Search Results for 'madden'
If a bank makes a legal loan to a consumer and then later sells the debt to a third party, the terms of the loan are still legal right?
“Yes” should be the obvious answer, but in 2015 a federal appeals court said “no.” The case was Madden v. Midland Funding LLC, which started as a credit card debt owed by a consumer to Bank of America at 27% interest and ended as an allegedly illegal loan once the debt was sold to Midland Funding.
The ruling, which deBanked has covered extensively, shook the consumer and business loan markets in New York, Connecticut, and Vermont with its jurisdictional reach. Midland Funding appealed the ruling to the United States Supreme Court but the Court declined to hear the case.
Congress attempted to bring clarity to the lawfulness of the practice with a bill called the Protecting Consumers’ Access to Credit Act of 2017 but failed when the approved House bill never even came up for a vote in the Senate.
On Monday, the Office of the Comptroller of the Currency (OCC) proposed a rule to clarify the “Valid When Made” Doctrine that had been pierced in Madden. “This proposal will address confusion about the effect of a transfer on a loan’s valid interest rate, including confusion resulting from a recent decision from the U.S. Court of Appeals for the Second Circuit (Madden v. Midland Funding, LLC),” OCC wrote in a statement.
A 60-day public comment period will be open once the proposal is published in the Federal Register. To find out how to comment on the rule, click here.
In a dispute that reflects the nation’s rigid political polarization, a piece of legislation pending before Congress either corrects a judicial error or condones “predatory lending.” It depends upon whom one asks. Either way, the proposed law could affect the alternative small-business funding industry indirectly in the short run and directly in the long term by addressing the interest rates non-banks charge when they take over bank loans.
The easiest way to understand the controversy may be to trace it back to a ruling in 2015 by the United States Court of Appeals for the Second Circuit in New York. The case of Madden v. Midland Funding LLC started as claim by a consumer who was challenging the collection of a debt by a debt buyer, says Catherine Brennan, a partner in the law firm Hudson Cook LLP.
“Debt buyers like Midland are sued on a regular basis,” Brennan notes. “That’s a common occurrence.” What’s uncommon is that the appellate court affirmed the idea that the loan debt that Midland sought to collect from Madden became usurious when Midland bought it. The court ruled that because Midland wasn’t a bank it was not entitled to charge the interest the bank was allowed to charge, she maintains.
Under the ruling, non-banks that buy loans can’t necessarily continue to collect the interest rates banks charged because non-banks are generally subject to the limits of the borrower’s state, according to the Republican Policy Committee, an advisory group established by members of the House of Representatives in 1949. Banks can charge the highest rate allowed in the state where they are chartered, which could be much higher than allowed in the borrower’s state.
“So it undermines the concept that you determine the validity of a loan at the time the loan is made,” Brennan says of the decision in the Madden case. The “valid-when-made” doctrine – a long-established principle of usury law – states that if a loan is not usurious when made it does not become usurious when taken over by a third party, published reports say. In 2016, the U.S. Supreme Court declined to hear the Madden case, which in effect upheld the appellate court ruling.
In response, both houses of Congress are considering bills that would ensure that the interest rate on a loan originated by a bank remains valid if the loan is sold, assigned or transferred to a non-bank third party, the Republican Policy Committee says.
On Feb. 14, 2018, the House passed its version of the proposal, H.R. 3299, the Protecting Consumers’ Access to Credit Act of 2017, or the “Madden fix,” as it’s known colloquially. The vote was 245 to 171, mostly along party lines with 16 Democrats joining 229 Republicans to vote in favor. The Senate version, S. 1642, had not reached a vote by press time.
“It’s not a revolutionary concept,” Brennan says of the proposed law. “It had been understood prior to Madden that you determine usury at the time the loan is originated, and that should be restored.”
As the alternative small-business funding industry continues to mature it could benefit from the legislation, Brennan predicts. In the future, alt funders may begin to buy or sell more debt, which would make it subject to the state caps if the legislation fails to pass, she says.
The proposed law would also benefit partnerships in which banks refer prospective borrowers to alternative funders because it would eliminate uncertainty and would thus improve the stability of the asset, Brennan continues. “I would think anyone in the commercial lending space would want to see the Madden bill pass,” she contends.
Stephen Denis, executive director of the Small Business Finance Association, a trade group for alt funders, agrees. While most of the SBFA’s members don’t work with bank partners, the trade group has supported the lobbying efforts of other associations and coalitions representing financial services companies directly affected, he says. “We are concerned on behalf of the broader industry because we all work closely together and everyone has the same goal of making sure that we’re providing capital to small businesses,” he maintains.
That goal of keeping funds available to entrepreneurs also motivates the sponsor of H.R. 3299, Rep. Patrick McHenry, R-N.C., who’s chief deputy whip of the House and vice chair of the House Financial Services Committee. His interest in crowdfunding, capital formation and disruptive finance is fueled by events he experienced in his childhood, when his father attempted to operate a small business but struggled to find financing, according to the Congressman’s website.
Although H.R. 3299 passed in the House with mostly Republican votes, it attracted bipartisan co-sponsors in that chamber. They are Rep. Gregory Meeks, D-N.Y.; Rep. Gwen Moore, D-Wis., and Rep. Trey Hollingsworth, R-Ind. The Senate version of the legislation is sponsored by Sen. Mark R. Warner, D- Va.
But opponents of the proposed law aren’t feeling particularly bipartisan and argue vehemently against it, Brennan contends. “There’s been a lot of misinformation put out there by consumer advocates saying this would somehow embolden payday lending in all 50 states,” she says. “It’s simply not true.”
Payday lenders aren’t banks, so the proposed legislation would not apply to them and thus would not enable them to avoid interest caps imposed by borrowers’ states, Brennan notes, adding that some states don’t even allow payday consumer lending.
Consumer advocates are spreading propaganda because they oppose interest rates they consider high, Brennan continues. Advocates are incorrectly conflating payday lending with marketplace lending, she maintains.
The latter is defined as partnerships where non-banks sometimes work with banks to operate nationwide platforms, mostly online and sometimes peer-to-peer, she says, noting that examples include LendingClub and Prosper.
There’s no evidence marketplace lenders would astronomically increase their interest rates if the president signs into law a bill that resembles those now before Congress, Brennan says. It wasn’t happening before Madden, she notes, and banks involved in those partnerships operate under strict guidance of the Federal Deposit Insurance Corp. (FDIC) or the Office of the Comptroller of the currency, depending upon their charters.
But consumer advocates haven taken to the warpath, Brennan reports. Opponents of the legislation call partnerships between banks and non-bank lenders by the derogatory term “rent-a-bank schemes.” But it’s lawful to create such relationships because the FDIC oversees them, she asserts.
Just the same, the House is considering H.R. 4439, a bill to ensure that in a bank partnership with a non-bank, the bank remains the “true lender” and can set the interest rate, Brennan notes. If the bill becomes law, it would clear up the conflict that has arisen in inconsistent case law, some of which has defined the non-bank as the true lender, she says.
Meanwhile, opponents of H.R. 3299 and S. 1642 have written a letter to members of Congress, urging them to vote against the bills. The letter, drafted by the Center for Responsible Lending (CRL) and the National Consumer Law Center (NCLC), was signed by 152 local, state, regional and national organizations. Most of the signers belong to a coalition called Stop the Debt Trap, says Cheye-Ann Corona, CRL senior policy associate.
The bills create a loophole that enables predatory lenders to sidestep state interest rate caps, Corona maintains. That’s because non-banks are actually originating the loans when they work in tandem with banks, she says. The non-banks are using banks as a shield against state laws because banks are regulated by the federal government. If the legislation passes, non-banks would not have to observe state caps and could charge triple-digit interest rates, she contends.
“This bill is trying to address the issue of fintech companies, but there is nothing innovative about usury,” Corona says. “They are just repackaging products that we’ve seen before. A loan is a loan. These lenders don’t need this bill if they are obeying state interest-rate caps.”
The lenders disagree. In fact, a trade group formed by OnDeck, Kabbage and Breakout Capital calls itself the Innovative Lending Platform Association, according to a report in the Los Angeles Times. The article cites the need for small-business capital but questions whether the loans are marketed fairly.
Innovative or not, lenders offering credit with higher interest rates could condemn consumers to a nightmare of debt, according to the letter from the CRL and NCLC to Capitol Hill. “Unaffordable loans have devastating consequences for borrowers – trapping them in a cycle of unaffordable payments and leading to harms such as greater delinquency on other bills,” the letter says.
However, alt funders say their savvy small-business customers understand finance and thus don’t need much government protection from high interest rates. But the CRL doesn’t adhere to that philosophy, Corona counters. “Small businesses are at risk with predatory lending practices,” she says, maintaining that some alt funders charge interest rates of 99 percent.
Small-business owners plunged themselves into hot water by borrowing too much in anecdotal examples provided by Matthew Kravitz, CRL communications manager. In one example, an entrepreneur found himself automatically paying back $331 every day. He overestimated his future income and now says he feels like hiding under the covers every morning.
Corona also dismisses the idea that high risk calls for high interest rates to compensate for high default rates. When interest rates rise to a level that borrowers can’t handle, no one wins, she maintains.
The right to charge higher interest rates could also encourage lenders to loosen their underwriting criteria, Corona warns. That could result in shortcuts reminiscent to the practices that gave rise to the foreclosure crisis and the Great Recession, she says, adding that, “we don’t want to see that happen again.”
At first, reversing the 2015 Madden v. Midland Funding court decision, which continues to vex the country’s financial system and which is having a negative impact on the financial technology industry, seemed like a fairly reasonable expectation.
The controversial ruling by the Second Circuit Court of Appeals in New York, which also covers the states of Connecticut and Vermont, had humble roots. Saliha Madden, a New Yorker, had contracted for a credit card offered by Bank of America that charged a 27% interest rate, which was both allowable under Delaware law and in force in her home state.
But when Madden defaulted on her payments and the debt was eventually transferred to Midland Funding, one of the country’s largest purchasers of unpaid debts, she sued on behalf of herself and others. Madden’s claim under the Fair Debt Collection Practices Act was that the debt was illegal for two reasons: the 27% interest rate was in violation of New York State’s 16% civil usury rate and 25% criminal usury rate; and Midland, a debt-collection agency, did not have the same rights as a bank to override New York’s state usury laws.
In 2013, Madden lost at the district court level but, two years later, she won on appeal. Extension of the National Bank Act’s usury-rate preemption to third party debt-buyers like Midland, the Second Circuit Court ruled, would be an “overly broad” interpretation of the statute.
