A watershed moment is “the exact moment that changes the direction of an activity or situation . . . a dividing point, from which things will never be the same.”1 The Second Circuit Court of Appeals’ 2015 decision in Madden v. Midland Funding2 was a watershed moment for what are commonly known as “bank sponsor” lending relationships between banks and nonbanks. As a result of Madden, the basic structure of these relationships continues to be transformed in a way that promises to promote the growth of marketplace lending by reducing legal uncertainty, but also realigns the parties’ respective responsibilities for managing legal and compliance risks.
In a bank sponsor lending program, a nonbank seeks to leverage an insured bank’s right under federal law to “export” its home state’s interest rates by charging those rates to consumers nationwide, irrespective of other states’ usury laws.3 Before Madden, most bank sponsor programs called for the bank to originate consumer loans, keep the loans on the bank’s books for an agreed-upon period of a few days, and then sell the loans to the nonbank, which also serviced the loans. During the brief interval between the origination of the loans and their sale, the nonbank would already have begun servicing the loans. If a state regulator or private litigant challenged the legitimacy of the program as an evasion of state usury laws, the bank and nonbank would cite to the “valid when made” legal doctrine. Under this longstanding but unwritten doctrine, a loan that is lawful when it is made cannot become unlawful due to subsequent events, including the loan’s sale and assignment. This doctrine is attractive for bank sponsor lending purposes because it allows a loan purchaser/assignee — the nonbank — to charge interest at the same rates that the bank originator/assignor would be able to charge if it had remained the lender. In addition, once a loan has been sold and assigned to the nonbank, the nonbank can manage that loan throughout its remaining lifecycle under own policies, including for account aging and charge-off purposes.
How Madden Changed the Game
Madden sent shockwaves through the marketplace lending industry by rejecting the valid-when-made doctrine. While Madden continues to represent the minority judicial view, the decision has had a huge effect on bank sponsor lending. For example, Colorado Administrator of Uniform Credit Julie Ann Meade cited Madden in her 2017 complaints against several online lenders and broadly asserted that an insured bank “cannot validly assign its interest rate exportation rights to a non-bank.”.4
According to Madden, a bank’s sale of a loan without recourse has the effect of completely removing the originating bank from the equation with respect to the interest rates that can be lawfully charged. The Second Circuit stated, “The [Madden nonbank] defendants did not act on behalf of [the banks] in attempting to collect on Madden's debt. The defendants acted solely on their own behalves, as the owners of the debt.”5 As entities acting only for themselves, the nonbank debt buyers in Madden therefore were not entitled to claim the protections of the federal banking laws, as none of their actions could have the effect of significantly interfering with the rights of the bank that had originated the contested loan.6
The Madden court refused to follow the Eighth Circuit Court of Appeals’ decision in Krispin v. May Department Stores,7 which the defendant debt buyers relied on as support for the valid-when-made doctrine. In Krispin, a retailer purchased credit-card receivables from an affiliated national bank on an ongoing basis, and also serviced the underlying loans. The Madden court determined that the facts of Krispin were clearly distinguishable because “when the national bank's receivables were purchased by [the retailer], the national bank retained ownership of the accounts,” which supported the conclusion that “the real party in interest [was] the bank.’”8 Given the facts before it, the Madden court held that “subjecting the [nonbank] to state regulations would not prevent or significantly interfere” with the exercise of a bank’s powers under federal law.9 In this regard, the court opined in a footnote that Krispin would have reached a different conclusion if the bank that originated the contested loans in that case “had sold them outright to a new, unrelated owner, divesting itself completely of any continuing interest in them.”10
Bank Sponsor Lending Programs Respond
In order to avoid the potential application of Madden, bank sponsor lending programs are increasingly being structured as participation-based relationships, whereby the bank keeps all program loans on its books and sells a participation interest in up to 95 percent of the loan receivables to the nonbank party, which, as in the case of a loan sale and assignment structure, performs all of the program’s loan servicing functions from the loan’s inception.11
This structure offers a number of legal advantages, including favorable judicial precedent12 and a better fact pattern for defending true lender lawsuits due to increased bank involvement in the loan program. For example, plaintiffs typically only sue the nonbank party when challenging these programs; if successful, this strategy avoids implicating the federal banking laws. If the bank in this relationship only owned the contested loans for a couple of days, it may be unable to show a sufficiently strong interest in the litigation to establish standing to intervene.13 If, on the other hand, the bank remains the lender at all times, as is true under a participation-based program, it should be far more difficult for a state regulator or private plaintiff to keep the bank out of the lawsuit.
