Guess Who's Supporting Predatory Lending?

Guess who’s sponsoring legislation to facilitate predatory lending? It’s not just the usual suspects from the GOP, but it looks like a number of centrist “New Democrats” are signing up to help predatory financial institutions evade consumer protections. 

Yup, you heard me right: Democrats. Ten years after the financial crisis, it seems like we’ve gone back to the mistakes of the Clinton years when centrist Democrats rode the financial deregulatory bandwagon. What I’m talking about is the McHenry-Meeks Madden “fix” bill, the “Protecting Consumers’ Access to Credit Act of 2017”. The bill effectively preempts state usury laws for non-bank finance companies like payday lenders in the name of ensuring access to credit, even if on extremely onerous terms.

Right now there's only one Democratic co-sponsor, but others seem to be preparing to join in. They shouldn't, and if they do sign onto this bill, it should only be in exchange for some solid consumer protections to substitute for the preempted state usury laws. This bill should be seen as a test of whether New Democrats "get it" about financial regulation. I'm hoping that they do. If not, perhaps its time to find some new Democrats.   

Here’s what’s going on. Every state has some sort of usury statute. The statutes have limited bite these days because of a 1978 Supreme Court decision that held that the usury rate applicable to a national bank is that of its home state, not that of the state in which it is conducting business. In other words, national banks can export usury limits from one state to another. As a result, national banks that have major credit card operations have congregated in states with no or high limits, such as Delaware, Nevada, and South Dakota. States then followed with parity laws to protect their own state-chartered banks competitiveness, and we ended up with a race to the bottom in which usury laws seldom matter for banks. But they still have plenty of bite regarding non-bank finance companies, such as payday lenders, vehicle title lenders, etc.

The current issue started in May of 2015, when the 2d Circuit Court of Appeals upheld a district court ruling in Madden v. Midland Funding. Madden involved a class action on usury claims against a debt buyer that purchased a bunch of charged-off Bank of America, N.A., credit card debt.  The debt buyer argued that because the National Bank Act preempted the state usury law, it was not in violation of the usury law for loans it bought from a national bank.  The 2d Circuit held that held that the National Bank Act preempts state usury laws only in regard to the national bank itself; the preemption is personal to the bank and not a feature of the loan, so if a national bank sells a loan to a non-national bank entity, then the state usury law will spring into force regarding the loan.  My earlier thoughts on the decision and more details are here. 

The financial services industry got terribly worked up over the Madden decision. Madden potentially affects not just the sale of loans by banks to non-banks, including both the sale of defaulted loans to debt collectors and the sale of performing loans, It might also cover the securitization of loans by banks because securitizations involve the sale of the loans to non-bank entities (that are often affiliated/controlled by the bank). The financial services industry pressed very hard to get the Supreme Court to hear the case (which was opposed by the Obama Department of Justice and OCC), but to no avail.

So instead, they went to work on the Hill. The result is a Madden “fix” bill co-sponsored by Rep. McHenry (R-NC) and Rep. Meeks (D-NY).

The McHenry-Meeks bill is cast as being about protecting consumers access to credit because Madden probably does reduce credit availability for some risky borrowers. It is also being cast as about protecting financial innovation in the form of “fintechs”. One of these days I’ll do a much longer blog post about the silliness of the term “fintech,” but let’s just say that this application doesn't just describe so-called "marketplace lenders," but also Internet-based payday lenders and the like. I’ll leave it to readers to make their own value judgments about such innovation.

So let’s be honest about what the McHenry-Meeks bill is. It’s not a “fix” bill. It’s a predatory-lending facilitation bill. If the concern were to insulate legitimate business functions such as securitization with retained servicing or the sale of charged-off loans for collection, it would be possible to draft a narrow bill that protects these practices. But that’s not what the McHenry-Meeks bill does. Instead, it enshrines a questionable legal doctrine known as the “valid-when-made” doctrine that says that if a loan wasn’t usurious when made, it cannot later become usurious.

Valid-When-Made Is Based on a Misreading of a Supreme Court Case by Someone Who Doesn’t Understand Negotiable Instrument Law

Valid-when-made is a wholly concocted doctrine without historical roots, at least as it is applied to the Madden situation. The McHenry-Meeks bill cites an obscure Supreme Court case, Nichols v. Fearson, 32 U.S. (7 Pet.) 103, 106 (1833), for the doctrine, specifically the allegedly “famous” line “Yet the rule of law is everywhere acknowledged, that a contract free from usury in its inception, shall not be invalidated by any subsequent usurious transactions upon it.”

There are two problems with the historical argument. First, this is an old general federal common law case under Tyson v. Swift whose validity after Tompkins v. Erie Railroad (1938) is questionable.  It's never been clear to me what happens to federal common law rulings that pre-date Erie; if federal courts lacked the power to make general common law, wouldn't that invalidate all of those decisions?  But if so, it would seem to create a commercial mess.  But this is a secondary issue.  Instead, the real problem is that the McHenry-Meeks bill, parroting the financial services industry's Madden briefs and some modern appellate decisions, simply misreads Nichols.