For the banking industry, the Madden decision – which after all involved the Bank of America — meant that they would be constrained from selling off their debt to non-bank second parties in just three states. But for the financial technology industry, says Todd Baker, a senior fellow Harvard’s Kennedy School of Government and a principal at Broadmoor Consulting, it was especially troubling.
“The ability to ‘export’ interest rates is critical to the current securitization market and to the practice that some banks have embraced as lenders of record for fintechs that want to operate in all 50 states,” Baker told deBanked in an e-mail interview.
A 2016 study by a trio of law professors at Columbia, Stanford and Fordham found other consequences of Madden. They determined that “hundreds of loans (were) issued to borrowers with FICO scores below 640 in Connecticut and New York in the first half of 2015, but no such loans after July 2015.” In another finding, they reported: “Not only did lenders make smaller loans in these states post-Madden, but they also declined to issue loans to the higher-risk borrowers most likely to borrow above usury rates.”
With only three states observing the “Madden Rule,” the general assumption in business, financial and legal circles was that the Supreme Court would likely overturn Madden and harmonize the law. Brightening prospects for a Madden reversal by the Supremes: not only were all segments of the powerful financial industry behind that effort but the Obama Administration’s Solicitor General supported the anti-Madden petitioners (but complicating matters, the SG recommended against the High Court’s hearing the case until it was fully resolved in lower courts).
Despite all the heavyweight backing, however, the High Court announced in June, 2016, that it would decline to hear Madden.
That decision was especially disheartening for members of the financial technology community. “The Supreme Court has upheld the doctrine of ‘valid when made’ for a long time,” a glum Scott Stewart, chief executive of the Innovative Lending Platform Association – a Washington, D.C.-based trade group representing small-business lenders including Kabbbage, OnDeck, and CAN Capital — told deBanked.
Even so, the setback was not regarded as fatal. Congress appeared poised to ride to the lending industry’s rescue. Indeed, there was rare bipartisan support on Capitol Hill for the Protecting Consumers’ Access to Credit Act of 2017 — better known as the “Madden fix.”
Introduced in the House by Patrick McHenry, a North Carolina Republican, and in the Senate by Mark Warner, Democrat of Virginia, the proposed legislation would add the following language to the National Bank Act. “A loan that is valid when made as to its maximum rate of interest…shall remain valid with respect to such rate regardless of whether the loan is subsequently sold, assigned, or otherwise transferred to a third party, and may be enforced by such third party notwithstanding any State law to the contrary.”
Just before Thanksgiving, the House Financial Services Committee approved the Madden fix by 42-17, with nine Democrats joining the Republican majority, including some members of the Congressional Black Caucus. Notes ILPA’s Stewart: “We were seeing broad-based support.”
But the optimism has been short-lived. The Madden fix was not included in a package of financial legislation recently approved by the Senate Banking Committee, headed by Sen. Mike Crapo, Republican of Idaho. Moreover, observes Stewart: “Senator Warner appears to have gotten cold feet.”
What happened? Last fall, a coast-to-coast alliance of 202 consumer groups and community organizations came out squarely against the McHenry-Warner bill. Denouncing the bill in a strongly worded public letter, the groups — ranging from grassroots councils like the West Virginia Citizen Action Group and the Indiana Institute for Working Families to Washington fixtures like Consumer Action and Consumer Federation of America – declared: “Reversing the Second Circuit’s decision, as this bill seeks to do, would make it easier for payday lenders, debt buyers, online lenders, fintech companies, and other companies to use ‘rent-a-bank’ arrangements to charge high rates on loans.”
The letter also charged that, if enacted, the McHenry-Warner bill “could open the floodgates to a wide range of predatory actors to make loans at 300% annual interest or higher.” And the group’s letter asserted that “the bill is a massive attack on state consumer protection laws.”
Lauren Saunders, an attorney with the National Consumer Law Center in Washington, a signatory to the letter and spokesperson for the alliance, told deBanked that “our main concern is that interest-rate caps are the No. 1 protection against predatory lending and, for the most part, they only exist at the state level.”
But in their study on Madden, the Stanford-Columbia-Fordham legal scholars report that the strength of state usury laws has largely been sapped since the 1970s. “Despite their pervasiveness,” write law professors Colleen Honigsberg, Robert J. Jackson, Jr., and Richard Squire, “usury laws have very little effect on modern American lending markets. The reason is that federal law preempts state usury limits, rendering these caps inoperable for most loans.”
While the battle over the Madden fix has all the earmarks of a classic consumers-versus-industry kerfuffle, the fintechs and their allies are making the argument that they are being unfairly lumped in with payday lenders. “Online lending, generally at interest rates below 36%, is a far cry from predatory lending at rates in the hundreds of percent that use observable rent-a-charter techniques and that result in debt-traps for borrowers,” insists Cornelius Hurley, a Boston University law professor and executive director of the Online Lending Policy Institute. Because of fintechs, he adds: “A lot of people who wouldn’t otherwise qualify in the existing system are getting credit.”
A 2016 Philadelphia Federal Reserve Bank study reports that traditional sources of funding for small businesses are gradually exiting that market. In 1997, small banks under $1 billion in assets –which are “the traditional go-to source of small business credit,” Fed researchers note — had 14 percent of their assets in small business loans. By 2016, that figure had dipped to about 11 percent.
The Joint Small Business Credit Survey Report conducted by the Federal Reserve in 2015 determined that the inability to gain access to credit “has been an important obstacle for smaller, younger, less profitable, and minority-owned businesses.” It looked at credit applications from very small businesses that depend on contractors — not employees – and discovered that only 29 percent of applicants received the full amount of their requested loan while 30 percent received only partial funding. The borrowers who “were not fully funded through the traditional channel have increasingly turned to online alternative lenders,” the Fed study reported.
The ILPA’s Stewart gives this example: A woman who owns a two-person hair-braiding shop in St. Louis and wants to borrow $20,000 to expand but has “a terrible credit score of 640 because she’s had cancer in the family,” will find the odds stacked against when seeking a loan from a traditional financial institution.
But a fintech lender like Kabbage or CAN Capital will not only make the loan, but often deliver the money in just a few days, compared with the weeks or even months of delivery time taken by a typical bank. “She’ll pay 40% APR or $2,100 (in interest) over six months,” Steward explains. “She’s saying, ‘I’ll make that bet on myself’ and add two additional chairs, which will give her $40,000-$50,000 or more in new revenues.”
In yet another analysis by the Philadelphia Fed published in 2017, researchers concluded that one prominent financial technology platform “played a role in filling the credit gap” for consumer loans. In examining data supplied by Lending Club, the researchers reported that, save for the first few years of its existence, the fintech’s “activities have been mainly in the areas in which there has been a decline in bank branches….More than 75 percent of newly originated loans in 2014 and 2015 were in the areas where bank branches declined in the local market.”
Meanwhile, there is palpable fear in the fintech world that, without a Madden fix, their business model is vulnerable. Those worries were exacerbated last year when the attorney general of Colorado cited Madden in alleging violations of Colorado’s Uniform Consumer Credit Code in separate complaints against Marlette Funding LLC and Avant of Colorado LLC. According to an analysis by Pepper Hamilton, a Philadelphia-headquartered law firm, “the respective complaints filed against Marlette and Avant allege facts that are clearly distinguishable from the facts considered by the Second Circuit in Madden.
“Yet those differences did not prevent the Colorado attorney general from citing Madden for the broad-based proposition that a non-bank that receives the assignment of a loan from a bank can never rely on federal preemption of state usury laws ‘because banks cannot validly assign such rights to non-banks.’”
Should the Federal court accept the reasoning of Madden, Pepper Hamilton’s analysis declares, such a ruling “could have severe adverse consequences for the marketplace and the online lending industry and for the banking industry generally….”
The US Supreme Court has decided not to hear the case of Saliha Madden v Midland Funding.
This was to be expected after US Solicitor General Donald Verrilli filed a devastating brief last month on behalf of the United States government that argued the US Court of Appeals for the Second Circuit was incorrect in its ruling. There is “no circuit split on the question presented,” he wrote, and “the parties did not present key aspects of the preemption analysis” to the lower courts.
Vincent Basulto, a partner at Richards Kibbe & Orbe LLP in New York, said “While it is not expected that other circuits will adopt the reasoning of the Second Circuit, in part due to the arguments made by the Solicitor General, the appellate decision stands as good law in NY. The case will return to the district court for further consideration of other issues and there is reason to believe that the outcome there may be favorable for the financial services industry due to a choice of law issue which remains to be decided.”
US Solicitor General Verrilli resigned three days before the Supreme Court’s decision, but his brief on the case will likely be cited for years to come.
“For the foreseeable future,” Basulto added, “parties can be expected to structure their arrangements in an attempt to distinguish the Madden decision from their transaction, though it is not clear how best to do that.”
If you thought the Madden v Midland decision was a future risk for marketplace lenders alone, think again. According to a joint study by law professors from Stanford, Columbia and Fordham, one group is already suffering as a result of the decision, people with lower FICO scores.
Since the Second Circuit’s decision only affected borrowers in New York, Vermont and Connecticut, researchers were able to monitor behavioral changes there against other states. They used data from three of the nation’s top marketplace lenders.
In the Second Circuit’s jurisdiction, approved borrowers showed a significant increase in annual incomes, years of employment and FICO scores compared to other districts. Specifically, growth was concentrated among borrowers with FICO scores over 700. Approvals for borrowers with scores below 644 “virtually disappeared” while literally zero loans were issued to borrowers with FICO scores below 625.
“Madden’s effect on loan volume grows as the borrower’s FICO score falls,” the data reveals.
But even though lenders became afraid of the usurious implications in these states, borrowers did not take the Madden decision as a signal to stop payment. “[We] are unable to find any evidence of strategic delinquencies,” researchers concluded after a series of tests.
We find, consistent with basic economic theory, that the sudden enforceability of usury laws had the greatest impact on higher-risk borrowers. In a market where consumer loans are generally increasing in volume, the Madden decision disproportionately affected loan volume for borrowers with the lowest FICO scores.
Read the full study titled, The Effects of Usury Laws on Higher-Risk Borrowers
Given the Madden v Midland decision, does the National Bank Act continue to have preemptive effect after the national bank has sold or otherwise assigned the loan to another entity?
This question was presented to the US Solicitor General, the person appointed to represent the federal government of the United States of America in Supreme Court cases. The US Supreme court had asked the Solicitor General to weigh in before deciding to take on the case. And the answer is in:
The US Court of Appeals for the Second Circuit was incorrect in its ruling, the federal government believes.
Nevertheless, the US Supreme Court should not even hear the case, they say, because there is “no circuit split on the question presented” and “the parties did not present key aspects of the preemption analysis” to the lower courts. Put simply, “The court of appeals’ decision is incorrect,” they explain, and the heart and soul of preemption itself has never been in question.
