Court To Fed: Keep The (Inter)Change

Attorney Mark D. Rasch is the former head of the U.S. Justice Department's computer crime unit and today is a lawyer in Bethesda, Md., specializing in privacy and security law.

On July 31, a federal court in Washington sent shock waves through the merchant, banking, and credit/debit card industry by overturning the Federal Reserve's rules implementing limitations on the interchange fees banks can charge merchants for processing signature- and PIN-based debit cards. In doing so, the Judge ruled that the Fed had not reduced these fees enough to comply with the wording and the intent of Congress. While this is good news for merchants and bad news for banks, how much the good news is worth depends on how much a debit card transaction costs. And just as important is who gets to decide what a "cost" is.

At issue in the case was the Federal Reserve's "Final Rule" implementing the so-called "Durbin Amendment" to the Dodd-Frank financial reform act.

The purpose of the law was to reduce the interchange and other fees charged by banks to merchants for processing debit cards, while permitting the banks to recover their actual direct costs associated with such processing. But the Fed permitted banks to add into what they could recover a host of fees that had nothing to do with processing a specific transaction, but represented "unassociated" costs (overhead, lawyers, etc.)

As a result of the Fed's interpretation of the statute, interchange fees to merchants, which were proposed to be from 7 to 12 cents per transaction, rose to 21 cents per transaction plus an ad valorem fee of .05 percent.

That's big bucks. How much of those big bucks merchants have to pay was determined by Congress—or it was until the Fed and bank lobbyists got involved. While the statute was intended to shift these costs (fees) from merchants to banks, the Fed rule didn't quite do that, and fueled ever increasing fees (although it did reduce the fees charged by banks to merchants, it didn't reduce them as much as Congress intended, at least according to the court).

In a typical debit card transaction, whether it's processed like a credit card transaction with a signature or using a PIN at a terminal, the acquiring bank charges merchants an interchange transaction fee for accepting the debit card. The network also charges acquirers and issuers a "switch fee" or "network fee."

These, together with an additional markup, are used to compute the "merchant discount"—which is not a discount to the merchant, but a reduction in the money the merchant receives after the fees are taken out. In layman's terms, this is the "vig" or the "juice"—the fee extracted from merchants for the benefit of doing business. (A mafia informer once told me that it's called the "juice" because, after all, you have to "squeeze" to get the "juice.")

When PIN-based debit cards were first introduced, they reduced costs for both banks and merchants. No longer did merchants have to handle, process, deposit and authenticate checks, or run the risk that cash would have the problem of "shrinkage." This was an easy way for merchants to effectively directly remove money from a customer's bank account. The risk of default was low, as was the cost of processing. Merchants had to install new PIN-based POS terminals, but many banks and acquirers helped to subsidize these costs by setting the interchange fees at "par" (no fee) or even reverse fees as a subsidy.

But then debit cards took off.But then debit cards took off. By 2011, debit cards were used in 35 percent of noncash payment transactions, and have eclipsed checks as the most frequently used noncash payment method. Acquiring banks realized that they were sitting on a potential pile of revenue. ("That's an awfully sweet Point of Sale terminal you got there. It would be a shame if anything happened to it...") Acquirers, once eager to get adoption of both signature and PIN-based debit cards, now started jacking up the fees.

From 1998 to 2006, merchants faced a 234 percent increase in interchange fees for PIN transactions, and by 2009, banks were making over $16 billion on debit card fees alone. For most retailers, debit card fees were their single largest operating expense behind payroll. Banks and card brands (Visa and MasterCard, for example) wanted to do everything they could to force merchants to take debit cards (especially signature-based debit cards with even higher fees) and to have consumers use them, since more use meant more money in fees.

As part of financial reform and the Dodd-Frank legislation, Congress acted to address what it perceived as ever increasing fees for debit card transactions. They passed laws limiting the interchange and other fees that could be charged on both PIN- and signature-based debit cards, with the intent of putting downward pressure on these fees, and they tasked the Federal Reserve to issue regulations to reduce these fees.

The idea was that banks could be reimbursed for their actual costs associated with processing the debit cards, but that the fees were not intended to be a profit center for the banks. The law required that the Fed issue regulations to ensure that the fee charged by the issuer "with respect to an electronic debit reasonable and proportional to the cost incurred by the issuer with respect to the transaction." In doing so, Congress directed the Fed to consider the incremental ACS costs relating to particular transactions, but not to consider "other costs."

So what is the issuer's "cost" with respect to the transaction? If I am an issuer, I want to recover not only the costs of the hardware and software associated with processing, but personnel, insurance, real estate, taxes, marketing, advertising, promotion, legal fees—well, you get it: a pro rata share of everything.

As a merchant, I want much more "costs" excluded. So are lawyers and lobbyist costs, air conditioning and public relations fees "associated with" a transaction?

All of this was hashed out in the regulations when the lobbyists descended on the Federal Reserve. Ultimately, with prodding from lobbyists, the Fed concluded that, in allowing costs "associated with" transactions and disallowing costs not "associated with" transactions, the Fed would allow acquirers to charge merchants pro rata costs of a bunch of things which might otherwise be considered to be overhead costs. It's an interpretation that eats up the rule. Some small portion of the costs of the bank CEO's private jet to fly to a business meeting is "associated with" my transaction of buying a cheeseburger with a debit card. After all, a bank needs a CEO, and the CEO needs to go to meetings, right?

The Federal Court disagreed.The Federal Court disagreed with the Fed's interpretation of both the statute and the legislative debate. The Court concluded that Congress wanted costs split between those actual incremental costs directly associated with processing my debit card transaction for the cheeseburger and those overhead or other profit center costs of operating a bank. The former could be part of the interchange fee, the latter, not so much. But since the statute didn't define what was directly associated with a transaction, the Fed said they could decide that anything was associated with a transaction, right? Wrong. As the Court explained:

The Board contends that the statute's failure to define the terms "incremental cost" or "authorization, clearance, or settlement," or to delineate which types of costs are "not specific to a particular electronic debit transaction," renders those terms ambiguous, thereby giving the Board the authority to fill those statutory gaps. Not quite! If I were to accept the Board's argument, then every term in the statute would have to be specifically defined or otherwise be deemed ambiguous. This result makes no sense, and more importantly, it is not the law. When a term is not defined in a statute, a court must assume that "the legislative purpose is expressed by the ordinary meaning of the words used."

Moreover, Congress directed the Fed to look at the fees associated with writing a check when considering the "incremental costs" that should be allowed in debit card transactions. Writing checks is very expensive to merchants, banks, and even consumers, while debit cards are very cheap. Yet there are zero interchange fees charged to merchants for collecting and depositing checks. Clearly banks incur substantial overhead and transaction costs for accepting checks—they just don't pass those on to merchants. That's what it means to be a bank, right?

Ultimately the Court found that the Fed's rule was too kind to banks and allowed them to collect a host of fees that had nothing to do with the actual costs of processing debit cards. It sent the Fed (and bank lobbyists) back to the drawing board to rehash what fees are directly associated with processing, and which ones were not. This will likely result in dramatically lower fees to merchants.

And lower costs to consumers? Not so much. As a result of the rules already in place, fees from merchants to banks have dropped by as much as 50 percent. But because the fees are so universal and so incorporated into the merchant's business process, no individual merchant obtains a competitive advantage by reducing its prices over competitors simply because of the lower fee. Instead, mostly this translates into higher profits for merchants, and a greater incentive to accept debit cards.

If you disagree with me, I'll see you in court, buddy. If you agree with me, however, I would love to hear from you.