Examining Madden v. Midland Funding
by Richard Kelly, Managing Director, NewOak NewOak is an independent financial services advisory firm. Led by a team of experienced market and legal practitioners, NewOak provides a broad range of services across multiple asset classes, complex securities and structured products for banks, insurers, asset managers, law firms and regulators, including financial advisory and dispute resolution, valuation, credit and compliance, risk management, stress testing, model validation and financial technology solutions. Reprinted with permission.
Over time, we have grown accustomed to banks and credit card companies charging high interest rates on consumer loans, sometimes upwards of 30%. This raises the question: whatever happened to the usury laws enacted by many states to prevent the collection of “unconscionable” interest rates? The answer, at least for national banks and their affiliated credit card companies, is that state usury laws are preempted by the National Bank Act (NBA), which allows national banks to charge the lawful interest rate of their home state, regardless of the usury laws of the consumer’s domicile. Needless to say, most banks have chosen to domicile their credit card financing operations in states with extremely high usury rates.
However, what happens when debt is assigned by a national bank to an entity that is not a national bank? A recent decision by the U.S. Court of Appeals for the Second Circuit (which includes New York) has brought the availability of a usury defense in such a situation to the fore.
In Madden v. Midland Funding, LLC, the plaintiff filed a class-action complaint against the defendant, a debt collection firm that purchased her charged-off account from a bank, claiming that, since New York usury law caps annual interest at 25%, Midland’s attempt to collect the debt (which included interest at 27%) violated the Fair Debt Collection Practices Act. The Second Circuit held that Midland, which is neither a bank nor acting on behalf of a bank, was not entitled to the benefit of the preemption provisions of the NBA.
In other words, while the bank that originated the loan could collect interest at 27%, the non-bank holder of the loan was subject to the usury law of the borrower’s domicile. Commentators have suggested that this holding, if affirmed, could have a significant impact on the secondary market for consumer loans by impairing banks’ ability to move assets off their balance sheets via securitization and dispose of nonperforming assets through discounted sales to debt collectors.
Decision Sparks Debate
Not surprisingly, the decision has spurred strong reactions. Some commentators argue that the Second Circuit ignored the “valid-when-made” doctrine, a fundamental principal of contract law that states a valid contract may be assigned unless the assignment would materially increase the obligation or change the duty of the obligor. In the case of a monetary contract, the identity of the payee is generally irrelevant to the payor.
Assuming that the Second Circuit did not disregard (without comment) a legal principle that lawyers learn in first-year contracts class, it may be a better interpretation to say the court found the NBA’s provisions remedial rather than substantive, meaning that the NBA provisions apply exclusively to a certain class of contracting parties (national banks), notwithstanding state provisions to the contrary, and address the issue of available remedies against that class of parties rather than the substantive law of the contract itself. The Court speaks of the “protections” of the NBA, which it suggests extend only to the defined class (national banks). The protection ceases when a member of the protected class no longer has any interest in the contract (when it is assigned to a third party for value).
Key Issues Undecided
Equally important as its holding is what the Second Circuit did not decide: the effect of the choice of law provision in the credit agreement itself, which specified that Delaware law applies. Because of its erroneous decision on the reach of the NBA, the trial court dismissed the case without reaching this question. The Second Circuit did not address it either, but remanded the case to the District Court for determination. Of course, if Delaware law (including its 27% usury ceiling) governs the contract, the plaintiff is out of luck.
The Second Circuit also did not decide (or even refer to) the possible effect of a “savings clause” in a credit agreement. Such a clause typically provides that if the stated interest rate is found to be usurious, it will automatically be reduced to the maximum legal rate. It is not clear whether the agreement in Madden had such a clause. Finally, the Second Circuit did not decide whether class certification could be granted in this case.
That too was left for the District Court on remand. As mentioned below, even if the plaintiff wins on the choice of law question, class certification is the only feasible mechanism for the assertion of usury claims by numerous small plaintiffs.
Secondary Market Concerns Overblown?
Much of the commentary on this case suggests that the holding in Madden, if it stands, will jeopardize the secondary market for consumer loans. This concern is exaggerated for several reasons.
First, only two classes of consumer debt purchasers exist in the secondary market: collection firms, who buy defaulted debt at greatly discounted prices in hopes of collecting some portion of it; and the far larger class of entities that purchase non-defaulted debt in connection with securitizations. We believe both classes of purchasers are capable of “pricing in” any usury risk without materially damaging the market for such assets.
The vast majority of consumers pay their credit cards on time, and many are unaware of the actual amount of interest they are paying. And few individuals (who typically have credit card balances of a few hundred to a few thousand dollars) have the will or wherewithal to litigate this issue. It is far cheaper simply to pay. If class certification were granted, the situation might be different. Even then, however, the amount of damages that the class could collect might be limited. The Madden plaintiff was being charged interest at 27%; on average, credit cards are currently charging (non-penalty) interest rates a little over 16%. Thus, the “average” cardholder is paying a rate that may well be below (or only slightly above) the usury rate in the holder’s domicile state.
Second, even if a usury defense is permitted (as against a nonbank holder), in most states this means the holder will be limited to collecting interest at the legal rate. Furthermore, this limitation applies only to interest that accrues after the debt is transferred to a nonbank entity: pre-transfer interest is “protected”. So the transferee is exposed only to the extent of the difference, and only from the date of transfer. In the case of collection firms, who are purchasing only defaulted debt (and always at very significant discounts), the effect of this exposure on their net realization likely will be minimal (and priced in by means of a greater discount).
In the securitization context, if the originating bank retains an interest in the pool (i.e., the residual equity), Madden indicates that the NBA protection applies. However, even if this were not the case, the securitization structure would allow the usury risk to be priced in with a level of comfort by a minimal increase in overcollateralization. Credit card receivables are a large, liquid asset class. At the moment, typical overcollateralization for AAA securities is 18.5%, not including the excess spread (the difference (around 12% p.a.) between the interest rate paid by the cardholder and the interest being paid by the issuer to the AAA bondholder). Given this amount of credit enhancement, the usury risk should not have a material effect on either rates or liquidity.
In summary, the Madden decision will have a limited effect on the secondary market for consumer debt. If the securitization market remains relatively broad and deep, there should also be no material impact on the availability of consumer credit.
 New York has a particularly stringent usury law: the civil usury rate is 16%; the criminal usury rate is 25%. In addition, while many states simply prohibit the collection of usurious interest, under NY law a usurious contract is void, which means that the holder of a usurious note may not be able to collect the principal.
 It could be argued that a contract made in NY with a NY domiciliary that calls for payment of a usurious rate of interest is not “valid-when-made” under the law that, absent the NBA, would govern the contract. NY usury law reflects strong public policy considerations of the state, which suggests that federal preemption provisions should be read as narrowly as possible.