On June 27, 2016, the US Supreme Court (Supreme Court) declined to review the Second Circuit’s controversial decision in Madden v. Midland Funding, LLC. As a result, the appellate court’s ruling regarding the applicability of state law usury limits to non-bank debt purchasers will remain the law of the land in the Second Circuit.1 After briefly discussing the background of the case, this client alert will discuss: (1) the important choice of law issues that remain unresolved in the case; (2) the uncertain scope and precedential effect of Madden, both within the Second Circuit and outside of it; and (3) how Madden will affect originating banks and secondary market debt purchasers going forward.
Saliha Madden, a New York resident, opened a credit card account with Bank of America (BoA). Her account was later transferred to FIA Card Services, N.A. (FIA). After the transfer to FIA, the account’s terms and conditions were amended upon the receipt by Madden of a document titled “Change in Terms,” which contained a Delaware choice-of-law clause. In 2008, her account was charged-off by FIA and sold to Midland Funding, LLC (Midland Funding), a non-bank entity. After the sale to Midland Funding, neither FIA nor BoA had any further interest in the account. Midland Credit2 sent a letter to Madden attempting to collect payment of her debt and stating an annual interest rate of 27 percent (which exceeded various New York usury limits) applied. Madden filed a class-action lawsuit in the Southern District of New York alleging violation of New York state usury law and the Fair Debt Collection Practices Act. The suit objected to the interest charges that accrued after the account had been transferred to Midland—not to those that were accrued and charged by FIA prior to the assignment.
Midland argued that, as an assignee of a loan originated by a national bank, the assignee was entitled to the preemption of the National Bank Act (NBA) over the New York law usury limits. Section 85 of the NBA provides that a national bank may charge interest at the rate allowed by the state where it is located. Midland also argued that since the Change in Terms provided that Delaware law applied to the agreement with FIA, defendants were permitted to charge a higher rate. The district court granted defendants’ summary judgment motion on the basis of their preemption argument, but without issuing any findings on their Delaware choice of law argument.
The Second Circuit reversed the district court’s findings of NBA preemption. It gave two reasons for doing so. First, neither Midland Funding nor Midland Credit was a national bank, nor were they subsidiaries or agents of, or acting for the benefit of, such a bank. Second, the application of the New York state law on usury to Midland Funding and Midland Credit did not “significantly interfere” with a national bank’s ability to exercise its powers under the NBA. The court did not discuss whether Delaware or New York usury law should apply. That issue was remanded to the district court.
Defendants then filed a petition for a writ of certiorari with the Supreme Court, which has now been denied.
Choice of Law Issues
Even after denial of the writ of certiorari by the Supreme Court, important choice of law issues remain unresolved and will now need to be litigated at the district court level. Midland argued in the courts below that, even if Madden’s claims were not preempted by the NBA, her credit card agreement contains a choice of law provision that mandates the application of Delaware law. The Second Circuit did not decide that issue, but instead remanded that question for the district court to consider. If, on remand, the district court decides that Delaware law applies, then the interest rate charged likely would be found to be permissible, notwithstanding the absence of NBA preemption, because Delaware does not impose a usury limit on bank-made loans. This would, however, require the district court to conclude that the New York usury statutes do not represent a fundamental public policy of New York that would require their application notwithstanding the Delaware choice of law provision in the contract. Even if the New York usury laws were applied, Midland still could prevail if the district court decides that New York usury law itself incorporates the valid-when-made principle (as discussed below). However, this assumes that the district court finds that Midland preserved that argument.
The remainder of this alert will assume, for the sake of argument, that the district court finds against defendants—i.e., that the New York usury limits do in fact apply.
The Uncertain Scope of Madden within the Second Circuit
Borrowers located in the Second Circuit (Second Circuit Borrowers) who are in circumstances similar to the Madden plaintiffs will be encouraged to bring cases similar to Madden (i.e., alleging that the related third party debt buyers are charging impermissible interest rates). Any third party debt buyer subject to personal jurisdiction in the Second Circuit could potentially be sued on these grounds. However, given the specific facts of the Madden case and the Second Circuit’s holding, the courts in such cases will likely be required to revisit many of the same issues and Madden may only have limited precedential value.