The message from the US Solicitor General is clear, carry on friends, nothing to see here with Madden v Midland.
The US Supreme Court could still opt to hear the case but that is very unlikely at this point. Lawsuits filed against alternative lenders such as Lending Club in recent months had used the Madden ruling as evidence to support usury complaints. The connection between a case where a debt collector bought a charged off credit card debt from a bank (which is what Madden was about) and the business model of Lending Club was already weak, but several plaintiffs hoped to use it as a stepping stone. The Solicitor General’s opinion could likely derail attempts by other plaintiffs to cite Madden.
Of notable mention is that many of today’s alternative lenders have relationships with state chartered banks that are covered under the Federal Deposit Insurance Act, not the National Bank Act which the US Supreme Court was asked about. While the two laws are very similar, it did put alternative lenders at an additional arm’s length from Madden.
Read revious posts about this case:
3/22/16 Plot Twist: Obama Administration to Comment on Madden v Midland
3/2/16 Lending Club Class Action Lawsuit Predicated on Madden v Midland Risk
2/26/16 Lending Club Shifts Fee Arrangement With WebBank
2/18/16 Without Scalia, Media Outlets Reporting Marketplace Lenders Supposedly Doomed With Supreme Court Case (They’re Wrong)
11/15/15 Madden v. Midland Appealed to the US Supreme Court
8/13/15 Madden vs. Midland Funding, LLC: What does it mean for Alternative Small Business Lending?
8/13/15 Madden v. Midland Appeal Rejected
8/8/15 Renaud Laplanche on Madden v. Midland
7/28/15 Blyden v. Navient Corp: A Glimpse of a Post-Madden Future?
6/11/15 Legal Brief: Madden v. Midland Funding
The U.S. Supreme Court wants to know what the Obama administration thinks of the Madden v Midland case.
The potential impact of Madden v Midland on marketplace lending was finally starting to fade away until the U.S. Supreme Court made an unexpected move yesterday. “The Solicitor General is invited to file a brief in this case expressing the views of the United States,” the docket states. At issue is the scope of preemption under the National Bank Act (i.e. can you buy a loan issued by a nationally chartered bank that legally circumvented state usury laws at the time it was originated and still enforce the interest rate?)
The Solicitor General is responsible for arguing cases on behalf of the U.S. government in the U.S. Supreme Court. The position is appointed by the President and confirmed by the Senate. That seat is currently filled by Donald B. Verrilli, Jr., an Obama appointee and the man credited with saving Obamacare. He was the attorney that helped persuade the Supreme Court to treat the individual mandate of the Patient Protection and Affordable Care Act as a tax and not as an exercise of Congress’s power under the Commerce Clause.
Any brief filed is bound to become politically significant since the Obama Administration is on its way out. Therefore any views it expresses in the next few months may not be the same views of the next administration scheduled to be sworn in ten months from now.
Madden v Midland will have no bearing on merchant cash advances and little if any bearing on commercial marketplace lenders. That’s because most not only work with state chartered banks instead of nationally chartered banks, but also face more favorable state usury laws since they do not lend to consumers.
UPDATE: This case is unrelated to another class action filed against Lending Club on April 6th
Lending Club is the latest publicly traded online lender to get hit by a shareholder class action lawsuit (OnDeck was first). Filed in the Superior Court of the State of California, plaintiff alleges in the complaint that Lending Club misleadingly concealed the fact that:
- Lending Club had an unsustainable business model that was predicated on it being able to issue loans with extremely high and/or usurious rates across the country
- that their loan investors would not be able to enforce the extremely high and/or usurious rates imposed by Lending Club because they violated state usury laws
- that without the extremely high and/or usurious rates, the loans generated through Lending Club’s marketplace would not be attractive to investors because the loans had very high credit risk and were subject to issues concerning insufficient documentation
- that a substantial portion of its loans were issued with rates in excess of those allowed by applicable state usury laws
The action seeks “recovery, including rescission, for innocent purchasers who suffered many millions of dollars in losses when the truth about Lending Club emerged and the its stock price plummeted.”
Among the Defendants is former US Treasury Secretary Larry Summers.
The complaint alleges that the truth about Lending Club began to emerge after “the Second Circuit affirmed [in Madden v Midland] that the business model used by Lending Club was not valid because loans sold by banks to non-banks, third parties (such as Lending Club and its investors) are not exempt from state usury laws that limit interest rates.”
–In actuality, no such affirmation was made. Lending Club does not specifically use Midland Funding’s business model and the case was not about Lending Club, nor was Lending Club mentioned in it.
“Specifically, the Second Circuit observed that assignees and third-party debt buyers could not rely on the National Bank Act to export interest rates that were legal in one state but usurious in another, to the states where those rates were impermissible,” the complaint states.
–Perhaps, but Lending Club’s bank makes loans under the Federal Deposit Insurance Act, not the National Bank Act.
As supporting evidence, the complaint cites statements from Moody’s analysts, Morgan Stanley, Cross River Bank CEO Gilles Gade, and Lending Club CEO Renaud Laplanche himself in a quarterly earnings call.
While the impact of Madden v Midland has been seriously overblown, Lending Club’s stock has no doubt taken a beating since its IPO. The complaint states a loss of 43% from the original offering price. Among the defendants are:
- LendingClub Corporation
- Renaud Laplanche
- Carrie Dolan
- Daniel Ciporin
- Jeffrey Crowe
- Rebecca Lynn
- John J. Mack
- Mary Meeker
- John C. (Hans) Morris
- Lawrence Summers
- Simon Williams
- Morgan Stanley & Co. LLC
- Goldman, Sachs & Co.
- Credit Suisse Securities (USA) LLC
- Citigroup Global Markets Inc.
- Allen & Company LLC
- Stifel, Nicolaus & Company, Incorporated
- BMO Capital markets Corp.
- William Blair & Company, L.L.C.
- Wells Fargo Securities, LLC
NOTE: This case is unrelated to another class action filed against Lending Club on April 6th
The Madden v. Midland decision has been appealed to the US Supreme Court and the future of non-bank lending potentially hangs in the balance. The introductory statement reads as follows:
This case presents a question which is critical to the operation of the national banking system and on which the courts of appeals are in conflict. The National Bank Act authorizes national banks to charge interest at particular rates on loans that they originate, and the Act has long been held to preempt conflicting state usury laws. The question presented here is whether, after a national bank sells or otherwise assigns a loan with a permissible interest rate to another entity, the Act continues to preempt the application of state usury laws to that loan. Put differently, the question presented concerns the extent to which a State may effectively regulate a national bank’s ability to set interest rates by imposing limitations that are triggered as soon as a loan is sold or otherwise assigned.
Several attorneys have said off the record that the likelihood the US Supreme Court would actually hear the case is about 100 to 1, because the issue lacks sex appeal. Gay Marriage, Obamacare, these are the type of things that make their way through the system.
Nevertheless, the petition argues the matter at hand:
The Second Circuit vacated the judgment, holding that the National Bank Act ceased to have preemptive effect once the national bank had assigned the loan to another entity. App., infra, 1a-18a. In so holding, the Second Circuit created a square conflict with the Eighth Circuit, and its reasoning is irreconcilable with that of the Fifth Circuit. The Second Circuit also rode roughshod over decisions of this Court that provide broad protection both for a national bank’s power to set interest rates and for its freedom from indirect regulation. And it cast aside the cardinal rule of usury, dating back centuries, that a loan which is valid when made cannot become usurious by virtue of a subsequent transaction.
The Second Circuit, of course, is home to much of the American financial-services industry. And if the Second Circuit’s decision is allowed to stand, it threatens to inflict catastrophic consequences on secondary markets that are essential to the operation of the national banking system and the availability of consumer credit. The markets have long functioned on the understanding that buyers may freely purchase loans from originators without fear that the loans will become invalid, an understanding uprooted by the Second Circuit’s decision in this case. It is no exaggeration to say that, in light of these practical consequences, this case presents one of the most significant legal issues currently facing the financial-services industry. Because the Second Circuit’s decision creates a conflict on such a vitally important question of federal law, and because there is an urgent need to resolve that conflict, the petition for a writ of certiorari should be granted.
Brian Korn, a partner at Manatt, Phelps and Phillips, told the LendAcademy blog in an interview that the Court could rule on the motion at any time and that it takes 4 out of 9 justices to agree to accept the case.
The plaintiff, Madden, has until December 10, 2015 to file a response to the petition.
On Friday, May 22, 2015, while the rest of us were gearing up for the long Memorial Day weekend, three judges of the United States Court of Appeals for the Second Circuit quietly issued their decision in Madden v. Midland Funding, LLC. Though issued to little fanfare, the decision, if upheld on appeal—may lead to significant changes in consumer and commercial lending by non-bank entities.
Loans that were previously only subject to the usury laws of a single state may now be subject to more restrictive usury laws of multiple jurisdictions. Commercial transactions that could be affected include short-term loans by a number of alternative small business lenders.
The plaintiff, Saliha Madden, opened a credit card account with a national bank in 2005. Three years later, Madden’s account was charged off with an outstanding balance. The account was later sold to Midland Funding, LLC, a debt purchaser.
In November 2010, Midland sent a collection letter to Madden’s New York residence informing her that interest was still accruing on her account at the rate of 27% per year. In response, Madden filed a class action lawsuit against Midland and its servicer. In her complaint, Madden alleged that Midland had violated state and federal laws by attempting to collect a rate of interest that exceeded the maximum rate set by New York State’s usury laws. Midland countered that as a national bank assignee, it was entitled to the preemption of state usury laws granted to national banks by the National Bank Act (the “NBA”). The district court agreed with Midland and entered judgment in its favor. Madden appealed to the Second Circuit.
After reviewing the record, the Court of Appeals reversed the district court’s decision. The appellate court found that the NBA’s preemption provision did not apply to Midland as a mere bank assignee. Instead, the court held that in order “[t]o apply NBA preemption to an action taken by a non-national bank entity, application of state law to that action must significantly interfere with a national bank’s ability to exercise its power under the NBA.”
The court explained that the NBA’s preemption protections only apply to non-bank entities performing tasks on a bank’s behalf (e.g. bank subsidiaries, third-party tax preparers). If a bank assignee is not performing a task on a national bank’s behalf, the NBA does not protect the assignee from otherwise applicable state usury laws. Therefore, as Midland’s collection efforts were performed on its own behalf and not on behalf of the national bank that originated Madden’s account, the appellate court found that New York’s usury laws were not preempted and that Midland could be subject to New York’s usury restrictions.
