Editor’s note: This is an altered version of a post that originally appeared on the Credit Slips blog.
Currently pending in both houses of Congress are versions of the Protecting Consumers Access to Credit Act of 2017 — bills that would “fix” the 2015 appellate court decision in Madden v. Midland Funding LLC. Unfortunately, these so-called legislative solutions are based on a faulty reading of case law.
The Madden case held that National Bank Act preemption of state usury laws applies only to a national bank, and not to a debt collector assignee of the national bank. The decision has potentially broad implications for all secondary markets in consumer credit in which loan assignments by national banks occur: securitizations, sales of defaulted debt and rent-a-BIN lending.
Unfortunately, the “Madden fix” bills are overly broad and unnecessary and will facilitate predatory lending. Specifically, the Madden fix bills claim to be restoring the so-called “valid-when-made” doctrine, which, according to proponents of the legislation, means that the usurious or nonusurious nature of a loan is fixed at the time when the loan is made. The problem is that this particular doctrine is wholly concocted. There is a “valid-when-made” doctrine in commercial law, but it means something entirely different than the Madden fix proponents claim.
The actual “valid-when-made” doctrine provides that the maker of a note cannot invoke a usury defense based on an unconnected usurious transaction. The basic situation in all of the 19th-century cases establishing the doctrine involves X making a nonusurious note to Y, who then sells the note to Z for a discount. The discounted sale of the note can be seen as a separate and potentially usurious loan from Y to Z, rather than a sale. The valid-when-made doctrine provides that X cannot shelter in Y’s usury defense based on the discounting of the note. Even if the discounting is usurious, it does not affect the validity of X’s obligation on the note. In other words, the validity of the note is a free-standing obligation, not colored by extraneous transactions.
“Valid-when-made” was a sensible and indeed critical rule for 19th-century commercial law. In the 19th century, negotiable instruments such as notes passed as currency, and their liquidity depended on them being “travelers without baggage,” such that parties could accept them without undertaking diligence beyond the four corners of the note itself. The rule is not only practical, but also just — why should X get a windfall because of Y’s separate dealings with Z?
But notice that the actual valid-when-made doctrine has absolutely nothing to do with the Madden situation. The consumer in the court case did not attempt to invoke the rights of the national bank against the debt collector. Instead, the consumer’s argument was that the interest rate on the debt was usurious — and clear — under state law from the get-go. The state usury law’s application is preempted by the National Bank Act as applied to national banks, but only as to national banks; the National Bank Act does not void the state usury law, only stay its application. Once the note leaves the hands of a national bank, the state usury law applies as it always would. This too is a sensible outcome. National banks are not subject to certain state laws because they are subject to an alternative federal regulatory regime. An assignee of a national bank is not subject to that regulatory regime, however, so it should not get that regime’s benefits lest there be a regulatory vacuum. And because consumer debts are not used as currency, there is no policy reason to enhance their liquidity by excusing debt purchasers from basic diligence.
The point is that Madden did not reverse long-standing case law; the National Bank Act was not held to preempt state usury laws in any circumstances until 1978. Instead, Madden reversed some relatively recent assumptions of the financial services industry about the scope of National Bank Act preemption in secondary markets, the foundations of which I questioned in a 2009 article. The Madden fix bills are not restoring long-standing doctrine, but creating it out of whole cloth to meet the financial services industry’s desires about what the law should be, not what it is.
The flawed legal foundations of the Madden fix bills also present another problem: They fail to incorporate an important corollary doctrine. The courts have consistently distinguished between a situation in which there is a legitimate loan and an unconnected usurious transaction, and situations in which the assignee is the true lender and the assignment is a sham. Thus, the sale of defaulted loans to a debt collector who has had no input in the loan’s underwriting is entirely different under this doctrine than a rent-a-BIN operation, in which the assignee is substantially involved in marketing and underwriting the loans.
The Madden fix bills fail to distinguish between these situations. Instead of merely protecting relatively benign financial transactions, like credit card securitization or even facilitating a secondary market in defaulted loans, the Madden fix bills are actually facilitating predatory lending through rent-a-BIN and rent-a-tribe schemes that have no purpose other than the evasion of state usury laws and other consumer protections.
In any event, it’s not clear that the Madden court decision poses any problem that needs fixing. The bills cite a single, unpublished academic study that shows that some marketplace lenders responded to Madden by limiting credit to borrowers with low FICO scores. The study does not indicate the total dollar amount of that credit contraction, much less if it was offset by increased lending from other sources, or its effect on consumer welfare. We simply don’t know the net effect of Madden on credit markets.
Even if there were a net reduction in credit as a result of Madden, that access to credit must be balanced against sensible borrower protections. If access to credit were everything, we should be eliminating limitations on debt collection and allowing consumers to pledge their children and organs as collateral.
Usury laws are the oldest form of borrower protection known. They are blunt tools, but that is also their virtue, insofar as they are easy to administer. Congress should be hesitant to do a quickie, backdoor repeal of laws that have been on the books since colonial times, especially as state legislatures are free to repeal their usury laws directly.
It’s reasonable to rethink the role of state usury laws in national credit markets, but any erosion of consumer protections on the state level must be matched by a strengthening of those protections on the federal level, such as with a federal usury floor or an ability-to-repay requirement. Sadly, the Madden fix bills don’t do this, and instead gut state usury laws in the name of restoring an imaginary legal doctrine that never existed.