Marketplace lenders that have partnered with banks face more regulatory and legal scrutiny after a federal judge in California handed a legal victory to the Consumer Financial Protection Bureau.
A federal district court judge found on Aug. 31 that CashCall, an online loan servicer, engaged in unfair, deceptive and abusive practices when it sought to bypass state usury caps by partnering with an online tribal lender to collect debts from borrowers.
The decision raises fresh questions for marketplace lenders that have teamed up with banks to avoid the hassle of getting state lender licenses. Lenders can either invoke a national bank's federal pre-emption or a state bank's right to export interest rates nationwide to charge a uniform rate for all customers. As a result, consumers can end up paying higher rates than what is allowed under state regulations.
The question in the CashCall case is what constitutes the "true lender," with courts increasingly looking more closely at how lending partnerships are structured.
"It's a pretty big deal because this is going to add another layer of regulatory uncertainty," said Ori Lev, a partner at Mayer Brown. "This will impact lenders' willingness to fund marketplace lending and will cause some companies to change their structures."
Lending Club and Prosper, the two largest marketplace lenders, do not originate loans themselves but rather have teamed up with the $378 million-asset WebBank in Salt Lake City, which funds the loans. Both lenders have taken steps to protect themselves against legal challenges to their business models.
Mike Whalen, a partner and co-leader of Goodwin Procter's fintech practice, said case law in various jurisdictions has provided the industry with guidance on structuring bank partnerships. An institution must go beyond the loan documents and ensure that the bank maintains authority over the loan program and an economic interest in the loans, and in lender-related risk, he said.
"The key factors in many jurisdictions is the bank partner putting its own money at risk and funding the loans from its own balance sheet, as well as maintaining a level of economic interest and risk that one would reasonably expect of a lender," Whalen said.
Some marketplace lenders have changed the structures of their partnerships so the bank retains a percentage of the loans to prove an ownership risk in the business.
Marc Franson, a partner at Chapman and Cutler in Chicago, called the CashCall case "unsettling" but said there was "no cause for panic."
"The potential uncertainty is, how far down the road do you take this?" Franson asked. "Does this put a burden on servicers who now have to figure out if a loan is serviceable or not?"
The CashCall case was unique because the company had teamed up with an individual member of a Native American tribe, setting up a reserve account to fund a South Dakota company, Western Sky. Moreover, CashCall purchased all of Western Sky's loans, guaranteed a minimum payment every month, paid all marketing expenses, and fully indemnified the company for all legal costs.
The judge found that CashCall had a "predominant economic interest" in the loans and determined that the borrowers' debts were void and uncollectible in 16 states.
Will Black, a managing director at Moody's Investors Service, said the ruling was just the latest development to confirm that there are legal risks that could affect marketplace loans, particularly those that employ a "bank-partner" business model.
"The implications for the broader marketplace lending market remains unclear," Black said in an email. "Important differences exist between the business and origination models of marketplace lenders and the lenders losing these sorts of challenges. It appears that the details can matter greatly."
Regulators could address the problem on their own. The Office of the Comptroller of the Currency is contemplating a "limited-purpose" charter designed for fintech companies, a move that could propel them into the banking system and help resolve questions about their regulatory structure.
Richard Eckman, a partner at Pepper Hamilton, said the impact of the case on marketplace lenders could turn out to be minimal.
"A lot of times judges just get concerned about the price of these loans and it's a way for them to figure out how to put an end to it," Eckman said. "Marketplace lenders are operating in a totally different sphere with [annual percentage rates] below 36%, so there is less of a problem with state usury laws, which is a big distinction to make."
The Dodd-Frank Act essentially barred the CFPB from setting interest rates. Yet some think the CashCall case is another way for the bureau to seek jurisdiction to enforce state usury rates.
"This is a back-door way to achieve that," Eckman said. "I expect there will be some concern on Capitol Hill. You can't do indirectly what you can't do directly."
Others said the CFPB found a creative way to enforce a federal claim of unfair, deceptive or abusive acts or practices, known as UDAAP, for a violation of state usury laws.
"This will understandably embolden the CFPB to say what other places can we apply this in," Lev said.