Recently, the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) issued final rules designed to resolve the uncertainty created by the Second Circuit Court of Appeals’ decision in Madden v. Midland Funding, 786 F.3d 246 (2d Cir. 2015). In Madden, the court called into doubt the valid-when-made doctrine, a legal concept that — for over a century — has facilitated the nationwide banking system by allowing banks to sell, assign, or transfer loans freely. Unsurprisingly, there is widespread industry support for a “Madden Fix” by Congress or the prudential bank regulators, and the OCC and FDIC rules are seen as a welcome first step.
Both the OCC and FDIC’s new rules try to preserve the valid-when-made doctrine. Under this doctrine, a loan that is valid when it is created remains valid when it is sold, even if the purchaser of the loan resides in a jurisdiction where the loan would otherwise be invalid. This rule is fundamental for the proper functioning of banks and lending institutions. First and foremost, the valid-when-made doctrine allows banks to freely sell and transfer loans to other banking institutions and investors. As such, the doctrine encourages banks to exercise healthy balance-sheet practices and increases the availability of credit.
In 2015, though, the Second Circuit’s decision in Madden — which has been discussed in a previous blog post — introduced significant uncertainty about the applicability of the valid-when-made doctrine. The most direct and obvious consequence is that Madden has made it difficult for banks to sell loans to non-bank entities in the Second Circuit states of New York, Connecticut, and Vermont. One study suggests that the decision has led to a decrease in the availability of credit in those states. Madden has also proven to be a challenging hurdle for the emerging FinTech industry and the bank-partnership model, whereby banks partner with non-bank financial technology firms to offer credit to a wide variety of consumers in all 50 states. This model depends on the securitization of loans, and the ability of national and state-chartered banks to sell their loans to non-banks.
Although no other federal circuit has adopted Madden, state regulators outside of New York, Connecticut, and Vermont have made Madden-type arguments in lawsuits filed against FinTechs and other entities engaged in bank partnerships. As a result, non-bank investors and FinTech businesses have had to grapple with Madden when developing credit products even if they are not situated or doing business in Second Circuit states.
Against this background, the OCC and FDIC have issued final rules designed to affirm the valid-when-made doctrine and reintroduce some certainty into the lending market. Specifically, the OCC’s rule, which was made final on May 29, is fairly simple. The OCC amended 12 C.F.R. 7.4001 and 12 C.F.R. 160.110 to state that “[i]nterest on a loan that is permissible [under either 12 U.S.C. § 85 or 12 U.S.C. § 1463(g)(1)] shall not be affected by the sale, assignment, or transfer of the loan.” In other words, the OCC has amended its regulations to re-state the valid-when-made doctrine. According to Brian Brooks, Acting Comptroller of the Currency, the new rule “supports the orderly function of markets and promotes the availability of credit by answering the legal uncertainty created by the ‘Madden’ decision” and “allows secondary markets to work efficiently and to serve their essential role in the business of banking and helping banks access liquidity and alternative funding, improve financial performance ratios, and meet customer needs.”
Likewise, the FDIC’s final rule, published on June 25, adopts 12 C.F.R. part 331, containing similar language to the OCC’s final rule. The rule is based upon section 27 of the Federal Deposit Insurance Act (FDI) (12 U.S.C. § 1831d), which allows qualifying out-of-state banks to export the interest rate limit of their home states while lending in other states. The new rule confirms that, under section 27, the permissible interest on a loan is determined when the loan is made and will not be affected by the sale, assignment, or other transfer of the loan. For consistency, the FDIC intentionally patterned its final rule after the OCC’s final rule. FDIC Chairman Jelena McWilliams said in a statement, “The final rule accomplishes three important safeguards for the stability of our financial system by promoting safety and soundness, solidifying the functioning of a robust secondary market, and enabling the FDIC to fulfill its statutory mandate to minimize risk to the Deposit Insurance Fund (DIF).”
Unsurprisingly, not everyone is pleased with the new rules. During the notice and comment period, the OCC and FDIC received cumulatively around 120 comments. While they received many positive comments, some commenters wrote in opposition and argued that neither the OCC nor the FDIC had the statutory authority to issue rules on the subject. With regard to the OCC’s rule, they argued specifically that 12 U.S.C. 85 and 1463(g) unambiguously apply only to the interest a bank may charge, and the OCC cannot interpret the statutes contrary to that unambiguous interpretation or the result in Madden. Similarly, opponents of the FDIC’s rule argued that section 27 of the FDI Act makes no mention of a state bank’s ability to assign loans. Therefore, according to opponents, the FDIC could not interpret section 27 to allow state banks to sell to non-banks loans that the non-banks could not otherwise originate themselves (i.e., the loans would be invalid if made by the non-banks). Finally, some commentators also questioned the need for such a rule in the first place, contending that there is no real evidence that banks are unable to sell their loans in a post-Madden world. Moreover, some critics added that rules designed to overcome Madden would encourage predatory lending. Given this level of opposition, we would not be surprised to see one or more legal challenges to the final rules.
Taken together, the OCC and FDIC rules reduce but do not eliminate the uncertainty created by Madden. Apart from the uncertainty about the OCC or FDIC’s authority, and the possibility of legal challenges, the rules themselves are quite narrow and do not address many of the pressing issues facing the FinTech and bank partnership space. For instance, the OCC and FDIC rules do not overturn the main holding in Madden that non-bank debt purchasers are not entitled to preemption and rate exportation under the National Bank Act (NBA).
Second, and as noted by several commenters, the rules do not address the true lender doctrine — a legal concept utilized by regulators and plaintiffs to argue that a non-bank entity partnering with a bank to facilitate the offering of credit is the “true lender,” and is therefore subject to licensure and usury laws. Although not directly related to Madden, the true lender doctrine is often utilized in concert with Madden arguments, and has introduced a similar level of uncertainty in the FinTech and bank-partnership space. In recent remarks, Acting Comptroller Brooks indicated that the OCC would soon be issuing a proposed rule to address the true lender issue.
Finally, a recent Colorado state court ruling issued after the OCC finalized its rule (but before the FDIC published its rule) casts further doubts upon the rule’s applicability and highlights the need for additional action to ensure the continued viability of the valid-when-made doctrine. The ruling in Martha Fulford, Administrator, Uniform Consumer Credit Code v. Marlette Funding, LLC et al., involved section 27 of the FDI Act. Colorado’s administrator for the Uniform Consumer Credit Code challenged transactions involving a New Jersey state-chartered bank originating and assigning loans in Colorado to non-bank partners. The state court found the reasoning in Madden with respect to the NBA to be persuasive and applied Madden to its own analysis of section 27 to conclude that the non-bank partners could not take advantage of the higher rates upon transfer. Acknowledging proposed interpretations by both the OCC and the FDIC to the contrary (but not acknowledging the OCC’s final rule), the court concluded that “the rule proposals are not yet law and the Court is not obligated to follow [the agencies’] proposals.”
Ultimately, Madden will not be “fixed” until Congress acts to overturn the decision through legislation or the Supreme Court opines on the matter. Either contingency appears to be a long way off, so the best we can hope for in the short-term is action by the prudential bank regulators. The OCC and FDIC have given the industry a new tool in its legal arsenal when facing Madden arguments. We will continue to monitor the space for new developments.