By Dawn Causey, Thomas Pinder and Andrew DoersamThanks to the Second Circuit’s 2015 decision in Madden v. Midland Funding, lenders are operating in an unpredictable marketplace, facing uncertainty whether the Madden court’s questionable analysis will infect other circuits. According to Madden, when nonbanks purchase loans from banks on the secondary market, the usury laws of other states can apply. To stop Madden from flooding into other circuits, the OCC and FDIC filed a compelling friend-of-the-court brief urging a Colorado federal district court to ignore Madden and uphold the sanctity of the “valid when made” doctrine. What is more, OCC and FDIC each proposed rules to codify the “valid when made” doctrine.
For nearly two centuries, the valid when made doctrine has served as the bedrock for bank lending. Under this doctrine, a loan that is valid from the start cannot become usurious after the loan is sold or transferred to another person. Incredibly, the Second Circuit did not acknowledge the doctrine in Madden. The Second Circuit reasoned that applying New York usury law to Midland, a purchaser of charged-off credit debt, did not “significantly interfere” with a national bank’s ability to exercise its powers under the National Bank Act.
The OCC swiftly criticized Madden. In an amicus filing, the U.S. solicitor general and the OCC called Madden “incorrect.” They implored the Supreme Court to deny Midland’s petition, because the case was a poor vehicle for the court to address the merits given the Second Circuit’s failure to consider the valid when made doctrine. After Supreme Court refused to review Madden, overzealous plaintiffs’ attorneys had an opportunity to cite Madden as precedent for litigation in other circuits.
And this prescience was validated in Colorado. During a bankruptcy proceeding, Rent-Rite tried to halt a $660,000 proof of claim submitted by World Business Lenders. WBL acquired a business loan from Bank of Lake Mills, a state-chartered bank, that carried an interest rate of 120.86 percent. Rent-Rite sought to disallow the claim because the interest rate exceeded Colorado’s 45 percent state-law maximum. However, the bankruptcy court ruled that under Section 27(a) of the Federal Deposit Insurance Act, Bank of Lake Mills could charge the 120.86 percent interest rate because the rate was permissible under Wisconsin law. “The valid when made rule remains the law,” the court wrote. “Any contrary legal standard would interfere with the proper functioning of state banks and risks a myriad of problems.”
The OCC and FDIC lauded the bankruptcy court in their joint brief for brushing aside Madden. Describing Madden as “unfathomable,” the agencies strongly asserted that under the valid when made doctrine, an interest rate that is non-usurious when the loan is made remains non-usurious after the assignment of the loan. According to the agencies, the Second Circuit “blink[ed]reality” by ignoring the fact that “if the interest rate is not enforceable upon assignment, there is nothing for the bank to assign.” In other words, banks must be able to sell their loans, and the state law at issue in Madden was preempted because banks would be precluded from transferring their rates to assignees. What is more, if banks cannot transfer their usury-exempted rates, and assignees cannot enforce them, the agencies emphasized that loan sales to the secondary market would be “disastrous” for banks, which need the ability to sell loans to properly maintain their capital, liquidity and ultimately their safety and soundness.
The long-running saga of Madden entered a new phase when OCC and FDIC issued proposed rules that codify the “valid when made” doctrine. To end the Madden uncertainty, OCC proposed to amend 12 C.F.R. § 7.4001 (for national banks) and 12 C.F.R. § 160.110 (for federal savings associations) by providing that interest on a loan will not be affected by the sale, assignment, or other transfer of the loan. Additionally, FDIC proposed a new regulation (12 C.F.R. § 331) to clarify that an interest rate is determined at the time that the loan is made, and that the interest rate is not affected by later events. However, neither proposal addresses the “true lender” doctrine. Under the true lender doctrine, the entity that makes a loan and then assigns it to a third party is the true lender.
It remains to be seen if the Madden mess will finally be fixed. The proposed rules are an important development given that plaintiffs have relied on Madden to challenge marketplace lending arrangements or other traditional secondary market loan sales. Hopefully the agencies’ brief and proposed rules will serve as a levee to stop the Madden flood waters from expanding.
Dawn Causey is general counsel at ABA, where Thomas Pinder is depty general counsel and Andrew Doersam is a paralegal.