Rick Antonoff, Ritika Kapadia, and Marianne Caulfield
On June 27, 2016, the Supreme Court of the United States (the “Court”) denied Midland Funding LLC’s petition for certiorari in Madden v. Midland Funding, thereby letting stand a ruling by the Court of Appeals for the Second Circuit (the “Second Circuit”) that the National Bank Act (“NBA”), which preempts state usury laws for national banks, is not applicable to debt a bank transfers to a third party that is not a national bank or acting on behalf of a national bank. The Second Circuit also raised (without deciding) the issue of whether an interest rate that is valid in a state identified in a debt instrument’s choice-of-law provision applies to assignees that are not national banks.
Although Madden involved consumer credit card debt, the proposition that third-party assignees are not entitled to charge and collect contractual interest rates for debt acquired from national banks may have broader implications. First, the Second Circuit ignored a long-standing principle that if an interest rate is valid when the loan is made, it remains valid even when the loan is sold or transferred to a third party. (See Nichols v Fearson, 32 U.S. 103, 108 (1833)). The ruling may thereby weaken the secondary market for loans originated by national banks, at least within the Second Circuit, which includes New York, a major financial center. Second, the Second Circuit concluded that enforcing state usury law against a non-bank assignee does not significantly interfere with an assignor national bank’s rights notwithstanding the potential effect on its sale of the loan to investors.
Section 85 of the NBA
Section 85 of the NBA permits national banks to “charge on any loan . . . interest at the rate allowed by the laws of the State, Territory, or District where the bank is located.” For example, as in Madden, a national bank located in Delaware may collect an interest rate that is valid in Delaware, even though it may be usurious in the state where the borrower is located. As a federal law, Section 85 preempts state usury law.
In Madden, the Second Circuit addressed whether Section 85 of the NBA continues to preempt the borrower’s state usury law after a national bank lender sold the loan to a third party that is not a national bank. Midland Funding, a non-bank that acquired the loan from a national bank, argued that a loan, which is valid when made, cannot become usurious by virtue of a subsequent transaction. Midland relied on a principle known as “valid-when-made” which, it argued, has been firmly established in common law long before the NBA was enacted and was therefore incorporated into Section 85 of the NBA. See Nichols v Fearson, 32 U.S. 103, 108-09 (1833) (confirming the “cardinal rule” that the determination of whether a loan is usurious occurs at the time of origination). Midland prevailed in the District Court but the Second Circuit reversed on appeal and remanded the case to the District Court.
The Second Circuit held that in order “[t]o apply National Bank Act preemption to an action taken by a non-national bank entity, application of state law to that action must significantly interfere with a national bank’s ability to exercise its power under the National Bank Act.” In so holding, the Second Circuit reasoned that it would be an overly broad application of the National Bank Act to extend its protections to non-national bank entities that are not acting on behalf of a national bank.
Implications of the Supreme Court’s Decision Not to Review the Second Circuit
Courts of Appeals for the Fifth, Seventh and Eighth Circuits, have upheld the valid-when-made principle. The Second Circuit in Madden did not address the principle at all and instead based its ruling on the absence of significant interference with the assignor bank’s powers under the NBA. It remains to be seen whether the Supreme Court’s decision to decline review of Madden will result in loans to borrowers located in states within the Second Circuit (Connecticut, New York and Vermont) being more difficult for lenders to sell or securitize, and thereby tightening the availability of consumer credit in those states. It also remains to be seen whether Madden’s impact will extend beyond consumer loans.
Going forward, non-bank debt purchasers acquiring loans to borrowers in the Second Circuit must ensure that the loans do not exceed applicable state usury laws. Alternatively, such non-bank debt purchasers could restructure financial transactions so that originating national banks retain material economic interests in, or contractual obligations with respect to, all loans once they are assigned or sold.
Finally, the Second Circuit in Madden remanded the case to the District Court to determine whether a contractual choice-of-law provision in the loan documents requires application of Delaware law, in which case the higher interest rate permitted in Delaware may be enforceable. The Second Circuit noted that the District Court should decide the choice-of-law question “in the first instance,” suggesting that regardless of the District Court decision, the choice-of-law question would be ripe for appeal.