Madden Matters: Structuring Bank-Origination Partnerships In a Post-Madden World

Thomas Brown Molly Swartz

By Thomas Brown and Molly Swartz

Thomas Brown is a partner in the Antitrust and Competition and the Global Banking and Payment Systems practices at Paul Hastings in San Francisco. Molly Swartz is an associate in the Global Banking and Payment Systems practice at Paul Hastings in San Francisco.

Marketplace lenders, bank-affiliated lenders, and debt collection startups face an evolving legal landscape. Madden v. Midland Funding, LLC unsettled the relatively well-established body of law stipulating that loan assignees step into the shoes of the lender and are entitled to enforce the rights of the lender pursuant to agreement terms determined at the time the loan is made. As marketplace lenders, bank-affiliated lenders, i.e., nonbank entities that market, fund, service, or collect on loans originated by a depository institution, debt collectors and other loan assignees review existing assignment agreements and evaluate loan purchase programs, it’s worth examining the reach of Madden since the Second Circuit’s February 2015 decision.

Benefitting from federal preemption, banks are uniquely privileged to export the interest rates of their home state to borrowers in other states. The National Bank Act (“NBA”) (for national banks) and the Depository Institution Deregulation and Monetary Control Act (“DIDA”) (for state-chartered banks) preempt the application of state usury laws to federally insured banks. Thus, for example, a bank situated in South Dakota, a state with no usury cap, may offer loans to consumers in any of the other 49 states at any interest rate, regardless of whether the consumer’s home state recognizes a lower usury cap. Yet this “passporting” ability does not extend to nonbanks. Nonbank lenders remain subject to state-specific usury rates and licensing requirements.

Banks’ monopoly on rate exportation has forced many nonbank lenders into bank partnerships; a simpler alternative than obtaining consumer lender licenses. The purpose of this structure is to allow the lender to take advantage of the bank’s ability under federal law to charge interest rates in excess of the rates permitted by the borrower’s home state. The bank, in effect, “rents” its charter powers in exchange for a fee associated with each loan. Many pejoratively refer to this type of partnership as the “rent-a-charter” model.

Prior to Madden, this type of bank partnership made a lot of sense. A bank’s loan assignee, e.g. a third party who purchases a loan from a bank, could continue to enforce the terms of the bank’s original loan, including an interest rate higher than the usury cap of the borrower’s home state. Madden, however, threw that understanding into question. Even though, as discussed below, the Solicitor General agreed that Madden was wrongly decided, the Supreme Court declined to review it. And post- Madden, lower courts have continued to struggle with how to apply state law to loan programs that involve both nonbanks and banks, particularly state-chartered, federally insured banks.

I. Madden: An Overview

In Madden, the Second Circuit Court of Appeals held that a debt collector that purchased charged-off consumer (credit card) loans from a national bank was not entitled to rely on the bank’s federal preemption of New York’s usury law. In reversing the lower court’s ruling, the Second Circuit explained that the NBA preempts the application of state law to nonbanks only when application of the state law would “significantly interfere” with a national bank’s ability to exercise its powers under the NBA. According to the court, because application of state law to Madden’s claims would not significantly interfere with the national bank’s exercise of NBA powers, the debt collector could not rely on the bank’s preemption privilege and was, instead, subject to state usury law.

Defendants appealed to the Supreme Court. In a brief requested by the Supreme Court, the Solicitor General (“SG”) and the Office of the Comptroller of the Currency (“OCC”) asked that the Court deny the petition for certiorari, despite noting that Madden was wrongly decided. While the SG and OCC stated that Madden was “incorrect”, they noted that Supreme Court review was “not warranted at the present time” because: (1) there is no circuit split on the question presented; (2) the parties did not present the full range of preemption arguments to the courts below; and (3) the Second Circuit decision was interlocutory and the resolution of the preemption issue might not affect the ultimate outcome of the case.

Perhaps persuaded by the SG and OCC, the Supreme Court denied certiorari in June 2016. In doing so, the Court effectively “kicked the can down the road” and the Second Circuit’s decision remains “good law” for the time being.

II. Industry Response to Madden

In response to Madden, a number of marketplace lenders and debt collectors reviewed their assignment agreements and loan programs. WebBank, for example, Lending Club’s originating bank, and Lending Club revised their loan program in February 2016. WebBank revised its borrower account agreement to specify that the bank maintains an ongoing contractual relationship with the borrower for the life of each and all Lending Club loans. WebBank and Lending Club also modified their fee arrangement such that WebBank now receives fee payments in installments from Lending Club rather than a single lump sum fee on every loan it originates. As such, WebBank’s financial interests remain tied to loan performance: Lending Club will stop paying fees to WebBank in the event of default. The revised borrower account and fee agreements are intended to provide WebBank with an ongoing economic interest in each loan sufficient to protect against a Madden-type challenge.

