Threat for bankers or jumpstarting innovation?
This article was originally published in the Winter 2016 issue of Delaware Banker. No part of this publication may be reproduced without the written permission of the editors. Copyright 2016 by the Delaware Bankers Association. All Rights Reserved. It is reprinted here with permission.
The impact of the marketplace lending phenomenon on the banking industry is evolving. While some thought that Lending Club and Prosper’s success signaled marketplace lenders as competitors, with the possible consequence of threatening banking’s traditional role as a consumer and small business lender, recent developments suggest that collaboration and innovation may prove to a more accurate outcome. Recent partnerships between Regions Bank and Fundera, and JP Morgan Chase with OnDeck show that the banking industry may be starting to embrace the advantages that these fintech lenders have over the traditional banking delivery channels by banks to offer a superior customer experience, greater accessibility, and faster decision making then they could do on their own.
At the same time, the marketplace lending industry has seen a significant uptick in attention from federal banking regulators. Marketplace lenders, or “peer-to-peer lenders” as they are often called, are online platforms that match investors with borrowers. The marketplace lending industry originated $12 billion in loans of various types in 2014, two platforms (Lending Club and OnDeck) have gone public, and several securitizations of these loans have been packaged and sold. Yet until this year, the industry has remained largely ignored by policymakers and regulators in any systemic way. In the consumer arena, there are a host of federal laws that apply to loans made to consumers, and many states have protections for borrowers, regardless of who the lender is. The state-by-state patchwork of laws and regulations, and application of securities and banking laws designed for other purposes, but applied to marketplace lending, have slowed the evolution of this marketplace more than would otherwise have been possible if the rules had been more carefully and robustly coordinated.
In 2015, we saw two of the major federal banking agencies focus their attention on this industry. First, the U.S. Department of the Treasury (the Treasury) issued a notice and request (the Request) for public information concerning the role of marketplace lending in the financial services industry. Second, the Federal Deposit Insurance Corporation (FDIC) issued Financial Institution Letter FIL-49-2015, warning banks about the risk of purchasing and participating in loans ordinated by non-bank third parties, such as marketplace lenders. Additionally, the recent 2nd Circuit decision in Madden vs. Midland muddied the waters for many is this growing industry.
Treasury Request for Information
The July 16, 2015 Treasury Request bore the hallmark of a preliminary, information-gathering inquiry. The Treasury posed 14 detailed questions to market participants regarding a wide range of topics including: the types of models used by marketplace lenders; the role of electronic data and their risks; how lenders tailor their business models to meet the needs of diverse consumers; whether marketplace lending expands access to credit to underserved markets; the marketing techniques used; the process used to analyze the creditworthiness of borrowers; the relationship between the industry and traditional depository institutions; the role the government could play in effecting positive change in the marketplace lending industry; whether risk retention rules should be applied to marketplace lenders; any harms marketplace lending may pose to consumers; and the secondary market for loan assets originated in the peer-to-peer marketplace.
This request was generally positive in tone and discussed the role that marketplace lenders have played to date in providing access to credit to small businesses and consumers who, in many cases, have faced barriers in accessing credit. Marketplace lenders continue to be able to deliver credit at a lower cost, in a more expedited fashion, and to a more diverse group of borrowers than traditional banks. This was recognized in the question posed by the Treasury what asked how marketplace lenders can continue to meet the needs of consumers who are part of traditionally underserved markets. However, some of the questions posed reflect a complete misunderstanding of how marketplace lenders operate.
By way of background, loans facilitated by marketplace lenders, which often use third-party banks to originate loans to consumers, are subject to a complete framework of federal and state consumer financial protection laws because they are typically originated by regulated financial institutions. Then, investors in marketplace loans typically are investing in securities, thereby providing them with the protection of the U.S. securities laws relating to disclosure and fraud. Additionally, some new investors are investing in marketplace loans through investment funds designed for these specific purposes, which funds are subject to regulation by both the Securities and Exchange Commission and the states.
