Federal Court Sends Colorado's Case Against Online Lending Platform Back to State Court
On May 22, 2015, the U.S. Court of Appeals for the Second Circuit held in Madden v. Midland Funding that the federal preemption provision of the National Bank Act, 12 U.S.C. § 85, could not be invoked by a non-national bank assignee. Consequently, even though the debt in that case was procured from a national bank, the interest rate the non-bank assignee could charge was subject to state usury law scrutiny.
The Court’s decision was informed by the policies underlying the National Bank Act. The Act was designed to create uniform rules that limit the liability of national banks and prescribe exclusive remedies for their overcharges so as to protect them from unfriendly state legislation. The Court explained that these purposes are not served in the case of a non-national bank assignee because invocation of state usury laws in that context would not interfere with the business of national banks. The Court further explained that the national bank would still be able to sell the debt—it’s just that the debt’s exposure to state usury law could affect its market price.
We expect that Midland Funding will file a certiorari petition in the United States Supreme Court on November 10. When filed, we will send a follow up. For now, there are three quick points worth highlighting:
With anticipated extensions, the earliest we may find out if the Court is going to take the case would be February 22, 2016. If the Court does take the case, it would not be heard until October 2016, with a ruling no earlier than January 2017 and perhaps as late as June 2017.
There is also the possibility that before deciding to grant the writ of certiorari, the Court may ask to Solicitor General of the United Sates for the views of the Executive Branch on whether the Court should take the case. If the Court does make such a request, that could slow down the process at least another three to four months. So, even under the likely best case scenarios, we are stuck with the Madden ruling for a good while.
Of course, the likelihood of a cert. grant at all is always pretty low. Here, the Court could deny the petition because it wants to wait for additional courts of appeals to weigh in. Moreover, there are a number of potentially dispositive state law issues that remain in the Madden case. In such circumstances, the Justices often prefer to let the case to play out in the lower courts so they can see if the federal issue really was that important.
Some have argued that the court of appeals’ ruling somehow rejected the common law principle that the validity and lawfulness of a loan’s interest rate is to be judged at the time of issuance, and not later. The court of appeals, however, left the valid-when-made doctrine untouched. All the court of appeals held in Madden was that the interest rate was not protected by the National Bank Act from state law scrutiny. It did not answer the question of whether the Delaware interest rate, which was valid when issued, would still be respected under New York law. There is good reason to think it would be.
As the Supreme Court observed as far back as 1833, “the rule of law is every where acknowledged, that a contract, free from usury in its inception, shall not be invalidated by any subsequent usurious transactions upon it.” Nichols v. Fearson, 32 U.S. (7 Pet.) 103, 106 (1833). Notably, the relevant precedents today show that New York, like other states, still embraces the valid-when-made doctrine. See Eikenberry v. Adirondack Spring Water Co., Inc., 65 N.Y.2d 125 (1985). Therefore, it is very possible that the marketplace is overreacting to Madden. The interest rates on the loans issued by a national bank may not have the direct protection of the National Bank Act once sold to a non-bank entity, but state law, nonetheless, may respect the issuing rate in any event under the valid-when-made doctrine.
The other issue left brewing is the impact of a choice of law provision. In Madden, the parties agreed that Delaware law would control the terms of the loan agreement. It is very possible that a court applying New York law may respect that choice, as long as there was a bona fide nexus to Delaware. And in the Madden case it appears unlikely that there is any significant conflict between New York law and Delaware law that would warrant rejection of the choice of law. Notably, Madden only deals with the rates charged for the period after default and Madden has herself conceded that New York’s “civil usury rate of 16% has been held not to apply where only charged after default.” Mem. ISO Certification at 4. See also Kraus v. Mendelsohn, 97 A.D.3d 641, 641, 948 N.Y.S.2d 119, 120 (2d Dep’t 2012). Thus, application of the Delaware rate in that case (through a choice of law provision, or otherwise) is unlikely to be deemed contrary to public policy.
These important, and potentially dispositive, state law issues are teed up to be resolved by the district court on remand in Madden. But no action on those issues is expected until after the request for Supreme Court review runs its full course. And as detailed above, that could take until at least February 2016, and if the Court grants review, or asks for the views of the United States, much longer.
Clients may want to evaluate whether state law precedent in the relevant jurisdictions is sufficiently strong in regard to the valid-when-made doctrine, and/or choice of law, to mitigate the risks and uncertainties raised by the Madden ruling.
Finally, it is worth noting that Madden dealt with distressed, indeed defaulted, debt. In that context, the Court felt comfortable refusing to let the purchaser step into the bank’s shoes for the purposes of federal preemption based on speculation that there would not be a major market impact on the power and business of the national banks. In the minds of the appellate judges in Madden, the debt value was already marked down and a possible decrease in the stated interest rate was not likely to have a material impact, if any, on the value of defaulted debt.
It is possible that an argument could be successfully mounted that Madden’s reasoning should not extend to the sale of fully performing debt. A strong common sense and factual case could be built on the negative impacts on the national banks that flow from denying the purchaser of performing debt the benefit of the federal preemption offered by the National Bank Act. Notably, for a performing loan, the result of a rate being found to be usurious is not necessarily simply ratcheting down the rate of the loan. Rather, it can lead to a performing loan being deemed void. See N.Y. General Obligations Law § 5-511 (any loan under which there “shall be reserved or taken, or secured or agreed to be reserved or taken” something greater than permitted by the civil usury cap of 16% interest “shall be void”). That would, of course, be expected to have far greater market impact than the slightly lower sale price the Madden expected for the defaulted debt.
Certainly, if the Supreme Court refuses to hear Madden, a test case seeking to marginalize the impact of the Second Circuit’s ruling, as limited to distressed or defaulted debt, is worth contemplating.