Interchange developments: Lawyers, courts and an ongoing process
On Friday, January 17, 2014, attorneys representing the Federal Reserve (the Fed), retailers and retailer trade groups appeared before the U.S. Court of Appeals for the District of Columbia as the Fed appealed an earlier pro-merchant ruling that found that the Fed had failed to properly interpret and implement the Durbin Amendment through Regulation II. The lower District Court found that:
- The Fed had set regulated debit interchange rates too high.
- The Fed should require at least two network routing options for PIN debit and another two networks for signature debit.
In filing this appeal, the Fed may have found an Appeals Court receptive to its arguments.
The Durbin Amendment and Regulation II
The Durbin Amendment is a pro-merchant addition to the Dodd-Frank Act intended to lower the interchange fees paid by merchants by more closely aligning the interchange fees charged to them with the actual costs incurred by debit card issuers in providing those services. The Fed was tasked with ensuring that debit interchange reflect only “reasonable and proportional” issuer costs, as well as ensuring that debit issuers offer merchants at least 2 network routing options.
Durbin created a two-tier interchange system and is enforced by Fed Regulation II. The first tier consists of FIs with over $10 billion in assets that are subject to regulated debit interchange rates and required to quantify their costs for purposes of setting interchange rates. The second tier consists of FIs with less than $10 billion in assets (such as community banks and credit unions) that are exempted from regulated interchange rates and from demonstrating their costs associated with operating their debit programs.
High Interest to Appeals Court: Debit Interchange
In December 2010, the Federal Reserve initially recommended that for non-exempt issuers, regulated debit interchange would be allowed to float between $0.07 and $0.12 per transaction. After further Fed review, considering an abundance of public commentary, that cap under Regulation II was set at $0.21 plus five basis points.
Shortly following the October 2011 implementation of Regulation II, merchants challenged the Fed’s final rules in the U.S. District Court for the District of Columbia (the third highest court in the land). The District Court ruled in favor of the merchants in July 2013.
In response, the Fed filed an appeal to the Court’s decision in August 2013 to the U.S. Court of Appeals for the District of Columbia (the second highest court in the land), and based on initial testimony in January 2014, this Appeals Court seems to be lining up with the Federal Reserve.
CUNA’s general counsel noted that the U.S. Court of Appeals seemed to “recognize that additional costs can be properly considered under the statute,” and extrapolating from the pro-issuer tone of the appellate court judges that the Fed’s final, 2011 rule may be allowed to stand. That would keep maximum interchange fee for non-exempt issuers equal to the sum of 21 cents plus five basis points on each transaction.
Low Interest to Appeals Court: Network Exclusivity
The Federal Reserve allowed issuers to comply with Durbin mandated non-exclusivity by requiring, at minimum, one card network for signature transactions and a second unaffiliated payment card network for PIN transactions.
The Fed argued that the language of Durbin allows for multiple networks enabled on each debit card, not multiple networks available for each method of authentication supported by a merchant at the point of sale.
However, the District Court found that compliance with Durbin entailed allowing merchants the option of running every debit transaction type over at least two unaffiliated networks.
The Fed has appealed this ruling at the U.S. Court of Appeals. While there is no clear cut way to know what the Court’s final ruling will be, the judges, based on initial testimony, seem to be in favor with Fed Regulation II.
U.S. Court of Appeals: Tip of the Hand?
From the 50 minutes of oral arguments presented by all three groups testifying in the Appeals case (FIs, Merchants, Federal Reserve) on January 17, the financial press has been expressing cautious optimism about the U.S. Court of Appeals ruling.
The judges were keenly interested in how the Fed had determined what costs to include or exclude in setting interchange caps. While the Fed included labor, computer software and hardware, network processing fees and fraud losses in its calculation, it did not explain “incremental costs” in its Durbin rule. One judge expressed surprise at that decision.
Alternately, when discussing costs the Fed could add to interchange beyond those enumerated in Durbin, one justice put the onus of proof on the merchants to show that the Fed was “unreasonable” in its application of costs.
The case’s oral argument section gave hope to the financial services industry that the Federal Reserve’s interchange guidelines would be allowed to stand; however, it is far too early to lock in future debit strategies based on a possible legal outcome.
