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House committee considers fix for fintech-bank uncertainty

The House Financial Services Committee will today review legislation that would clear some uncertainty around the business model of several digital lenders.

Among nearly two dozen bills the committee is considering Oct. 11 is a bill that would effectively overturn the controversial ruling in Madden v. Midland. Rep. Gregory Meeks, D-N.Y., and Rep. Patrick McHenry, R-N.C., co-sponsored the legislation, and the bill appears to have broad support with "enactment likely during this Congress," according to Isaac Boltansky, a policy analyst for Compass Point Research & Trading LLC. The Senate already has companion legislation in the works under the same name, Protecting Consumers' Access to Credit Act of 2017.

The nation's largest digital lenders rely on bank partnerships that have been shrouded in uncertainty following the Madden v. Midland ruling, which suggested that the fintechs might not be entitled to the bank's protection from state usury laws. Nonetheless, the digital lenders have been able to grow their operations, with the three largest lenders — LendingClub Corp., On Deck Capital Inc. and Prosper Marketplace Inc. — reaching $4.3 billion in originations by the 2016 first quarter before funding issues precipitated a drop-off. In the 2017 second quarter, the three companies combined to originate $3.4 billion loans.

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Banks that have partnered with the companies are increasingly reliant on the partnerships as a source of revenue. The three banks with the largest fintech partnerships — WebBank, Cross River Bank and Celtic Bank — have all reported steady increases in loans held-for-sale as a portion of total assets. Under the partnership model, the bank generally issues the loan and keeps it in "held-for-sale" for a short period of time until the fintech either buys the loan or finds a buyer.

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At first glance, the Madden v. Midland Funding LLC case seems to have little to do with digital lending. The case, which was most recently heard before the U.S. Court of Appeals for the Second Circuit, was brought forth by a New York-based individual against Midland Funding LLC, which had been assigned the individual's debt for collection. The lawsuit claimed that because the debt was transferred to a nonbank entity in a different state the original terms of the debt were no longer valid and Midland Funding was violating New York debt collection laws and specifically that the interest rate violated New York's usury limits.

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The argument went against a long-standing common law idea that loans are valid when made, and their original characteristics remain even if the loan is sold or transferred. It also raised questions around exemptions under the National Bank Act that allow chartered institutions to export the rates of their home state when providing services to those in other states.

The Second Circuit reversed an earlier district court ruling stating that the debt was valid and found that because Midland Funding was not a national bank the exemptions provided for national banks did not apply. This immediately sent shockwaves through the digital lending community where partnerships with nationally charted issuing banks are widely used.

In response to the uncertainty created from the decision some lenders sought to exit the markets covered by the court's jurisdiction: New York, Connecticut and Vermont. Demand from this region had been historically high and exits from these states helped compound slowing originations seen during 2016.

The Meeks-McHenry legislation specifies that "valid-when-made doctrine" enhances liquidity and would codify the standard into law. The legislation also cites academic research showing decreased credit availability in New York, Connecticut and Vermont due to the Madden ruling.

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S&P Global Market Intelligence compiled data for the charts using the Regulated Depositories dataset in SNL Office.

For data on digital lender origination totals, reference the companies' briefing book pages.