In a significant decision that has far-reaching consequences for the U.S. financial market, the U.S. Court of Appeals for the Second Circuit - which includes Connecticut, New York, and Vermont - has held that non-national bank entities that purchase loans originated by national banks cannot rely on the National Bank Act ("NBA") to protect them from state-law usury claims. The decision in Madden v. Midland Funding LLC undermines the "valid when made" theory on which assignees have relied for many years. It also impedes the ability of national banks to sell the loan obligations they originate, thus reducing their ability to lend. And although Madden was argued under the NBA, anyone involved in a bank partnership model of lending, including partnerships with state-chartered banks, as well as anyone, such as a debt buyer like Midland, that purchases loans or lines of credit originated by a bank, must consider whether the purchased credit obligations can be enforced as originated after the sale of the obligations from a bank to a non-bank purchaser.
I. The Facts
Saliha Madden, who lives in New York, obtained a Bank of America ("BoA") credit card in 2005. As a national bank, BoA can export interest rates and certain fees permitted in its home state or any state in which it has a branch and performs certain activities. At some point, BoA collapsed its credit card program with MBNA, a national bank headquartered in Delaware that BoA purchased in 2005. The new credit card program, FIA Card Services ("FIA"), then sent Madden a change in terms document that allegedly advised Madden that Delaware law would now apply to the credit card agreement.
In 2008, after Madden failed to pay some $5,000 that she owed, FIA charged off the account and sold the debt to Midland Funding LLC, a debt buyer. Midland Credit Management LLC, an affiliate of Midland Funding, began to service the account. Neither Midland entity is a national bank and, after the sale, neither FIA nor BoA possessed any further interest in the account.
In November 2010, Midland Credit sent Madden a letter seeking to collect the debt, with interest accruing at a rate of 27% per year. This rate exceeds the 25% per year criminal usury cap in New York, but is a rate permissible to a national bank in Delaware.
II. Trial Court Proceedings
Madden filed a class action lawsuit in federal court asserting violations of the Fair Debt Collections Practices Act and a state-law usury violation. The federal trial court denied Midland's motion for summary judgment, concluding that genuine issues of material fact existed as to whether Madden received the notice that changed the applicable law and whether FIA actually assigned the debt to Midland. The trial court stated, however, that if Madden had received the change of terms notice specifying that Delaware law applied, Madden would lose her usury claim because Delaware law allows the rate of interest Midland sought pursuant to the terms of the bank's agreement. The trial court further held that such a ruling would necessarily kick out the FDCPA claim, as it is not a violation of the FDCPA to collect a lawfully owed debt.
In denying Madden's motion for class certification, the trial court found that "assignees are entitled to the protection of the NBA if the originating bank was entitled to the protection of the NBA."
Madden appealed, arguing that because Midland is not a national bank or a subsidiary or agent of a national bank, or otherwise acting on behalf of a national bank, and because application of the usury law does not "significantly interfere" with the national bank's ability to exercise its powers under the NBA, NBA preemption does not apply. The U.S. Court of Appeals for the Second Circuit agreed.
III. The Second Circuit's Decision
The Second Circuit's Decision is notable for at least two reasons. First, its discussion of what constitutes a "significant interference" with the business of banking under the NBA is cursory at best and appears to ignore years of well-established case law. Second, there is no discussion at all of the "valid when made" theory, a doctrine that has been widely accepted for decades.
In addressing preemption under the NBA, the Second Circuit correctly noted that there is no such thing as a state-law claim of usury against a national bank. Section 85 of the NBA authorizes a national bank to export interest charges permitted by the state where the national bank is located to the bank's out-of-state debtors. The NBA provides, in relevant part, that:
Any [national bank] may take, receive, reserve, and charge on any loan or discount made, or upon any notes, bills of exchange, or other evidences of debt, interest at the rate allowed by the laws of the State, Territory or District where the bank is located or at a rate of 1 per centum in excess of the discount rate on ninety-day commercial paper in effect at the Federal reserve bank in the Federal reserve district where the bank is located, whichever may be the is greater...
In 1978, the United States Supreme Court held in Marquette Nat. Bank of Minneapolis v. First of Omaha Service Corp. that Section 85 "plainly provides that a national bank may charge interest 'on any loan' at the rate allowed by the laws of the State in which the bank is 'located.'" As such, a national bank can charge and collect interest rates and interest fees allowed in its home state without regard to other state laws that authorize a lower rate of interest.
