Whose Loan Is It Anyway?

Innovative lenders and banks rely on each other to expand credit access. Unfortunately, the future of a lynchpin of that partnership is…

The show got weird after Drew Carey left

Innovative lenders and banks rely on each other to expand credit access. Unfortunately, the future of a lynchpin of that partnership is unclear. The latest risk comes from Colorado, though the implications will likely be nationwide.

As I have mentioned previously, the bank partnership model relied on by many marketplace lenders is under legal and regulatory threat. A new front recently opened up in Colorado. The Colorado Attorney General’s office has brought suit against two marketplace lenders, Avant and Marlette Funding, for violating state laws governing the provision of credit. These suits are causing concern in the marketplace lending industry that will likely result in a reduction of credit availability to borrowers within, and possibly outside the state. Colorado’s actions are not going uncontested, however. Avant and Marlette are disputing Colorado’s legal analysis, and Web Bank and Cross River Bank, the bank partners for Avant and Marlette respectively, have filed declaratory actions seeking injunctive relief, in effect asking the court to declare the loans valid and to prevent Colorado from continuing its enforcement effort. The results of these legal fights will likely influence the future of the bank partnership model, and the future of innovative lending as a whole.

Colorado’s complaints against Avant and Marlette allege that the companies made loans with interest rates, fees, and choice of law provisions that are not legal under Colorado law. Colorado further alleges that while the loans were nominally made by banks in compliance with the requirements of the laws of banks’ home states, which is consistent with the power banks enjoy under federal law, the marketplace lenders cannot rely on those powers. Colorado, citing the Madden v. Midland Funding decision, argues that non-banks that purchase loans from banks cannot continue to enjoy the preemption the bank enjoyed. Colorado also argues that the banks were not the true lenders because the marketplace lenders had the “predominant economic interest” in the loans. Because of this, Colorado argues the loans marketplace lenders “make” are required to comply with Colorado law. Unsurprisingly, Avant and Marlette disagree.

I like to think the banks’ lawyers looked like this

Both Webbank and Cross River Bank, peeved that they weren’t sued by Colorado at the same time their partners were sued, have filed declaratory actions in federal court seeking to stop Colorado’s enforcement actions against their partners. (Complaints courtesy of Robert Loeb of Orrick.) The banks argue that they have the right under federal law to make loans nationwide in compliance with their home state’s laws, and to sell those loans to non-banks. They further argue that Colorado’s enforcement action against the banks’ partners improperly interferes with the banks’ powers to make and sell loans. The banks also dispute Colorado’s contention that the banks have a de minimis role or interest in the loans, highlighting their ongoing financial interest in the loans, as well as their regulatory interest, since any significant problem with the loans or their partners’ behavior could result in sanction from the banks’ regulators.

These suits touch on two related but separate questions: (1) Who is the actual lender of a particular loan? and (2) Do the legal rights and privileges that attend a loan change or become invalid based on the nature of the holder? However, the suits also highlight how needless and artificial this controversy is. Why should it matter who the true lender is, or who holds the loan on their books? If (and it is a very big “if”) the state should be prohibiting certain loans, shouldn’t the prohibition be based on the loans’ characteristics, not on who makes or holds the loan? A loan does not transform from harmful to wholesome simply because it is made by a bank instead of a non-bank. If (again, a big “if”) the state has a legitimate interest in limiting consumers’ choice, that interest applies to all loans, regardless of who makes or holds them. Conversely, if the state should not be able to interfere with consumer choice, that prohibition should apply to non-banks as well as banks.

What if it was the characteristics of the loan, not who made or owned it, that mattered?

These cases also show that the bank partnership is largely a reaction to an outdated and arbitrary regulatory structure that ultimately harms consumers. The banks do play a role in the creation of the loans, they take on risk, they are lenders. However, the one essential role the banks play, the one role that the marketplace lenders could not duplicate, is not based on technology, access to funding, or experience; it is based entirely on accessing a more rational and efficient regulatory system based on a bank charter. Such access isn’t free to the consumer. The banks charge a fee, both directly and through a stake in the ongoing profits of the loan, to the marketplace lenders. Without the need to partner with banks this money could be saved, and those savings passed on to borrowers. Instead, borrowers are forced to finance an outdated regulatory regime.

The outcomes of these cases will influence the trajectory of innovative lending. These new cases will either bolster or stifle the momentum for undoing valid-when-made and the ability of banks to partner with firms that need help navigating the regulatory morass that lending is trapped in. What the cases will not do is move us to a more rational system. To get there will likely require Congress to act, with or without the states. In the meantime millions of dollars in litigation will be spent determining just whose loan is it anyway.

No reason, but look at the little guy go.