Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It may not have been previewed, commissioned or otherwise endorsed by any of our network partners.
Updated on Thursday, August 13, 2015
A Federal Appeals Court has declined to reconsider a May ruling that threatens marketplace lenders and credit card companies. (The original court decision is covered here). The ruling threatens the ability for certain lenders to charge interest rates that exceed a state’s usury cap after the debt has been sold. This ruling could prove to be particularly important for marketplace leaders Lending Club and Prosper, but it will also impact credit card companies that regularly sell charged off debt.
Some of the nation’s wealthiest and most influential lobby groups had fought for the reconsideration. Now the only hope for a reversal is for the Supreme Court to accept the case.
What Has Changed With This Ruling?
Although every state in the nation has the ability to set a usury cap, those usury caps can be largely ignored. Any nationally chartered bank can export the laws of its home state to people across the country. For example, Delaware has very lenient usury rules. Most credit card companies have created nationally chartered banks in Wilmington, Delaware. The credit card companies set their interest rates according to Delaware law, and that interest rate can be exported to all other states, regardless of the local usury cap.
Historically, the original interest rate remained intact even if debt is sold. The recent court ruling has changed everything. If debt is sold, the borrower can demand that her interest rate should not be higher than her state’s cap. That means interest rates may have to be reduced.
Why Are Marketplace Lenders At Risk?
Most marketplace lenders have odd legal structures. Borrowers never actually sign a legal contract with the marketplace. Imagine you apply for a loan with Lending Club. The role of the marketplace is to match borrowers with investors. When the loan is booked, the customer signs a contract with WebBank, based in Utah. As a result, the usury laws of Utah apply nationally. The loan sits on WebBank’s books for about 24 hours, before they are then sold to the investors. Lending Club never owns the loans, and the loans never touch Lending Club’s balance sheet.
Historically, the Utah usury rate would survive the sale of the debt to the investors. However, with this court case, the Utah laws would no longer apply. If the usury cap of the borrowers’ state is lower than Utah, the interest rate would have to be reduced. Lending Club revealed that about 12.5% of its loans exceed local state usury caps.
What Happens Next?
According to American Banker, the ruling only impacts New York, Connecticut and Vermont. However, there is a high likelihood that other lawsuits will come. At the moment, Lending Club is standing behind its legal position. And there is a high likelihood that the Supreme Court will be petitioned.
The marketplace lending sector is coming under increasing regulatory scrutiny. Rules will be written, and they may not always be compatible with existing business models. Today’s ruling just adds further uncertainty to the sector. Lenders who have chosen to be regulated in each state, like Avant, will not be impacted. Others, who focus on super-prime and charge low interest rates (SoFi and Earnest) will also not be impacted. But Lending Club and Prosper, the parents of this marketplace revolution, are most at risk.