LendingClub Corp. and other companies that arrange consumerloans over the Internet are running out of options in avoiding alegal blow that may force them to lower interest rates they chargecertain borrowers.

The U.S. Court of Appeals in Manhattan refused this week toreconsider its decision that effectively restricts the so-calledmarketplace lenders from bypassing state usury laws by partneringwith banks in states where there are no such rules. The rulingeffectively would stop a practice whereby the lenders can make aloan to a borrower in, say, New York—where interest rates arecapped at 16 percent for most loans—by originating it in Utah,which has no usury limits.

Firms like LendingClub and Prosper Marketplace Inc., also knownas peer-to-peer lenders because they started out by directlylinking borrowers and funders over the Internet, match up peopleseeking consumer or small-business loans with investors such ashedge funds.

Barring a successful request for review by the U.S. SupremeCourt, the lower court's May ruling means some of these firms'existing loans may suddenly be deemed in violation of stateinterest-rate caps, Moody's Investors Service said in June. Thatposes a risk to loans already sold into securities that are helpingto finance the industry's growth, and it presents an obstacle tofuture originations of the highest-yielding credits, which arereceiving the most investor demand.

The decision “may create a catastrophe” for companies andinvestors trying to trade in the debt, Richard Eckman, a partner atPepper Hamilton LLP wrote in June on the firm's website.

LendingClub, the largest marketplace lender, estimated in anAug. 4 presentation to investors that 12.5 percent of itsconsumer-loan portfolio may be affected by the court decision.LendingClub has originated $11.2 billion in loans since 2011, itsaid. It may have to lower the interest it charges on those loansin order to comply with state laws, or face the prospect of theloans being considered null. Beth Haiken, a spokeswoman forLendingClub, declined to comment.

That's also unwelcome news for debt investors like RiverNorthCapital Management LLC and others that seek high returns for theirinvestors. Moody's warned last month that the ruling poses a creditrisk to existing securities tied to the debt, as investment firmslike BlackRock Inc. pool loans into bundles to be sold as bonds.Carissa Felger, a spokeswoman for RiverNorth at Sard Verbinnen& Co., declined to comment.

“If interpreted broadly, interest rates on some loans backingmarketplace lending asset-backed securities transactions could bereduced, or the loans themselves be void,” Moody's analysts AlanBirnbaum and Matias Langer wrote in a report.

Some investors have warned they may simply shun loans toborrowers in certain states, because they either don't yield asmuch or could be affected by the decision, Gilles Gade, chiefexecutive officer of Cross River Bank, said by phone last month.The New Jersey-based bank is an origination partner for more than adozen lending platforms.

The case itself is binding only in New York, Connecticut, andVermont, but may have broader implications as market participants“begin to question” marketplace lenders' origination frameworks,said Isaac Boltansky, an analyst at Compass Point Research &Trading LLC.

The case is Madden v. Midland Funding, LLC, No. 14-2131, U.S.Court of Appeals for the Second Circuit (New York).

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