Usury Law Compliance
The Madden decision undermines a method of state usury law compliance that I’ll refer to as the “exportation model”. In a typical exportation arrangement, a non-bank lender contracts with a national bank to originate loans that the lender has previously underwritten and approved. After a deal has been funded, the bank sells the loan back to the lender for the principal amount of the loan, plus a fee for originating the deal.
1F.3d —, 2015 U.S. App. LEXIS 8483 (2d Cir. N.Y. May 22, 2015).
The exportation model allows non-bank lenders to benefit from the preemption protections granted to banks under the NBA. Specifically, the NBA provides that a national bank is only subject to the laws of its home state. This provision allows a bank to ‘export’ the generally less restrictive usury laws of its home state to other states where it does business. As bank assignees, lenders that have purchased loans from a bank are only subject to the laws of the originating bank’s home state. This exemption saves these non-bank lenders from having to engage in a state-by-state analysis of applicable usury laws.
The Madden decision, however, casts doubt on the ability of these non-bank assignees to benefit from the NBA’s preemption protections. The Second Circuit’s decision makes clear that non-bank assignees that are not performing essential acts on a bank’s behalf—which would seem to include alternative small business lenders—are not entitled to NBA preemption and are subject to the usury laws of the bank’s home state as well as any otherwise applicable state’s
While the Court of Appeals’ decision foreclosed Midland’s preemption argument, other issues remained unresolved. Specifically, the circuit court did not decide whether the choice-of-law provision in Madden’s cardholder agreement—which provided that any disputes relating to the agreement would be governed by the laws of Delaware—would prevent Madden from alleging violations of New York State usury law.
In the district court proceeding, both parties had agreed that if Delaware law was found to apply, the 27% interest rate would be permissible under that state’s usury laws. The district court, however, did not address the choice-of-law issue because the court had found that the NBA’s preemption protections were sufficient grounds upon which to resolve the case. As the issue had not been addressed, the circuit court remanded the case back to the district court to decide which state’s law controlled.
But before sending the case back down, the appellate court made two points worth noting. First, the court stated that “[w]e express no opinion as to whether Delaware law, which permits a ‘bank’ to charge any interest rate allowable by contract…would apply to the defendants, both of which are non-bank entities.” The court’s statement suggests that it may not have completely agreed with the parties that 27% would be a permissible interest rate under Delaware law.
Second, the court highlighted a split in New York case law on the enforceability of choice-of-law provisions where claims of usury are involved. Generally, courts will refuse to enforce a choice-of-law provision if the application of the chosen state’s law would violate a public policy of the forum state. As usury is sometimes considered an issue of public policy, the enforceability of such clauses is commonly a point of contention in usury actions. The cases cited by the Court of Appeals show that some courts in New York have enforced choice-of-law provisions—even where the interest rate permitted by the chosen state would violate New York’s usury laws—while other New York courts have refused to enforce such provisions in light of public policy concerns.
New York, however, is by no means the only state with usury laws that are less than straightforward. The general complexity of state usury laws is evidenced by the circuit court’s hesitation to agree with Madden’s concession that a 27% interest rate would be permissible under Delaware law. The court made clear that an argument could be made that the rate was usurious under both New York and Delaware law.
An important legal principle that was not addressed in either the district or circuit court proceedings is the ‘valid when made’ doctrine of assignment law. The ‘valid when made’ doctrine provides that a loan that is valid at the time it is made will remain valid even if the loan is subsequently assigned. This doctrine may have led to a different outcome in the case had Midland argued it before the district or circuit court. Midland is now appealing the Second Circuit’s decisions and many expect a ‘valid when made’ argument to be a primary point of Midland’s appeal (SEE NOTE BELOW). If this argument is successful, the practical impact of Madden would be greatly diminished.
NOTE: The Second District Court rejected a request to rehear the case. Read that decision here.
In the meantime, the Madden decision will likely increase the importance of choice-of-law analysis in relation to usury law. Assignees that previously relied on the NBA’s preemption provision as a method of state usury law compliance will now need to address the enforceability of their contractual choice-of-law clauses where claims of usury may become an issue. This analysis is often a complex undertaking because states take varying views of what constitutes usury as well as whether or not usury is an issue of public policy.
While the Madden decision may have been published before the long Memorial Day weekend, analyzing its consequences will likely keep many non-bank lenders (and their attorneys) busy, even on their days off.
Alternative lenders might have reason to lose a little bit of sleep going forward. The United States Court of Appeals for the Second Circuit shot down a request for a rehearing of Madden v. Midland. The original ruling stated that third party debt buyers are not covered under National Bank Act pre-emption. That decision had major ramifications for alternative lenders who often rely on banks to issue the loans and then immediately sell them to the “lender” to book and service.
You can read a legal brief of the case here.
Lending Club’s CEO recently addressed this case and he explained that he believed his company would be unaffected because of their choice of law provision.
And Patrick Siegfried, Esq, the author of the Usury Law Blog, has previously said that Madden v. Midland may be the start of new usury Litigation.
In case you missed the comments by Lending Club’s CEO regarding the Madden v. Midland decision, we’ve got the transcript of it from the Q2 earnings call below. A brief of that case was published on deBanked back on June 11th by lawyers from Giuliano McDonnell & Perrone, LLP.
Smittipon Srethapramote – Morgan Stanley
And do you have any comments on the Madden versus Midland funding case that’s going through the court system right now in terms of how it potentially impacts your business?
Renaud Laplanche – Founder & CEO
Yes, so we’ve seen that case that came out a couple of months ago. I think the –our take there is obviously the particular circumstances of the case are different from what we’re seeing on our platform. But in general what really helps us apply Utah law to most of our loans is really a couple of things. One is for the all preemption. And the second is choice of law provision in our contract. The Madden case really challenged the federal preemption but did not challenge the choice of law provision, so that’s really the – and we don’t need both, we need one of them. So we continue to operate in the Second Circuit district where that decision was rendered exactly as we did before and are relying on our choice of law provisions.
Note that this particular case is getting challenged by a lot of players in the banking industry, including the American Banking Association. And I think it’s an unusual case, but certainly that doesn’t come back to us in that the sense that we continue to rely on choice of law provision. If we were to see that the choice of law provision was getting challenged elsewhere which there’s no reason to expect at this point, we could also think of a different issuance framework than the one we’re using now where we would switch to a series of state licenses. And that’s in [indiscernible] we provided in our slide deck that shows that using the current mix we have about 12.5% of our loans that would exceed the state interest rate caps.
So that certainly would be [indiscernible] demand and we’d have to revise our pricing in certain states, but that certainly would be another option available to us if our choice of law provision and federal preemption was getting challenged in other states.
On July 28th, Attorney Patrick Siegfried pointed out that the Madden case could be the start of a chilling trend after a subsequent ruling in Blyden v. Navient Corp. In that brief, he wrote, “Blyden also demonstrates that debtors that become aware of subsequent assignments of their loans may be inclined to use the assignment event as a way to invalidate otherwise legitimate debts.”
A recent US District Court decision out of California offers a rough idea of the usury litigation that may begin to occur if the decision in Madden vs. Midland Funding, LLC ultimately stands.
The case involved a student loan that the plaintiff had received that had been originated by a national bank. The loan charged an interest rate of 10.25% which the plaintiff believed to be lawful because the loan had been made by a bank.
When the plaintiff later learned that her loan had been assigned to a non-bank entity, she instituted a usury class action arguing that the assignee was not been permitted to charge more than 10% interest under California law. She sought to represent a class of borrowers whose loans had been made by the national bank and later assigned.
In an effort to represent the largest class possible, the plaintiff named as defendants various investment trusts that had purchased loans from the bank despite the fact that most of the trusts had never had any interest in her specific loan. While the court ultimately dismissed the case because of pleading deficiencies, it granted the plaintiff leave to amend her complaint and the case seems likely to continue.
What’s noteworthy about the Blyden case is that it is illustrative of some of the possible consequences of the 2nd Circuit’s decision in Madden. In particular, it shows that a large number of unrelated entities may be drawn into extended litigation by a plaintiff that is unable (because of a lack of information) or unwilling (because of a desire to represent the largest class possible) to limit its claims to those specific entities that have had or presently maintain an interest in the loan at issue. While this desire to cast the widest net possible is common to most class action plaintiffs, it seems likely to prove especially true in cases involving securitized products that have passed through numerous investment vehicles.
Blyden also demonstrates that debtors that become aware of subsequent assignments of their loans may be inclined to use the assignment event as a way to invalidate otherwise legitimate debts. The plaintiff in Blyden conceded that she was unable to pursue a usury action against the national bank that had originated the loan because of NBA preemption. She also acknowledged that the original transaction had been legal. Only when the plaintiff later learned of the assignment of her loan to a non-bank entity did she seek to recover the allegedly usurious interest charges.
What may be most disconcerting for assignees about the Blyden case is that it only demonstrates some of the complex consequences that may result from the Madden decision.
Blyden v. Navient Corp., 2015 U.S. Dist. LEXIS 96824 (C.D. Cal. July 23, 2015)
Madden v. Midland Funding, 2015 U.S. App. LEXIS 8483 (2nd Cir. May 22, 2015).
This is an interesting case for the alternative lending industry that deals with the interplay between the National Banking Act and New York State’s usury laws.
The plaintiff borrower opened a credit card account with a national bank, Bank of America (“BoA”). BoA sold the account to another national bank, FIA. FIA subsequently sent a change of terms notice stating that, going forward, the plaintiff’s account agreement would be governed by the law of Delaware, FIA’s home state. FIA later charged off the account and sold it to a third-party debt purchasing company, Midland. FIA did not retain any interest in the account after selling it to Midland and Midland was not a national bank.
Midland attempted to collect on the account and sent the plaintiff a demand letter indicating that there was a 27% interest rate on the account. Plaintiff sued Midland, alleging violations of the Fair Debt Collection Practices Act and New York’s criminal usury laws. New York law limits effective interest rates to 25 percent per year. The parties agreed that FIA had assigned plaintiff’s account to Midland and that the plaintiff had received FIA’s change in terms notice. Based on the agreement, the trial court held that the plaintiff’s state law usury claims were invalid because they were preempted by the National Bank Act.
The National Bank Act supersedes all state usury laws and allows national banks to charge interest at the rate allowed by the law of the bank’s home state. Midland argued that, as FIA’s assignee, it was permitted to charge the plaintiff interest at a rate permitted under Delaware law. FIA was incorporated in Delaware and Delaware permits interest rates that would be usurious under New York law.
