United States: The Small Bank Exemption To Dodd-Frank's Swipe Fee Regulations: "Honor-All-Cards" Contractual Provisions May Not Protect Small Banks

Previously published in Bloomberg Law Reports

An amendment to the Dodd-Frank Wall Street Reform and Consumer Protection Act authored by Senator Richard Durbin (Durbin Amendment) requires issuers of debit cards to set the swipe fees they charge for processing transactions at levels that are "reasonable and proportional to the cost incurred by the issuer."¹ As required by the Durbin Amendment, the Board of Governors of the Federal Reserve System (Federal Reserve) has published proposed regulations that would implement this provision by capping the swipe fees issuing banks can collect on purchases made with debit cards.² The Durbin Amendment exempts banks with less than $10 billion in assets from the Federal Reserve's proposed regulations because these smaller banks could find it difficult to compete in a regulated debit card market.³

During a February 17, 2011 hearing before the Senate Banking Committee to discuss the proposed swipe fee cap, Federal Reserve Chairman Ben Bernanke questioned whether the exemption for small banks would work in practice.⁴ In response, Senator Durbin accused Chairman Bernanke of adopting the banking industry's taking points, which he characterized as nothing more than "scare tactics" that ignore several "critical realities" in the debit card market.⁵ At least one of the "realities" that Senator Durbin cited, however, should provide small banks with little comfort that the exemption from the swipe fee cap will prove effective. In short, Chairman Bernanke's concerns about the negative impact the swipe fee cap may have on the ability of smaller banks to compete effectively in the debit card market appear to be justified.

Background on Swipe Fees

When a customer uses a credit or debit card to make a purchase, the merchant does not receive the entire purchase price. Rather, a percentage of the purchase price, commonly referred to as a "swipe fee" or "interchange fee," is held back. The swipe fee is divvied up between the bank that issued the card (such as Chase or Citibank) and the payment network on which the card operates (such as Visa or MasterCard) in accordance with the terms of agreements that the card networks negotiate with the issuing banks.⁶ Swipe fees vary depending on a number of factors, including the type of card used in the transaction. For instance, cards that offer rewards such as airline miles or cash rebates carry higher swipe fees than basic cards that do not offer these additional incentives.⁷ Merchants have little ability to negotiate the amount of the swipe fees and, for the most part, are required to pay the swipe fee the issuers set if they want to accept credit and debit cards.⁸

Swipe fees have been increasing in recent years; in 2009 card issuers collected $16.2 billion in debit card swipe fees alone.⁹ The average debit card swipe fee in 2009 was 1.14 percent of the amount of the transaction.¹⁰ At least one merchant trade group estimates that swipe fees are the second highest operating expense for many merchants.¹¹ Merchants pass the cost of swipe fees along to their customers in the form of higher prices.¹²

The Durbin Amendment Seeks To Curb Debit Card Swipe Fees

The Durbin Amendment, which Senator Durbin proposed to combat what he saw as the anti-consumer impact of rising swipe fees, includes a provision designed to limit the swipe fees that certain debit card issuers can charge.¹³ Specifically, the Durbin Amendment provides that: "The amount of any interchange transaction fee that an issuer may receive or charge with respect to an electronic debit transaction shall be reasonable and proportional to the cost incurred by the issuer with respect to the transaction."¹⁴ The Durbin Amendment instructs the Federal Reserve to establish regulations that can be used to ascertain whether a swipe fee is "reasonable and proportional."¹⁵ In December 2010, the Federal Reserve proposed regulations that would implement the Durbin Amendment by capping debit card swipe fees at no more than 12 cents per transaction.¹⁶ That is more than 70 percent lower than the current 44 cents per transaction average swipe fee for debit card purchases.¹⁷

The Durbin Amendment exempts "smaller" banks—defined as banks with less than $10 billion in assets—from the regulations.¹⁸ The exemption was included to assuage concerns that smaller banks might not be able to effectively compete in the debit card market if subjected to regulations limiting swipe fees.¹⁹ In short, the Durbin Amendment does not prohibit smaller banks from continuing to charge higher swipe fees.

