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The Second Circuit Got It Right in Madden v. Midland Funding

posted by Adam Levitin

Professor Peter Conti-Brown of the Wharton School has written a short article for Brookings decrying the Second Circuit’s 2015 Madden v. Midland Funding decision. Professor Conti-Brown doesn’t like the Madden decision for two reasons. First, he thinks its wrong on the law. Specifically, he thinks it is contrary to the National Bank Act because it "significantly interferes" with a power of national banks—the power to discount (that is sell) loans. Second, he's worried about Madden from a policy standpoint both because he fears that it is unduly cutting of access to credit for low-income households and because he thinks it is reinforcing the large bank’s dominance in the financial system and impairing the rise of non-bank “fintechs”. I disagree with Professor Conti-Brown on the law and think that attacking Madden is entirely the wrong way to address the serious policy question of what sort of limitations there ought to be on the provision of consumer credit. As for fintechs, well, I just don't see any particular reason to favor them over banks, and certainly not at the expense of consumers.  

Let’s start with the legal argument.  

Most Madden critics wave their arms about the decision being inconsistent with a so-called “valid-when-made” doctrine that supposedly means that a loan's non-usurious character is fixed when the loan is made. I’ve argued in past editorials and amicus briefs that the “valid-when-made” doctrine is a modern invention—there is no evidence of the doctrine existing prior to the Madden litigation. It doesn't show up in case law, in scholarly writing, or even in treatises on usury. The proponents of the doctrine cite some language from 19th century Supreme Court cases, but those quotations are cherry-picked out of context--the situation discussed is that a usurious discounting of a loan does not render a non-usurious loan itself usurious. To his credit, Professor Conti-Brown recognizes that “valid-when-made” isn’t the place to make a legal stand. Instead, Professor Conti-Brown's legal argument is that Madden has the effect of allowing state laws to significantly interfere with one of the express powers of national banks under the National Bank Act is to discount loans—that is to sell them.  

There are two problems with this legal argument. First, the power of a national bank to discount loans is not absolute. The power to discount is always be subject to limitations on the underlying enforceability of the loan. Suppose that the loan had been discharged in bankruptcy before it was sold or made to a minor. The loan would not suddenly become enforceable in the hands of the assignee simply because the powers of a national bank include the power to discount loans. Note that this is true irrespective of whether the buyer would qualify as a holder in due course under the UCC; even holders in due course take subject to real defenses, including an illegality that renders an instrument void, which would include usury in some states.  

Second, the Dodd-Frank Act makes clear that state laws are only preempted by the National Bank Act if the state law “prevents or significantly interferes” the exercise of the powers of the national bank.  Professor Conti-Brown criticizes the Second Circuit for failing to address "whether upending the secondary market for loans is a “substantial impairment” of a national bank’s business." (I don't know where he is getting "substantial impairment"—the statutory standard is "significant interference.") Contrary to Professor Conti-Brown's claim, the Second Circuit undertook precisely the analysis he thinks appropriate. The Second Circuit rightly noted that the usury laws in question are not being applied to the national bank. They are being applied to non-bank assignees. There is no liability for the national bank.  The only effect of Madden is to constrict the market for a subset of loans made by national banks. National banks are still free to sell loans to non-bank assignees post-Madden. Madden has no effect whatsoever on non-usurious loans, which are the overwhelming majority of loans made by national banks. That alone suggests that there is not "significant interference" in the power to sell loans--national banks can sell non-usurious loans just as before.  

As for the minority of usurious loans, Madden has not killed off the market.  Instead, it has affected the pricing in the market. Assignees now demand a greater discount for usurious loans, but that is a business decision for them; the National Bank Act does not guaranty minimum resale pricing for bank loans. Given that usury laws are not self-executing and that damages in many states are fairly limited (New York is one of only a few states with criminal usury laws), buyers might reasonably continue to buy usurious loans if they are discounted sufficiently. Moreover, even if Madden resulted in all non-bank buyers staying away from usurious loans, there would still be a market for usurious loans: other banks. There are thousands of federally insured banks, all of which are exempt from usury laws. That’s more than enough for a robust loan market.  