On appeal, The Second Circuit Court of Appeals noted that some non-national banks, such as subsidiaries and agents of national banks, might enjoy the same usury-protection benefit as a national bank. However, third-party debt buyers, such as Midland, are not subsidiaries or agents of national banks. Midland was not acting for BoA or FIA when it attempted to collect from the plaintiff. Midland was acting for itself as the sole owner of the debt. For this reason, the Second Circuit held that Midland could not rely upon National Bank Act preemption of New York State’s usury laws.
With the doors to 2019 firmly closed, alternative financing industry executives are excited about the new decade and the prospects that lie ahead. There are new products to showcase, new competitors to contend with and new customers to pursue as alternative financing continues to gain traction.
Executives reading the tea leaves are overwhelming bullish on the alternative financing industry—and for good reasons. In 2019, merchant cash advances and daily payment small business loan products alone exceeded more than $20 billion a year in originations, deBanked’s reporting shows.
Confidence in the industry is only slightly curtailed by certain regulatory, political competitive and economic unknowns lurking in the background—adding an element of intrigue to what could be an exciting new year.
Here, then, are a few things to look out for in 2020 and beyond.
There are a number of different items that could be on the regulatory agenda this year, both on the state and federal level. Major areas to watch include:
- Broker licensing. There’s a movement afoot to crack down on rogue brokers by instituting licensing requirements. New York, for example, has proposed legislation that would cover small business lenders, merchant cash advance companies, factors, and leasing companies for transactions under $500,000. California has a licensing law in place, but it only pertains to loans, says Steve Denis, executive director of the Small Business Finance Association. Many funders are generally in favor of broader licensing requirements, citing perceived benefits to brokers, funders, customers and the industry overall. The devil, of course, will be in the details.
- Interest rate caps. Congress is weighing legislation that would set a national interest rate cap of 36%, including fees, for most personal loans, in an effort to stamp out predatory lending practices. A fair number of states already have enacted interest rate caps for consumer loans, with California recently joining the pack, but thus far there has been no national standard. While it is too early to tell the bill’s fate, proponents say it will provide needed protections against gouging, while critics, such as Lend Academy’s Peter Renton, contend it will have the “opposite impact on the consumers it seeks to protect.”
- Loan information and rate disclosures. There continues to be ample debate around exactly what firms should be required to disclose to customers and what metrics are most appropriate for consumers and businesses to use when comparing offerings. This year could be the one in which multiple states move ahead with efforts to clamp down on disclosures so borrowers can more easily compare offerings, industry watchers say. Notably, a recent Federal Reserve study on non-bank small business finance providers indicates that the likelihood of approval and speed are more important than cost in motivating borrowers, though this may not defer policymakers from moving ahead with disclosure requirements.
“THIS WILL DRIVE COMMISSION DOWN FOR THE INDUSTRY”
If these types of requirements go forward, Jared Weitz, chief executive of United Capital generally expects to see commissions take a hit. “This will drive commission down for the industry, but some companies may not be as impacted, depending on their product mix, cost per lead and cost per acquisition and overall company structure,” he says.
- Madden aftermath. The FDIC and OCC recently proposed rules to counteract the negative effects of the 2015 Madden v. Midland Funding LLC case, which wreaked havoc in the consumer and business loan markets in New York, Connecticut, and Vermont. “These proposals would clarify that the loan continues to be ‘valid’ even after it is sold to a nonbank, meaning that the nonbank can collect the rates and fees as initially contracted by the bank,” says Catherine Brennan, partner in the Hanover, Maryland office of law firm Hudson Cook. With the comments due at the end of January, “2020 is going to be a very important year for bank and nonbank partnerships,” she says.
- Possible changes to the accredited investor definition. In December 2019, the Securities and Exchange Commission voted to propose amendments to the accredited investor definition. Some industry players see expanding the definition as a positive step, but are hesitant to crack open the champagne just yet since nothing’s been finalized. “I would like to see it broadened even further than they are proposed right now,” says Brett Crosby, co-founder and chief operating officer at PeerStreet, a platform for investing in real estate-backed loans. The proposals “are a step in the right direction, but I’m not sure they go far enough,” he says.
Precisely how various regulatory initiatives will play out in 2020 remains to be seen. Some states, for example, may decide to be more aggressive with respect to policy-making, while others might take more of a wait-and-see approach.
“I think states are still piecing together exactly what they want to accomplish. There are too many missing pieces to the puzzle,” says Chad Otar, founder and chief executive at Lending Valley Inc.
As different initiatives work their way through the legislative process, funders are hoping for consistency rather than a patchwork of metrics applied unevenly by different states. The latter could have significant repercussions for firms that do business in multiple states and could eventually cause some of them to pare back operations, industry watchers say.
“While we commend the state-level activity, we hope that there will be uniformity across the country when it comes to legislation to avoid confusion and create consistency” for borrowers, says Darren Schulman, president of 6th Avenue Capital.
The outcome of this year’s presidential election could have a profound effect on the regulatory climate for alternative lenders. Alternative financing and fintech charters could move higher on the docket if there’s a shift in the top brass (which, of course, could bring a new Treasury Secretary and/or CFPB head) or if the Senate flips to Democratic control.
If a White House changing of the guard does occur, the impact could be even more profound depending on which Democratic candidate secures the top spot. It’s all speculation now, but alternative financers will likely be sticking to the election polls like glue in an attempt to gain more clarity.
Election-year uncertainty also needs to be factored into underwriting risk. Some industries and companies may be more susceptible to this risk, and funders have to plan accordingly in their projections. It’s not a reason to make wholesale underwriting changes, but it’s something to be mindful of, says Heather Francis, chief executive of Elevate Funding in Gainesville, Florida.
“Any election year is going to be a little bit volatile in terms of how you operate your business,” she says.
The competitive landscape continues to shift for alternative lenders and funders, with technology giants such as PayPal, Amazon and Square now counted among the largest small business funders in the marketplace. This is a notable shift from several years ago when their footprint had not yet made a dent.
This growth is expected to continue driving competition in 2020. Larger companies with strong technology have a competitive advantage in making loans and cash advances because they already have the customer and information about the customer, says industry attorney Paul Rianda, who heads a law firm in Irvine, Calif.
It’s also harder for merchants to default because these companies are providing them payment processing services and paying them on a daily or monthly basis. This is in contrast to an MCA provider that’s using ACH to take payments out of the merchant’s bank account, which can be blocked by the merchant at any time. “Because of that lower risk factor, they’re able to give a better deal to merchants,” Rianda says.
Increased competition has been driving rates down, especially for merchants with strong credit, which means high-quality merchants are getting especially good deals—at much less expensive rates than a business credit card could offer, says Nathan Abadi, president of Excel Capital Management. “The prime market is expanding tremendously,” he says.
Certain funders are willing to go out two years now on first positions, he says, which was never done before.
Even for non-prime clients, funders are getting more creative in how they structure deals. For instance, funders are offering longer terms—12 to 15 months—on a second position or nine to 12 months on a third position, he says. “People would think you were out of your mind to do that a year ago,” he says.
Because there’s so much money funneling into the industry, competition is more fierce, but firms still have to be smart about how they do business, Abadi says.
Meanwhile, heightened competition means it’s a brokers market, says Weitz of United Capital. A lot of lenders and funders have similar rates and terms, so it comes down to which firms have the best relationship with brokers. “Brokers are going to send the deals to whoever is treating their files the best and giving them the best pricing,” he says.
Profitability, access to capital and business-related shifts
Executives are confident that despite increased competition from deep-pocket players, there’s enough business to go around. But for firms that want to excel in 2020, there’s work to be done.
Funders in 2020 should focus on profitability and access to capital—the most important factors for firms that want to grow, says David Goldin, principal at Lender Capital Partners and president and chief executive of Capify. This year could also be one in which funders more seriously consider consolidation. There hasn’t been a lot in the industry as of yet, but Goldin predicts it’s only a matter of time.
“A lot of MCA providers could benefit from economies of scale. I think the day is coming,” he says.
He also says 2020 should be a year when firms try new things to distinguish themselves. He contends there are too many copycats in the industry. Most firms acquire leads the same way and aren’t doing enough to differentiate. To stand out, funders should start specializing and become known for certain industries, “instead of trying to be all things to all businesses,” he says.
Some alternative financing companies might consider expanding their business models to become more of a one-stop shop—following in the footsteps of Intuit, Square and others that have shown the concept to be sound.
Sam Taussig, global head of policy at Kabbage, predicts that alternative funding platforms will increasingly shift toward providing more unified services so the customer doesn’t have to leave the environment to do banking and other types of financial transactions. It’s a direction Kabbage is going by expanding into payment processing as part of its new suite of cash-flow management solutions for small businesses.
“Customers have seen and experienced how seamless and simple and easy it is to work with some of the nontraditional funders,” he says. “Small businesses want holistic solutions—they prefer to work with one provider as opposed to multiple ones,” he says.
This year could be a “pivotal” year for open banking in the U.S., says Taussig of Kabbage. “This issue will come to the forefront, and I think we will have more clarity about how customers can permission their data, to whom and when,” he says.
Open banking refers to the use of open APIs (application program interfaces) that enable third-party developers to build applications and services around a financial institution. The U.K. was a forerunner in implementing open banking, and the movement has been making inroads in other countries as well, which is helping U.S. regulators warm up to the idea. “Open banking is going to be a lively debate in Washington in 2020. It’ll be about finding the balance between policymakers and customers and banks,” Taussig says.
The funding environment
While there has been some chatter about a looming recession and there are various regulatory and competitive headwinds facing the industry, funding and lending executives are mostly optimistic for the year ahead.
“If December 2019 is an early indicator of 2020, we’re off to a good start. I think it’s going to be a great year for our industry,” says Abadi of Excel Capital.
We recently sat down with Todd Hamblet, Fundbox’s new Chief Legal Officer, and asked his thoughts about what legislative or legal issues would be shaping the fintech industry this year. Between presidents and precedents, decisions are coming down within the next 12 months that will have a significant effect on the way Fundbox and other fintechs do business. Here’s what Todd had to say:
Q: What key issues or predictions do you see when it comes to legal compliance in the fintech industry in 2020?
A: My basic view is that I expect to see continued efforts to regulate the financial services industry and fintech. These regulations are likely to focus on protection of consumer and commercial borrowers, privacy, or data protection. That said, I don’t think that innovation and regulation are incompatible. I think that there is sensible regulation that can achieve the goals of protecting consumers of financial services without completely stifling fintech innovation.
I think the outcome of the election will have a significant bearing on how active regulators are in the fintech space. In the absence of leadership from Washington, I’m concerned that we’re going to continue to see state-by-state legislation instead of a federal overlay. California and New York are two states actively working to fill this void. State versus federal regulation creates the challenge of needing to comply with 50 state requirements, which sometimes might be at odds with each other, as opposed to a more unified regulatory regime. You just have to spend a lot of resources in researching, staying up to date, and modifying what in many cases is a fairly streamlined product offering to comply with different state laws.
