The legal and regulatory risks in U.S. consumer loan securitizations that could arise when a third-party loan origination model is utilized--as is common for marketplace or fintech lending platforms--have continued to evolve over recent years. In a previous commentary, "Marketplace Lending And The True Lender Conundrum," published Feb. 22, 2019, S&P Global Ratings highlighted the emerging regulatory and legal challenges for non-bank companies that originate loans via third-party lending arrangements with national-chartered or state-chartered banks (partner banks) that are allowed to export rates. Rate exportation allows the partner bank to originate loans across the country at interest rates that are legal in the partner bank's home state, but that may exceed the maximum rates permitted by usury laws in other states. Once the originating bank transfers or assigns the loan to the non-bank partner, "valid when made" and "true lender" legal and regulatory risks can emerge. These risks could bring potential negative consequences for securitizations backed by loans originated through these arrangements, including a reduction in the interest rate on the loan, a voiding of the entire contract, or litigation and related costs. We have been monitoring the evolution of these risks and want to clarify how we assess them in our rating analysis of U.S. consumer loan asset-backed securities (ABS) transactions (see "Marketplace Lending And The True Lender Conundrum," Feb. 22, 2019; "U.S. Structured Finance Asset Isolation And Special-Purpose Entity Criteria," May 15, 2019; and chart 1 below).

Chart 1

Assessing Partner Bank Loan Origination Risks In Our Rating Analysis

In our previous commentary, we stated that if we receive information on the identified loans in a proposed collateral pool exposed to interest rates above other states' usury caps, we may be able to analyze and assign ratings to the transaction if, in our view, the credit enhancement in the proposed structure fully mitigates the risk. We also stated that legal comfort in some form may mitigate our concerns and proposed that we could receive legal opinions to determine whether such risks do not exist or are otherwise mitigated.

Since that commentary, we have observed that third-party lending arrangements continue to proliferate in the market. Certain legal and regulatory developments--which we discuss in The Evolution Of "True Lender" Risks section below--have supported this expansion, but in our view, some legal risks may remain. As such, we are clarifying our view on the legal and regulatory risk of third-party lending arrangements and providing insight into the types of questions we typically pose to issuers about compliance strategies and transaction features that may potentially mitigate these risks. We will continue to assess this risk on a case-by-case basis.

We analyze securitizations of unsecured consumer receivables under our Global Consumer ABS Methodology And Assumptions criteria unless other asset specific criteria is applicable (e.g., student loans). As stated in that criteria, we may apply cash flow stresses to account for legal, operational, and counterparty risks that are not mitigated by the transaction structure. Specifically, our analysis generally considers any relevant legal risks that potentially could arise from the use of third-party lending arrangements in structured finance transactions. Depending on the circumstances, we generally request additional information to assess whether such risks do not exist or are otherwise mitigated. To date, S&P Global Ratings has rated transactions backed by loans originated by third-party lending models where "true lender" legal risks have not been material in our view. In certain transactions, we received and reviewed loan level interest rate information compared to usury limits in the loans' state of origination. Any material exposure to loans with rates above state usury limits that could potentially become the subject of a "true lender" challenge was considered in our analysis. We have also rated transactions where the originating bank has retained the loans instead of selling the loans to its non-bank partner and completed a transaction using its own securitization platform. Based on our observation of legal and regulatory trends, third-party lending arrangements may also be able to demonstrate qualitative considerations that effectively mitigate "true lender" risks. Chart 2 provides a summary of the types of questions we typically ask, among others, when assessing "true lender" risk in a transaction, including our previously stated considerations.

Chart 2

We believe the use of third-party lending arrangements in the consumer loan sector is likely to continue despite the potential legal and regulatory risks, including the risk of "true lender" challenges. Regulators are likely to continue to exercise oversight over third-party lending arrangements, and the questions we ask of issuers seek to understand how they are responding to ensure compliance with state and federal laws and regulations. While legal risk continues to evolve as the market matures, we do think these risks may be mitigated in select cases by certain factors. In our ratings analysis of securitizations backed by consumer loans originated through third-party lending platforms, we will assess all related risks including "true lender" and consider any measures in place to mitigate these risks on a case-by-case basis. Where we do not believe that the legal risk has been sufficiently mitigated, our analysis typically would account for a scenario where these risks could materialize, or we may choose not to rate the transaction.

The Evolution Of "True Lender" Risks

The marketplace lending sector, where borrowers and lenders connect through online platforms to apply for and fund loans, emerged in 2005 and has seen rapid growth since the Great Finance Crisis. As the sector has matured, developments in the legal landscape have created uncertainty surrounding the "valid when made" doctrine and raised questions of who is the "true lender" for loans originated by marketplace lending platforms through their partner banks. Chart 3 shows the evolution of the sector and these risks since 2008. The following discussion serves only as a high-level overview of certain key trends and developments we view as important from a legal perspective.

