Supreme Court Declines to Provide Clear Direction to Debt Buyers

On June 27, 2016, the United States Supreme Court denied a petition asking it to consider an appeal of the decision of the United States Court of Appeals for the Second Circuit in Madden v. Midland Funding, LLC. In Madden, the Second Circuit held that a consumer borrower might have a valid claim against a debt purchaser, Midland Funding, for violating usury laws even though the interest that Midland Funding was seeking to collect would have been perfectly legal if the original lender and debt seller, Bank of America, had been seeking to collect it. By declining to consider the appeal, the Supreme Court left debt purchasers uncertain as to what interest they may charge on loans without subjecting themselves to potential liability.

The issue in Madden was whether the exemption from local usury laws afforded to national banks by the National Bank Act continues to apply when a national bank sells a loan to a party who is not a national bank. The NBA permits national banks to charge “interest at the rate allowed by the laws of the State, Territory, or District where the bank is located.” A national bank incorporated in Delaware, for example, may charge the rate of interest that Delaware law allows even when the loan is made to a resident of another state from a branch of the bank located where the borrower resides and the laws of that state mandate a lower rate. The NBA also provides the exclusive cause of action against a national bank for usury, preempting state law. Thus, a New York resident who obtains a loan from a New York branch of a national bank cannot sue the bank under New York usury law, but can sue only under the NBA and can prevail only if the bank charged interest in excess of the rate permitted under the laws of the state where the bank, not the branch at which the loan was obtained, is located.

Under what is known as the “Valid When Made Doctrine,” as a general matter of contract law, a contract that is valid between the initial parties is not invalidated when one of the initial parties assigns the contract to someone who could not have entered into the contract itself without violating a law. Before Madden, several courts had held or suggested that if a national bank made a loan that was legal under the NBA and then sold the loan to a buyer who was not a national bank, the borrower could sue the buyer for usury only under the NBA and could prevail only if the loan purchaser charged the borrower interest in excess of the rate allowed by the law of the state where the original national bank lender was located. Indeed, in Madden, the United States District Court for the Southern District of New York had dismissed the borrower’s suit against Midland Funding on that basis.

On appeal, however, the Second Circuit held that the District Court and the cases on which Midland Funding relied in the District Court had overstated the extent to which the NBA preempted state law. According to the Second Circuit, the NBA preempts state law as to parties who are not national banks only if subjecting them to state law “would significantly interfere with any national bank’s ability to exercise its powers under the NBA.” The Second Circuit distinguished most of the cases relied upon by Midland Funding holding that the NBA preempted state law and insulated parties who were not national banks from liability under state usury law on the grounds that the non-national bank parties in those cases were “acting on behalf of national banks in carrying out the national bank’s business” or that national banks still held some economic stake in the transactions at issue. By contrast, the Second Circuit noted that Midland Funding and its affiliated loan servicer “acted solely on their own behalves, as the owners of the debt” in attempting to collect from the plaintiff and that Bank of America, the initial national bank lender, “possessed no further interest in the account” once it was sold to Midland Funding. The Second Circuit rejected the one case relied on by Midland Funding that was indistinguishable from the case before it on the ground that the court in that case had applied “unwarranted significance” to the identity of the “originating [lender] entity” and strayed from the “essential inquiry-whether applying state law would significantly interfere with the national bank’s exercise of its powers.”

Based on the facts of the case before it, the Second Circuit said that “no other mechanism appears…by which applying state usury laws to the third-party debt buyers would significantly interfere with [a] national bank’s ability to exercise its powers under the NBA.” It concluded that “state usury laws would not prevent consumer debt sales by national banks to third parties.” On the other hand, extending the protection of the NBA exemption from state law usury claims, the court said, “would create an end-run around usury laws for non-national bank entities that are not acting on behalf of a national bank.”

While it is true that the holding in Madden does not “prevent consumer debt sales by national banks,” the holding is certainly likely to make consumer debt sales by national banks more difficult. Before Madden, it was widely believed that a purchaser of a portfolio of consumer debt from a national bank only had to be concerned about whether the interest rates on the loans in the pool of loans it was buying were allowed under the laws of the state where the national bank seller was located and could continue to accrue interest at those rates after purchasing the loans. After Madden, a purchaser of a portfolio of loans from a national bank may now have to examine the laws of multiple states to determine what interest rates may be charged on loans after they are purchased under applicable state law and assess the purchaser’s potential liability under multiple state laws of charging a rate that is not permitted. After purchasing the loans, purchasers may then need to adjust the rates at which it accrues interest on them on a state by state basis. Even if the heightened level of due diligence and increased post-purchase loan administration required by Madden do not cause purchasers to shy away from purchasing loans from national banks, the costs associated with that heightened due diligence and more burdensome post-purchase loan administration are almost certain to result in a reduction of the amount that purchasers are willing to pay.

Time will tell if subjecting the purchasers of debt from national banks to a myriad of state laws materially reduces the ability of national banks to sell consumer debt. If it does, the inability of national banks to raise capital by selling loans may significantly interfere with the exercise of their powers under the NBA to make new loans.