September 14, 2017

Credit Markets Need Legislative Guidance after Madden Decision

Brian Knight

Senior Research Fellow

In a recent op-ed in American Banker (derived from a longer blog post), professor Adam Levitin argues that the recent legislative proposals to “fix” the repercussions of the United States Court of Appeals for the Second Circuit’s Madden v. Midland Funding decision are “overly broad and unnecessary and will facilitate predatory lending.” The legislation Levitin opposes would restore the ability of banks to sell loans to nonbanks and have the loans remain valid on their original terms, the type of transaction on which the Madden decision has cast doubt. I disagree, at least with regard to marketplace lending. There are compelling legal and policy arguments to undo the Madden decision that Congress should consider. (To be clear, this is not an endorsement of any particular legislation.)

Applying valid-when-made is appropriate

The text of the Protecting Consumers Access to Credit Act of 2017 states that the principle that a loan is “valid at inception cannot become usurious upon the subsequent sale or transfer of the loan to another person” has been a cornerstone of banking law, “as provided in the case of Nichols v. Fearson.Levitin argues that supporters of the legislation rely on an incorrect interpretation of “valid-when-made.” Levitin points out that the Nichols case, as well as a number of other 19th-century cases dealing with whether “in a string of transactions from X to Y to Z, if X to Y is nonusurious, but Y to Z is usurious, can X shelter in Y’s usury defense[?]” The answer those cases gave was “no.” Levitin considers this a just result because the originator of the note should not get off the hook simply because a subsequent unrelated transaction was usurious.

Levitin argues that the Madden case is different. In Madden, the ultimate purchaser of the loan (Midland Funding) wanted to take advantage of the state usury law preemption enjoyed by the originator of the loan (the bank). Levitin argues that valid-when-made has nothing to do with the issue in Madden and similar arrangements where banks sell loans to nonbanks.

Levitin is certainly right that the Nichols case and the similar 19th-century cases reflect a different fact pattern than was presented in Madden. It does not necessarily follow, however, that the principle of valid-when-made should not also apply under the Madden facts. The drafters of the Madden fix bills might have set themselves up for trouble by saying that valid-when-made “as provided by Nichols v. Fearson” (emphasis added), since that implies that the court created the doctrine, or set out its boundaries in the Nichols case. But this isn’t what happened. Instead, the Nichols court cited a preexisting maxim and applied it to a certain set of facts. Proponents of the Madden fix can’t cite Nichols as controlling legal precedent (or else we wouldn’t be having this debate), but that doesn’t mean that the maxim of valid-when-made is limited to the Nichols facts or shouldn’t apply in the present case.

In fact, courts have cited Nichols and the principle of valid-when-made in other contexts. Perhaps the most direct example is the case of FDIC v. Lattimore Land Corp. In that case, the U.S. Court of Appeals for the Fifth Circuit held that a nonusurious loan made by a nonbank under Georgia law and subsequently transferred to a Tennessee-based national bank did not become usurious, even though it exceeded Tennessee’s usury cap, because “[t]he nonusurious character of a note should not change when the note changes hands.” The Lattimore court cited to Nichols for the proposition that:

"If, in its inception, the contract which that instrument purported to evidence was unaffected by usury, it was not invalidated by a subsequent transaction.”

This proposition was articulated by the Supreme Court as one of the “cardinal rules in the doctrine of usury.”

In Lattimore, as well as in Madden, the original borrower is trying to assert a usury defense because the loan changed hands. This case is not identical to the issue in Madden, because the loan in Lattimore went from a nonbank to a bank. As the United States Solicitor General and Office of the Comptroller of the Currency point out, however, there is an “appealing symmetry” to the idea that if valid-when-made applies in the context of a nonbank assigning a loan to a bank, the reverse should also be true.

Applying valid-when-made is just

There is also a strong argument that applying valid-when-made to cases like Lattimore and Madden is just. Recall Levitin’s argument that X, the original borrower, should not get out of her original and valid contract simply because a usurious transaction happened downstream. In the present case, we have a borrower who took out a legal loan, something happened to the loan downstream (a sale) that did not change the original borrowers’ obligations, and now the original borrower wants to use that downstream event to get out of their obligation to repay. Why should the borrower get a windfall because a loan is sold?

Levitin argues that the loan is only valid when held by a bank; the loan was actually usurious from the start and the law only stayed the application of the usury laws so long as the loan was held by a bank. This interpretation of the law is not shared by, among others, the solicitor general and the OCC, who argue that the ability of a bank to sell a loan contains the ability to have the loan remain valid on its original terms.

And why should the validity of the loan hinge on who holds it anyway? Levitin argues that banks are subject to an “alternative federal regulatory regime” that does not apply to nonbanks, and therefore nonbanks should not be entitled to the benefits of federal regulation.

However, it is unclear what relevant regulation banks are subject to that nonbanks aren’t. The issue at question in Madden, the interest charged on the loan, was set by the bank at the loan’s inception. The borrower got the benefit of the federal regulatory regime, which includes the incorporation of the bank’s home state usury law, when the loan was created, and the relevant characteristics did not change. So why is there suddenly a problem?