I worry that too disparate of a regulatory regime can, in fact, stifle innovation. It won’t stop innovation, but it can make it more challenging. I am certainly not opposed to sensible regulation, but sometimes the best intentions can lead to anomalous outcomes. You always have good actors and bad actors, and in our space, for example, we’re trying to disrupt a very traditional way of underwriting and lending in a commercial space that just hasn’t been compatible with or user friendly for small businesses.
The small business community is under-served, in part because you’re talking about smaller dollars than your traditional banks are even willing to underwrite. You’ve started to see community banks and credit unions step in a bit, but even in those cases, the lending model is still paper-heavy. It’s not optimized for all the data that’s out there, the ability to use technology, or alternative data sources. I think that fintech companies like Fundbox are serving and filling a niche that is really valuable for small businesses. Think about a mom-and-pop shop. They need to be able to run their business. They don’t need to spend all their time going back and forth with their bank, trying to get a loan. They need quick access to capital that may be just to solve a short-term problem. It may be to meet payroll during a slow month. That’s the problem we’re trying to solve, and also doing it in a way that is bringing it into the 21st century. This means using alternative data sources and machine learning, not relying exclusively on credit reports or FICO scores, and using other metrics to look at the credit worthiness of an enterprise.
I find it really exciting. It’s really satisfying to know that we’ve helped a lot of small businesses at the heart of our economy. So I think additional regulation is inevitable, but I hope it’s reasonable and sensible, and that it serves the purpose of protecting the borrower but doesn’t impose so many requirements or obligations that it makes it impractical for a fintech company to try to serve that population.
Q: Is there anything else you see happening in the realm of compliance?
A: I think we’re going to continue to face additional regulation in the areas of privacy and data protection. In California, we have the California Consumer Privacy Act (CCPA) that came online on January 1st. This is a good example of how, in the absence of federal action, states are going to take up their own legislation. California is the first to have enacted a comprehensive privacy act that companies are now trying to deal with. It impacts not just California companies but any companies dealing with California residents.
We’re tracking legislative developments in other states who are looking to implement their own privacy acts. Absent some sort of harmonized federal overlay (such as the GDPR in Europe), if you have 50 states with disparate privacy regulations, it just becomes very challenging. Of course, we will do everything we can to be compliant, but we have limited resources—we’d love to dedicate our resources to developing and improving products for our customers, instead of worrying about whether we’re tripping up a novel requirement of a particular state’s privacy law. So a federal framework would be really helpful. I already mentioned regulation in the context of the next election, and I think whether there is interest in Washington with a federal privacy law will depend on that outcome.
Q: Aside from the 2020 election, what other issues is the fintech industry keeping an eye on?
A: There have been some interesting cases out there in the fintech space. There’s one case in particular that has created some uncertainty and confusion: the Madden case. Although the case was decided a few years ago, it looks like federal regulators are trying to take steps to clarify the ruling. I hope that 2020 brings better visibility into what’s going to happen there, since the uncertainty is impacting the financial services industry and fintechs.
Generally, Madden is a case that dealt with the “valid when made” concept. When a bank makes a loan, there are various usury laws that can be applicable, depending on the state in which the loan was originated. Under federal law, an FDIC-insured state chartered bank can originate a loan using the maximum rate of interest permitted in the home state of the bank and then “export” that rate into another state, regardless of the state where the borrower is located. Some states have higher usury rates than others, so the maximum rate can vary. It is well settled that when that loan was initially made by the bank, it was “valid when made.” But what happens if that bank decides to sell off that loan to a third party in another state? The Madden case (read broadly) calls into question the “valid when made” doctrine. It said that if the loan had an X percent interest rate when it was originated, but it was sold to a third party in a state that had a usury rate lower than X, that original interest rate may not be valid anymore because of the transfer. Studies have shown that this ruling has led to a decrease in the availability of credit in the states affected by the decision.
Banks have to rely on being able to originate and sell loans—this is a well-settled concept. The question is whether the Madden case is distinguishable enough from the traditional practice that it applies only to a particular scenario (a sale of debt) or whether it is calling into question the broader concept. The reason this impacts fintechs is because a lot of us rely on bank partnerships in order to serve customers in all 50 states. Through these partnerships, fintechs may acquire the receivables on loans originated by partner banks. The question for fintechs in the context of Madden is: when the fintech acquires a receivable, does the interest rate originally offered by the bank partner continue to be valid…or because the fintech is a third party, does some other interest rate cap apply depending on where the borrower is located?
Congress and some other federal regulators are working to clarify that the Madden case should be limited to a narrow set of facts, and that it should not serve as a precedent for disrupting the traditional understanding of “valid when made”. This would be welcome relief to the entire financial services industry, including fintechs. We hope to have this clarification in 2020.
The New York State Department of Financial Services (DFS) released a report on Wednesday on the subject of online lending in the state. The report was mandated by a bill signed by New York Governor Andrew Cuomo on June 1 of last year. According to the original bill, this report was to be researched and composed by a task force of multiple parties. But in the eleventh hour, the section regarding the task force was struck. The report is to be presented to the governor, the temporary president of the senate, the speaker of the assembly, the chair of the senate standing committee on banks, and the chair of the assembly standing committee on banks.
Wednesday’s 31-page report is based on survey responses from 35 online lenders operating in the state, lending both to businesses and to individuals. One of the revelations in the report is that, from the data obtained, “New York individuals appear to account for a higher total dollar amount of loans than New York businesses.”
The report presents three primary assertions:
Equal Application of Consumer Protection Laws.
The report establishes that New York has strong consumer protection laws and regulations that apply to financial institutions. “These protections should apply equally to all consumer lending and small business lending activities,” the report reads. The report explains that there are strong protections against payday lenders and indicates that there should be strong protections across the board, even though the financial products and the consumers may vary widely.
Usury Limits Must Apply to All Lending in New York.
The report asserts that access to credit at usurious rates has long been prohibited in New York and that online lenders should not be able to bypass this by having arrangements with banks in other states, like Utah, where the usury laws are different. In New York, the civil usury rate is 16% and the criminal usury rate is 25%. But because online lenders have arrangements with out-of-state banks, they can charge interest at rates well above 25%.
Currently, if an online lender sues a merchant for not paying, the merchant cannot use usury as a defense. In the report, DFS recommends that a business should have the right to present usury as a defense.
All Online Lenders Should be Licensed and Supervised.
The report states that New York State chartered banks, credit unions and licensed non-depositories are subject to regular examinations by the DFS and, if applicable, federal regulatory agencies.
“Many online lenders remain unlicensed in New York with no direct supervisory oversight from a safety and soundness or consumer compliance perspective,” the report reads. “Direct supervision and oversight is the only way to ensure that New York’s consumers and small business owners receive the same protections irrespective of the channel of delivery [of financing.]”
Some of these issues relate to the well-known 2015 Madden v. Midland Funding court decision, in which a credit card consumer (Madden) won a case against a debt-collection agency (Midland Funding) because the court decided that Midland, as a non-bank, was not allowed to charge interest above what was allowed in the state.
deBanked Magazine recently caught up with Peter Renton, founder of Lend Academy, a leading educational resource for the marketplace industry. Through his writing, podcasts and video courses, he’s been helping multitudes of people better understand the industry since 2010. Renton is also the co-founder of LendIt, one of the world’s largest fintech conventions, which recently branched out beyond its marketplace lending focus to include other types of fintech. The flagship U.S. conference will take place April 9 through April 11 in San Francisco. The following is an edited transcript of our discussions.
deBanked: Why did you decide to rebrand LendIt as LendItFintech?
Renton: The main reason is that we have moved beyond the online lending space. While it’s still the core of what we do, it’s not all of what we do anymore. Many of the large online lenders have also moved beyond online lending. Lending is part of financial services, but our attendees want to know what else is important. Our attendees also want to look at other opportunities for expansion. They want to know how other areas of fintech are going to affect their business—topics such as blockchain and digital banking. LendItFintech tells people that lending is what we focus on, but it also makes clear that we’re about more than lending.
deBanked: In addition to your marketplace lending investments, you entered into the cryptocurrency space back in early 2015. Tell us what you’re doing now with respect to cryptocurrency?
Renton: This was not something that I spent much time thinking about back then. At the time, I expected bitcoin to never amount to anything. But I’m interested in financial innovation and I decided to give it a go. I never thought in my wildest dreams that it would get to $10,000. (Editor’s note: In 2017, bitcoin climbed to nearly $20,000; in early February it fell below $8,000 for the first time since Nov. 2017)
I opened up a Coinbase account with $2,000, which got me 10 bitcoins. I have since sold a portion of it gradually as the price of bitcoin went up, and I diversified into a handful of other coins as well. I have recently moved a significant portion of my investment into a privately managed cryptocurrency fund, and I still maintain my Coinbase account too.
deBanked: How are things different now than when you first entered the digital currency market?
Renton: In January 2015, I created my bitcoin account and I don’t think I ever logged in over the next 18 months, or if I did, it was maybe just once or twice. No one was talking about bitcoin back then. It was still on the fringe of fintech. Sure, there were some people focused on it, but it wasn’t part of mainstream media coverage. Then, all of a sudden, it became hot because people love get-rich-quick schemes and hearing about people who hit the big time from nothing. These stories really fuel people’s imagination. Then suddenly bitcoin became one of the biggest phenomena of 2017; no one would have predicted a few years ago that would happen.
deBanked: What are the biggest risks you see with cryptocurrency today and how can investors best overcome these challenges?
Renton: Many people are buying purely on speculation with no thought that bitcoin could go down in price. You hear of people buying bitcoin on their credit card and paying 20 percent interest on that purchase. It’s insane. I feel that cryptocurrencies are here to stay, but I don’t like that they have these massive 20 percent to 30 percent swings in a day. The speculators have helped drive the price up, but they’ve also driven the volatility up and that’s been a bad thing.
deBanked: Do you think cryptocurrency will ever dethrone cash? If so, what will it take to get to that point?
Renton: I feel that some kind of digital currency is inevitable—but whether it’s a Federal Reserve-backed currency or something else remains to be seen. I have an 11-year-old and a 9-year-old and I am confident that at some point in their lifetime there will be no such thing as cash. In China, for example, there are some places where you can’t even use cash. You can go to a street vendor and buy a piece of fruit with your phone. Certainly in the U.S. we’re not there yet, but I think China shows where we are going to be.