The Treasury Request received more than 100 comment letters from marketplace lenders, online financial services providers, community banks, credit unions, institutional investors, payment services providers, public interest groups, consumer advocates, trade associations, and others. Such a broad response shows the impact that marketplace lending has had on traditional lending and the disruption that can occur when technology and innovation are combined in an industry ripe for innovation.
On November 6, 2015, the FDIC issued FIL-49-2015 in an effort to address perceived underwriting and credit risks to FDIC-supervised institutions associated with purchased loans and loan participations from third parties. The letter reminds those institutions of the importance of underwriting and administering purchased credits as if the loans were originated by them. This means that banks are required to perform a complete analysis of collateral and credit risk of each loan or participation and must have a complete understanding of the borrower’s market and industry. According to the letter, “this assessment and determination should not be contracted out to a third party.”
Banks must also conduct an independent analysis and validation of any credit models used by third-party originators. Finally, any third-party arrangements to facilitate the purchase of loans and loan participations must be managed by an effective third-party risk management process.
The FDIC pointed to the specific risks of purchasing and participating in loans originated by non-bank third parties, particularly loans that are unsecured, are made to out-of-territory borrowers, are to borrowers in industries unfamiliar to the bank, or are underwritten using proprietary models that limit the ability of the bank to assess underwriting quality.
The FDIC noted that it has seen several instances where “it is evident that financial institutions have not thoroughly analyzed the potential risks arising from third-party arrangements.” As if those requirements were not enough, the FDIC added additional burdens for banks as they are now required to obtain necessary board and committee approvals for purchases of loans or participations in loans, as well as when the banks intend to enter into a third-party arrangement to purchase or participate in loans.
These changes do not have a specific impact on marketplace platforms that purchase loans from banks that do the origination. Rather the FIL impacts banks that purchase loans from marketplace lenders. However, the banks that are impacted by the FIL will likely have substantial increases in costs imposed, particularly on smaller banks that wish to purchase market place loans. Although the number of loans being purchased by banks that are originated by marketplace lenders is not readily available, it appears that many lenders view loans originated by marketplace lenders as attractive for a number of reasons, including the elimination of origination expenses, the ability to obtain an attractive asset, and the difficulty that banks have in efficiently making smaller loans. These new requirements will undermine the ability of banks to purchase marketplace loans since they now come with increased costs.
The FDIC’s FIL is in direct contrast to the mostly supportive Treasury request for information. While Treasury is focused in part on how the federal government can be supportive of innovation in marketplace lending, the FDIC appears to be creating roadblocks to having banks participate in this dynamic and rapidly growing space.
Madden v. Midland Funding, LLC
In a controversial opinion decided on May 22, the U.S. Court of Appeals for the Second Circuit held that the National Bank Act does not preempt the application of state usury laws to third-party, non-bank assignees, in this case a debt buyer. The Court’s decision in Madden v. Midland Funding — which is inconsistent with long-standing circuit court precedent — complicates interest rate exportation authority for any non-bank party that purchases loans from a bank, including those involved in peer-to-peer or marketplace lending platforms. Third-party, non-bank entities risk losing the exportation advantage that an FDIC-insured bank has and may be subject to substantial penalties, including voiding of loans, for violating a borrower’s state usury laws.
In Madden, the plaintiff brought a class action against two non-bank defendants for violations of the Fair Debt Collection Practices Act and New York usury law. The plaintiff, a New York resident, opened a credit card account with Bank of America in 2005. The account was subsequently consolidated with the accounts of FIA Card Services, N.A. (FIA), a national bank headquartered in Delaware. Delaware does not have an interest rate cap for banks, so, under the National Bank Act (NBA), 12 U.S.C. § 85, FIA could collect interest at the rate set forth in the terms and conditions provided to the plaintiff, notwithstanding the usury limits in New York. The plaintiff owed a large balance on the credit card account, which was deemed uncollectable, so FIA sold it to the defendants, Midland Funding, LLC and Midland Credit Management, Inc. (collectively, Midland), which are large non-bank debt purchasers. Midland, after purchasing the account, exercised the right granted to it as assignee in the cardholder agreement to increase the interest rate to 27%, which exceeded the 25 percent per annum criminal usury rate in New York.