Chart 3

FDIC and OCC rules provide clarification on "valid when made" doctrine…

In 2015, the Second Circuit's Madden vs. Midland Funding ruling created uncertainty for banks by rejecting the long-standing "valid when made" doctrine. According to the "valid when made" doctrine, the interest rate on a loan remains valid and enforceable even if the bank sells or transfers the loan to an entity that could not have made the loan under the same terms. In 2020, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) finalized rules to clarify that the valid interest rate for a loan is determined when the loan is made and not impacted by subsequent transfer of the loan. Since the federal rules were established, we have not observed material litigation similar to the Madden vs. Midland Funding case.

…But "true lender" risk remains in various states…

The FDIC and OCC "valid when made" rules did not address the separate but related matter of "true lender" risk. "True lender" risk is a regulatory risk that occurs when a plaintiff or regulator claims that the non-bank entity that acquired the loan after origination is the "true lender" of a loan, and not the originating bank. In October 2020, the OCC finalized a "true lender" rule that would have provided clarity around the issue of "true lender" and supported third-party loan origination models. However, certain consumer advocacy groups and state regulators opposed the rule, citing its ability to allow these arrangements to evade state consumer protection laws. The rule was repealed by Congress in 2021, forcing the matter of "true lender" back to a case-by-case assessment at the state level.

Since the establishment of the federal "valid when made" rules and the repeal of the federal "true lender" rule, the obscure regulatory landscape has prompted some one-off "true lender" litigation across various states. For example, the attorney general of Colorado filed "true lender" cases in 2017 in state court against two lending platforms that used third-party loan origination models. Both litigations were settled in 2020, allowing the marketplace platforms to continue to utilize third-party loan origination models provided the loans have annual percentage rates (APRs) under 36% and subject to certain restrictions for loans above the Colorado's 21% statutory limit. Another closely watched case has been a "true lender" case that began in 2022 in California related to legislation passed by the state in 2019 to limit interest rates on certain loans at 36%. At the time of this article, the outcome of that case remains pending. Based on our observations, "true lender" litigation has primarily targeted arrangements that regulators consider to be involved in abusive consumer practices or charge excessive interest rates. We also have noted that the majority of the "true lender" cases result in arbitration between the litigants versus broader class action suits.

…Along with regulatory oversight at the state level.

In addition to litigation, state authorities may restrict third-party loan origination models through various legislative actions. The focus in much of the "true lender" legislation to date considers the "totality of the circumstances" in determining the "true lender," including, for example, who holds the predominant economic interest in the loan, or who markets, brokers, arranges, or services the loan. State legislators may also revise their regulatory statutes to require licensing or registration for a broader range of entities, including those who purport to act as an agent or service provider.

State authorities can opt out of the legislation that allows state-chartered banks to export rates. The ability of a bank to export its home state's interest rate cap is supported by section 85 of the National Banking Act for federal-chartered banks and by section 521 of the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) for state-chartered banks. Section 525 of DIDMCA allows states to enact laws opting out of section 521, effectively limiting the rate exportation ability of state-chartered banks. Iowa and Puerto Rico opted out of DIDMCA when the act was established in 1980, and several states historically had opted out but ultimately opted back in. To date, a limited number of additional states have recently introduced legislation to opt out, including the District of Columbia, Rhode Island, Minnesota, and Nevada.

Along with heightened scrutiny from state regulators, federal oversight of third-party lending arrangements has also intensified. In June 2023, the FDIC and the OCC published updated guidance for banks on the risk management of third-party relationships. The guidance is intended to provide the regulator's view on sound risk management principles that banks can implement in managing the risks of all third-party vendors. While not specific to third-party lending models, we expect this guidance provides insight into how the FDIC intends to review the bank's risk management in those arrangements. Recent enforcement actions and consent orders also highlight what regulators may emphasize in their examination of a bank's fintech partner arrangements. In July 2024, the FDIC, OCC, and Board of Governors of the Federal Reserve System published a request for information (RFI) seeking information on bank-fintech arrangements. The RFI seeks input on the types of bank-fintech arrangements, their benefits and risks, and the implications of these arrangements, including whether enhancements to existing supervisory guidance may be helpful in addressing associated risks. The comment period for the RFI was extended by the FDIC to October 2024. The FDIC is now likely reviewing the comments received and may use this information to inform future supervisory guidance, but at the time of this article, no additional information was available.

Despite Ongoing Legal Challenges, The Use Of Third-Party Loan Origination Models Continues To Grow

Despite increased legal and regulatory scrutiny, the adoption of third-party lending arrangements continues to grow. This trend encompasses both new market participants in emerging sectors and established lenders that have transitioned from a state-by-state licensing model to leveraging third-party arrangements. As origination platforms continue to leverage third-party lending arrangements to expand their operations, navigating the complex legal landscape will be important for ensuring compliance and safeguarding against potential litigation.