The new partnership structure will ensure WebBank is financially invested in the loans it originates, continues to have an ongoing contractual relationship with the borrower, and that the economics of the bank are tied to the performance of those loans.

On February 26, Lending Club, the world’s largest online credit marketplace, announced that it had made significant changes to the way it structures its relationship with WebBank in response to the Second Circuit’s Madden v. Midland decision. This action will likely cause ripples through marketplace lending industry.

Bank Origination Model

Until the recent change, Lending Club partnered with WebBank in an arrangement whereby Lending Club would find potential borrowers, WebBank would originate the loans, and then WebBank would sell those loans to Lending Club. Those loans would then be made available to investors by Lending Club through “borrower dependent notes,” which are notes that mirror the economic performance of the underlying loan.

The bank origination model is designed to be an effective way for non-bank marketplace lenders to take advantage of a bank’s interest rate exportation authority. For example, because the loans were originated by WebBank, a Utah state-chartered bank, the Utah favorable interest rate authority under which WebBank operates could be exported to consumers residing in other states, regardless of the usury limits in those states. Under the “valid at inception” rule, the loans sold to Lending Club maintained the interest rate that was valid at inception.

On May 22, 2015, the U.S. Court of Appeals of the Second Circuit issued a decision in Madden v. Midland, which cast a significant cloud of uncertainty as to the future of the bank origination model.

Madden v. Midland

The court’s decision — which is inconsistent with 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, by not following the long-standing “valid at inception” rule. 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. For a detailed explanation of the case itself and its current status, please see our client alerts here and here.

Lending Club’s Response

In response to Madden, Lending Club announced that it would restructure its relationship with WebBank by increasing the fees paid to the bank. In doing so, WebBank has agreed to maintain an ongoing economic interest in all loans made after they are sold and will have a continuing contractual relationship with the borrower. Lending Club will pay WebBank a fee in installments that terminate if the loans stop being repaid. A majority of the revenue that the bank receives will be tied to the performance of the loans. By structuring the partnership in this way, WebBank is financially invested in the loans it originates and continues to have an ongoing contractual relationship with the borrower. It also ensures that the economics of the bank are tied to the performance of those loans.

Pepper Points

• Although we have not yet seen the specifics of how the Lending Club-WebBank relationship is being restructured, using a participation agreement would achieve the result described by Lending Club in its recent press release because, in a participation, the bank continues to retain the loan on its books but sells some or all of the economics of the loan to a third party. Because WebBank would continue to own the loan and not assign it to Lending Club, the concerns over Madden are likely mitigated or eliminated.
• This new structure provides additional protection to “true lender” claims made against Lending Club. By retaining the loan until maturity rather than owning it for only two days, the road to proving that Lending Club is the true lender just got much steeper because, as described, WebBank now has an ongoing risk of nonpayment for its retained interest, a key factor in a true lender analysis. Without a more detailed description of how the economics of this new structure work, whether this alone will prevail in any challenge is unclear but the new structure is a much more robust one to address the true lender concern.
• Whether this new approach will attract other marketplace players, such as Prosper and Cross River Bank, will be interesting. Given the current agreement in place, whereby Cross River Bank acts as Lending Club’s back-up bank in the event WebBank can no longer be the initial lender, the question arises as to whether it will also adopt this approach.