Nichols v. Fearson--Indorsement Isn't Just a Sale

Here’s the story with Nichols. Fearson sold some goods to X in exchange for a $101 promissory note. Fearson then indorsed the note to Nichols and received $97 for it. It’s important to understand that by indorsing the note, Fearson became liable on the note along with X. When Nichols attempted to enforce the note against Fearson, Fearson argued that it was unenforceable because it was usurious: Fearson had received $97 from Nichols against a promise to pay $101. That’s 4.1% interest annually, which apparently violated whatever the New York usury law was at the time.

The issue in the Nichols was whether the indorser could raise usury as a defense against the indorsee, not whether the maker could raise it as a defense against the indorsee. In other words, in a string of transactions from X to Y to Z, if X to Y is non-usurious, but Y to Z is usurious, can X shelter in Y's usury defense?  The indorser could raise usury as a defense if and only if the indorsement transaction was a loan, as the Court noted, “the rule is universal that there can be no usury, where there is no loan.” What made this question tricky for the Court was that under New York law if the discounting were usurious, it would render the note itself invalid, producing a windfall for the maker X, who would get out of paying a non-usurious note because of a subsequent usurious discounting.   The valid-when-made doctrine, to the extent it existed, was not about preemption.  It was about a maker's ability to shelter in an indorser's defense. 

How do I know I’m reading this case correctly? First, there’s the language itself, “any subsequent transactions upon it.” That means any subsequent indorsement transactions. It doesn’t simply mean subsequent sales, because an indorsement is more than a sale. It is a sale plus a guaranty by the indorser of payment on the note. The indorser has become liable on the note, which is different than with a straight sale. Hence the words “upon it”—indorsement is from the Latin “in dorso”—on the back. Second, I went back and looked at a bunch of old NY usury cases involving discounting of negotiable notes. They’re messy for modern readers, but a pleasure for a commercial law geek. And they’re quite clear about the issue. Consider this snippet from an 1831 New York Court of Correction of Errors cases (the state’s highest court at the time):

From this review of the cases, it appears that in most of our sister States, which have adopted the English usury laws, as well as in the Supreme Court of the U. S., and in England, it is held that a sale of a note for less than its nominal amount, on an advance of money or other thing, in the nature of a discount of the note, is usurious between the parties to such transaction, if the seller indorses the note, or otherwise guaranties the repayment of the purchase money. But there is a great conflict of opinion on the question whether any person who was legally bound to pay the note to the seller can take advantage of such usury as a defense. 

CRAM v. HENDRICKS, 7 Wend. 569, 581, 1831 N.Y. LEXIS 228, *23 (N.Y. 1831).

Here’s the point. The “valid-when-made” doctrine is about a totally different situation than in Madden. Valid-when-made is about whether a later usurious act can be bootstrapped into a defense by the maker:  in X to Y to Z, can X shelter in Y's usury defense.  It rightly cannot. But that’s not Madden. No one is claiming that the sale of the notes in Madden involved a usurious discounting.  Ms. Madden wasn't trying to shelter in Bank of America's usury defense against Midland enforcing its indorsement.  Ms. Madden was simply claiming that her loan was usurious from the getgo, only she was precluded from raising that claim against Bank of America on National Bank Act grounds.  Madden is all about the personal nature of National Bank Act preemption, an issue that didn’t exist at the time of Nichols v. Fearson.  

The National Bank Act does not render a loan non-usurious. Instead, it preempts application of the usury law against the National Bank. In other words the loan is not valid when made, but attempts to raise a usury defense are estopped as against a national bank. The current version of valid-when-made is a wholly-concocted doctrine created by reading a sentence in an old Supreme Court case completely out of context. It’s the kind of sloppy and disingenuous legal move a lawyer should be ashamed of (although that hardly stopped the financial services industry’s briefs against Madden). Someone should’ve taken a negotiable instruments course in law school….

Valid-When-Made Facilitates Predatory Rent-a-BIN Lending 

The concocted modern valid-when-made doctrine is a green light for predatory lending. It allows national banks to make otherwise usurious loans and immediately sell them to third-party finance companies that would not be subject to the usury laws on these loans. Whatever one thinks of the wisdom of usury laws (and there’s a good conservative Hayekian case for them), if we’re going to repeal them, let’s do it directly and after a frank debate on the issue, not through this kind of backdoor move. National banks should not be in the business of laundering loans for finance companies. And if you don’t think that will happen, then you aren’t familiar with the whole phenomenon of rent-a-BIN (and its cousin, rent-a-Tribe) in which payday lenders or refund anticipation lenders, or simply subprime credit card lenders like CompuCredit enter into arrangements with banks to purchase some or all of their receivables for loans made meeting certain program requirements set by the finance company.

