Court ruling threatens securitised loans issued by Lending Club and other US platforms
Lending Club are headed to the US Supreme Court to defend the practice of using out of state banks as a way to charge interest rates that are higher than they would otherwise be allowed to do. The court's decision has far reaching implications, as Lending Club and other platforms have sold the loans on to hedge funds and other investors in the form of securitised loans, which will be re-priced lower, if the decision is upheld. The case highlights the need for the Fed to grant national lending licences to non-depository institutions.

A backhoe operator demolishes smuggled luxury vehicles seized by a presidential anti-smuggling task force inside the former naval security depot in Subic bay freeport, north of Manila August 16, 2007. REUTERS/Romeo Ranoco

It's been a terrible summer for Lending Club and other startups that make loans to consumers and businesses online.



Shares of Lending Club are down about 30% since the beginning of June. That's when the US Court of Appeals for the Second Circuit upheld a decision that could have the lenders lowering interest rates they charge a big chunk of customers.



Now, the US Supreme Court is its only hope. It could decide whether it'll hear their case as early as October, according to a note this week from Morgan Stanley.

At issue is the question of whether companies can use out-of-state banks as a way to charge interest rates that are higher than they'd otherwise be allowed. A number of lenders were making loans in New York, Vermont, and Connecticut using a bank in Utah called WebBank.



The practice, dubbed "exporting" interest rates, means the ultimate loan is being made in Utah, even if the borrower is in New York. As a result, companies like Lending Club can charge rates that are higher than New York's usury laws allow. Lending Club said on its August earnings call that 12.5% of its loans cross borders this way.



The court decision doesn't just change the rates borrowers in New York, Connecticut, and Vermont pay. Lending Club and others have sold asset-backed securities based on those loans to hedge funds and other investors. These buyers could blanche at the prospect of taking on debt that just became riskier to hold.

Making matters worse for hedge funds, if the New York court's decision is upheld, it means the some of its existing investments in debt could be repriced lower.



"Hedge funds and other providers of debt are concerned," said Richard Eckman, partner at law firm Pepper Hamilton LLP.

But because the court decision is out of step with precedent, it could be overturned, said Al Goldstein, CEO of another lender called Avant.



“The beauty of the WebBank relationship is that is allows uniform pricing across state lines,” says Goldstein. Uniform pricing means businesses don’t have to worry about individual state regulators and tailoring products to regional requirements.



Having to modify loans to individual states' guidelines could raise their cost of compliance to burdensome levels, people in the startup lending industry argue. Lending startups can still originate loans in other places. South Dakota regulations allow for a bank similar to WebBank to exist, where it can export interest rates to other US states and market them to consumers.

At New York-based OnDeck, the online lending startup for small businesses says at its website that it generates loans “under either Virginia or California law.” At California-based SoFi, the student lending startup has individual state licenses where required, its CEO Mike Cagney said, which equates to more than half the US.

“This underscores the need for the Fed to grant national lending licenses to non-depository institutions,” he said.