The Debate About The Efficacy of the Small Bank Exemption

The banking industry has suggested that the exemption may not actually succeed in allowing smaller banks to compete in the debit card market. Rather, the industry has argued, the market will force smaller banks to lower their swipe fees to compete with the capped rates the larger banks will be required to charge. In the words of the American Bankers Association: "[T]his 'exemption' will not work because marketplace pressures will force all banks to conform to the artificially lower government mandated interchange rate restrictions to which larger banks will be subject."²⁰ During a February 17, 2011 Senate Banking Committee hearing, Chairman Bernanke also raised this concern: "We are not certain how effective that exemption will be because merchants may be able to reject [more expensive] cards from smaller institutions . . . [the] exemption may not be effective in the marketplace."²¹

After the hearing, Senator Durbin sent Chairman Bernanke a letter stating that he was "disappointed that [Chairman Bernanke's] testimony about interchange fee reform . . . echoed the financial industry's talking points and failed to acknowledge several critical realities."²² In response to Chairman Bernanke's concern that merchants would refuse to accept higher-fee debit cards issued by smaller banks, Senator Durbin noted that merchants who accept debit cards agree to abide by rules that would prohibit such discrimination:

Senator Durbin went on to draw an analogy to the provisions in agreements between credit card issuers and merchants that prohibit merchants from steering customers from higher-cost reward credit cards to lower cost basic credit cards:

Senator Durbin correctly points out that both the "honor-all-cards" provisions and "anti-steering" provisions prohibit merchants from discriminating against higher-cost debit and credit cards. However, small banks cannot, as Senator Durbin suggests, rely upon the "honor-all-cards" provisions as a safety mechanism because the Department of Justice (DOJ) recently concluded that the analogous "anti-steering" provisions are illegal and because merchants themselves have alleged in a pending, putative class action that the "honor-all-cards" provisions violate the antitrust laws.

The DOJ's Challenge to "Anti-Steering" Provisions

The "anti-steering" provisions to which Senator Durbin refers prohibit merchants from, among other things, encouraging or incentivizing customers to use lower-cost credit cards. So, for instance, if a customer presents a merchant with a reward credit card, the contract prohibits the merchant from asking the customer to use or offering the customer an incentive to use a less expensive form of payment, such as a basic credit card.²⁵ The "anti-steering" provisions, in effect, require merchants to accept the card their customers present. Alleging that these "anti-steering" provisions ultimately harm consumers, in October 2010 the DOJ filed an antitrust suit against Visa, MasterCard, and American Express (Amex) seeking to invalidate the provisions.²⁶ Specifically, the DOJ argued that the "anti-steering" provisions are anticompetitive because they prohibit merchants from taking action to reduce high swipe fees, which merchants then pass along to consumers by raising prices: "Because [the anti-steering provisions] obstruct merchants from encouraging customers to use less costly payment methods, merchants bear higher costs and their customers face higher retail prices."²⁷ The DOJ reached a settlement with Visa and MasterCard pursuant to which those networks agreed to drop the "anti-steering" provisions from their agreements with merchants.²⁸

Like "anti-steering" provisions, "honor-all-cards" provisions require merchants to accept the card presented by their customers. Specifically, Visa's "honor-all-cards" provision prohibits merchants from "refus[ing] to accept a Visa product that is properly presented for payment."²⁹ MasterCard's similar provision requires merchants to "honor all valid Cards without discrimination when properly presented for payment."³⁰ Therefore, once the Durbin Amendment is implemented and debit card swipe fees charged by large banks are capped, the "honor-all-cards" provisions, like the "anti-steering" provisions challenged by the DOJ, will prohibit merchants from discriminating against more expensive debit cards issued by banks exempt from the swipe fee cap in favor of debit cards that charge the statutorily-capped rate. Merchants, then, presumably will pass those higher swipe fees along to consumers in the form of higher prices, causing the very problem that the DOJ sought to rectify by challenging the credit card industry's analogous "anti-steering" provisions in court. In other words, the contract provisions that Senator Durbin claims will protect small banks from discrimination by merchants may well be illegal in the eyes of the DOJ.

