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 debit card transactions could be routed.

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.

Preliminary approval to the $7.25 billion class action interchange was granted in November, 2012, providing for a $6.05 billion fund, a temporary reduction in interchange fees worth $1.2 billion, modifications to the Visa/MasterCard rules, and the ability for merchants to impose a surcharge on credit card purchases under certain circumstances. In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation applies to all persons, businesses, and other entities that have accepted Visa- and MasterCard-branded credit cards in the U. S. since January 1, 2004, as well as anyone who will accept such cards in the future. A class action lawsuit against American Express is still pending.

The settlement was preceded by seven years of contentious litigation, beginning in 2005 when the first of more than 40 class complaints was filed. The class plaintiffs allege that Visa and MasterCard conspired with its member banks to establish default interchange fees, and that the network rules insulated those interchange fees from competition by preventing merchants from steering customers to less expensive forms of payment (such as rules preventing surcharging and discounting).

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With respect to the settlement’s surcharge provision, the Class Settlement Agreement with Visa and MasterCard (“Agreement”) provides that merchants are permitted to assess surcharges on Visa/MasterCard transactions either at the “Brand Level” (e.g., an assessment on all Visa-branded credit card transactions) or “Product Level” (e.g.,, an assessment on all Visa-branded “Reward Card” credit card transactions), provided that (i) the fees are not prohibited by state law, (ii) the fees do not exceed the costs that the merchant pays to accept cards and (iii) the merchant complies with the disclosure requirements at the point of entry, point of sale and on the receipt. A checkout fee at the issuer level (e.g., an assessment on Visa-branded credit cards issued by Citibank and Bank of America, but not on Visa-branded credit cards from Capital One or from local banks) is not permitted. The Agreement also requires a level playing field by permitting a surcharge if (i) the merchant is able to surcharge each other credit card it accepts or actually does so and (ii) the merchant also surcharges equal or higher cost cards on networks that maintain non-discrimination rules (e.g. American Express, Discover).

Permitted “Brand Level” and “Product Level” Surcharges

More specifically, a permitted “Brand Level” surcharge with respect to Visa/MasterCard credit card transactions is one in which:

• A merchant adds the same surcharge to all Visa/MasterCard credit card transactions, regardless of the card’s issuer or product type, after accounting for any discounts or rebates offered by the merchant at the point of sale; and
• The surcharge on each Visa/MasterCard credit card transaction is no greater than the merchant’s Visa/MasterCard surcharge cap (which is the average Merchant Discount Rate applicable to transactions at the merchant for the preceding one or twelve months, at the merchant’s option).

“Merchant Discount Rate” is defined as the fee, expressed as a percentage of the total transaction amount, that a merchant pays to its acquirer or processor for transacting on a credit card brand.

On June 29, 2011, the Federal Reserve Board approved its final interchange rules, entitled Regulation II, “Debit Card Interchange Fees and Routing,” setting the maximum permissible interchange fee that an issuer may receive for an electronic debit transactions made with debit cards and general use prepaid cards, codes, and other account access devices.

Under the final rules, issuers are permitted to charge a base fee of 21 cents plus 5 basis points (.05%) multiplied by the full value of the transaction, to cover fraud losses.  In addition, a 1 cent per transaction fraud prevention adjustment was also proposed, for those issuers who meet eligibility requirements (such as having fraud prevention and data security policies and procedures in place, which must be updated and certified on an annual basis.)  The fraud prevention adjustment rules are new, and are open for comment through September 30, 2011.

Under the new rules, a covered $50 debit or prepaid transaction would have a total possible interchange fee of  = 23.5¢ [21¢ + 2.5¢ ($50 x .05  /100) + 1¢], and a $500 transaction would have a total possible interchange fee of  = 47¢  [21 ¢ + 25¢ ($500 x.05 /100) + 1¢].   While this is a significant improvement over the original suggested cap of 12¢, it still represents a substantial decrease in interchange revenues for both prepaid and debit card issuers.

Prepaid Industry Gets Some Relief but General Purpose Reloadable Cards Face Unanticipated Restrictions

At a publicly held board meeting on June 29, 2011, the Federal Reserve Board approved its final interchange rule, entitled Regulation II, “Debit Card Interchange Fees and Routing,” setting the maximum permissible swipe fee an issuer may receive for an electronic debit transactions, adopting routing requirements and applying unanticipated new restrictions to General Purpose Reloadable (GPR) cards to take advantage of the interchange cap exemption. In addition—to the relief of the banking industry—the Fed announced that the rules on pricing requirements will go into effect on Oct. 1, 2011, as opposed to July 21 as dictated by the Durbin Amendment.

Under the final rule, issuers are permitted to charge a base fee of 21 cents (representing 80 percent of an issuer’s average transaction cost), plus five basis points on the full value of the transaction to cover fraud losses (representing the average per-transaction fraud loss of the median issuer). The fraud loss recoupment (referred to by the Fed as an “ad valorem” or “according to value” charge) came as a surprise to most and is viewed as a big win for the banking industry. The Fed also issued an interim final rule that would allow issuers to charge an additional fraud prevention adjustment of one cent if the bank meets, and certifies compliance of, certain security standards. The Fed requested comments on whether the one-cent cap should be adjusted.

In addition, the Fed approved rules governing routing and exclusivity, requiring issuers to offer two unaffiliated networks for routing debit transactions.

Perhaps the biggest surprise in the final rule is that GPR cards will not benefit from the interchange cap exclusion if they allow funds to be accessed through means other than the card.

