(Article from Registered Funds Alert, September 2015)
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The Second Circuit’s June 2015 decision in Madden v. Midland Funding, LLC, potentially complicates purchasing loans originated by national banks. Interpreting the National Bank Act (“NBA”), the court held that an assignee of a loan originated by a national bank could not rely on federal NBA preemption to avoid liability under state usury laws if the assignee was not itself a national bank. If interpreted broadly, the Madden decision could affect a wide array of bank-originated loans that are subsequently sold to non-bank investors (such as funds and business development companies).
Federal law permits national banks to “take, receive, reserve, and charge” interest at the rate allowed by the state where the bank is located.[1] It also provides the exclusive cause of action for usury claims against national banks, and therefore completely preempts analogous state-law usury claims.
In Madden, a New York resident plaintiff opened a credit card account with a national bank. Subsequently, the national bank amended the credit card agreement to permit the bank to charge an interest rate that, while permissible under the law of the bank’s home state of Delaware, exceeded the limit set by New York law. After the plaintiff defaulted, the national bank charged off plaintiff’s $5,000 remaining balance as a bad debt and sold the account to the defendant Midland, which is not a national bank. Midland subsequently sent a letter to the plaintiff seeking to collect on her debt and applying the interest rate that exceeded the New York limit.
The plaintiff filed a putative class action alleging that Midland had violated the federal Fair Debt Collection Practices Act and New York law by charging a usurious interest rate. Midland responded that the NBA preempted the plaintiff’s claim because a national bank had originated the debt. The district court initially decided in favor of Midland but, on appeal, the Second Circuit reversed.
The Second Circuit recognized that while the Supreme Court has held that NBA preemption may extend to operating subsidiaries and agents of national banks when those entities effectively exercise the powers of the national bank, that authority does not extend to Midland as an unrelated entity that merely purchased the debt. Thus, although NBA preemption applies to claims arising out of alleged violations of state usury laws, Midland was not entitled to rely upon NBA preemption because it was not a national bank. In vacating the district court judgment for Midland, the Second Circuit reasoned that applying NBA preemption to encompass Midland under the circumstances presented “would create an end-run around usury laws for non-national bank entities that are not acting on behalf of a national bank.”
In the weeks since the decision, commentators have criticized the economic conclusions the Second Circuit relied upon in its opinion. In particular, the opinion noted that the application of state usury laws to third-party assignees of bank-originated loans would not prevent or “significantly interfere” with the exercise of national bank powers, which the court noted includes the power to sell debt for a fee. To the contrary, critics argue that if for any reason non-national bank purchasers are unable to enforce the terms of a loan according to the pre-sale terms between the bank and borrower, there could be a chilling effect on the bank-originated debt market. Further, the viability of related activities such as certain types of securitizations and originate-to-sell business models may have to be reevaluated entirely. The potential for the application of criminal usury statutes from states such as New York and Florida will also increase the price of the transactions as buyers begin to factor greater legal risks into their pricing models.
While state usury laws do not apply to all loans—for example, New York usury laws only apply to loans of less than $2.5 million—as the industry awaits further guidance from the courts and regulators, investors purchasing debt, such as bank loan funds, can take certain steps to minimize their exposure. To begin, it may be beneficial to review existing and pending loan purchase agreements for potential violations of usury laws in states where borrowers reside, starting with the Second Circuit states (New York, Connecticut, and Vermont). Further, a preference for transactions where the originating bank retains some aspect of ownership or other continuing interest in loans sold may also avoid many of the complications potentially introduced by the Madden decision.
[1] See 12 U.S.C. § 85.