March 24, 2014
Authored by: Dan Wheeler
In the bankers’ version of March Madness drama, on March 21, 2011, a three judge panel of the U.S. Court of Appeals for the D.C. Circuit handed down a decision that is broadly perceived as a significant victory for banks at the expense of merchants. (The decision is captioned NACS f/k/a National Association of Convenience Stores, et al. v. Board of Governors of the Federal Reserve System.)
The issue was the legality of the Federal Reserve’s rules implementing the “Durbin Amendment” portion of Dodd-Frank. That portion of the legislation is generally viewed as having required regulatory caps on the interchange fees that can be charged to merchants. Merchants criticized the Federal Reserve’s rules for allowing interchange fees at a level much higher than allowed by Dodd-Frank and for allowing interchange competition rules less strict (and thus more favorable to banks) than permitted under Dodd-Frank. The merchants essentially won this argument at the lower court, the U.S. District Court for the District of Columbia. The Court of Appeals reversed the district court on all key issues. The merchants can still appeal the decision to the entire D.C. Circuit appeals court, or to the U.S. Supreme Court. However, based on our review of this decision, such an appeal appears to have a limited chance of success. And it seems highly unlikely that either party in Congress is willing to legislate any further on interchange fee issues.
To understand the scope and effect of the decision, a brief review is in order. The Dodd-Frank Financial Reform Act passed in 2010 included a provision now widely known as the Durbin Amendment, due to its authorship by Illinois Sen. Richard Durbin. It is widely believed that Senator Durbin authored the provision at the request of the merchant Walgreens, one of his important constituents. One portion of the Durbin Amendment applies to banks and credit unions with over $10 billion in assets. For those institutions, the Federal Reserve was required to promulgate regulations to cap interchange or “swipe” fees on debit-card transactions at a level “reasonable and proportional” to the cost the financial institution actually incurs. Another part of the Durbin Amendment required the Federal Reserve to promulgate regulations to ensure that merchants had at least two unaffiliated networks through which bank account transactions could be completed by using the correct routing numbers.
In response to the Durbin Amendment, the Federal Reserve initially proposed capping interchange fees at about $0.12 per transaction. Then, after considerable study, analysis and uproar from the banking industry that argued with some force that a $0.12 rate would force them to operate at a loss, the Fed’s final regulation capped interchange fees at approximately $0.24 per debit transaction. The Fed also provided in its final regulations that debit cards may use one PIN debit network and one signature debit network, as long as the two networks were not affiliated.
Merchants, not content with the billions in annual savings represented by the $0.24 fee cap, filed suit in the District Court, in essence arguing that the Fed should have stayed with the $0.12 rate it initially proposed. (In a twist, several financial industry groups desiring higher fee caps, also participated as amici curia, ostensibly in support of neither party.) The thrust of the merchants’ argument was that the evidence—properly understood–showed that banks’ marginal costs per transaction were much less than $0.24 per transaction. U.S. District Judge Richard Leon agreed with that argument, taking a sarcastic tone in reference to the Federal Reserve’s views. On the anti-exclusivity issue, the district court also agreed with the merchants, finding that the Fed’s rules should have required two networks for signature debit transaction and two networks for PIN debit transaction.
Armed with that background, the D.C. Circuit panel and its decision is quite interesting. The opinion was filed by Circuit Judge David Tatel, a Clinton appointee. The other panel members were Senior Circuit Judges Edwards, a Carter appointee, and Senior Circuit Judge Williams, a Reagan appointee. Collectively, they comprise a panel that one might have expected to find the Federal Reserve too lenient in regulating under the Durbin Amendment.
However, the Appeals Court’s opinion appears well-reasoned and based on the statute’s grammar and other standard statutory interpretation principles. In the background section of the opinion, the court acknowledged that Congress, in enacting the Durbin Amendment, was trying to remedy a perceived market failure, namely the purported lack of ability on the part of merchants to resist debit card network fees. The court noted the distinction between networks that handle either PIN transactions or signature transactions and discussed why some merchants, such as hotels and sit-down restaurants, do not accept PIN debit transactions. The reasons for the fixed nature of debit card fees, as compared to the percentage of transaction nature of credit card fees, was also outlined by the court. The court acknowledged that networks and card issues took advantage of quirks in the debit card market to increase fees and that merchants were effectively forced to accept those fees. (Merchants could either refuse to accept any Visa or MasterCard credit and signature debit cards or accept all of them and very few merchants could afford to refuse all “plastic.”) The court cited the Fed’s proposed rulemaking, which described the level to which interchange and network processing fees had risen by 2009: an average of $0.555 per transaction, including a $0.44 interchange fee.