Similarly, marketplace lender Prosper also revised its loan program in response to Madden. For all loans originated after July 31, 2016, WebBank—which also serves as Prosper’s bank origination partner—will maintain an ongoing economic interest in the loans after they are sold. Specifically, WebBank will receive an additional monthly program fee dependent on the amount and timing of principal and interest payments and paid so long as the borrower is making payments on the loan.

In contrast, Commonbond, a marketplace lender focused on student loans, moved from a bank partner model to a lending license model. While this enables Commonbond to avoid Madden-esque litigation, the company must now obtain and maintain state-specific lender licenses.

III. Congressional Action

In August, Rep. Patrick McHenry (R-N.C.) introduced the Protecting Consumers’ Access to Credit Act of 2016. As proposed, the bill would amend the NBA and the DIDA to provide that federal interest rate preemption applies “regardless of whether the loan is subsequently sold, assigned or otherwise transferred to a third party.” However, the bill stalled in the House Financial Services Committee after its introduction.

IV. Post- Madden Cases

In the wake of Madden, a number of challenges have been made to rent-a-charter models. For the most part, these cases have tested the bank-partnership model of lending through a “true lender” theory. Under this framework, a court assesses whether a nonbank servicer or its bank partner should be deemed the “true lender” of credit extended, and thus whether state usury laws are applicable or preempted.

A. CashCall v. Maryland Commissioner of Financial Regulation

In June 2016, the Maryland Court of Appeals affirmed a lower court judgment holding that CashCall, a nonbank payday lender that assisted consumers to obtain loans from out-of-state banks, engaged in the “credit services business” without a license in violation of the Maryland Credit Services Business Act at interest rates above Maryland’s usury cap. Despite its partnership with banks, CashCall could not access the banks’ interest rate exportation privileges.

In the case, CashCall advertised consumer lending on its website. When consumers filled out a loan application, the application was forwarded to out-of-state banks for approval. The loans were made by the banks at interest rates well above Maryland’s usury cap and coupled with high origination fees. Shortly after origination, the banks sold the loans to CashCall which collected all payments on the loans, including the origination fee.

Based on the breadth of Maryland’s statute, the court found that CashCall was a “credit services business.” More importantly, however, the court noted, in dictum, that CashCall was the “ de facto lender” because it “received, through contracts with the banks, the exclusive right to collect all payments of principal, interest and fees, including the origination fee.” Although the lending bank charged the origination fee, “[t]he bank never received payment of that fee from the consumer but, as noted, CashCall did.”

While this true lender discussion was tangential to the merits of the case, it suggests that the bank-partner model may not shield nonbank lenders from the licensing and usury laws in Maryland. To the extent that a bank retains no right to collect from a borrower, the nonbank loan servicer may be considered the “true lender.”

B. Commonwealth of Pennsylvania v. Think Finance, Inc.

Similarly, in Commonwealth of Pennsylvania v. Think Finance, Inc., the Eastern District of Pennsylvania also refused to allow a nonbank loan servicer to benefit from its bank origination partner’s rate exportation privilege. In Think Finance, a group of nonbank loan servicers partnered with a Delaware bank, to market and purchase loans made by the bank to Pennsylvania residents at rates that exceeded that allowed by Pennsylvania law. The Office of the Attorney General (“OAG”) of Pennsylvania alleged that the defendants operated a “rent-a-bank” scheme whereby the bank “acted as the nominal lender while the nonbank entity was the de facto lender – marketing, funding and collecting the loan” in order to take “advantage of federal bank preemption doctrines to insulate the Defendants from state regulations.” In response, the OAG brought suit against the loan servicers.

The loan servicers claimed that the bank’s preemption rights did not disappear when a loan was assigned or transferred from the bank. Rejecting this argument, the court ruled that the Third Circuit distinguishes between claims against banks and claims against nonbanks for purposes of preemption. Because no claims were made against the bank, the court determined that the loan servicers could not benefit from the bank’s preemption, despite the fact that the bank retained interest in the loans.

Notably, this was an order on a motion to dismiss. Although the Court did not reach a final decision on the merits, it refused to accept federal preemption as grounds to dismiss an enforcement action brought against a payday lender who arranged for a bank to fund loans at rates above Pennsylvania’s usury law.

C. Consumer Financial Protection Bureau v. CashCall, Inc.

In CFPB v. CashCall, Inc., the Central District of California found that the defendant, CashCall, Inc., was the de facto lender of payday loans originated by a tribal entity called Western Sky Financial. In determining that CashCall was the true lender, the court considered the totality of the circumstances and applied a “predominant economic interest” test. Under this test, the key factor is whether the “originator” placed its own money at risk at any time during the transactions. According to the court, CashCall, not Western Sky, placed its money at risk. The court also noted that CashCall deposited funds in a Western Sky account to fund loans, CashCall purchased all of Western Sky’s loans before any payments on the loan had been made, paid Western Sky to “originate” these loans, and indemnified Western Sky for all costs and claims arising from the loan transactions. In sum, CashCall assumed the entire monetary burden and risk of the loan program such that CashCall had the predominant economic interest in the loans. As a result, CashCall was the true lender, not Western Sky.