Cryptocurrency is only one type of digital cash, and it’s hard to say how it will ultimately fit into the larger picture. To dethrone cash as we know it today, cryptocurrency needs to be a quick and efficient way of transacting, and right now it’s not quick and it’s not cheap.
That said, I believe there will be some kind of digital currency in the future. It will take a long time for the Federal Reserve to say cash is no longer legal tender, but I expect we’ll see some kind of digital currency in the next 10 years for sure.
deBanked: How do you think regulation will change the cryptocurrency landscape? Is it inevitable and, more importantly, do you think regulation of cryptocurrency is necessary to take it beyond the level it is today?
Renton: Right now bitcoin is not systemically important. At a market cap of around $156 billion in early February, if something happens and it completely crashes, it won’t make a dent on the U.S. or world economy. But if bitcoin continues to rise and reaches a market cap of say $16 trillion, and then it falls to zero, that would reverberate around the world. The largest economies that have the most bitcoin would be the most impacted.
At some point governments will step in with regulation. It’s already happening in places like China and South Korea and there are rumors of other governments taking action. I don’t think the largest governments will allow their economy to be at the whim of speculators.
deBanked:deBanked: How do you feel about the SEC stepping into regulate ICOs? Is this necessary to protect investors?
Renton: There are certainly some ICOs that are complete scams while others are obviously violating securities laws. But many ICOs have strong legal teams supporting them and are doing it right now. The SEC should absolutely clamp down on those doing the wrong thing, but my hope is that they don’t overreact and throw the baby out with the bathwater.
deBanked: What about online lending? The industry has gone through a lot of changes in its relatively short history. How do you expect to see the competitive landscape change in the next year or so? What about farther out?
Renton: The online lending space has gone through a lot of changes in its short history. I feel like the biggest trend we’re seeing right now is banks launching their own platforms. Take Goldman Sachs with the Marcus online lending platform, for example. More than anything else that has happened in the history of online lending that is among the most telling for the future, I think. Goldman has gone all in with this effort, and that move woke up all the large banks. Top banks like PNC and Barclays are also launching their own initiatives instead of partnering with others, which was surprising to me. I would have thought there would be more partnerships. There are still some, but several banks have decided to do it themselves rather than partnering. Smaller banks, however, that want to get into the space, will likely partner because they can’t afford to do it themselves. While we have seen a few partnerships develop, I expect we will see many more over the next couple of years.
deBanked: What do you see as the biggest risks for online lenders today? How can they best overcome these challenges?
Renton: As an industry, we have to focus on profitability. Profitability comes down primarily to two things. First, you have to get your cost of acquisition down. Some of the companies that failed recently were never able to get their costs of acquisition down to a manageable level. Underwriting is the second piece. Particularly if you’re a balance sheet lender and you’re not underwriting well, you can’t make money. The pullback in the industry in 2016 occurred because many of the major platforms got a little too aggressive in their underwriting. Investors are still paying for some of those mistakes.
Successful companies are ones that have figured out how to profitably acquire customers and how to underwrite effectively. Most of them have learned their lesson, but in business companies sometimes have short memories. We need to keep a close eye on it.
deBanked: What advice do you have for alternative lenders and funders?
Renton: In addition to paying careful attention to profitability and underwriting, another important piece is having diversified funding sources. You want to make sure that you don’t have one big bank or some other source providing 90 percent of your funding. You should really have different kinds of lending sources. Some loans you can fund through a marketplace, some loans you can fund through your balance sheet. It’s good when you’re not reliant on one particular way of funding your loans.
deBanked: How is regulation likely to impact the online lending industry?
Renton: Having support in Congress for the online lending space is important. Congress hasn’t devoted a lot of attention to it in the past few years, but it’s starting to. The Madden decision—which has the potential to lead to significant nationwide changes in consumer and commercial lending by non-bank entities—has created uncertainty in the industry. In states affected by the decision (Connecticut, New York and Vermont) already there has been less access to credit. I’m hopeful that Congress moves ahead with legislation to override the Madden decision that’s having such an impact in the Second Circuit states. People are worried that it could expand nationwide and Congress needs to act so there’s clarification. There’s too much uncertainty right now.
deBanked: Several platforms have closed their doors in the past year or so. Do you expect to see this trend continue?
Renton: There are companies out there still trying to raise money and struggling to do so. That’s a healthy thing for an industry. You want the strong players to survive and thrive and for the weaker ones to go away.
deBanked: How big do you think an online lender has to be to thrive?
Renton: There’s no doubt that scale is important. If you’re a small player, you have to have some kind of niche in order to acquire customers. If you have that, you have the ability to compete. Even with that sometimes, it’s going to be difficult. It’s a pretty complex business. You need to have a lot of staff for compliance and operations and that can be expensive. When you have high fixed costs, you have to have scale to be able to make a profit. That said, I think there’s room for more than just the ultra-large players in the online lending space. I think there will be plenty of opportunity for strong, well-positioned medium-sized players to compete.
deBanked: What about M&A in the industry?
Renton: Valuations at many of the large platforms are way down from where they were several years ago. As long as valuations stay depressed, I think we could see a big acquisition of a major platform this year. Some of these platforms have millions of customers. Having the ability to pick up such a large number of customers instantly through an acquisition could be compelling for the right buyer, such as a large bank.
deBanked: Is this a good time or a bad time to be an online lender in your opinion?
Renton: It is still a good time to be an online lender. We are expanding access to credit and making the world a better place. I have never been more excited about the industry than I am today.
- Prospa, an online small business lender based in Australia, was valued at $235M (AUD) in a $25M capital raise
- Square announced funding $248 million worth of business loans in Q4 2016
2/21 A Massachusetts state court vacated a merchant cash advance COJ
2/24 SoFi raised $500M in a financing round led by Silver Lake Partners that reportedly gave SoFi a $4.3B valuation
2/27 Prosper Marketplace closed a loan purchase agreement with a consortium of lenders for up to $5 billion of loans that has a provision that also enables the lenders to buy up to 35% of the company
2/28 BlueVine secured a warehouse line of up to $75M from Fortress
3/1 Lendio launched a new franchise program, allowing local offices around the country to become Lendio franchisees
3/3 Citing Madden v Midland, Colorado regulator brought a federal lawsuit against Marlette Funding for violating the state’s usury cap
3/5 Two trade associations, the Innovative Lending Platform Association (ILPA) and the Coalition for Responsible Business Finance (CRBF), joined forces. The merged company will continue to be known as ILPA
3/6 Upstart raised $32.5M
- It’s reported that former CAN Capital CFO Aman Verjee is now the COO of 500 Startups
- Kabbage priced a $525M securitization. It was oversubscribed
3/9 Citing Madden v Midland, Colorado regulator brought a federal lawsuit against Avant for violating the state’s usury cap
- Melvin Chasen, the founder of Rewards Network (originally Transmedia Network, Inc.) passed away. He was 88.
- The New York State Assembly rejected the Governor’s proposal to grant the Department of Financial Services (DFS) regulatory authority over any online lender doing business in the state
- The New York State Senate also rejected the proposal to further regulate lending
- The OCC published a manual on how it will evaluate charter applications from fintech companies
- The New York DFS published a statement rejecting the OCC’s plans
- The WSJ reported that Marlette Funding was cutting nearly 1/5th of its workforce
3/16 WebBank announced that it had a net income of $29.2M for 2016 and that it had a market valuation of $319.4M
3/20 Prosper Marketplace announced that it had originated $2.2B in loans in 2016, down from $3.7B in 2015, and had a net loss of $119M.
3/21 It’s reported that Kabbage will set up its European headquarters in Ireland
3/22 OnDeck expanded its credit facility with Deutsche Bank by $52M to a total of up to $214M
3/27 IOU Financial wins Gold Stevie Award for Best Use of Technology in Customer Service
3/30 In Advance Capital announced that they had secured access to an additional $50M
- Budget passes in New York. Proposed lending legislation was not included in it.
- Kabbage surpasses $3 billion funded to small businesses
Regulation around technology-enabled lending has generally been a point of contention in the US. Even regulators are finding themselves at odds with other regulators, like the OCC vs. the NYDFS for example. Might relationships like these be contributing to America’s innovative decline?
At LendIt last month, Congressman Patrick McHenry (R-NC) said, “Is it any wonder that Fintech has a distinctively British accent these days? It’s good reason. We have regulatory competition around the globe, but we don’t have the right regulatory competition here in the United States. And while we have a patchwork of conflicting, and overlapping, and confusing regulations, in places like the U.K., they’re creating an entire ecosystem of financial innovation and allowing it to flourish. And they become the model for the rest of the world and the intellectual property center for the rest of the globe when it should be here in the United States.”
Forward-looking regulation has helped a nation like Kenya make the movement of money cheaper in their country than it costs to move money here, McHenry said. “They’ve moved generations ahead overnight,” he exclaimed.
If you haven’t seen the video, check it out below:
Or you can read the full text from our transcription of it:
“And thank you all for being here. This is a wonderful celebration on, you know, a stereotypical February or March day here in New York. Cold as can be. Good to be inside. But thank you for taking the time to gather. The work that you’re about improves the American economy, gives more options for my constituents and for the citizens across this great country of ours, and gives them better options and opportunities to make decisions for themselves and put power back into their hands in a very competitive environment.
In fact, it’s really liberating to be out of D.C. especially at moments like this. You don’t know what the latest news story is gonna be or the latest tweet, so good to talk about something meaningful over the long run. And the reason why I’m here is because my focus legislatively has been around utilizing technology for innovative forms of finance.
I came about this in a very simple way that’s relatable to other people. But you know, the idea of Fintech, in 10 years, in 20 years, the term “Fintech” will be scoffed at kind of the way that we scoff at how they described Amazon 20 years ago. They said it was an e-Commerce site, that it was a webpage. Right? And we laugh at people that would describe it that way today. Every company that’s in the retail space has an e-Commerce site. Everyone is competing in this new form that Amazon represented the new wave of 20 years ago. So, the term “Fintech” may be much like referring to something as not a website, but a webpage. And in time, the way people are interacting with the banking system is going to continue to change in fundamentally different ways.
It’s exciting to think about how consumers and small businesses across America are gonna find these new ways to access capital over the next generation. And you all are at the forefront of that. And at D.C., I’ve tried to lead the change of that change in mindset. And you know, this is not only about helping Fintech companies, but also about fundamentally altering how regulators interact with innovative companies. And so, the focus on lending, helping families access capital as I said in the beginning, I came to it in a very natural way.
I saw my father start a small business as a child. When I was a child, the youngest of 5 kids, I saw my father start a business in the backyard mowing grass. Very simple, relatable thing. Most of us have mowed grass at some point in our life. And my father started that small business in our backyard and he used the great financial innovation of his time to buy his second piece of equipment, which he put on a MasterCharge. Great financial innovation and that helped him start a small business.