In its fee analysis, the court analyzed Durbin Amendment language that instructs the Fed to promulgate regulations ensuring that “the amount of any interchange transaction fee . . . is reasonable and proportional to the cost incurred by the issuer . . .” and that the Fed’s rules distinguish between the “incremental cost” incurred by an issuer and other costs not specific to a particular transaction. As the court acknowledged, the Fed’s final rule chose not to define “incremental costs” and decided to allow issuers to recover all costs “other than prohibited costs,” i.e. those costs in between the clearly permissible and the clearly forbidden categories of cost recoveries.
The court applied the familiar two-step framework established by the Supreme Court in 1984 in analyzing the Fed’s regulation: (1) whether Congress directly spoke to the precise question at issue and (2) if not, did the Fed, having sole discretion to administer the Durbin Amendment, rest on reasonable interpretations of the Durbin Amendment. In language that is funny to many (although apparently enraging to Senator Durbin), the court noted the difficulty of understanding Dodd-Frank:
. . . Congress put the [Federal Reserve], the district court, and us in a real bind. Perhaps unsurprising given that the Durbin Amendment was crafted in conference committee at the eleventh hour, its language is confusing and its structure convoluted. But because neither agencies nor courts have authority to disregard the demands of even poorly drafted legislation, we must do our best to discern Congress’s intent and to determine whether the Board’s regulations are faithful to it.
The court noted that the term “incremental” as used in connection with “authorization, clearance and settlement costs” (“ASC costs”) logically leaves open the possibility of a third category of transaction-specific costs that are legally recoverable, a possibility that Congress could have closed off but did not. The court rejected the merchants’ argument that the term “other costs” in the statute should be read descriptively rather than restrictively, reasoning that restrictive clauses are, under established rules of grammar, demarcated with commas, as was the language at issue in the Durbin Amendment. As a result, the court held that the Durbin Amendment world was not divided into two categories of permitted ASC costs and everything else, but rather three categories of permitted ASC costs, prohibited costs and non-prohibited costs, exactly as the Federal Reserve read the Durbin Amendment.
In addition, the court was persuaded that, in view of the overall ambiguity of the Durbin Amendment, it should defer to the apparent reasonableness of the Fed’s determination, particularly the Fed’s very specific “ratemaking” determinations that fixed ACS costs, network processing fees, fraud losses and transaction-monitoring costs were all recoverable. The court said that it saw no reason to upset the Fed’s reasonable line-drawing in light of its expertise in the area. In a side note, the court disparaged the merchants for making a half-hearted effort in fighting the recoverability of network processing fees, an issue on which the court felt the Fed was obviously in the right. However, the court did remand the issue of transaction-monitoring costs back to the Fed so it could better articulate a reason why those costs properly fall outside the fraud-prevention adjustment.
In its analysis of the anti-exclusivity portion of the Fed’s regulation, the court first cited Durbin Amendment language that instructs the Fed to promulgate regulations preventing any “issuer or payment card network” from “restrict[ing] the number of payment card networks on which an electronic debit transaction may be processed to . . . 1 such network; or . . . 2 or more [affiliated networks].” As the court acknowledged, the statute also directs the Fed to prescribe regulations that prohibit issuers and networks from “inhibit[ing] the ability of any person who accepts debit cards for payments to direct the routing of electronic debit transactions for processing over any payment card network that may process such transactions.” The Fed’s final rule on the anti-exclusivity issue required issuers to activate at least two unaffiliated networks on each debit card, regardless of method of authentication, even though this method gave merchants fewer routing options. The Fed’s reasoning was that all merchants could accept PIN debit even if some chose not to and the Durbin Amendment was silent as to what should result. The court saw this as a reasonable approach and as compliant with the statute and Congressional intent.
In summary, the Federal Reserve’s careful efforts in parsing the Durbin Amendment and its effective advocacy on appeal have paid off for the banking and payments industries, at least in the sense of preserving a fee structure that is not nearly as bad as it could have been. The merchants appear to have been out-lawyered as well as in the wrong on the substance.
As a postscript, the numerous references in this decision to the Durbin Amendment and the Fed’s interchange rules being a “cap” makes one wonder about TCF National Bank’s failed effort in 2010 – 2011 to enjoin the Durbin Amendment as an unconstitutional “taking” without just compensation. In the TCF lawsuit, the 8th Circuit essentially refused to acknowledge that the legislation constituted a price control at all, a necessary predicate finding to a takings analysis. Might such a challenge succeed today?