In order to apply NBA preemption to an action by a non-national bank entity, the Second Circuit reasoned that application of state law to that action must "significantly interfere" with a national bank's ability to exercise its power under the NBA, a standard derived from the U.S. Supreme Court's 1996 decision in Barnett Bank of Marion County, N. A. v. Nelson, Florida Insurance Commissioner, et al. and codified in the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") in 2010. In applying this standard, the Madden court concluded summarily, without engaging in any meaningful analysis, that application of state law to this scenario would not significantly interfere with the bank's ability to exercise its powers under the NBA. This ruling is not consistent with case law or with Dodd-Frank.
Dodd-Frank amended the NBA to establish a preemption standard that preempts state consumer financial laws, defined as state laws that do not directly or indirectly discriminate against national banks and that (1) directly and specifically regulate the manner, content, or terms and conditions of any financial transaction (as may be authorized for national banks to engage in), or (2) any account related to a financial transaction, with respect to a consumer. This preemption standard preempts state laws as they apply to national banks in three circumstances:
Thus, as relevant to the Madden case, Dodd-Frank allows a court to declare preempted state consumer financial laws that prevent or significantly interfere with a national bank's exercise of its powers, and confirms the validity of Barnett and its progeny.
In Barnett, the state of Florida tried to enforce a state law that prohibited banks from selling insurance, while a federal law expressly authorized national banks to engage in such sales. The U.S. Supreme Court determined that Florida's law was preempted. In doing so, the Court said that, in determining whether a particular law is preempted, courts generally take the view that "Congress would not want States to forbid, or to impair significantly, the exercise of a power that Congress explicitly granted." The Barnett court further noted that prior decisions by the Supreme Court did not deprive states of the power to regulate national banks, where doing so does not "prevent or significantly interfere with the national bank's exercise of its powers." Thus, a national bank cannot preempt a state law that only interferes with a national bank's exercise of its powers in an insignificant way.
After Barnett, more than 500 court decisions have weighed whether specific state laws "prevent or significantly interfere with" a national bank's powers to warrant a finding of preemption. For example, since Barnett, courts have found that that the NBA preempts state law licensing requirements, state law requirements that a "convenience check" include specific disclosure language, and state law restrictions on the amount of non-interest fees a national bank can charge.
Had the Second Circuit engaged in an analysis of whether application of state law to a consumer obligation originated but later sold by a national bank would interfere with the bank's business, perhaps it would have reached a different conclusion in Madden. A bank's ability to sell loans or debts in the secondary market is an exercise of bank powers, and an important one. The OCC recognizes in its Risk Management Guidance concerning consumer debt sales (a document cited by the Second Circuit in its decision) that debt sales turn nonperforming assets into immediate cash proceeds and assist banks in meeting their responsibility to shareholders to recover losses. At best, the application of state usury caps significantly decreases the value of loans that banks sell, and could preclude some loans sales altogether. Certainly, if requiring a bank to include disclosure language on a convenience check or limiting non-interest fees is considered a significant impairment of bank powers, reducing the value of a bank's loans would meet this standard. Indeed, it seems to be a "significant interference" to tell a national bank, which is entitled under federal law to charge the interest permitted by its charter state, that such power is subject to state usury laws when the obligations are sold.
Instead of focusing on the Barnett standard, the court seemed focused on the fact that NBA preemption generally applies to the non-bank where the non-bank is acting on the bank's behalf and carrying out the bank's business. Such fact pattern is distinguishable from the facts in Madden, where the debt buyers act on their own, as debt owners. Notably absent from this decision is any discussion of the "valid when made" theory, a bedrock principle that provides certainty and validity to the secondary market. Under this theory, an obligation is considered valid under the law that applied at the time of origination. The obligation continues to be valid under that law even after it is transferred to subsequent parties. If not for this theory, loan terms would be subject to change each time the accounts are transferred. From a review of the record, it does not appear that the "valid when made" theory was argued or briefed.
Finally, and importantly for non-bank partners and other purchasers of loans from national banks, the court noted that extending preemption to non-bank third parties "would create an end-run around usury laws for non-national bank entities that are not acting on behalf of a national bank." In reaching this conclusion, the court discusses two cases regularly discussed in bank partnerships: Phipps v. FDIC and Krispin v. May Department Stores.
