Morriello and Camp Discuss Heightened Regulatory Scrutiny on Marketplace Lending with SCI
Finance Department chair and partner and head of the firm’s Structured Finance practice, Henry Morriello, joined Finance partner, Lawton Camp, during a recent live webinar with Structured Credit Investor (SCI) on the impact of heightened regulatory scrutiny on the U.S. marketplace lending industry.
In their interview, Morriello and Camp discussed how the Madden case is expected to impact the marketplace lending industry specifically, as the case decision could affect a wide array of bank-originated loans that are then sold to non-bank entities.
“A typical marketplace lending structure involves a national bank or federally chartered institution originating loans based on criteria established by the bank and the marketplace lender. The bank transfers that loan to the marketplace lender or to investors that are funding the loan after a certain period of time has passed.
Pursuant to the National Bank Act and Section 27 of the Federal Deposit Insurance Act, a bank that is federally insured may impose fees in accordance with the usury laws of the State in which it is located. Web Bank, for example, is located in Utah; therefore, you would look to Utah's usury law–regardless of the location of the borrower. Before Madden, it was assumed by marketplace lenders and investors that if the loan was enforceable at the time of issuance, it would be enforceable by any subsequent assignee.
The Madden case involves a collection action with respect to a charged-off credit card account. The credit card was issued by a bank in Delaware related to Bank of America. The charged-off account was purchased by Midland Funding, who attempted to collect on the outstanding balance. Midland continued to charge interest on the outstanding balance after it purchased the charged-off account at the original default rate.
Madden sued in the District Court of New York, claiming–among other things–that as Midland isn't a bank, it may not rely on the federal pre-emption relied on by the Delaware bank. This pre-emption had allowed the Delaware usury laws to be exported to New York, where Madden resided.
The District Court upheld the exporting of the interest rate, but the Second Circuit subsequently overturned the ruling and stated that once the Delaware bank had sold the entire account to a non-bank, the non-bank holder of the account could not rely on the federal pre-emption relied on by the Delaware bank. However, the Second Circuit remanded the case to the District Court to determine whether the law of the State of the consumer or the governing law of the underlying contract would apply.
In the context of marketplace lending, the decision creates concerns by non-bank holders of marketplace loans that they may not be able to enforce collection on a loan if the interest rate on the loan is above the relevant State usury rate.”
“The Madden ruling has the greatest impact in the consumer sector, where civil usury limits come into play. The ruling has implications for everyone involved in marketplace lending, especially as loans move from platforms to investment vehicles to securitization vehicles. It has precipitated a good deal of proactive structuring to allow issuers to get comfortable that the ruling won't interfere with cash flows, nor subject them to any sanctions.”
Camp also noted that “With respect to Madden, the district court will need to determine which State usury rate applies. Beyond the specific facts in Madden, the appropriate State usury limit may depend on the law of both the State where the loan was originated and the State in which the borrower resides. It will be interesting to see if the Supreme Court decides to review the decision.”
When asked to opine on the ramifications of the Madden decision being adopted by other States, Camp shared, “A number of other States also have precedents that are the contrary to Madden. But there are cases in other States, such as West Virginia, that are not as favorable.”
Morriello further explained:
“Generally speaking, usury is a matter controlled by State law and, therefore, the outcome of situations like the Madden case will likely vary State-to-State. For States that have adopted the Uniform Consumer Credit Code (UCCC), the law of the State in which the consumer resides will generally control. However, in States that aren't subject to the UCCC, a further analysis must be made as to whether the controlling law will be the law in which the consumer resides or the governing law of the contract.
Against this backdrop, during the aggregation phase prior to tapping the capital markets, various provisions are being inserted in financing documents for loans to become ineligible if Madden spreads to jurisdictions beyond those located in the Second Circuit.”
During the interview, SCI noted that the Treasury, in its RFI, asked if marketplace lending platforms should be required to have skin in the game for the loans they originate. Morriello commented on how this issue is likely to play out. He stated:
“Our view is that there needs to be alignment of interest among participants in the market, but that the Dodd-Frank provisions are adequate to cover ABS investors that aren't 'at the table' to negotiate risk retention into their own contracts. Generally under these provisions, the sponsor in a securitization is required to hold 5% of the risk associated with the ABS.
That 5% can be attained in different formats, from horizontal to vertical or even L-shaped tranches. The goal is to encourage sponsors to “issue responsibly because they're retaining 5% of the risk.
Marketplace lending securitization participants generally include the originating bank, the platform, the aggregator (which buys the loans from platforms to then securities) and the ABS issuer (which is normally an affiliate of the aggregator). The view of many trade organizations is that these parties are able to negotiate for themselves the appropriate level of risk that they should take and that regulation isn't necessary to protect them.”
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