The Merchants' Challenge To "Honor-All-Cards" Provisions

Amex not only prohibits its merchants from encouraging customers to use cards issued by Amex's competitors through its "anti-steering" provision, but, like Visa and MasterCard, Amex also mandates through its own "honor-all-cards" provision that merchants accept any card bearing the Amex logo: "Merchants must accept the Card [defined as any form of payment bearing the Amex logo] as payment for goods and services . . . sold."³¹ Since 2003, though, merchants who are subject to Amex's "honor-all-cards" provision have been pursuing a putative class action against Amex alleging that the provision violates the antitrust statutes.³²

The Amex litigation centers around the two types of cards that Amex issues. Amex issues charge cards, which require the holder to pay his or balance every month, primarily to corporate and affluent customers; i.e., customers who are particularly attractive to merchants.³³ Amex issues credit cards, which allow holders to carry a balance, to the general public.³⁴ The merchants in the Amex litigation note that Amex charges significantly higher swipe fees on its credit cards than its competitors charge for similar mass-market cards.³⁵ Amex's "honor-all-cards" provision, the merchants complain, requires them to pay these allegedly supracompetitive swipe fees if they want to lure the affluent customers who carry Amex's charge cards.³⁶ Thus, say the merchants, Amex's "honor-all-cards" provision constitutes an illegal "tying arrangement" that violates the Sherman Act.³⁷

Once the Durbin Amendment is implemented, Visa and MasterCard's "honor-all-cards" provisions will prohibit merchants from rejecting higher-fee debit cards issued by small banks if they wish to continue accepting lower-fee debit cards issued by large banks. In other words, the outcome that merchants contend is illegal in the Amex litigation will come to pass in the debit card market; namely, merchants will be required to pay small banks supracompetitive swipe fees if they wish to accept debit cards.

"Honor-All-Cards" Provisions Offer Small Banks Little Solace

Given the DOJ's opposition to "anti-steering" provisions, the analogous "honor-all-cards" provisions could be the DOJ's next target. And, given that merchants believe Amex's "honor-all-cards" provision is illegal, Visa and MasterCard's "honor-all-cards" provisions for debit cards may be the merchants' next target. Therefore, small banks would be ill-advised to rely on such provisions as protection against the market forces that will come to bear when, as required by the Durbin Amendment, their large bank competitors significantly lower their debit card swipe fees. Indeed, unless Congress passes legislation exempting from the reach of the antitrust laws contractual provisions that prohibit discrimination between payment types, the Durbin Amendment's small bank exemption may, as Chairman Bernanke suggested, prove ineffective.

Footnotes

1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1075, 124 Stat. 1376, 2068 (2010) (implementing § 920(a)(2) of the Electronic Fund Transfer Act).

2 See Debit Card Interchange Fees and Routing, 75 Fed. Reg. 81722, 81755-56 (proposed Dec. 28, 2010) (to be codified at 12 C.F.R. § 235.3). For more information regarding the Federal Reserve's proposal, see Bloomberg Banking & Finance Law Report®—Federal Reserve Releases Debit Card Proposal Pursuant to Dodd-Frank Act's "Durbin Amendment".

3 See Pub. L. No. 111-203, § 1075, 124 Stat. at 2070 (implementing § 920(a)(6)(A) of the Electronic Fund Transfer Act).

4 American Bankers Association, Dodd-Frank Tracker (Feb. 17, 2011), http://regreformtracker.aba.com/2011/02/bernanke-small-institutions-not-fully.html .

5 Letter from the Honorable Richard J. Durbin, Assistant Majority Leader, United States Senate, to the Honorable Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System (Feb. 17, 2011), http://durbin.senate.gov/showRelease.cfm?releaseId=331310 .

6 See United States Government Accountability Office, Credit Cards: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges, GAO-10-45, 1 (2009), http://www.gao.gov/new.items/d1045.pdf.

7 See id. at 10.

8 See id. at 29.

9 See Debit Card Interchange Fees and Routing, 75 Fed. Reg. 81722, 81725 (proposed Dec. 28, 2010) (to be codified at 12 C.F.R. pt. 235).

10 See id.

11 See Richard Newman, Taking a Swipe at Fees: Planned Cap on Debit-Card Charge Pits Banks vs. Merchants, The Record, Feb. 18, 2011, http://www.northjersey.com/news/116456348_Taking_a_swipe_at_fees.html .

12 See The Food Marketing Institute, Hidden Credit Card Fees: Interchange Fees Cost Consumers Billions Each Year, FMI Backgrounder, June 2007, http://www.fmi.org/media/bg/interchange_fee_backgrounder.pdf .

