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From Banking and Finance Law Daily, March 21, 2014

Fed’s debit card swipe fee, network exclusivity regulation upheld

By Richard A. Roth, J.D.

The Federal Reserve Board’s rules limiting debit card interchange fees and network exclusivity provisions are reasonable interpretations of the Dodd-Frank Act, the U.S. Court of Appeals for the District of Columbia Circuit has decided. A July 31, 2013, decision striking down the rules by the U.S. District Court for the District of Columbia has been reversed, and the rules will remain in effect (NACS v. Board of Governors of the Federal Reserve System, March 21, 2014, Tatel, Circuit Judge).

According to the appellate court, debit cards are the most popular noncash payment method in the United States, and they generate large amounts of revenue for card network owners and operators. The court said that debit card holders carried out 37.6 billion transactions in 2009, generating more than $20 billion in fees.

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 what were seen as excessive interchange fees, also known as “swipe fees,” and the lack of choice over which networks could be used to route debit card transactions. It instructed the Fed to set limits that would make swipe fees “reasonable and proportional to the cost incurred by the issuer with respect to the transaction” and to ensure that merchants had some choice about which card network would be used to route a transaction.

Issues in suit. The suit, brought by two retail businesses and four industry associations, asserted that when the Fed adopted Reg. II—Debit Card Interchange Fees and Routing (12 CFR 235) it 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 Reg. II 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.

Lower court decision. In a strongly worded opinion, the district court judge rejected the Fed’s claims of ambiguity (NACS v. Board of Governors of the Federal Reserve System, D.D.C.). The act’s provisions were clear, the lower court said, and the Fed had disregarded them (Banking and Finance Law Daily, July 31, 2013).

The appellate court now has disagreed with the lower court’s emphatic opinion, deciding instead that the act is, indeed, ambiguous. According to the appellate court, the Fed’s interpretations—with one minor exception—will stand.

Debit card system. Debit card transactions take place within a “four party system,” the appellate court began. Each transaction involves a cardholder, a merchant, the cardholder’s bank that issued the debit card, and the merchant’s bank that acquires the funds from the cardholder’s account and deposits them in the merchant’s account. Additionally, the transaction must be processed over a debit card network. Networks transmit information that is needed to complete transactions.

A bank that issues a card can choose the networks that are activated for that card. Most networks can process both transactions authorized by the consumer using a personal identification number and those authorized using a signature, the court said, but some networks can process only one of the two transaction types.

Several fees are incurred in the process, the court said. Swipe fees are charged by the cardholder’s bank to the merchant’s bank; network processing fees or “switch fees” are charged by the network to both the cardholder’s bank and the merchant’s bank; and a merchant discount is charged by the merchant’s bank to the merchant. This discount includes essentially all of the fees imposed on the merchant’s bank, the court said. As a result, the merchant ends up paying most of the transaction costs.

Three aspects of the system allowed networks and issuers to increase their fees without driving away business, according to the court. Issuers had the ability to decide which networks to activate on their cards; networks had the ability to set interchange and processing fees; and the market essentially was controlled by Visa and MasterCard, which required a merchant that accepted any of a company’s cards to accept all of them.

The combination of the three gave issuers and networks the ability to reach cooperative agreements that increased their revenue by increasing fees and forcing the use of networks that charged those higher fees. The Durbin Amendment attempted to both limit the fees and end the routing restrictions.

Categories of costs. The act gave the Fed two specific instructions on which issuer fees it was to consider when adopting the rule (12 CFR §235.3) setting the swipe fee limit. First, the Fed was directed to consider “incremental cost[s] incurred by an issuer for the role of the issuer in the authorization, clearing, and settlement” of a particular debit card transaction. Second, it was directed not to consider “other costs incurred by an issuer which are not specific to a particular electronic debit transaction.”

According to the merchants, this divided costs into two categories. The Fed, however, claimed that a third category existed: costs that are not incremental authorization, clearing, and settlement (ACS) costs but that are specific to a transaction. The Fed asserted that it had the authority to consider costs in this third category when setting the swipe fee limit.

Either interpretation of the act would have been reasonable, the court said; however, the Fed was not required to use the merchant’s proposed interpretation. “Incremental cost” could be defined in more ways than one, and whether incremental costs that were not ACS costs should be considered was unclear.

The court rejected the merchants’ arguments based on grammar and narrow interpretations of the act’s text. The act was ambiguous as to whether there were two categories of costs or three, and the Fed’s interpretation of three was said to be reasonable.