In addition, because the nonbank acts a loan servicing agent to the bank for the entire lifecycle of all loans made under the program, as opposed to just a few days, more persuasive arguments can be made that requiring the nonbank to become licensed under state law will significantly interfere with the bank’s rights under the federal banking laws to both employ third-party agents under the authority of the Bank Service Company Act14 and export its home state’s interest rates under the authority discussed earlier.15 In short, the facts presented by such a participation-based relationship essentially mirror the facts of Krispin, in which the court found that the bank was “the real party in interest.”
An Additional Challenge
Although a participation-based structure avoids Madden, it also shifts the primary responsibility for maintaining legal and regulatory compliance from the nonbank to the bank.16 In contrast to federal bank agency supervisory expectations for debt sales, which primarily emphasize pre-sale due diligence, the bank should be actively involved in all aspects of the participation-based lending program. In this regard, we note that the policies and procedures governing the program must be those of the bank itself — designed to achieve both bank safety and soundness expectations and comply with legal requirements — as opposed to the policies and procedures of the nonbank. To this end, the fact that program policies may have originated with the nonbank is irrelevant, as at all times the program loans will be bank-held assets. In short, unlike a program in which loans are sold without recourse to a nonbank, there is no point at which the policies and procedures of the nonbank spring into effect and take over from those of the bank.
Under this structure, where the bank has no choice but to be actively involved, there is less risk that the participation-based lending program will be characterized as an unlawful “rent a charter” scheme. To this end, we expect the FDIC will begin exerting a stronger hand in supervising bank sponsor lending programs17 as it becomes routine for banks to remain the lender throughout the life of the loan assets. If so, this regulation will have the ancillary effect of serving to solidify that bank sponsor lending programs are a bona fide use of an insured bank’s charter.
On the other hand, if the parties to a participation-based bank sponsor lending program fail to recognize the important distinctions between such a program and a program based on loan sale and assignment — where the bank’s involvement is fleeting in comparison — the legal advantages of a participation-based program will prove illusory. In that event, the fact that the bank involvement has been inconsistent with its ostensible status as the lender would strongly bolster the position that the actual lender is the nonbank.
Given the material differences between participation-based bank sponsor lending programs and sale and assignment-based programs, we strongly recommend that, before entering into such a program, the bank and the nonbank confer on the policies and procedures that will govern the program to confirm that they will be fully commensurate with the bank’s policies, including its strategic risk appetite. In this regard, because the bank likely will be engaged simultaneously in multiple programs with other nonbank partners, the possibility of inconsistent treatment of customers should be evaluated prospectively, including in connection with loan servicing and collections activities18 Moreover, because supervisory expectations for bank board and senior management involvement naturally will be greater under a participation-based program, the nature and frequency of the program reporting provided by the nonbank party should reflect and support an active level of engagement. For example, because the rules governing loan delinquency aging and charge-off will be necessarily those of the bank, bank management should receive routine reporting on loan performance. Finally, given the need for consistency of operations within the bank, requiring each nonbank program partner to adopt what amount to standalone “cloned” bank policies, which is a standard practice for loan sale and assignment-based programs, may prove counterproductive.