13 See The Honorable Richard J. Durbin, Statement (May 13, 2010), http://durbin.senate.gov/showRelease.cfm?releaseId=324958 .

14 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 1075, 124 Stat. 1376, 2068 (2010) (implementing § 920(a)(2) of the Electronic Fund Transfer Act).

15 See id. (implementing § 920(a)(3)(A) of the Electronic Fund Transfer Act).

16 See Board of Governors of the Federal Reserve System, Press Release (Dec. 16, 2010), http://www.federalreserve.gov/newsevents/press/bcreg/20101216a.htm .

17 See 75 Fed. Reg. at 81725. As of 2010, 105 of the roughly 7,750 banks in the United States (about 1.4 percent) held more than $10 billion in assets. See Nigel Holmes and Sarah Richardson, The Rise of the Monster Bank, American History, Feb. 2011 at 27.

18 See Pub. L. No. 111-203, § 1075, 124 Stat. at 2070 (implementing § 920(a)(6)(A) of the Electronic Fund Transfer Act).

19 156 Cong. Rec. S4977 (daily ed. June 16, 2010) (statement of Sen. Durbin) ("[T]o preserve the ability of small banks and credit unions to compete with big banks in issuing debit cards . . . [w]e specifically exempted any financial institution with a value of less than $10 billion.").

20 Letter from the American Bankers Association to Member of Congress (Feb. 8, 2011), http://www.aba.com/aba/documents/blogs/DoddFrank/InterchangeToCongressFeb8.11.pdf .

21 American Bankers Association, Dodd-Frank Tracker (Feb. 17, 2011), http://regreformtracker.aba.com/2011/02/bernanke-small-institutions-not-fully.html .

22 Letter from the Honorable Richard J. Durbin, Assistant Majority Leader, United States Senate, to the Honorable Ben S. Bernanke, Chairman, Board of Governors of the Federal Reserve System (Feb. 17, 2011), http://durbin.senate.gov/showRelease.cfm?releaseId=331310 .

23 Id.

24 Id.

25 Under the Amex "anti-steering" provision, merchants may not, among other things: (1) "indicate or imply that they prefer . . . Other Payment Products;" (2) "try to dissuade Cardmembers from using the [American Express] Card;" or (3) try to persuade or prompt Cardmembers to use any Other Payment Products or any other method of payment." American Express Merchant Reference Guide – U.S. § 3.2 (Oct. 2010), https://www209.americanexpress.com/merchant/singlevoice/singlevoiceflash/USEng/pdffiles/MerchantPolicyPDFs/Oct2010_US_%20RefGuide.pdf .

26 See Amended Complaint, U.S. v. American Express Co., No. 10-CV-4496 (E.D.N.Y) (filed December 20, 2010).

27 Id. at ¶ 72.

28 See United States Department of Justice, Press Release (Oct. 4, 2010), http://www.justice.gov/opa/pr/2010/October/10-at-1115.html . Amex has not settled and is fighting the suit. See id.

29 Visa International Operating Regulations, Core Principle 6.2 (Oct. 15, 2010), http://corporate.visa.com/_media/visa-international-operating-regulations.pdf.

30 MasterCard Rules § 5.8 (Oct. 29, 2010; updated Dec. 10, 2010), http://www.mastercard.com/us/merchant/pdf/BM-Entire_Manual_public.pdf.

31 American Express Merchant Reference Guide – U.S. § 3.1 and p. 52-53 (Oct. 2010), https://www209.americanexpress.com/merchant/singlevoice/singlevoiceflash/USEng/pdffiles/MerchantPolicyPDFs/Oct2010_US_%20RefGuide.pdf .

32 See In re: American Express Merchants' Litigation, 554 F.3d 300, 305, 308 (2d Cir. 2009).

33 See id. at 307.

34 See id. at 308.

35 See id. at 307-308.

36 See id. at 308.

37 See id. After some preliminary legal wrangling, including a trip to the Supreme Court and back, about the enforceability of the arbitration clause in Amex's agreement with its merchants, the case now appears set to proceed on the merits. See In re: American Express Merchants' Litigation, No. 06-1871-CV, 2011 BL 60262 (2d Cir. Mar. 8, 2011).

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