Phipps involved second mortgage loans made in Missouri by Guaranty National Bank of Tallahassee ("GNBT"). GNBT later failed and was taken over by the Federal Deposit Insurance Corporation. The loans at issue were originated by GNBT with the assistance of Equity Guaranty LLC and later sold to GMAC-RFC and Household. The plaintiffs filed a putative class action in Missouri state court against GNBT, GMAC-RFC, Household and others claiming, among other things, that GNBT and Equity Guaranty conspired to "give the appearance of making these loans through a national bank . . . to . . . avoid the consumer protection laws of the states." The plaintiffs also argued that the loan origination and loan discount fees charged by GNBT were actually "finder's fees" made to Equity Guaranty. The defendants removed the case to federal court. The federal district court refused to remand the case to state court and, because the plaintiffs were raising a state law usury claim against a national bank, the lower court granted the motions of the FDIC, GMAC-RFC and Household to dismiss the complaint. The Eighth Circuit affirmed the district court's decision, relying on its earlier decision in Krispin to hold that courts must look at the originating lender, and not the ongoing assignee, to determine whether the National Bank Act applied. The court also noted that the plaintiffs had signed numerous loan documents in which they acknowledged that GNBT was the lender that funded and made the loans and charged the fees. In Krispin, the Eighth Circuit rejected a challenge that certain retail store accounts that had been transferred from a department store to an affiliated national bank were still governed by state law as opposed to the National Bank Act. One hundred percent of the subject receivables were sold to the bank by the department store. In holding that the accounts represented loans made by the national bank, the court noted that the bank extended the credit, processed and serviced the consumer accounts.
Midland attempted to rely on Krispin for the proposition that it - as a non-bank - was entitled to NBA preemption, just as the store was, because the "originating lender" (i.e., the bank) was permitted to impose the fee. But the Madden court noted that in Krispin, the language regarding the "originating lender" was misleading - the bank only sold its receivables and retained ownership of the accounts, a fact that supported the finding in Krispin that the bank was the real party in interest. In the Madden case (and in most bank partnerships where the underlying transactions are closed-end loans), the bank sold the account and the receivables, and retained no further interest in it.
IV. What now?
On June 19, 2015, Midland filed a petition for rehearing before the Second Circuit. During the appeal process, the issues of significant interference with bank powers, and the valid when made theory will no doubt be raised and argued. We hope, but cannot be certain, that this decision will be ultimately overturned. Unfortunately, the Second Circuit is generally regarded as expert on financial services matters, and other federal appellate courts defer to it. The question for now is when will the financial markets achieve some greater comfort, and how long will the industry have to wrestle with this uncertainty in the meantime.
Although the Madden case was wrongly decided and injects a large amount of uncertainty into the market, the court did provide some guidance on what would constitute an acceptable loan sale structure that would withstand a Madden attack. Based on its discussion of Phipps and Krispin, it appears that the Second Circuit would find that bank partnerships where the bank has ongoing involvement, or "skin in the game," would justify application of NBA preemption. So, for example, bank partnerships could be structured such that the originating bank retains ownership of some piece of the account or loan, and does not sell the entire obligation.
And there is a potential saving grace for Midland: Midland argued that even if the usury claim is not preempted by the NBA, under the change in terms Delaware law applies, and the interest charged by Midland is permissible under Delaware law. Because that argument was not well developed, the appellate court did not consider it. On remand, the lower trial court will examine this issue. It is possible that, if Midland can argue Delaware law applies, the court may dismiss the case. However, it is also possible that if Delaware law applies, Midland, as a non-bank, may have needed a license to purchase the loans at that rate. If that is the case, non-bank entities that purchase credit obligations from banks should consider whether they need state lending licenses to engage in such activity. By holding the license, the non-bank partner in a bank partnership with banks located in Delaware may be able to argue that it could have originated the loans with the rates of interest imposed by the bank, as Delaware lending licensees can impose the rate of interest to which the parties agree. As always, participants in this space should consult with counsel to ensure that they structure their dealings so as to minimize the likelihood of a successful Madden challenge.
Catherine M. Brennan is a partner in the Hanover, Maryland office of Hudson Cook, LLP. Cathy can be reached at 410-865-5405 or by email at cbrennan@hudco.com.
Meghan S. Musselman is a partner in the Hanover, Maryland office of Hudson Cook, LLP. Meghan can be reached at 410-865-5406 or by email at mmusselman@hudco.com.
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