August 04, 2020

The Elusive Madden Fix Part 2: FDIC Codifies "Valid When Made" for Loans by State Banks

5 min

As we explained in Part 1, the Office of the Comptroller of the Currency (OCC) implemented a "Madden Fix" for national banks and federal savings associations (OCC Rule) in early June. Later that month, the Federal Deposit Insurance Corporation (FDIC) followed suit with its own Madden Fix, this one for state banks and insured branches of foreign banks. The FDIC's final rule on Federal Interest Rate Authority (FDIC Rule) addresses ambiguities in section 27 of the Federal Deposit Insurance Act (Section 27) that were revealed by the Second Circuit's 2015 decision in Madden v. Midland Funding, LLC (Madden). The FDIC Rule provides that under Section 27 the permissible interest on a loan is (i) determined at the time the loan is made and (ii) not affected by a subsequent change in state law or relevant commercial paper rate, or by the sale, assignment, or other transfer of the loan.

In Madden, the Second Circuit held that a New York-based secondary market purchaser of national bank credit card debt could not continue to charge the contract rate of interest imposed by the bank that initially extended the credit. The court held that while the interest rate was permissible for the national bank under preemption laws, it was not permissible for the non-bank debt buyer because the rate exceeded the New York state usury limit.

Although Madden involved a national bank and section 85 of the National Bank Act (Section 85), the FDIC notes that the Second Circuit's decision unsettled the status quo and caused uncertainty for all banks. The Madden court cast aside the long-standing "valid when made" doctrine, pursuant to which "usury must exist at the inception of the loan for a loan to be deemed usurious." The OCC Rule codified the valid when made doctrine under Section 85 and under the Home Owners' Loan Act for federal savings associations. The FDIC Rule is consistent with the OCC Rule "[b]ecause section 27 was patterned after Section 85 and uses similar language, [and] courts and the FDIC have consistently construed section 27 in pari materia with section 85."

Section 27, which is intended to provide competitive equality among federally and state-chartered insured depository institutions, authorizes state banks and insured branches of foreign banks to make loans charging interest at the greater of (i) the maximum interest rate permitted by the state in which the bank is located or (ii) 1% in excess of the 90-day commercial paper rate. Section 27 does not, however, explicitly address the effects of subsequent transactions or changes in law on the validity of that interest rate. Until Madden, this silence was not seen as gaps in the law because the application of contract law principles to loan agreements appeared sufficiently clear. The FDIC Rule fills these gaps in Section 27 and addresses the safety and soundness concerns created by the Madden-induced uncertainty, i.e., whether state banks would be able to readily sell their loans to satisfy liquidity needs in a crisis.

In issuing the rule, the FDIC addressed public comments submitted in response to the notice of proposed rulemaking. Despite the fact that the FDIC Rule reflects existing practice nearly everywhere except the Second Circuit, some consumer advocacy groups expressed concern that codification will increase predatory lending through bank partnership origination models. These groups assert that in some lending models it is actually the non-bank company making the loans, using the guise of a partnership to charge rates that would otherwise be usurious. In response, the FDIC emphasized that it "views unfavorably a State bank's partnership with a non-bank entity for the sole purpose of evading a lower interest rate established under the law of the entity's licensing State(s)."

In other comments, some consumer groups asserted that the FDIC Rule would be an FDIC overreach, viewing it as a regulation on the non-bank purchasers of loans, as opposed to the state bank sellers. It appears this view is based on a blurring of two distinct issues: (i) the point in time used to determine the permissibility of a loan—the FDIC Rule affirms it should be the point at which it is made (not the point when it is sold or assigned), and (ii) which entity in a bank partnership origination model is actually making the loan—the "true lender" issue. The FDIC Rule does not address the true lender issue, which the FDIC says would be more appropriately addressed in a separate rulemaking. Notably, the OCC recently did just that, issuing a notice of proposed rulemaking for national banks and federal savings associations that addresses the true lender issue.

The critical public comments on the FDIC's Madden Fix rulemaking foreshadowed new objections to codifying the valid when made doctrine. On July 29, 2020, the attorneys general for California, Illinois, and New York filed a complaint (State Challenge) in the U.S. District Court for the Northern District of California challenging the OCC Rule. The complaint focuses primarily on national banks and the OCC's interpretation of Section 85, but it does reference the FDIC's parallel effort.

In forthcoming articles, we will explain the State Challenge, discuss the agencies' true lender rulemakings, and analyze the overall environment for lending partnerships in light of the pending and anticipated suits challenging the OCC and FDIC rulemakings.

Readers seeking more information on lending through bank partnerships, the valid when made doctrine, the pending true lender rules, or the related litigation should contact the authors.