Madden certainly affects national bank's ability to sell a subset of loans, but its effect is to constrict the market, not prevent the sale altogether, and the Second Circuit reasonably concluded that this was not "significant interference." I think the Second Circuit actually got Madden right on the law. 

What about on the policy?  

This is more complex. The real issue underlying Madden is whether usury laws are a good thing.  Professor Conti-Brown seems to think they are not insofar as usury laws limit credit availability to riskier borrowers (who are likely to include lower income borrowers, if only because of the volatility of the financial lives of lower income households). There's a trade-off involved between greater access to credit and greater harms to consumers who cannot responsibly handle such credit. Credit is a double-edged sword, and given the spillover effects when a consumer becomes over-indebted, there's good reason for regulatory intervention in the market. Reasonable minds might differ about where/how to draw the line. I tend to think that the more personalized approach of ability-to-repay requirements is superior to the one-size-fits-all approach of usury laws, but this is the conversation that we should be having, rather than urging reversal of Madden, which would open the floodgates to anything-goes lending.  

In any case, I agree with Professor Conti-Brown that this is an area of policy best reserved for the legislatures and regulatory agencies, not the courts. Professor Conti-Brown and I part ways here only on the question of whether the Second Circuit was being faithful to legislative policy. He thinks the answer is no because he (wrongly) believes that the National Bank Act trumps the application of state usury laws to non-bank assignees of national banks, while I think that the answer is yes because the National Bank Act reaches no farther than national banks themselves precisely because it is part of a complex regulatory scheme that only covers the national banks. (Indeed, section 25b of the National Bank Act makes clear that even national bank subsidiaries are subject to state consumer financial protection laws just like anyone else.) 

What about Conti-Brown's argument that Madden entrenches megabanks as against fintechs?  This argument here puzzles me. I don't see any inherent reason to favor one type of institution. Both add value to the financial system and both add risks. Megabanks can be loci of systemic risk, but they are also subject to an extensive regulatory system that does not apply to fintechs, which raise greater consumer protection concerns. Moreover, I am not ready to lionize all fintechs, particularly in the credit space. I know that everyone is going gaga about fintechs, but a fintech lender is just a lender without a brick-and-mortar presence, and that doesn't seem very special to me.  Both banks and fintechs can (and do) deploy the same sort of alternative underwriting technology, etc., so I don't see any reason to prefer non-bank finance companies to banks, and I certainly can't see any reason to subsidize fintechs at the expense of consumer protection. 
I'd love to see a national policy debate about usury laws and ability-to-repay requirements. Our current patchwork of usury laws is surely suboptimal. But gutting state usury laws through preemption without an alternative consumer protection apparatus is the same sort of move that got us into the destructive mortgage lending of the 2000s. Attacking Madden is the wrong way to advance a rationalization of usury laws or encourage greater credit provision to low-income households.  


I agree. And have two other points to add:

The discount of a loan is not the same as the sale of a loan. (I address that in great detail here: https://syntheticassets.wordpress.com/2018/11/14/a-taxonomy-of-liquidity-i/ ) So Professor Conti-Brown's claim that "Selling loans has been part of the “business of banking”—the business protected by federal law—since before the passage of the National Banking Act." is not supported by the historical discount market. Perhaps he has other evidence of the historical sale of loans, but I am unaware of such a 19th century norm.

Also, I have written elsewhere that one economic rationale for usury laws is that credit markets have multiple equilibrium price levels and that in such environments usury laws have the effect of ensuring that consumers get some of the gains created by the finance of transactions. In short, it's not clear that relying on the most simplistic of economic models which have only one market clearing price is the best way to frame arguments about the economics of credit markets.

I can't see the point to fintechs. They're simply unregulated (or less regulated) consumer banks, allowed to affiliate with people who really really want your financial information for all kinds of interesting purposes.

New Silicon Valley insights? Banks have been doing two-way markets for -- uh -- 350 years?

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