Notably, while CashCall did not rely on the preemption provisions of the NBA, the case would appear to apply equally to a preemption defense raised in relation to a bank-affiliated loan program.

D. Beechum v. Navient Solutions, Inc.

The Central District of California—the court that decided CashCall—opted not to apply this true lender analysis in a case decided one month later. In Beechum v. Navient Solutions, Inc., plaintiffs alleged that private student loans that were marketed, underwritten and serviced by the Student Loan Marketing Association (“SLMA”), its affiliates, and Navient Solutions, identified Stillwater National Bank as the lender, and were repurchased by the SLMA, were usurious under California state law. Defendants countered by claiming that these loans were originated by a national bank and thus, preempted California’s usury laws.

Under the arrangement, SLMA agreed to originate, underwrite, market and fund student loans for which Stillwater would be identified as the lender and which the SLMA would then purchase from Stillwater. The SLMA committed to funding and purchasing a minimum amount of loans. The SLMA disbursed the loan proceeds, on behalf of Stillwater, using funds in a Stillwater account over which it has been granted rights under a power of attorney. SLMA controlled all of the loan marketing and Stillwater was not allowed to alter the content or description of loan application materials without the SLMA’s express written consent. Finally, the SLMA set the terms of the loan, controlled the schools at which the loans could be made, determined which students would be approved, and determined the interest rate based on credit criteria established by the SLMA.

While plaintiffs argued that the SLMA, not Stillwater, was effectively their “lender” and therefore, the national bank exclusion did not apply, the court disagreed. In rejecting plaintiff’s argument, the court noted that plaintiffs alleged that their loans were issued by a bank. Under California law, courts may consider the intention of the parties, or the substance of a transaction, in assessing whether the transaction itself is a disguised loan intended to evade the usury laws courts, but “must look only to the face of a transaction when assessing whether it falls under a statutory exemption from the usury prohibition.” Because plaintiffs’ loans were, on their face, issued by a bank, the loans were exempted from California’s usury prohibition. The court did not discuss the true lender analysis that would have been applied had plaintiffs alleged that SLMA was the true lender.

Notably, unlike CashCall and Madden, Beechum involved only state law violations. As such, the court interpreted California true lender law, not federal law.

The case is ongoing. The Beechum plaintiffs filed a notice of appeal to the Ninth Circuit on Oct. 20, 2016.

E. Bethany v. Lending Club Corporation

In April 2016, New York resident, Ronald Bethune, accused Lending Club of violating New York usury law by charging interest above New York’s 16 percent limit. In a putative class action challenging Lending Club’s practices between 2007 and February 2016 (the period before WebBank and Lending Club restructured their loans), Bethune claimed that WebBank, was not the “true lender” of Lending Club’s loans and was, instead, merely a “‘pass through’ sham party to the transaction.” Because Lending Club was the true lender, the company should not have been able to take advantage of WebBank’s rate exportation privileges, but instead, remained subject to New York State’s usury cap. (Note that while Madden addressed the transferability of bank-originated loan terms to a nonbank, Bethune focuses on the legitimacy of the originating bank.)

In January 2017, the court compelled arbitration and stayed the case pending the outcome of arbitration.

V. So What Do These Decisions Mean?

These rulings raise questions regarding the viability and structuring of bank origination partnerships. Courts’ reluctance to preempt state usury laws for online lenders suggests that a true “rent-a-charter” model is unlikely to survive judicial scrutiny. Federal case law suggests that courts will not necessarily dismiss “true lender” claims at an early stage solely because a bank is the named lender on the loans (though a facial recognition of the bank as lender may be sufficient in certain circumstances under California law). As this area of law remains dynamic, bank-affiliated lenders, marketplace lenders and third party debt collectors must continually evaluate regulatory risk. While conforming a particular company’s loan structure to the strictures outlined by current case law is a company-specific exercise, there are some general actions that regulated entities may take to bolster against true lender claims:

  •  Review existing and pending loan sale/purchase agreements for potential violation of usury laws in states where borrowers reside, starting with the Second Circuit states (New York, Connecticut, and Vermont). Assess the potential effects of violations of these laws (e.g., civil and criminal violations, potential damages and fines). Where potential risks are evident, amend existing agreements.
  •  Ensure and potentially change the structural framework for originating and purchasing loans. In particular, ensure that the originating bank retains some aspect of an ownership or other continuing economic interest in loans that are sold to third parties. Origination charges should be paid to the bank partner and the nonbank should not retain exclusive rights to own the loans and collect principal, interest and fees, damages and fines.
  •  Ensure that the bank-partner shares in the risk of the loan, beyond mere contractual obligations; the bank must bear some of the financial risk associated with borrower default or nonpayment.
  •  Extend the period of time during which the bank-partner retains loans on its balance sheet. Where the nonbank purchases loans originated by the bank, a longer period of retention will better document how a lender shares in the risk of the loans.

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