The one-two punch to Madden - FDIC, following the OCC, finalises its regulation clarifying the Valid-When-Made doctrine

Among growing concern about the long-term implications of Second Circuit’s decision in Madden v. Midland Funding, LLC and other cases following it, the FDIC has issued rules clarifying the law governing interest rates that assignees of loans originated by state-chartered banks and insured branches of foreign banks (collectively, “state banks”) may charge when a loan is sold or transferred.

Consistent with the OCC’s parallel rule, the regulation clarifies that the sale of an interest in a loan is also covered by the regulation. The stated objective is to clarify that banks can transfer enforceable rights in the loans they make under the preemptive authority provided under Section 27 of the Federal Deposit Insurance Act. Under the rule, the interest rate set by the bank at the time of loan origination will be enforceable by the assignee, regardless of where the assignee or the underlying borrower is located.

The FDIC’s “Federal Interest Rate Authority” regulation comes less than a month after the OCC issued its regulation addressing “Permissible Interest on Loans that are Sold, Assigned, or Otherwise Transferred.” (See our prior OCC alert here). The FDIC release makes it clear that the FDIC’s regulation and the OCC’s regulation should be interpreted together, noting that Section 27 of the Federal Deposit Insurance Act is closely modeled after Section 85 of the National Bank Act and the two statutes have a long history of being interpreted consistently.

In Madden, the Second Circuit held that the defendant debt buyers were not entitled to charge the rate of interest stated in the plaintiff’s credit card agreement — which was usurious in New York, where the plaintiff resided — because the defendants were acting “solely on their own behalves, as the owners of the debt” and not on behalf of any bank. As a result, according to the Madden court, the defendants could not rely on the bank/maker of the loan’s ability under federal law to “export” its home state’s interest rate to other states.

While Madden concerned an assignment by a national bank, state banks operate under Federal statutory provisions that are patterned after and interpreted in the same manner as the statutory provision for national banks. As a result, the FDIC stated that Madden has created legal uncertainty regarding longstanding market practices about the enforceability of loans originated and sold by state banks.

The FDIC regulation is designed to address what the FDIC identifies as two statutory gaps present in Section 27 of the Federal Deposit Insurance Act. Under Section 27, state banks have the authority to charge interest at the rate allowed by the law of the state where the bank is located, or one percent more than the rate on ninety-day commercial paper, whichever is greater.

The first gap is the lack of clarity about when the validity and enforceability of the interest rate term of the loan should be determined. The FDIC regulation clarifies that the permissibility of interest is determined at the time the loan is made. This means that the permissibility of interest is not affected by a change in state law, a change in the relevant commercial paper rate, or the sale, assignment, or other transfer of the loan. This also means that the loan rate that is not usurious when originated remains so even when held by a non-bank assignee in a state where such a loan rate would be usurious.

The second gap is the lack of clarity about whether the power to originate loans includes the power to assign loans. The FDIC regulation clarifies that the interest on a loan that is permissible under Section 27 is not affected by the sale, assignment or other transfer of a loan, in whole or in part.

The FDIC release states that the FDIC regulation does not address “true lender” status, which is whether a state bank is a real party in interest with respect to a loan or has an economic interest in the loan under state law or whether a non-bank is the true lender with respect to a loan. However, recent statement by both the Acting Comptroller of the Currency and the Chairman of the FDIC indicate that true lender clarification is going to be issued soon.

The FDIC release notes that a particular concern has been the practice of non-bank entities partnering with state banks with the sole goal of evading a lower interest rate established under the law of the entity’s licensing state(s). Given the more immediate need to address Madden, the FDIC stated that the policy issues associated with this type of partnership warranted consideration in the future. In any event, the FDIC believes that the regulation will not prevent true lender status from being litigated.

Relatedly, the FDIC release addresses the concern of some commenters that states need to be able to prevent non-banks that buy loans from state banks from charging rates exceeding state law limits. Under the heading “Consumer Protection”, the FDIC points out that Congress recognized states’ interest in regulating interest rates within their jurisdictions, giving states the authority to opt out of the coverage of Section 27 with respect to loans made in the state.

Key Points

  • The clarification that the sale of an interest in a loan, such as a participation, is covered by the valid-when-made rule should be very helpful to companies involved in bank sponsorship programs where the bank originates a loan and then sells a participation interest in the loan to a third party.
  • State banks and non-banks participating in bank sponsor lending are sure to cheer this FDIC regulation. In such programs, a non-bank 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. Congressional action, or judicial challenge may result to resolve the disparity between Madden and the recently finalized Federal banking regulations.
  • Opponents have already questioned the FDIC regulation; FDIC member Gruenberg issued a statement that the regulation further insulates high-cost loans made through bank sponsor lending programs from legal challenge and that on-going litigation in this area frequently involves attempts by states to rein in non-banks that have partnered with state banks to evade state interest rate laws. Whether states will take additional action remains to be seen. The FDIC states that true lender status warrants additional consideration but did not indicate what that consideration would be. Recent statements by the FDIC Chairman seem to indicate that consideration will occur soon. Given the recent Acting Comptroller’s comments, it appears likely that the OCC may also soon consider true lender clarification.

While the FDIC release notes that the FDIC continues to support the position that it will view “rent-a-charter” loan partnering unfavorably, nothing in the release suggests that the FDIC views existing arrangements as unfavorable.

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