First, the Madden court merely dealt with whether the NBA preempts state law usury limits on loans held by third-party debt buyers. While the court held that such preemption would not apply, the court did not address the “valid-when-made” doctrine (i.e., the common law principle that the usurious nature of a loan should be judged at inception and not thereafter).3 As such, defendants will continue to be able to rely upon that doctrine and a court will likely be required to reconcile it with the Madden holding in any subsequent case.
In addition, defendants in subsequent cases will likely question the Madden court’s preemption analysis. That analysis was very specific to the NBA and relied on a version of preemption discussed in Barnett Bank of Marion Cnty., N.A. v. Nelson,[4 which provided that in order to apply NBA preemption to an action taken by a non-national bank entity, application of state law to that action must significantly interfere with a national bank’s ability to exercise its powers under the NBA. The Madden holding focused on New York state’s usury limits not “significantly interfering” with a national bank’s ability to exercise its powers generally. The court did not directly address the preemptive effect of Section 85 of the NBA itself, which expressly specifies the interest rates that national banks may charge. Many commentators, including the U.S. Solicitor General, feel that the court’s preemption analysis should have focused on how Section 85 specifically interacts with state usury law limits (particularly when read in conjunction with the ability of national banks to sell loans).5
Furthermore, the Madden holding is limited to the preemptive effect of the NBA on loans originated by national banks —it does not address the preemptive effect of Section 27 of the Federal Deposit Insurance Act (FDIA) upon loans originated by FDIC-insured state banks.6
Plaintiffs may argue by analogy that the same reasoning should apply to third party purchasers of loans originated by state-chartered banks—that is, that a third party debt purchaser should not be able to avail itself of such preemption because it is not itself a state-charted bank. However, as noted above, the Second Circuit’s analysis in Madden was based on a very specific interpretation of preemption under the NBA. It is therefore not settled that third party debt buyers of state-bank originated loans are bound by Madden.
It is also worth noting that Madden involves charged-off, defaulted credit card debt and the ability of an assignee to charge higher interest rates after purchasing such charged-off debt. In any future cases involving performing loans, the defendants may be able to distinguish Madden on the basis that, unlike the ability to sell charged-off debts, limiting national banks ability to sell performing loans would “significantly interfere” with a national bank’s ability to exercise its powers under the NBA.
Madden as Precedent in Other Circuits
Madden also has the potential to be cited as precedent in, and used as the basis for, litigation in other circuits. Of course, defendants are free to question the Second Circuit’s reasoning in Madden, including the lack of consideration of the valid-when-made doctrine and the version of the preemption analysis on which the court relied. Concerned parties would be well advised to consider the treatment of the valid-when-made doctrine in their own circuit and whether there is sufficient precedent to deny a Madden-based challenge.
However, from the perspective of an originator or debt purchaser, this does raise the question of whether there is now a split between the Second Circuit, on the one hand, and the Eighth (and Fifth) Circuit, on the other, and, accordingly, whether such parties should evaluate loans made to borrowers located in such jurisdictions in a different manner. In the U.S. Solicitor General’s amicus brief opposing the writ of certiorari, the Solicitor General argues that there is no such split given the particular facts of each of the most notable cases. The Solicitor General notes that Madden is a case addressing whether federal preemption applies to interest rates charged by an assignee in a situation where the originating national bank entirely terminates its relationship with the borrower. By contrast, the Solicitor General notes that: Phipps v. FDIC, 417 F.3d 1006 (8th Cir. 2005) only addressed whether mortgage-loan fees charged by a national bank (as opposed to an assignee) was interest not subject to preemption; Krispin v. The May Department Stores 218 F.3d 919 (8th Cir. 2000) addressed a situation where a national bank retained a credit card customer’s accounts, along with the processing and servicing responsibilities, and only assigned the related receivables to a non-bank; and FDIC v. Lattimore Land Corp., 656 F.2d 139 (5th Cir. 1981) involved a loan originated by a state regulated entity (as opposed to a national bank). For that and other reasons, the Solicitor General argued that there was no circuit split requiring resolution by the Supreme Court.
