As every banker knows, the secondary market for bank-originated loans is enormous. Banks depend heavily on the secondary market for liquidity, diversification of funding sources, and as a source of capital for their lending activities, both consumer and commercial. And it is not just the secondary market for newly originated loans that is important for banks – banks also tap into the secondary market to extract residual value from delinquent or charged off debt. That latter type of activity received a severe and potentially painful jolt when the United States Court of Appeals for the Second Circuit, based in New York, handed down its decision in Madden v. Midland Funding, LLC on May 22, 2015.
The facts that give rise to the court issue in the Madden case are relatively simple. The plaintiff in the case, Saliha Madden, opened a credit card account at Bank of America, a national bank. At some point Ms. Madden defaulted on her account and the balance was charged off, and ultimately the charged-off receivable was purchased by Midland Funding, LLC. After acquiring the charged-off debt Midland Funding attempted to collect the balance due from Ms. Madden.
The interest rate which governed Ms. Madden’s credit card account was based on Delaware law, and Midland Funding attempted to collect interest on the account at a rate permitted by Delaware law but in excess of that permissible under New York law, where Ms. Madden resided. For that reason, Ms. Madden sued Midland Funding in an attempted class action, arguing that the interest rate which Midland Funding sought to apply on the account was usurious and in violation of New York law. It is certainly well known that banks have the ability to “export” their home state usury limits under federal statutes that provide that a bank may charge interest at a rate permissible under the laws of the state where it is located, regardless of whatever interest rate limitations may exist in the borrower’s state. For national banks this right to export their home state usury limits is found in the National Bank Act and codified at 12 U.S.C. § 85.
The Madden case squarely puts at issue the question of whether the exportation doctrine applies to debt that has been originated by a national bank but then sold to a non-bank entity. Not surprisingly, Midland Funding argued that it was entitled to rely on the exportation doctrine and argued that 12 U.S.C. § 85 preempts any conflicting state law, i.e., New York’s usury limits. The Madden court rather summarily rejected that argument, concluding that because Midland Funding is not a national bank it is not entitled to the protection of the exportation doctrine created by the National Bank Act.
In reaching the result that it did the Madden court had to deal with well-established precedent concerning the extent of federal preemption of state law that is created by the National Bank Act. According to the United States Supreme Court and a wealth of caselaw elsewhere, the National Bank Act not only preempts state laws that expressly prohibit a national bank from doing things it may do under federal law – beyond that, the National Bank Act also preempts state laws to the extent that they significantly interfere with a national bank’s ability to exercise its powers (such as the power to loan money) under federal law.
With virtually no analysis of the issue, the Madden court rejected the contention that failure to apply the exportation doctrine to buyers of debt from national banks would significantly interfere with a national bank’s powers. The effect of Madden is that buyers of bank-originated debt, at least in the Second Circuit, can no longer rely with certainty on the exportation doctrine and instead may need to worry about complying with usury laws in every state in which the underlying borrowers reside. The Madden court seemed to simply assume that such a state of affairs would be of no concern to national banks.
In reaching the result that it did the Madden court had to distinguish two other federal Circuit Court of Appeals decisions that reached the opposite result on the same issue, both from the Eighth Circuit (South Dakota is in the Eighth Circuit). Indeed up until Madden the leading case on this issue was Krispin v. May Dept. Stores Co., handed down by the Eighth Circuit in 2000. In Krispin May Department Stores set up a subsidiary national bank to issue its department store credit cards, but May Department Stores on a regular basis bought all credit card receivables originated by its subsidiary bank. A cardholder brought suit against the department store chain, claiming that once the receivables were sold to the retailer it could no longer rely on the national bank’s exportation rights. The Eighth Circuit disagreed, holding that if the fees and interest rates charged on the account were permissible in the hands of the originating national bank, they remain permissible and immune from challenge notwithstanding the subsequent sale of those receivables to the non-bank retailer.
The Madden court distinguished Krispin by noting that in the case before it the underlying credit card account had already been closed and the originating bank had no more interest in the credit card relationship once it sold the charged off receivable to Midland Funding, while in Krispin the bank continued to hold the underlying credit card account even after its sale of receivables arising from that account to the retailer. Madden used that fact as a basis for distinguishing the case before it from Krispin.
The problem with the distinction made by the Madden court is that banks sell an enormous amount of loans into the secondary market in which they retain no continuing interest in the loan once it is sold; this would be especially true, for example, in the case of closed-end loans such as residential mortgage loans and auto loans. The rationale of the Madden decision presumably could be used to challenge the exportation doctrine with those types of loans once they are sold off by the originating bank.
The statute before the Madden court was the federal statute giving national banks the power to export their home states’ usury limitations. The Madden decision does not touch on the corresponding federal statute that provides state banks with the ability to export their home state usury limitations. Presumably the rationale used by the Madden court could also be applied to challenge interest rates charged on loans sold in the secondary market by state banks.
Following the release of the Madden decision the defendants promptly filed a motion for a rehearing of the case. Not surprisingly, nearly a dozen financial services organizations and trade groups (including the ICB) filed amicus briefs urging the court to rehear the case, pointing out flaws in the Madden court’s reasoning and the potential damaging effects of the case on the ability of banks to sell their loans in the secondary market. Unfortunately, on August 12 the Second Circuit issued an order denying the request to rehear the case.
There remain two routes for the defendants to avoid the consequences of the Madden decision. One would be to seek review of the case by the United States Supreme Court. Although over the years the US Supreme Court has seemed to take interest in cases involving the preemptive authority of federal banking laws and the exportation issue, there is no guarantee that the Supreme Court would take the appeal.
There is one other route Midland Funding could pursue for a reversal of its fortunes. Ms. Madden’s credit card agreement provided that is governed by Delaware law. In the lower court proceedings, in addition to relying on the exportation doctrine, the defendants also argued that they should be able to enforce the Delaware choice of law clause in the underlying credit card agreement (the interest rates charged on the account were legal under Delaware law). Because the lower court relied on the exportation doctrine to find for the defendants it would not reach the question of whether the defendants could enforce the choice of law clause. After finding for Ms. Madden on the exportation doctrine the Second Circuit Court of Appeals remanded the case to the lower court for consideration of whether in fact the defendants could enforce their choice of law clause. However, that will be a tough row to hoe for Midland Funding.
The Madden decision introduces a significant amount of uncertainty as to the interplay of state usury laws and loans sold in the secondary market. Even if the federal judiciary ultimately finds some way to fix the problem created by Madden, it may take several years to get there.
Davenport, Evans, Hurwitz & Smith, LLP, located in Sioux Falls, South Dakota, is one of the state’s largest law firms. The firm’s attorneys provide business and litigation counsel to individuals and corporate clients in a variety of practice areas. For more information about Davenport Evans, visit www.dehs.com.