Open Board Meeting

At the board meeting, Chairman Ben Bernanke stated that the interchange rule has been one of its most challenging rulemakings under the Dodd-Frank Act to date. The Fed had to consider myriad players impacted by debit interchange, as demonstrated by the more than 11,000 comment letters the Fed received.

Goldman Settles Massachusetts Trading Investigation

On Thursday, the Massachusetts Securities Division announced that Goldman Sachs agreed to a consent order to pay $10 million and to ban so-called “trading huddles.”  The Massachusetts Securities Division had been investigating Goldman for the past two years to determine whether the trading ideas that analysts had shared with traders during these huddles “favored the interests of certain priority clients.”  Goldman settled the matter without admitting or denying the state regulator’s allegations and agreed to disclose to future research clients that they would not all be treated equally.  In its consent order, the Massachusetts regulator said it found no instances of fraud.

Senate Defeats Bill to Delay Interchange Fee Caps

On Wednesday, after a long and divisive lobbying fight, retailers defeated the banking industry in the Senate on a vote to delay new caps on debit-card swipe fees.  The legislation was offered by Sens. Jon Tester (D-Mont.) and Bob Corker (R-Tenn.) and failed on a 54-45 vote, falling just six votes shy of the 60 needed for passage and clearing the way for a provision in last year’s Dodd-Frank Wall Street reform law to take effect July 21.  The provision, often referred to as the “Durbin Interchange Amendment,” required the Federal Reserve to establish fair and reasonable interchange fees for many debit and prepaid card transactions.  Last fall, the Federal Reserve proposed new rules which (among other things) would limit to 12 cents per transaction the fee that large banks (with more than $10 billion in assets) can charge merchants every time a consumer uses a debit card or a prepaid gift card.  These proposed rules garnered significant criticism and final rules, which are now overdue from the Federal Reserve, are expected shortly.  Senators Tester and Corker initially proposed legislation to delay the Durbin amendment from taking effect for 24 months. The final version of the Tester-Corker bill cut the delay in half to 12 months and called for a six-month study of the costs associated with debit transactions and their impact on consumers and community banks.

Bernanke Signals End to Fed’s Monetary Stimulus

On Tuesday, in a speech at the International Monetary Conference in Atlanta, Fed Chairman Ben Bernanke signaled that the central bank plans to end its “quantitative easing” program on schedule this month.  Bernanke’s announcement comes seven months after the central bank began a historic round of monetary stimulus.  In his speech, Bernanke acknowledged the recovery has fallen short of the central bank’s expectations because of the high unemployment rate and falling home prices.

Goolsbee Leaving Council of Economic Advisors

On Monday, Austan Goolsbee, chairman of the White House Council of Economic Advisers, announced that he plans to leave the White House and return to teaching economics at the University of Chicago this fall.  Goolsbee has been on leave for four years from the University’s Booth School of Business where he was a professor for 14 years before joining the Administration.

Diamond Withdraws Fed Nomination

On Sunday, MIT professor Peter A. Diamond announced he was withdrawing his nomination to the Federal Reserve Board from consideration before the Senate.  Diamond’s nomination had been blocked by Senate Republicans for over a year because of Senate Banking Committee Ranking Member Richard Shelby’s (R-AL) contention that Diamond lacked the proper qualifications.  President Obama first nominated Diamond in April 2010.

After a long and divisive lobbying fight, retailers defeated the banking industry Wednesday as the Senate narrowly defeated legislation to delay new caps on debit-card swipe fees.

The legislation was offered by Sens. Jon Tester (D-Mont.) and Bob Corker (R-Tenn.) and failed on a 54-45 vote, falling just six votes shy of the 60 needed for passage and clearing the way for a provision in last year’s Dodd-Frank Wall Street reform law to take effect July 21.

The provision, often referred to as the “Durbin Interchange Amendment” required the Federal Reserve to establish fair and reasonable interchange fees for many debt and prepaid card transactions.  Last Fall, the Federal Reserve proposed new rules which (among other things) would limit to 12 cents per transaction the fee that large banks (with more than $10 billion in assets) can charge merchants every time a consumer uses a debit card or a prepaid gift card.  These proposed rules garnered significant critcism and final rules, which are now overdue from the Federal Reserve, are expected shortly.

Senators Tester and Corker initially proposed delaying the Durbin amendment from taking effect for 24 months. The final version of the Tester-Corker plan was to cut the delay in half to 12 months and called for a six-month study of the costs associated with debit transactions and their impact on consumers and small, community banks.

The House and Senate conferees approved the financial regulatory reform conference report (otherwise known as the Dodd-Frank Wall Street Reform and Consumer Protection Act) late last week, and the House and Senate are now poised to vote on the legislation. As expected, the final version of the bill incorporates a provision requiring the Federal Reserve Board to write restrictions on the ability of card issuers to set interchange fees (see Section 1075 et seq.).

However, the interchange provision was substantially modified from its original form. Thanks to the successful lobbying efforts on the part of state governments, the prepaid industry and advocates for the unbanked community, prepaid cards used to disburse government benefits as well as reloadable prepaid cards are exempt from the interchange limits. It should be noted that such cards are exempt provided that they do not charge any overdraft fees and provide one fee-free withdrawal from the issuer’s ATM network per month.

The various lobbying efforts in support of striking the entire interchange provision from the bill proved less successful and ultimately failed. And while small issuers (i.e., issuers, together with it affiliates, having assets of less than $10 billion) are exempt from the interchange provisions, many have argued that the exemption is meaningless since small institutions will be forced to cut their interchange fees to compete with large banks.