Now, that small business didn’t change the world, but it changed my brother’s and sister’s lives and put the 5 of us through college. That’s a meaningful thing and that is the American dream as my father defined it and as I define it. Now, that’s not creating Facebook. It’s not this other sort of revolution of internet technology, but it certainly made a huge difference in our community and for our family.
So, how did we utilize technology and help those small businesses like my father access and grow? The plight of small business in America though right now is real. The next generation of small business owners are struggling to get off the ground. The facts are that small business loans used to make up a majority of bank balance sheets. Now, 20 years— Well, in 1995, they were majority of the bank balance sheets. Now, it’s 20% of bank balance sheets.
Now, you also see small town America, which used to lead the country in small business starts, small counties, small communities across the country have lagged. So, smaller counties used to lead the nation in new businesses even as late as the 1990s, mid `90s. But just in this decade alone, small counties have lost businesses. U.S. counties with 100,000 people or fewer residents lost more businesses than they created. We see stagnation among small business owners and small business starts. This is why Fintech is so vital and so important. Technology is the only way to ensure that we spread and democratize capital outside of Austin, Boston, Silicon Valley, and New York.
How do we get the rest of the country, small town America, and even the urban areas that don’t get the focus and attention? And so, I think the power of harnessing big data is gonna fundamentally change the way we look at debt. It’s already happening. And you’re the leaders of it. Instead of relying on the credit score, which was a great innovation in the 1970s, fixed the problem in the 1970s, today, companies are using big data to better understand who will and who should qualify for loans. And what we’re discovering is that the way we help people out of debt is by understanding the data behind the debt.
Look at the way technology is fundamentally changing lives and places like Kenya. Think of this. In Kenya, the phone, your smartphone, our smartphone is that way to financial inclusion in Kenya. The movement of money cheaper in Kenya than it is here because of this simple device. It’s more powerful in that jurisdiction than in ours because of regulation and forward-looking regulation. And instead of loading buses filled with luggage that’s filled with cash in moving money in Kenya, they’re now doing it through a fast transfer over their mobile device. They’ve moved generations ahead overnight. And in fact, in many ways, they’re leading the world in Fintech deployment. So, we’re living in a new and exciting era in financial services. It’s actually matched the best interest of consumer protection with the demands of global smartphone-led revolution that we, as consumers, are driving. Now, that’s what’s happening in the real world.
So, let me translate back to you what is happening in the analog world of Washington. D.C. The regulatory challenges of Fintech are real. It’s major in Washington. We have a diversity of regulators. That’s certainly part of our American system. And that’s not gonna change any time soon. So, what is the current landscape? If you are in Fintech and you wanna make sure you’re complying with financial laws and regulations, where do you go? Who do you ask? Who do you talk to? Is there an open door in Washington? Do you know who your regulator is? Do you know who your regulator should be? Do they meet with you? Are they willing to meet with you? What’s your legal and compliance cost before you even get a product hashed out? These are major things you have to wrestle with in starting your businesses or growing your businesses. So, believe it or not, the difficult question is who do you talk to in Washington? And there is no simple answer. And because there’s so little clarity on which regulator to go to, often there’s even less clarity of how the underlying laws or regulations are being enforced by that regulator in this new marketplace.
And so, this is the hidden secret of Washington. The regulators themselves are so behind when it comes to understanding technology that they themselves do not really know how to apply regulation to innovations in Fintech. They just simply do not know. And trust me, I realize this as a legislator. 5 years ago, I helped craft what is called the JOBS Act. I wrote a piece of the JOBS Act. It resulted in 14 pages of legislative text around investment crowdfunding. 14 pages of legislative text. 3 years later, the Securities and Exchange Commission wrote 700 pages of regulation around my 14 pages of law. And if you are all involved in investment crowdfunding under Title 3 of the JOBS Act,— three of you, right— there will be a lot more had they written good regulation and actually complied with the mindset of Congress when we passed the JOBS Act.
So, I see this when regulators don’t actually know how to meet the demands of innovation and what’s happening in this information revolution that we have. And so, as a result, America is actually falling further behind the rest of the world. And unlike other areas of the world, which have created regulatory sandboxes for banks and technology companies to innovate and find a light-touch regulation, here in Washington or there in Washington, regulators are struggling to adapt.
And is it any wonder that Fintech has a distinctively British accent these days? It’s good reason. We have regulatory competition around the globe, but we don’t have the right regulatory competition here in the United States. And while we have a patchwork of conflicting, and overlapping, and confusing regulations, in places like the U.K., they’re creating an entire ecosystem of financial innovation and allowing it to flourish. And they become the model for the rest of the world and the intellectual property center for the rest of the globe when it should be here in the United States.
Well, while we’re all trying to figure out whether or not virtual currencies are more like property or money here in the United States, top countries around the world are using digital currency to move payment platforms overnight, change payment platforms, make it cheaper, more affordable to move funds for the smallest and the biggest. So, while the world’s rapidly adopting new financial technology to expand the middle class, our country’s regulators have created capital deserts here in the United States in rural and in urban areas. We understand the notion of an urban food desert. If you can get good food that is close to your home in an urban area, you can actually feed your children wholesome meals. We understand that. That’s a big discussion. Well, likewise, we’re starving off small business innovators in urban areas and let’s say less desirable zip codes in urban areas and less desirable zip codes in rural areas. And so, we’re starving off opportunity and that has a result in small business starts and the rise from the turn in the economy from those that are living on the margins to those that move up to the upper middle class and upper class based off being starved from capital.
We have to fix that. Fintech is the solution, but the regulation has to change. And that is something that I’ve been focused on over the last 6 years. And I think we have a trilogy of good ideas that I would submit to you this morning. First is let me just tell you my mindset in regulating and legislating. And to borrow from startup culture, the bills that I try to focus on are minimal viable bill. It’s a simple idea.
One idea that focuses on solving a discrete problem. Something in the marketplace that needs a regulatory fix in order to flourish. And it will help the greatest number of people and have the greatest impact on tech companies, bank startups, and small business folks and families. So, looking at the headache test, one of the areas of interaction with the government that’s creating unnecessary delay is the IRS not having a piece of technology that will allow people to verify income data.
And so, as a result of that, I’ve — legislation that is called the IRS Data Verification Modernization Act, 45060 for those of you who are in the game on this, but it simply will do this. It will automate a bottleneck manual process that is utilized via e-mail and fax with the IRS in verifying basic information that you, as lenders, need to allow mortgages, student debt, refinancing, and small business loans. It’s the taxpayer’s information. You pay for the service to verify it. We should have better service rather than the shoddy service IRS is currently giving you. You should be able to get this in an instant with an API rather than getting something faxed to you in 7 to 10 days. It’s absurd that the IRS can’t update and we’re gonna force them to update.
Our second bill, it goes directly to returning consistent uniform systems for our capital markets, which I believe is a fundamental thing in our 50-state regime with a variety of regulators. We have to have some base level of understanding on what is valid. And the bill is simple. It codifies the Valid-When-Made Doctrine that we’ve had in this country for nearly 100 years. And that was an established legal precedent prior to the Second Circuit Court’s decision in the Madden case. Madden versus Midland. And our view is the Second Circuit’s opinion was unprecedented. It’s created uncertainty for Fintech companies, banks, and the credit markets; making credit less available and more expensive. So, the simple fix is returning to the Valid-When-Made Doctrine. Congress under our constitutional system has the right to make this very clear to the courts of our intention when we pass the original law and nothing has changed when it comes to this. And this is the second bill that I’ll be pushing this year.
And finally, a third piece of legislation that is broader in discussion and it’s the Financial Services Innovation Act. This bill creates a new paradigm for regulators in Washington. It says in a first of a kind way, it forces regulators to meet the demands of rapid innovation in financial services. Instead of the old analog version of command and control regulation that’s messy and rigid based off of opinion, not fact, my bill requires agencies of jurisdiction to create offices of innovation that will engage with entrepreneurs and provide a regulatory on-ramp for financial innovation. It basically forces all the regulators, all the financial regulators to create a new door for financial innovation. A welcoming door. Come in with your ideas. Let’s talk about regulations that can enable this technology to flourish. And in getting data in return, the agency would be in permanent beta testing mode, which would give them data to prove out consumer benefit or consumer harm. It will give them data to adopt the whole footprint of regulation in all these financial regulators.
Now, that is a major mindset shift for our financial regulators, a major mindset shift for any regulator in our American system of governance. But with thorough analysis, I believe that innovators will be better off in this regime when you have data that is driving the decision making of regulators and regulators driving decisions that are informed rather than opinion based.
Now, saying that we’re gonna base our politics off of fact these days is its own enormous political challenge, but I think it’s important that we all agree facts are important things and we should base our decision-making solely on that set of facts in order to do the right thing for our country, the right thing for our economy, right thing for families, right thing for small business starts. So, permanent beta testing involves continuously evolving, testing, and proving. It’s what you do everyday as innovators.
Now, those are 3 major pieces of legislation that can have an impact, but the mindset in Washington is much— Well, it’s much different than you might think. Legislators are eager for new ideas, for new information. They’re eager to hear what you are about and what you’re doing. And given the nature and the speed of innovation, you have an obligation to be engaged in Washington. If you’re not engaged in Washington, Washington is still gonna be engaged in what you do. You’re just gonna get worse rather than better. So, if you inform decision makers you have data to backup what you’re expressing, what you’re advocating for, we’re gonna be better off, but you all in your pitches, right, have to— The basic startup pitch, you’ve got to answer one question. Why now? Why now? I think American financial innovation is at an inflection point. I really do. We’ll either lead the world in the next few years or we’re gonna be left behind. It’s our choice. It’s our choice. And it’s time that regulators treat innovation no longer as a threat, but as an opportunity to consumers. It’s time to recognize that regulators need to recognize— I think it’s time that they recognize that consumer protection and innovation are not mutually exclusive. Now, that’s the reason why it’s now, but it’s not gonna happen unless you engage in Washington and make your voices heard. You’ve gotta make your voices heard in order to get the results we need so we can have innovation flourish in this country, that we can be the market leader for the world, that we can be an exporter of these ideas rather than having to export ourselves to different markets in order to take that data and that mindset and deploy those resources globally.
Let’s make sure that we can lead this market to better and greater things. With your engagement, we can. Without your engagement, we’re gonna be left behind. So please, please engage in Washington. Make your voices heard. And with your voices being heard, I think we can have change for the better. So, thank you for your leadership. Thank you for the opportunity to be here with you. God bless.”