The financial services industry is expressing alarm over a recent federal appeals court decision that threatens to curtail a key regulatory advantage held by depository institutions: their ability to sell off high interest-rate consumer loans to third parties.
The ruling, a unanimous judgment by a three-judge panel in New York, involves the sale of charged-off credit-card debt by a Bank of America subsidiary. Essentially, the court found that the bank's legal authority to charge an interest rate that exceeds state caps did not transfer to the debt buyer. If the ruling is upheld, experts say, debt buyers could be reluctant to acquire credit card and other consumer loans, forcing lenders to keep such loans on their books.
Since its release on May 22, the 29-page decision has triggered a wave of anxiety at law firms, rating agencies and financial industry trade groups. They all predict far-reaching negative consequences from the decision, not only for banks, but also for the fast-growing marketplace lending industry.
"It really does have catastrophic implications for the financial industry in the United States, because it could just bring to a halt a lot of the transactions that people take for granted today," said Richard Eckman, a partner at Pepper Hamilton LLP.
[Coming this November: Marketplace Lending + Investing. Hear how participants in this fast-growth niche are using data and technology to propel lending into the 21st century.]
The case, Madden v. Midland Funding, has sparked such vociferous warnings because it touches on a bedrock legal foundation for the U.S. banking industry the idea that the determination of whether a loan violates state usury law happens only at the time the loan is originated.
The B of A unit, FIA Card Services, made credit-card loans to a New York resident named Saliha Madden. The debt carried an interest rate of 27%, which is above the Empire State's usury cap. That's a routine practice in the credit card business, which relies on the longstanding doctrine that banks are allowed to apply their home state's interest rate to loans made across the country.
But the appeals court ruled that after the debt was charged off and sold to Midland Funding, it was no longer protected from state usury law. In other words, the collections firm couldn't seek to recoup the debt based on the original 27% interest rate.
The fear in the financial industry is that the decision will hinder the ability of consumer debt purchasers to collect repayment at the agreed-upon interest rate, which would make such investments less attractive.
The Clearing House, a big bank trade group, wrote in a friend-of-the-court brief filed in early July, "For almost two hundred years, it has been well-established in America that a valid loan cannot be rendered usurious by selling or assigning the rights to the loan to a third party."
The court ruling is thought to have the most significant potential ramifications for those segments of the financial industry in which banks play a relatively minor role, and are only involved because of their unique ability to preempt state usury limits.
That's often the case among marketplace lenders, sometimes known as peer-to-peer lenders. The burgeoning industry's leader, San Francisco-based Lending Club, which has a market capitalization of $5.5 billion, uses a small Utah bank to originate its loans before quickly buying them back and passing them along to investors.
In a July 17 report, analysts at Moody's Investors Service warned about potential ripple effects from the appeals court ruling, even in contexts that do not involve debt sales by banks.
"The ruling could have negative implications for securities backed by marketplace lending loans because it contains broad language and is not limited to the specific facts of the case," the report states.
The ultimate implications of the ruling, assuming it's upheld, are not clear.
Industry lawyers said that the decision could have an impact on any consumer credit market where banks originate debt and later sell it. But they also said that the court's reasoning poses less of a threat in contexts where banks play some ongoing role in the loans they've sold for example, by retaining the servicing rights.
Even if the ruling is eventually overturned, it could have a short-term impact on the decision-making of investors in securitized consumer loans.
"All they want to know is what the risks are," said Kevin Petrasic, a partner at White & Case LLP. "What Madden presents is a new element of risk that had not previously been factored in."
The defendants in the lawsuit have asked the full 2nd Circuit Court of Appeals to rehear the case. If that request is denied, they would likely file an appeal to the U.S. Supreme Court.