Federal bank regulators have been worried about rent-a-BIN operations for a while and have even put out guidance about it. There are two key concerns. One is reputational risk. The other is counterparty risk: the bank makes a bunch of risky loans, assuming that they will be sold to the finance company, but the finance company fails to pay the purchase price (perhaps it’s been shut down by a state AG). The bank is then stuck with a bunch of risky loans it doesn’t want and a claim in the finance company’s bankruptcy.

Counterarguments Aren’t Very Convincing Because the “Fix” Is Overbroad

Madden “fix” proponents make a few arguments that all fail on close inspection. First, they argue that Madden is disturbing the credit markets. There’s no evidence of that. Madden came down two years ago and markets are operating just fine. The sky hasn’t fallen. Indeed, there are lots of ways for the market to adjust around Madden.  If a bank wants to shift credit risk on a loan portfolio to third parties there are lots of ways that it can do so short of outright assignment:  participations, credit-linked notes, both of which are clearly fine under Madden, and securitization, which might be an issue with Madden, but which can also be protected with a very narrow legislative fix.  

Second, they argue that Madden is constricting credit. They point to a study that shows a reduction in credit to low-FICO (<625) score borrowers in the Second Circuit post-Madden. That’s not surprising—the whole reason the national banks were selling the loans is that they were riskier than the banks wanted in portfolio. The study doesn't indicate the total magnitude of reduced credit, however, and it would appear to be relatively small as a relatively small percent of borrowers in the study had FICOs under 625.  Moreover, the argument proves too much. There are lots of regulations that constrain credit to riskier borrowers far more than Madden. If the goal is maximizing credit to riskier borrowers, why not get rid of federal wage garnishment restrictions and the Fair Debt Collection Practices Act, for example? Usury laws represent judgments by state legislatures about rates at which borrowing is presumptively too risky. If Congress wants to preempt those usury laws, that’s one thing, but it’s outrageous to allow national banks to launder usurious loans for predatory lenders.

Third, they argue that Madden interferes with the powers of national banks, which include selling loans. That’s just wrong. Madden doesn’t prevent loan sales. It prevents the sale of National Bank Act preemption rights. That’s not an asset the banks have to sell. (It’s worth noting that most community banks don’t sell their non-mortgage loans and don’t operate as origination front for finance companies. It’s just not their way of doing business. This is mainly about megabanks and big regionals.) For what it's worth, the OCC didn't think there was a problem here.  

Fourth, they argue that Madden reduces loans’ liquidity. Yup. It sure does. That’s the point. Liquidity reduces incentives to take care when lending because the lender isn’t stuck with the loan, and can exploit the informational advantages it has over loan buyers.  Such liquidity also undercuts relationship lending.  In any case, you want real liquidity benefits, you don’t sell the loans, you turn them into securities that are much more liquid than a loan can ever be. That’s securitization.  You get UCC Article 8 negotiability and limited liability (so no assignee liability issue for investors).  Again, if the “fix” were only about protecting securitization, that’s a different conversation.

Finally, a Madden fix proponents claim that “true lender” doctrine will handle the rent-a-BIN problem. Would that were the case. True lender doctrine is an equitable approach of looking through the sale to the buyer as the true lender. It is totally fact specific, so it has to be litigated in every instance. Moreover, true lender cases haven’t addressed the National Bank Act preemption issue, and defendants would surely argue that the McHenry-Meeks bill means that National Bank Act preemption attaches to any koan ever touched by a national bank.

So What Should Be Done?

My own sense is that there’s no problem with the world post-Madden, so why mess with things. But if a “fix” is needed, it ought to be (1) narrowly tailored, and (2) ensure maximum consumer protection. Democrats have the political leverage to get something out of the financial services industry’s desire to “fix” Madden. They should use it if they're serious about consumer protection. How they vote on this bill says a lot.  

By narrow tailoring, I think that any fix that goes beyond protecting securitizations by banks in which servicing is retained is facilitating predatory lending. Limit the “fix” to that situation and when the transfer occurs as part of a receivership or execution on a judgment or the like.

In terms of consumer protections, I think there are three key sets of consumer protections that should be required for what is effectively an override of state usury laws. This should be what Dems demand as the price for supporting any sort of Madden “fix”:

(1) an ability to repay requirement. Ability-to-repay is the new usury.It’s more flexible while getting at the same goal. And it can be made administrable with safe harbors, such as for loans with APRs under 36% or for portfolios with default rates under 5%. The CFPB’s proposed payday rule takes this approach, and we already have it on the federal level for mortgages and credit cards.  Some states also have ability-to-repay requirements.  

(2) the loans should have to positively amortize, have substantially level payments, and be freely prepayable. This is a move that already exists for credit cards (amortization and prepayable) and mortgages with QM.

(3) there should be no forced arbitration on the loans, and there should be full assignee liability (i.e., TILA assignee liability limitations do not apply).