The Madden Cloud is Lifting

Financial Industry Alert | September.23.2020

In 2015, the Second Circuit’s decision in Madden v. Midland Funding, LLC, raised doubts about whether banks could transfer, sell, or assign their interests in consumer debt without triggering the enforcement of state usury laws. Recent OCC and FDIC regulations have sought to eliminate that uncertainty. 

In Peterson v. Chase Card Funding, a federal district court in New York has now rejected a class action based on Madden. The federal district court limited Madden to its particular context and held that the substantial ongoing relationship of the bank in Peterson with the credit card account in question preempted the application of state usury law to the account’s transferred debt, even after the debt was sold.  The court further held that the application of state usury laws to the sold debt would interfere with the business of banking—as the OCC explained in enacting its new regulation, even if the ongoing relationship was not “substantial.” This ruling, if upheld on appeal, would significantly reduce concerns that arose from the Madden decision.   

Brief Background

Loans made by national and state-chartered, federally-insured banks are not subject to certain state-law usury limits thanks to federal preemption. The continued preemption of state usury laws after sale or assignment of a loan to a non-bank is rooted in the statutorily protected authority of banks to sell loans without significant interference from state law, as well as the long-standing principle that a loan that is valid when made does not become usurious through sale or assignment.  The Second Circuit’s decision in Madden v. Midland Funding, LLC, however, suggested that, at least in some circumstances, state usury limits apply once a bank sells or assigns its loans to a non-bank.

The Credit Card Securitization Cases – Peterson v. Chase Card Funding and Cohen v. Capital One Funding      

Relying on Madden, plaintiffs have filed two putative class actions in the context of securitization of credit card receivables.  Peterson v. Chase Card Funding, LLC, was filed in the Western District of New York and Cohen v. Capital One Funding, was filed in the Eastern District of New York. In each case, the actions were filed against the non-bank depositor and the securitization trusts (along with their trustees) that bought and securitized receivables from credit card accounts originated by the named bank.  Both complaints, citing Madden, assert that federal law does not preempt the application of state usury law to credit card receivables once they are sold to non-bank entities.  The complaints construe Madden to establish “that national banks could not sell or assign their ability to charge otherwise usurious interest rates to non-national bank third parties.” 

Motions to dismiss were filed in both cases.  The magistrate judge hearing the Peterson motion to dismiss recommended dismissal. After de novo review of the magistrate judge’s report and recommendation, the district court adopted that recommendation and granted the defendants’ motion to dismiss.

The district court’s ruling was premised on alternative bases—express preemption under Madden or implied preemption under the OCC’s recent rule: “Permissible Interest on Loans that Are Sold, Assigned, or Otherwise Transferred.”

First, the court noted that Madden precluded express preemption only where the bank no longer had any interest in accounts that it “sold … outright to a new, unrelated owner, divesting itself completely of any continuing interest in them.” The originating bank in Peterson, J.P. Morgan Chase Bank (“JPMCB”) sold only its interest in the receivables related to its loans but continued to own the accounts, a “critical distinction” that preserved its right to change such terms and conditions as the periodic interest charges and automatically to re-purchase the receivables in the event of default on the account. “[B]ecause a national bank (JPMCB) sets the interest rate on Peterson’s account, it may do so at the ‘interest … rate allowed by the laws of the States, Territory, or District where the bank is located,’ 12 U.S.C. § 85, and is not subject to the usury laws of other states.” Thus, the district court reasoned, by “the Second Circuit’s reasoning in Madden,” the National Bank Act expressly preempts application of New York’s usury laws to Peterson’s accounts with JPMCB.

In the alternative, the application of New York’s usury law to Peterson’s account was impliedly preempted because it would “significantly interfere” with JPMCB’s power to transfer, sell, or assign the loan at its established interest term. Those powers allow banks to reduce risk exposure by “access[ing] alternative funding sources, manag[ing] concentrations, [and] improv[ing] financial performance.” The district court emphasized that as long as the loan “remained in at least some legal sense with” JPMCB—even if its interest did not rise to the “substantial interest” that triggers express preemption—enforcing New York’s usury laws would interfere with the bank’s ability to manage risk effectively, “undermin[ing] the [National Bank Act’s] goals of uniformity and risk management.”

The district court’s order dismissing the complaint is significant for acknowledging the limitations of Madden. In distinguishing Madden, it concluded that any bank that maintained some connection to the loan or the debtor’s account could rely at least on implied preemption because of the importance of flexible securitization arrangements to banks’ risk management. By this reasoning, arrangements such as trailing fees and servicing agreements bring such transfers within a safe harbor. Moreover, where the bank retains a “substantial interest,” it was found to be entitled to express preemption. How substantial an interest must be is not spelled out by the court, but there appears to be good arguments that preemption should apply as long as the interest retained, or relationship to the debtor’s account, is not de minimis or insubstantial. In any event, the court’s conclusions provide banks with multiple layers of legal arguments to defend their reasonable risk management practices against application of state usury laws.

The Cohen v. Capital One Funding case has remained on hold awaiting the outcome of Peterson.  We anticipate a consistent resolution of the motion to dismiss in that case in the near future.