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From Banking and Finance Law Daily, July 31, 2013

Fed debit card rules rejected by federal district court

By Richard A. Roth, J.D.

The Federal Reserve Board’s rules on debit card interchange fees and network routing restrictions have been voided by the U.S. District Court for the District of Columbia. An emphatically worded opinion made clear the judge’s belief that the Fed had disregarded the Dodd-Frank Act provisions on several key points to such a degree that the judge went beyond enjoining enforcement of the rules to vacate them and order the Fed to adopt new rules (NACS v. Board of Governors of the Federal Reserve System, July 31, 2013, Leon, United States District Judge).

The rules being challenged were adopted by the Fed to implement a section of the Dodd-Frank Act known as the “Durbin Amendment” after its sponsor, Sen. Richard Durbin (D-Ill). The Durbin Amendment (15 U.S.C. 1693o-2) included efforts to remedy two problems encountered by merchants that accept debit cards—the imposition of excessive interchange fees, also known as swipe fees, and the lack of choice over which networks could be used to route debit card transactions.

According to the court, swipe fees are set by debit card networks, charged to merchants, and paid to the banks that issue debit cards. Card networks have an incentive to set swipe fees as high as possible in order to attract banks to issue cards. Merchants are compelled to accept debit cards because they do not want to lose sales, and the networks have so much market power that the merchants cannot effectively push back on fees, the court said.

According to one of the industry associations that brought the suit, debit card fees are the second largest operating expenses most retailers pay, exceeded only by payroll costs.

Claims in the suit. The Durbin Amendment instructed the Fed to adopt rules that set limits that would make swipe fees “reasonable and proportional to the cost incurred by the issuer with respect to the transaction.” It also required rules intended to ensure that merchants had some choice about which card network would be used to route a transaction. To fulfill the requirements, the Fed adopted Reg. II—Debit Card Interchange Fees and Routing (12 CFR 235).

The suit, brought by two retail businesses and four industry associations, asserted that when it adopted Reg. II the Fed failed to comply with the Durbin Amendment in two ways:

  • it considered impermissible issuer costs when it set the swipe fee limit; and
  • it required that merchants be given a choice of networks for each debit card, while the Dodd-Frank Act required that there be a choice for each debit card transaction.

The Fed defended its regulation by relying heavily on the assertion that the Dodd-Frank Act provisions were ambiguous. Because of that, the reasonable interpretations of the agency entrusted with implementing the act were entitled to judicial deference, the Fed said.

The court did not accept any of the Fed’s arguments.

Swipe fee limits. The Dodd-Frank Act says that, in setting the swipe fee limit, the Fed is to distinguish between “the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearing, and settlement” of a particular debit card transaction (incremental ACS costs), which could be considered in setting the limit, and “other costs incurred by an issuer which are not specific to a particular electronic debit transaction,” which could not be considered. The Fed claimed that this distinction omitted a third category of costs—ACS costs that are specific to a particular transaction but that are not “incremental costs.” According to the Fed, since the act was ambiguous as to how these fixed costs were to be treated, the Fed had the authority to make a reasonable interpretation as to whether they could be considered in setting the fee limit.

“I have no difficulty concluding that the statutory language evidences an intent by Congress to bifurcate the entire universe of costs associated with interchange fees,” the judge replied (emphasis in the opinion). The Dodd-Frank Act created two categories of costs, one of which could be considered and the other of which could not be considered. Relying on a detailed analysis of the act’s text and statements made by Sen. Durbin on the floor of the Senate, the judge made clear that the Fed was permitted to consider only the first category.

This meant that the Fed could consider only issuers’ variable costs, not their fixed costs. Moreover, the Fed was not permitted to consider any costs associated with fraud prevention or fraud loss recovery, the judge said. Those costs were to be accounted for separately. According to the judge, only “Incremental ACS costs of individual transactions incurred by issuers may be considered. That’s it!”

The Fed’s interpretation was “utterly indefensible,” the judge added.

Costs considered by the Fed. The Fed’s first specific proposal offered for consideration two alternative swipe fee limits: either allowing issuers to collect seven cents per transaction or up to 12 cents per transaction if they chose to calculate actual recoverable costs; or setting a fixed 12-cents-per-transaction limit. By the time the Fed adopted its final rule, the limit had risen to 21 cents per transaction plus .05 percent of each transaction’s value. The change, according to the court, resulted from the Fed’s decision to consider four impermissible costs:

  • fixed ACS costs, such as costs for network connectivity and software, hardware, equipment, and labor;
  • the costs of monitoring transactions for fraud;
  • allowances for fraud losses; and
  • networking processing fees-fees charged and received by the payment card network.

The judge also noted one of the arguments raised against the Fed’s regulation—the Fed’s fee limit actually resulted in the possibility of a swipe fee increase for transactions in small amounts. (This result was noted in an amicus curiae brief filed by Sen. Durbin attacking the Fed’s regulation.)

Routing alternative requirements. The Durbin Amendment also instructed the Fed to adopt regulations that would counteract network exclusivity rules. Included in this was the requirement that the rule prohibit debit card issuers and networks from “restrict[ing] the number of payment card networks on which an electronic debit transaction may be processed” to one network or to multiple affiliated networks. According to the court, the Fed interpreted this to require that two unaffiliated networks be available for each debit card. The merchants and associations challenging Reg. II, however, claimed the act required that multiple unaffiliated transactions be available not only for each debit card but also for each debit card transaction.

Again, the court agreed with the challengers.

As it had when discussing the swipe-fee provisions, the court said the Dodd-Frank Act was not ambiguous. The act made clear that issuers and networks were not to be able to restrict to fewer than two the number of networks on which a transaction could be processed. The requirement related to transactions, not debit cards, the judge said.

The Fed claim that the act was silent as to whether merchants were to have routing choices for each transaction also failed, the court continued. It was clear that regardless of how a transaction was authorized by the consumer, there were to be at least two available routing networks.

Because Reg. II only required that two networks be enabled on each debit card, it permitted the issuer to comply by enabling one network using personal identification numbers and one using signatures. This was especially troublesome because the Fed conceded that some common transactions could not be carried out using PIN networks, leaving the merchant with but a single routing possibility. Thus the regulation did not carry out the act’s mandate, the court concluded.

Banking industry response. Banking industry associations reacted negatively to the decision. American Bankers Association President and CEO Frank Keating said that the decision “will harm banks of all sizes and make it more difficult for institutions to serve their customers.” Keating did not explain how a regulation that exempts small banks would harm them.

Keating described the Durbin Amendment as a price control and charged that the decision would result in “further lining the pockets of our nation’s big-box retailers at their own customers’ expense,” and predicted “disastrous consequences” if the decision is not reversed.

Richard Hunt, President and CEO of the Consumer Bankers Association, said that “Congress ought to save families from this uncertainty by repealing this government mandated price-fixing.”

The case is No. 11-02075 (RJL).

Attorneys: Linda C. Bailey (Steptoe & Johnson, LLP) for NACS. Joshua P. Chadwick for the Board of Governors of the Federal Reserve System.

Companies: Boscov’s Department Store, LLC; Food Marketing Institute; Miller Oil Co.; NACS; National Restaurant Association; National Retail Federation

LitigationEnforcement: CreditDebitGiftCards DoddFrankAct FederalReserveSystem

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