Costs that can be considered. The Fed also reasonably interpreted the Durbin Amendment to allow it to consider three specific costs that were not incremental ACS costs, the court said. These were fixed ACS costs, network processing fees, and fraud losses.

The ordinary definition of fixed costs was that they were costs that were incurred regardless of the volume of transactions, the court said. That did not make sense in the context of debit cards. Instead, it was reasonable for the Fed to distinguish between costs issuers had to incur to handle a particular transaction, such as hardware, software, and labor, and costs that were incurred regardless of whether a transaction occurred, such as producing and delivering cards. The former could be considered when the Fed set the fee limits, but the latter could not, the court determined.

As far as network processing fees, “This is easy,” the court said. These fees were paid on a per-transaction basis and thus clearly related to particular transactions. Considering network processing fees did not run afoul of the ban on using network fees to compensate for reduced swipe fees, the court added.

There was no argument that fraud losses were not specific to a particular transaction, the court then said. However, the merchants argued that the Fed’s ability to adjust the swipe fee for approved fraud-prevention program costs prevented the consideration of fraud losses when the swipe fee limits were set.

There is a difference between fraud losses and fraud-prevention costs, the court observed. The fraud prevention program adjustment was intended to be over and above the established swipe fee limit. Issuers would continue to suffer some fraud losses despite fraud-prevention programs, the court noted.

Costs the Fed must justify. In the one argument the merchants won, the appellate court said the Fed needed to justify better why it could consider transactions-monitoring costs—costs incurred in monitoring transactions in order to give the issuer information needed to decide whether to approve or reject those transactions. These clearly were fraud-prevention costs, the court conceded.

However, that did not mean they were not also specific to a particular transaction, the court said. The act might give the Fed the discretion to allow the costs to be recovered by inclusion in the swipe fee, but the Fed had not convincingly explained how it had exercised its discretion in this case. The court said the Fed should explain its choice more clearly, but also refused to rely on that as a reason to interfere with the effectiveness of the swipe fee rule.

Network exclusivity. When analyzing the Fed’s rule on network exclusivity (12 CFR §235.7(a)), the court first noted that the proposed rule had offered two options: requiring debit card issuers and networks to activate two unaffiliated networks for each card, or requiring them to activate two unaffiliated networks for each debit card transaction. The Fed chose the first. The merchants asserted that the Dodd-Frank Act unambiguously required the second.

Most merchants would not accept transactions authorized by personal identification numbers, the court conceded. When PINs can be used, it is cardholders, not merchants, who decide whether to use PIN authorization networks or signature authorization networks, the court also agreed. Because of this, it was true that an issuer could activate one PIN-using network and one signature-using network for each card, which would comply with the regulation but still leave merchants with no choice as to which network to use.

Merchants simply could choose to accept PIN-authorized transactions, the Fed replied. According to the court, the question was whether the Durbin Amendment required that even merchants that chose not to accept PIN-authorized transactions would have a routing choice.

The court said no. The Fed’s rule did exactly what the act instructed it to do by preventing issuers and networks from restricting the payment card networks on which a transaction could be processed to only affiliated networks. There was no need to require unaffiliated networks be available for each individual transaction.

While the merchants’ preferred interpretation would increase competition more than the Fed’s rule, the rule had resulted in more competition, the court observed. Thus, the rule had advanced the pro-competition goal of the Durbin Amendment, the court reasoned.

Exclusivity v. routing. The merchants also argued that the Fed’s rules requiring that cards be activated for unaffiliated networks nullified the other procompetitive Durbin Amendment provision, the ban on routing restrictions (12 CFR §235.7(b)). If a merchant had no choice as to the network to be used, the ban on routing restrictions was meaningless, they argued.

The court said the opposite was true. The requirement that two unaffiliated networks be activated would be meaningless without the ban on routing restrictions. Without the ban, an issuer could activate two PIN networks and one signature network for each card, but require that transactions be routed over the PIN network affiliated with the signature network rather than the unaffiliated PIN network, according to the court.

Under the Fed’s rule, merchants and cardholders limited merchants’ processing options, not issuers and networks, the court concluded. Merchants chose not to accept PIN-authorized transactions, and cardholders chose which authorization method to use when both were available. The rule had the intended effect on issuers and networks, the court said.

The case is No. 13-5270.

Attorneys: Linda Bailey (Steptoe & Johnson LLP) for NACS, National Retail Federation, Food Marketing Institute, Miller Oil Co., Inc., and Boscov's Department Store, LLC. Richard M. Ashton 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

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