If fully embraced, a participation-based bank sponsor lending program presents a number of key advantages over a sale and assignment-based program structure. Because the bank remains the lender at all times during the life of the loan, and therefore must be actively engaged in the program at all times as a matter of necessity, stronger fact-based defenses will be available in the event of a true lender lawsuit. In addition, the existence of increased bank involvement, and the resulting greater exposure to program risks, should spur the federal banking regulators to federal legal and supervisory guidance regarding bank sponsor lending programs, which would help to alleviate the hodge-podge of state-by-state regulation that exists today.
None of the above is intended to imply that Madden was decided correctly as a matter of law — it was not — or to diminish the importance of the valid-when-made doctrine to the banking industry. Furthermore, it remains conceivable that Congress could take legislative action to reverse the effects of Madden; albeit, several such attempts to date failed to advance. Given their true lender-related advantages, however, the popularity of participation-based programs should be expected to continue, regardless of what happens with Madden. In sum, participation-based bank sponsor lending programs should be viewed as here to stay. Accordingly, the risks and advantages of this structure need to be fully understood by every bank and nonbank that is either contemplating or already engaged in bank sponsor lending.
2 786 F.3d 246, cert. denied, 2016 U.S. LEXIS 4211 (U.S. June 27, 2016).
3 For national banks, this right is provided under section 85 of the National Bank Act (12 U.S.C. § 85) and, for insured state-chartered banks, under section 27 of the Federal Deposit Insurance Act (12 U.S.C. § 1831(d)).
4 Meade v. Avant of Colorado LLC (1:2017cv00620); Colorado v. Marlette Funding LLC (1:17-cv-00575). These complaints spawned litigation that continues to cast a dark cloud over bank sponsor lending.
5 786 F.3d 251.
7 Krispin v. May Dep’t Stores, 218 F.3d 919 (8th Cir.2000).
8 Madden, 786 F.3d 252, 253.
10 Id. at 255, n. 2.
11 The Interagency Credit Risk Retention Rule (12 C.F.R. § 246) requires an issuer of asset-backed securities to retain a 5 percent equity interest in the underlying assets. By its terms, this rule does not apply to sales of loan receivables. However, in both of these mechanisms for selling the income stream generated by a loan asset, similar policy reasons exist for promoting the retention of meaningful credit risk. Moreover, for purposes of defending possible “true lender” lawsuits, the retention of a 5 percent equity interest by the bank provides substantive evidence of economic “skin in the game.”
12 See, e.g., Hudson v. ACE Cash, Inc., 2002 U.S. Dist. LEXIS 11226 (S.D. Ind. May 30, 2002).
13 Despite having sued Administrator Meade directly, the respective bank partners of Avant and Marlette were both ultimately unsuccessful in their attempts to participate in the actions filed by Meade.
14 12 U.S.C. §§ 1861 - 1867c; it may be impossible for a third-party service agent to obtain a state license if the interest rates to be charged by the bank will exceed the subject state’s usury limits. See e.g., CashCall, Inc. v. Md. Comm'r of Fin. Regulation, 448 Md. 412 (2016).
15 12 U.S.C. § 85.
16 As a contractual matter, the parties may place the primary responsibility for bearing the economic consequences of noncompliance with the nonbank, but the responsibility for maintaining compliance will, at all times, rest with the bank. See, e.g., OCC Bulletin 2013-29 and FDIC FIL-2008-44.
17 On March 28, 2018, the FDIC assessed a civil penalty against Cross River Bank in connection with the bank’s alleged failure to oversee appropriately a bank sponsor lending relationship.
18 On July 29, 2016, the FDIC published draft Third-Party Lending Guidance addressing bank sponsor lending. This guidance, which remains pending, notes that it is not uncommon for institutions that maintain bank sponsor lending relationships to originate loans “in volumes that exceed the size of the institution’s balance sheet by many multiples,” or to maintain relationships with “large, multiple, [or] widely dispersed third parties. . . (page 2).”