"Durbin" Is Here: Thoughts On The Federal Reserve’s Final Rule On Debit Card Interchange Fees And Routing (And A Little Second-Guessing On The TCF Lawsuit)

On July 20, 2011, the Federal Reserve published its controversial "Regulation II" (12 C.F.R. § 235.1 et seq.) on debit card interchange fees and routing, a regulation that implements the "Durbin Amendment" (Section 1075 of Dodd-Frank). Regulation II puts in place the price controls required by Dodd-Frank by prohibiting debit card issuers from receiving or charging an interchange transaction fee of more than $0.21 plus 0.05% of the transaction value. Debit card issuers are also forbidden from receiving net compensation from a payment card network. A "small issuer" exemption (consolidated assets of less than $10 billion) is included, although the practical effect for community banks is not yet clear.

Compliance deadlines. The rule is effective and compliance is mandatory on October 1, 2011, although there is a delayed compliance deadline of April 1, 2012, as set forth below (omitting references to deadlines for reloadable prepaid cards):

• Payment card networks must comply with the prohibition on network exclusivity on October 1, 2011.

• Issuers like community banks must comply with the prohibition on network exclusivity on April 1, 2013, with respect to debit cards that use transaction qualification or substantiation systems and general-use prepaid cards sold on or after April 1, 2013.

Controversial features. The final interchange rule has several controversial features:

• There is no requirement that payment networks use a 2-tier system to ensure that banks with less than $10 billion in assets actually benefit from their exemption. Rather, the Federal Reserve will study average interchange rates for both exempt and non-exempt banks and will try to monitor the effectiveness of the small bank exemption on an after-the-fact fashion.

• Section 235.5(b) says that the price controls don't apply to debit transactions on government-administered payment programs but only if (1) a "government administered payment program" (which can be a program outsourced to a third party administrator on behalf of a Federal, state, local or tribal government) is involved and (2) the cardholder may use the debit card "only to transfer or debit funds, monetary value, or other assets that have been provided pursuant to such program." For example, if the debit card is used to purchase goods or services, it appears that usage would entitle the relevant government to the discount for that transaction. In short, unless those two conditions are satisfied, the various governments are entitled to the discount and thereby become powerful vested interests against any lifting of the price controls. Note that TCF National Bank's otherwise thorough lawsuit against the Federal Reserve appears to overlook the "takings" aspect of this mandatory discount for government programs.

• Issuers can get a full exemption if they can show that their accounts are held under a custodial agreement that qualifies as a trust under the Internal Revenue Code. Appendix A says that the term "bona fide trust agreement" is not defined in the regulation and that institutions must look to state or other law for interpretation. It is not clear why businesses like flex spending card issuers get to charge their usual, full fees to consumers for health care expenses but banks cannot charge the same fees to commercial businesses.

• Appendix A says that payment card networks may, but are not required to, develop their own processes for identifying issuers and products eligible for exemptions. It is not yet clear whether and how the networks will do so.

• No distinction was made between business and personal accounts. Appendix A to Regulation II says that the definition of "account" in Section 235.2(a) includes business accounts as well as consumer accounts.

Enforcing regulators. The regulators that will enforce this rule are the "appropriate Federal banking agency" (the functional banking regulators) and, to the extent not given to another government agency, to the Federal Trade Commission (See section 235.9). (Unless of course the Consumer Financial Protection Bureau decides it wants to enforce or re-write Regulation II, which it is always free to do since the CFPB has power to regulate everything dealing with consumer financial products and services.)

The TCF lawsuit. The lawsuit filed by TCF National Bank to challenge the Durbin Amendment was detailed, thorough and highly informative in documenting the lack of analysis that went into the legislation and its unusually unfair effects. For example, TCF argued that large retailers like Walgreens (Senator Durbin's constituent) and Wal-Mart will reap a windfall in cost savings at the direct expense of banks.

The district court denied TCF's request for an injunction and the 8th Circuit appeals court affirmed. The 8th Circuit was not convinced that the effect of the Durbin Amendment was to set a maximum price, which TCF had to prove in order to challenge the amendment under the confiscatory rate analysis. Even if TCF had convinced the court that a price control was involved, it would have had to show that the Durbin Amendment was "arbitrary, discriminatory or demonstrably irrelevant" to the legislature's policy. The court felt that TCF could always fully recoup the costs of its debit card services by assessing other customer fees. The court also held that TCF's argument as to the unfairness of Durbin only applying to the over-$10 billion bank sector was "meritless. The decision was surprising in its disregard for TCF's factual arguments and in assuming that the court understood TCF's pricing power better than TCF itself. The court also signaled (for the banking industry) a disconcerting willingness to accord Dodd-Frank a high degree of deference.

TCF then decided to dismiss the lawsuit without prejudice (meaning they can re-file later), saying:

Unfortunately for TCF, it looks like the court totally rejected their arguments related to the exclusion of 99% of banks and cast severe doubt on their other arguments. It is tempting to second guess the litigation strategy in not raising certain arguments, but the tenor of the 8th Circuit's opinion suggests that the court would have found a way to rule against big banks one way or another. The unfortunate lesson is that lobbying pays. The big retailers got a senator to sponsor legislation that imposed price controls in their favor. Big banks might consider themselves informed.

Daniel Wheeler is a banking regulatory partner in the Buchalter Nemer law firm.

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