For the last nine months, marketplace lenders have been hoping the Supreme Court would save them from a lower-court ruling that raised fundamental questions about their business model.
But following the unexpected death of Justice Antonin Scalia, the nation's highest court suddenly appears less likely to come to the industry's aid.
"His passing marks a potential blow to the chances of the case being heard and ultimately overturned," said Brian Korn, a lawyer at Manatt, Phelps & Phillips.
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If the decision by the New York appeals court is upheld, banks and other lenders could have trouble finding buyers for credit card and other consumer loans.
July 24 -
In the worst-case scenario, they'll get state licenses and reprice a portion of their loans, but executives of the highflying industry say they doubt such steps will be necessary.
August 5 -
Banks, marketplace lenders and other nonbank lenders were dealt a setback when a federal appeals court declined to reconsider a ruling that has set off alarm bells across the consumer finance industry.
August 13
It's largely a matter of simple arithmetic. In order to shake off the effects of a ruling that has hurt some lenders' ability to operate in New York, Connecticut and Vermont, the industry needs two things to happen.
First, four Supreme Court justices must vote in favor of hearing the case, Madden v. Midland Funding.
Back in December, the Supreme Court asked the plaintiffs, who won at the appeals court level, to respond in writing to the losing side's arguments. That request made industry officials more optimistic that the court would decide to accept the case.
But Scalia's death leaves the Supreme Court with only eight members, rather than nine, which provides a smaller pool of justices to supply four votes in favor of hearing the case.
Second, even if the Supreme Court hears the case, the votes of five out of the eight remaining justices would be necessary to overturn a May 2015 ruling by the 2nd Circuit Court of Appeals. Prior to Scalia's death, five votes out of nine would have been needed.
In a scenario where the Supreme Court decides to hear the case, and then splits 4-4 on whether to overturn the appeals court ruling, the earlier decision would remain binding in New York, Connecticut and Vermont.
In other words, the status quo, which has been damaging to marketplace lenders, would continue.
Madden v. Midland Funding involves the sale of charged-off credit card debt by a Bank of America subsidiary. The appeals court found that the bank's legal authority to charge an interest rate in excess of state usury caps did not transfer to the debt buyer.
The decision has negative ramifications for marketplace lenders such as Lending Club and Prosper Marketplace because they issue their loans through banks. The purpose of that setup is to allow the nonbank firms to avoid complying with state-level interest rate caps, since banks can apply their home states' rules on loans made across the country.
But now, with a cloud of legal uncertainty hanging over this commonplace business model, some industry lawyers are advising marketplace lenders to get state lending licenses, even though it is a time-consuming and expensive endeavor.
"I think the stronger business model is the state licensing model, as opposed to partnering up with a bank," said Richard Eckman, a lawyer at Pepper Hamilton.
The appeals court decision has sparked worries that go beyond just marketplace lending. Some observers fear that it could create problems in the much larger market for asset-backed securities.
In December, the Structured Finance Industry Group and the American Bankers Association filed briefs arguing that the Supreme Court should overturn the 2nd Circuit's ruling.
"Unless corrected by this Court, the decision below will disrupt the secondary market for loans, upon which the primary market for lending depends," the ABA stated in its brief.
Observers offered differing opinions Monday about how Scalia might have voted on the merits of the case. Some noted that he often sided with business, while others pointed to opinions that suggest he would have been sympathetic to the 2nd Circuit's reasoning.
"I don't think there's a big philosophical question here. I think it is an issue as to how interest rate preemption works. And there's no reason that should be split between liberal and conservative justices," argued Jaret Seiberg, an analyst at Guggenheim Securities.
Still, the math just got harder for those in the consumer-finance industry who want the Supreme Court to overturn the 2nd Circuit's ruling.
Before, the votes of five Republican justices would have been enough for a reversal. Now, at least one of the four Democratic appointees, who more typically side with consumers in disputes with businesses, will have to be won over.
