A careful parsing of state laws should be done if a lender is relying on a choice of law to avoid states that have criminal usury statutes.
On February 27, the U.S. District Court for the Southern District of New York issued a highly anticipated decision in Madden v. Midland Funding1 on remand from the U.S. Court of Appeals for the Second Circuit. The decision dashes industry hopes for a favorable ruling on the case’s choice of law issues that would blunt the impact of the Second Circuit’s 2015 conclusion that the National Bank Act (NBA) did not preempt plaintiff Madden’s state law usury claim. Just as importantly, however, the decision turns a spotlight on lenders’ ability to override state usury laws by relying on choice of law clauses in their loan agreements with consumers in certain states like New York.
In its 2015 decision, the Second Circuit reversed the district court’s 2013 grant of summary judgment in favor of defendants Midland Funding and Midland Credit Management based on federal preemption under the NBA.2 To this end, New York resident and plaintiff Madden obtained her loan from a national bank, and the loan was subsequently sold and assigned to the defendants after Madden defaulted. A national bank has the undisputed right to charge interest on a nationwide basis at the rates permitted by its home state’s laws, irrespective of other states’ usury laws. Thus, if the Second Circuit had agreed with the district court’s finding that preemption extended to the defendants as assignees of a loan contract made by and with a national bank, questions regarding choice of law would have been rendered moot. Instead, the Second Circuit found that preemption was unavailable3 and returned the case to district court to consider whether the loan agreement’s choice of Delaware law was effective.
In evaluating whether Delaware or New York law should be deemed to govern the parties’ relationship, the district court first considered whether New York’s usury restrictions are applicable to a defaulted debt obligation.4 New York's "civil usury cap" forbids charging interest on a "loan or forbearance" at a rate above 16 percent annually.5 New York's “criminal usury cap,” in turn, makes it a felony to knowingly charge or collect interest on a “loan or forbearance” at a rate above 25 percent annually.6 The court engaged in a detailed analysis of New York case law before concluding that, although the civil usury cap does not apply once a debt is in default, the criminal usury cap remains applicable.7
The court then applied a two-pronged test in determining whether the loan agreement’s choice of clause was legally binding. First, the court noted that “[g]enerally courts will enforce choice-of-law clauses so long as the chosen law bears a reasonable relationship to the parties or the transaction”8 and cited the following factors as relevant to making such determinations:
[In considering whether to honor a choice of law clause,] courts have looked to the location of the following factors: the parties’ negotiation of the agreement; performance under the agreement, including where payments were received; the parties’ places of incorporation; the parties’ principal places of business; and the property that is the subject of the transaction.9
Next, the court noted that the defendants had failed to include documentation evidencing that the national bank from which they had received the assignment of the plaintiff’s loan was headquartered in Delaware. With respect to the relevance of that mistake, however, the court opined that, even if the record supported the conclusion that the bank had been domiciled in Delaware, there is no need to “decide whether the principal place of business of an intermediate creditor suffices to establish a reasonable relationship, because even if it does, to apply Delaware law would violate a fundamental policy of the State of New York.”10
In finding that New York’s criminal usury law constitutes a “fundamental public policy” of the state, the court cited the Eighth Circuit Court of Appeals’ decision in Electrical & Magneto Service Co. v. AMBAC International Corp. for the position that the “existence of a criminal provision ‘is significant because the legislature would not allow a criminal law to be bypassed by the mere existence a choice of law provision contained in a contract.’” 11
After concluding that New York law, not Delaware law, governs the parties’ relationship, the court accepted the defendants’ position that New York’s criminal usury cap is not enforceable by a private litigant. In this regard, however, the court noted that in the plaintiff’s federal Fair Debt Collections Practices Act and state unfair and deceptive acts and practices (UDAP) claims alleging material misrepresentations regarding the collectability of a debt, she was not seeking to “to subject Defendants to the punishment set forth in § 190.40 and thereby enforce the criminal law.”12 Rather, the defendants overstated the amount of interest that New York law allowed them to collect. Thus, the plaintiff’s federal and state claims alleging misrepresentation could proceed.13 In addition, the court granted the plaintiff’s motion for class certification.
The district court’s opinion should raise concern for all non-bank lenders because choice of law clauses are often relied upon in the industry as a means of overcoming more rigorous state usury restrictions. Consistent with the court’s position, a choice of law clause could never override a criminal usury cap, as the criminal nature of the cap evidences a fundamental public policy. Therefore, a careful parsing of state laws should be done if a lender is relying on a choice of law to avoid states that have criminal usury statutes.
In weighing the future relevance of this decision, a number of significant factors should be kept in mind. As noted throughout the opinion, interpretations of state law by federal courts carry little weight as precedent.14 A future court would be free to disregard the district court’s interpretations of New York law and might arrive at a different conclusion regarding the applicability of the criminal usury cap to defaulted debt.
A case presenting similar facts is unlikely to arise outside the Second Circuit if one accepts the position that the Second Circuit Court of Appeals decided Madden v. Midland Funding incorrectly, which was the position of the U.S. Office of the Solicitor General and the Office of the Comptroller of the Currency in their brief to the Supreme Court, which denied certiorari. If NBA federal preemption had applied based on the assignment of plaintiff Madden’s loan to the defendants from a national bank, the choice of law issue would have been moot.
A future case involving bank model lending would likely have a different outcome, even within the Second Circuit, because the arguments in favor of federal preemption would be stronger than what exists in a case involving the purchase and assignment of defaulted debt due to the bank’s greater degree of ongoing involvement.
1 2017 U.S. Dist. LEXIS 27109 (S.D.N.Y. Feb. 27, 2017).
2 Madden v. Midland Funding, LLC, 786 F.3d 246, 2015 U.S. App. LEXIS 8483 (2d Cir. N.Y. 2015), cert. denied, Midland Funding, LLC v. Madden, 2016 U.S. LEXIS 4211, 136 S. Ct. 2505, 195 L. Ed. 2d 839, 84 U.S.L.W. 3702 (U.S. 2016).
3 Madden, 786 F.3d at 252 n. 2 (describing circumstances under which federal preemption might apply to the assignee of a loan originated by a national bank).
4 N.Y. Gen. Oblig. Law § 5-501(1)-(2); N.Y. Banking Law § 14-a(1).
5 Madden, 2017 Dist. LEXIS 27109 at **9 -20.
6 N.Y. Penal Law § 190.40.
7 Madden, 2017 Dist. LEXIS 27109 at *20 (noting that “although the issue may ultimately have to be settled by the New York Court of Appeals, I conclude . . . that New York's criminal usury cap applies to prevent a creditor from collecting interest above 25% on a defaulted debt.”).
8 Id. at *24.
9 Id. at *25.
10 Id. at *27.
11 Id. at *29 (citing Electrical & Magneto Serv. Co. v. AMBAC Int'l Corp., 941 F.2d 660, 663 (8th Cir. 1991).
12 Id. at *22.
13 Id. at *55.
14 See, e.g., id. at *11 (“as a federal court applying state law, [I am] generally obliged to follow the state law decisions of state intermediate appellate courts. Broder v. Cablevision Sys. Corp., 418 F.3d 187, 199-200 (2d Cir. 2005) (internal quotation marks omitted)”).
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