The U.S. Court of Appeals for the Second Circuit's recent decision in Madden v. Midland Funding, LLC, which limits a non-bank's ability to enforce interest rates charged by an assigning national bank, has already given rise to class action lawsuits against online marketplace lenders, but the ripple effect of the decision only stands to grow as attention is focused on the enforceability of loans issued through certain marketplace lenders. As recently recognized by Moody's Investors Service, challenges to enforceability may ultimately impact cash flows to asset-backed securities (ABS) collateralized by such loans. Any impairment of cash flows, in turn, may precipitate a rise in litigation by or on behalf of investors in such securitizations.
Madden v. Midland and Its Effects
In May 2015, the Second Circuit sent shockwaves through the secondary debt market with its narrow application of the National Bank Act (NBA) in Madden v. Midland. Under the NBA, a national bank can charge the maximum interest rate permissible by the bank's home state, regardless of the usury laws of the state where the borrower resides. In Madden, the court held that a non-bank purchaser of a bank loan is not afforded the benefits of the NBA where the bank has no continuing interest in the loan. Consequently, interest rates charged by a selling bank may become illegal upon a non-bank's purchase of the debt. Depending on which state's laws apply, violations of state usury laws may render a purchased loan unenforceable and subject the non-bank to monetary penalties.
The Madden decision is particularly significant for online marketplace lenders (or so-called "peer-to-peer" lenders) that use a bank origination model. Marketplace lenders use online platforms to make loans to small businesses and consumers by matching investors and borrowers. For many of these lenders, the loans are initially originated by a partner national bank and then purchased by the lender. The success of this structure hinges in part on the ability to enforce the high interest rates charged by the originating national bank. For obvious reasons, the holding in Madden has the potential to severely disrupt this business model. In fact, to avoid the impact of Madden, some marketplace lenders have restructured their operations so that the selling bank maintains an ongoing economic interest in the loans sold.
In light of Madden, shareholders and borrowers have recently commenced class action lawsuits against one of the nation's most prominent online marketplace lenders, LendingClub Corporation. In the shareholder class action lawsuit, plaintiffs assert violations of federal securities laws in connection with LendingClub's IPO, alleging, among other things, that the offering materials failed to disclose that LendingClub would be unable to enforce the high interest rates that it imposes on borrowers. Similarly, in the class action lawsuit commenced by borrowers of LendingClub, plaintiffs allege violations of state consumer usury laws and the Racketeer Influenced and Corrupt Organizations Act (RICO).
Moody's Report and Potential Issues Going Forward
The holding in Madden and the borrower class action lawsuit against LendingClub have had an industry-wide negative impact on ABS collateralized by loans originated through online marketplace lenders that use a bank origination model. In fact, just last month, Moody's issued a report stating that victories by borrowers in similar actions could reduce cash flows to such securitizations. Moody's also reported that even if Madden is ultimately overturned by the U.S. Supreme Court, marketplace lenders that rely on a partner bank's federal preemption under the NBA could still face "true lender" challenges. To get the preemption benefits of the NBA, the partner bank, and not the online lender, must be considered the "true lender" of the loan. Any successful true lender challenges could also reduce cash flows to any related ABS.
Losses to ABS caused by successful legal challenges could in turn lead to claims by certificateholders and trustees against the marketplace lenders that issued the underlying loans and underwriters that marketed the related certificates, similar to the recent wave of lawsuits commenced in connection with residential mortgage-backed securities (RMBS). Any such claims may be based on representations in the underlying transaction documents and statements in the offering materials related to the enforceability of the underlying loans and compliance with applicable laws.
Certificateholders, and particularly trustees, which often have a contractual or fiduciary duty to pursue claims on behalf of certificateholders, should monitor the progress of litigation impacting the enforceability of loans originated through online marketplace lenders, as well as legal challenges to the Second Circuit's decision in Madden. If victories by borrowers cause losses to the related ABS, certificateholders and trustees may seek to assert claims against the issuers and underwriters of the ABS.
The ripple effects of the Second Circuit's decision Madden v. Midland may soon reach ABS backed by loans issued through marketplace lenders that use a bank origination model. Should performance of such securitizations suffer, history suggests lawsuits by and on behalf of investors will follow. At this time, both investors in and issuers of ABS backed by marketplace lending loans should consider actions to protect their respective interests going forward, including review of the representations and warranties made by lenders and issuers in existing deals and evaluation of their approach and criteria for future investments and transactions.
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