However, from a practical perspective, it cannot be denied that Madden creates a precedent (regarding the treatment of interest charged by non-bank assignees) in the Second Circuit that is simply lacking in the other circuits. The uncertainty created by such precedent will not be resolved until another district court in the Second Circuit (or perhaps the court of appeals itself) addresses the applicability of the valid-when-made doctrine to a loan held by a non-bank assignee.
In the short run, until that uncertainty is resolved, third party debt buyers, warehouse lenders and securitization vehicles may avoid purchasing, and/or reduce their purchases of, consumer and small business loans made to Second Circuit Borrowers and, as a result, such loans may trade at a discount. Subsequent assignees may need to amend their customer agreements to lower the rates they charge in order to prevent potential violations of state usury law. Assignees may also attempt to take advantage of any put-back rights or indemnity claims against sellers, to the extent the sellers have breached any representations and warranties regarding the enforceability of usurious interest rates.
Originating banks, on their own initiative or at the behest of third party debt buyers, may also revise their customer agreements to include governing law clauses, or choice of venue provisions, designating jurisdictions that are outside of the Second Circuit and that have liberal usury laws. However, courts may not enforce such provisions if they are found to be contrary to public policy. Different jurisdictions will also have different approaches to honoring choice of law provisions.
More fundamentally, the Madden decision will change the way third parties structure their purchases of debt. It has already had that effect. The Madden court distinguishes between (1) entities acting as an “equivalent to national banks” (such as operating subsidiaries and agents) or purchasers of interests in loans from banks who continue to have some interest in the loans, on the one hand, and (2) non-bank, unrelated third party purchasers of debt, on the other. Depending upon the facts, the former group may be entitled to the NBA’s preemption of state usury law limits, as such preemption is understood by the Second Circuit. The latter group is not so entitled. Accordingly, Madden will, and already has, encouraged debt buyers to restructure their purchases so that they fall into the first group. For example, certain platforms have recently announced an “enhanced program structure” (whereby the issuing bank maintains an on-going economic interest in all loans made after they are sold).
As a result, many banks and debt purchasers will be required to fundamentally reconsider their business models—if originate-to-distribute is no longer viable (in the Second Circuit), what is the nature of the interest that should be retained by the bank? Some banks may opt to retain a portion of every originated loan. Others may opt to maintain some economic exposure to the interest and fee income over the life of the loan. Others may take the approach in Krispin—maintaining the account and servicing relationship but assigning the receivable. Given the diversity of financing structures in the marketplace, no one approach will predominate.
The Madden holding affects fundamental assumptions about the free assignability of financial assets in our financial system and the nature of the preemption doctrine as applied to national banks. Nevertheless, the legacy of Madden remains unclear. Now that the Supreme Court has denied certiorari, the district court’s interpretation of the choice of law issue will be closely monitored by the market.
1 The Second Circuit encompasses the states of New York, Connecticut and Vermont.
2 Midland Credit Management, Inc. (Midland Credit), an affiliate of Midland Funding, services Midland Funding's consumer debt accounts. It is also a defendant in the case and is a non-bank entity.
3 The Madden defendants requested that the Second Circuit rehear their case to take into account the valid-when-made doctrine. This request was denied.
5 In the Solicitor General's amicus brief opposing the writ of certiorari, it notes that "The Court of appeals' decision is incorrect. Properly understood, a national bank's Section 85 authority to charge interest up to the maximum permitted by its home State encompasses the power to convey to an assignee the right to enforce the interest-rate term of the agreement. That understanding is reinforced by 12 U.S.C. 24(Seventh), which identifies the power to sell loans as an additional power of national banks."
6 Section 27 of the FDIA is the corresponding federal statute which permits state chartered banks to charge interest rates based upon the state in which they are located even if such rates exceed usury limits in the borrower's resident state.
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