The U.S. District Court for the Southern District of New York held that the plaintiff’s claims were preempted by the NBA, denied class certification and granted summary judgment in favor of the defendants. On appeal, the Court held that the NBA does not preempt state usury laws when loans are assigned to non-bank assignees. Although the Court correctly noted that section 85 of the NBA preempts state law limitations on interest rates, it found that such preemption does not apply when a third-party, non-bank assignee acts on its own behalf (as opposed to on behalf of the originating bank) in assessing interest after the account has been sold to it by the national bank.
The Court distinguished two contrary Eighth Circuit cases, which essentially reflect black letter law that a loan that is valid at inception retains that distinction when assigned to a third party, whether a bank or non-bank. In Krispin v. May Department Stores Co., 218 F.3d 919 (8th Cir. 2000), the Eighth Circuit held that the NBA preempted usury claims against a defendant that purchased accounts from a national bank and emphasized that a court should look to the originating entity and not the third-party assignee when determining whether the loan is valid based on the preemption available to the originating bank. The Court distinguished Krispin by explaining that, in Krispin, the national bank maintained a substantial interest in the accounts to warrant the application of preemption under the NBA.
In Phipps v. FDIC, 417 F.3d 1006 (8th Cir. 2005), the plaintiffs brought an action against a non-bank entity for charging allegedly unlawful fees relating to mortgage loans. The Eighth Circuit held that the court should look to the originating bank to determine whether the NBA applies. The Court distinguished Phipps and explained that, in Phipps, the national bank charged the allegedly unlawful interest rate while, in Madden, the interest rate was charged after the loan was transferred to the defendants. In overturning the district court’s decision in Madden, the Court explained that, since Midland is neither “a national bank nor a subsidiary or agent of a national bank, or . . . otherwise acting on behalf of a national bank, and because application of the state law on which [the plaintiff’s] claims rely would not significantly interfere with any national bank’s ability to exercise its powers under the NBA,” the NBA did not act to preempt the plaintiff’s claims.
The Second Circuit decided not to rehear Madden and the defendants have filed a writ of certiorari to the Supreme Court.
Madden creates a disturbing precedent with respect to whether non-bank assignees can enforce national or state banks’ rights under loan agreements and may create a catastrophe, in the secondary lending markets, including securitizations, where loans are sold into a trust or other entity to be held for the benefit of investors who purchase beneficial interests in the pool of loans. Marketplace lenders and investors that purchase interests in loans originated by banks should pay close attention to this case since, if not overturned, could spawn a host of class action lawsuits challenging the rights of holders of such loans to collect interest at the rates made by the originating bank.
What Does This Mean for the Future of Marketplace Lending?
The marketplace lending industry has seen significant growth through innovation that has benefitted consumers, investors, and the entire financial system over the last few years. Recent partnerships with banks may prove promising for those institutions that want to jumpstart their ability to compete with other marketplace lenders and raise their fintech profile. However, recent attention by government agencies suggests that more scrutiny and possibly additional regulation may impede the growth of this of this industry and may make it more difficult for partnerships to develop. Additionally, the Second Circuit’s decision in Madden creates uncertainty for some marketplace lending models. Developments in this area happen quickly, perhaps too quickly for federal regulators to keep up with them. Fintech startups continue to challenge traditional bank delivery systems and the Treasury Department’s RFI shows the Administration’s interest in understanding how marketplace lending works. The danger is that well intentioned regulators, such as the FDIC, will adopt policies that make it more difficult for bank-marketplace lending platforms to develop and flourish. The best the banking industry and the marketplace lending industry can hope for is a “hands off” approach by government to let the free market develop to bring greater efficiencies and access to financial products to the masses.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.