Will Congress Fix Supreme Court's Madden Mistake?

The Supreme Court’s refusal to hear the appeal of the deeply flawed Madden v. Midland Funding LLC decision has allowed significant doubt to mire what was once a clear foundation of American finance: the notion that a valid debt does not become usurious simply because the debt is sold. It may now be up to Congress to reaffirm one of the fundamental concepts that much of the American financial system rests on.

In Madden, the United States Court of Appeals for the Second Circuit held that a non-bank that buys a loan from a bank cannot service the loan on the same terms as the bank, and should instead be bound by the state’s usury law (which banks are generally exempt from).

The practice of banks selling loans to non-banks is vital to Americans’ access to credit because it allows for the securitization of debts ranging from mortgages to credit cards, and helps facilitate emerging innovations that may make credit more affordable for millions of Americans, including those poorly served by the traditional system.

The Department of Justice (DOJ) and Office of the Comptroller of the Currency (OCC) — the prudential regulator for nationally chartered banks — criticized the lower court’s decision as a “misunderstanding” of law and precedent. By allowing this decision to stand, the Court risks making access to credit more difficult, expensive, and uncertain — especially for borrowers with less-than-stellar credit or who do not fit the traditional mold.

Fortunately, Congress could fix this issue by making explicit that which was (until very recently) taken for granted — that a loan which is valid when it’s made remains valid, even if it is sold.

The Madden case implicates three well-established aspects of lending law: First, the concept—that a loan that was not usurious when made cannot become usurious because it is sold—is a foundational aspect of the common law of lending, and has been recognized as a “cardinal rule in the doctrine of usury” by the Supreme Court since the early 19th century.

Likewise, the ability of a bank to make a loan and then sell it is, as the DOJ and OCC acknowledged, a core power of banking that would be “significantly impaired” if the buyer of the loan couldn’t continue to charge the same rate the bank did.

Finally, the ability of banks to “export” the interest rate of their home state nationally, granted by federal law to both federally and state-chartered banks, as well as federal credit unions, is a key element in the creation of an efficient national system of credit.

By severing the link between the bank creating a loan—which was consistent with the interest rate limits of its home state—and the non-bank buyer of the debt, the Madden decision calls into question the ability of banks to sell loans off their books in securitization and mitigate risk by selling non-performing loans.

The decision also questions the bank’s ability to partner with innovative firms, such as the so-called “marketplace lenders,” who fund loans via non-depository investment capital and use hi-tech underwriting to offer better rates to some borrowers, including those unable to get comparable loans from banks.

This emerging innovation has been particularly hard hit by the Madden decision. As research from Profs. Colleen Honigsberg, Robert Jackson, Jr., and Richard Squire has shown, in the wake of Madden, funding for marketplace loans for risky borrowers in the area covered by the the Madden decision has dropped precipitously as would-be lenders worry about the uncertain legal status and enforceability of the loans.

This means that riskier borrowers who were able to access credit (and presumably found these loans to be their best option or else they wouldn’t have taken them) are now shut out.

Despite its manifest flaws, the DOJ and OCC argued that the Supreme Court should not hear Madden at this time, in part because the case was not yet final and may ultimately be resolved correctly. However, this delay is causing real harm to borrowers now, and there is no guarantee the resolution will be quick or correct.

Congress need not be concerned with the finality of the case, and could address the problem via legislation. Codifying the well-established doctrine of “valid-when-made” would make it clear that banks can sell loans to non-banks and that those non-bank buyers can continue to service the loan on the same terms agreed to by the borrower originally.

This clarification would provide needed certainty to the financial system without depriving borrowers of any rights. Instead, Congress would simply be plainly restating a “cardinal rule” that credit access can be built on.