the National Bank Act are not binding on MPL platforms. The vast majority of, if not all, lending partnerships are under state-chartered banks. Madden does nothing to disrupt the state model. In fact, each state supreme court is the final arbiter of interpretations of state law. Rate exportation and the ability to lend in other states are partially derived from the Federal Deposit Insurance Act, so the federal government does have a hand in here, but not under the National Bank Act. Therefore, Madden does not apply to MPL platforms.
If Madden is applicable only by factual analogy, there is little risk that a legal challenge could be mounted against MPL platforms using Madden without invoking state lending law, the Federal Deposit Insurance Act and other state full faith and credit parity principles.
While Madden is current law in the Second Circuit (New York, Connecticut and Vermont), MPL platforms can migrate to an even safer regulatory plateau by differentiating their facts from those in the case. The Second Circuit cited with great importance the fact that, in the collection context, the selling banks had nothing further to do with the loan following the sale. By involving the bank in other aspects of the process, including skin-in-the-game investments and appointment as master servicer, banks solidify their nexus to the loan. This is what LendingClub is attempting to do with its recent announcement. Whether variable compensation to the bank is enough of a nexus between borrower and lender remains to be seen. Ironically, by keeping the bank at risk for longer periods and in different ways, the bank safety and soundness regulators might become more concerned.
What about SCOTUS? I am now skeptical the Court will take the case, despite its request that Madden file a brief in opposition (which typically indicates serious consideration). Four justices are required to vote to hear the case and a majority is required to overturn the Second Circuit. The recent death of Justice Antonin Scalia might have altered the course of the case. Justice Scalia might have been the fourth vote to hear the case and fifth vote to overturn. Without five “conservative” justices, it might be difficult to overturn, especially since Midland’s case essentially boils down to the Cardinal Rule and market disruption, not typical Supreme Court issues of circuit splits, individual constitutional rights and legislative abuse of discretion. If the Court votes to hear the case and splits 4-4 (assuming no recusals), the Second Circuit’s decision will control.