Further, Levitin seems to accept that a bank should be allowed to shift the credit risks of the loan off of its portfolio. Why should a bank be allowed to shed risk via securitization (which he acknowledges may be implicated by Madden) or financial engineering but not a direct sale of the loan? Such efforts to shift credit risk would also seem to undo another supposed benefit of Madden, that it forces banks to take greater care underwriting. Banks shifting credit risk off their books, regardless of method, could lower their underwriting standards, but they still face the reality that selling interests in loans that fail to perform will be punished by the market.

Regardless of whether the bank sells the loan, securitizes it, or offers some sort of participation interest, the loan can only ever be what the bank is allowed to offer under its federal regulatory regime (or else it isn’t valid). If the loan remains what the borrower, the lender, and the law thought was acceptable when the loan was made, why should a change in ownership of the loan destroy the contract? Contrary to Levitin’s assertion, fixing Madden is not about repealing usury laws, it is about making clear that the usury laws applicable to a loan do not change suddenly and arbitrarily.

It is also unclear just how different the relevant law between banks and nonbanks actually is. As the Treasury Department noted, federal consumer protection laws apply equally to marketplace lenders and banks. Both are subject to Dodd-Frank’s prohibition against unfair, deceptive, or abusive acts or practices, and the Consumer Financial Protection Bureau has jurisdiction over both. For example, any qualifying loans, whether made in conjunction with a marketplace lender or not, will be subject to the CFPB’s anticipated small-dollar rule. Likewise, marketplace lenders who partner with banks are generally subject to examination and regulation by federal banking regulators under the Bank Service Company Act. There may be differences in how the law treats banks and nonbanks, but that doesn’t mean the differences are material. There is a robust federal and state consumer protection regime governing marketplace loans, not a “regulatory vacuum.”

Levitin calls for various new requirements for loans, including an ability to repay component, dictating certain loan characteristics other than the interest rate, and a prohibition on forced arbitration. All these requirements are beyond the scope of the laws implicated by Madden. While they may have merit as a matter of policy, that is a separate debate from the question posed by the Madden decision — whether a borrower should be held to the terms of her original contract if her loan is sold.

The impact of Madden on innovative credit is harmful to borrowers

Levitin argues that there is no policy justification for applying valid-when-made in the aftermath of Madden. However, this isn’t true. Besides the question of justice discussed above, Madden also appears, as would be expected, to be reducing access from marketplace lenders to credit for borrowers with lower credit scores. Contrary to Levitin’s argument, a recent study shows a reduction in credit availability not just for borrowers with FICO scores under 625 (though that is where the reduction is most pronounced). The study indicates that borrowers in New York and Connecticut with FICO scores under 700 saw a reduction in availability relative to comparable borrowers outside the Second Circuit.

Even if the Madden decision does reduce credit availability, Levitin finds the reduction acceptable; after all, we don’t let people “pledge their children and organs as collateral,” right? While it might be true that certain access-to-credit-enhancing policies might impose unacceptable costs, fixing Madden does not. The loans in question were societally acceptable to begin with. All fixing Madden does is ensure that the expectation of the borrower, seller, and the law at the time the contract was created are validated. Making people abide by the contracts they legally entered into is hardly the same as pledging a kid or kidney as collateral.

This hyperbole also ignores the reality that access to credit is often consumer protective. For example, it is important to keep in mind that the majority of marketplace loans are used to pay off bank-issued credit cards (which are not subject to borrower state usury laws) or consolidate existing debt. Denying borrowers access to these loans does not leave the borrowers unencumbered by debt; it leaves them in the situation they view as worse than taking out this new loan. We should not be dismissive of this risk, or throw roadblocks up that prevent borrowers from improving their situation. This is especially true given that there is evidence that marketplace lenders can help provide expanded access and competition, services in areas that have few banks, and better pricing for some borrowers than they would receive from banks. Cutting off access isn’t protecting borrowers, it is leaving them with fewer, perhaps inferior, tools to protect themselves.

As Levitin acknowledges, usury caps are crude tools. Interest rate caps impact only part of what determines the cost of a loan. Usury caps can lead to loan arrangements being distorted in ways that make the loans legal but worse for the borrower. We see examples of this in the shift from payday to “payday installment” and subprime auto loans, where lenders bound by interest rate caps change the loan principal amount or repayment schedule to make the loans viable. These loans can actually be more expensive in total because the lower interest rate is applied to a higher principal over a longer time period. Larger loans also can be more expensive for borrowers if they pay them off early or go into default. Borrowers also could be forced into using suboptimal options like pawn shops or illegal loans, or find themselves without credit altogether.

Levitin is right that we don’t know if the borrowers being cut off from marketplace loans are finding credit elsewhere. Even if borrowers are finding credit elsewhere, however, we should be concerned that the replacement credit is inferior to the marketplace loans they are being denied. The burden is on those who advocate denying borrowers their first choice to show that the borrower isn’t being harmed.

Madden should not be the end of the discussion

With the expansion of nonbank credit providers, the role of technology, and evolving regulation and consumer preferences, Levitin is absolutely right that the rules of the credit market should be rethought. After all, why should banks have a unique advantage to provide credit nationwide? Rather, lenders offering similar products, posing similar risks, should be held to similar standards. While that discussion absolutely should happen, in the meantime, Congress should correct the Second Circuit’s mistake and restore clarity to credit markets and access to borrowers who need it.