IMPACT OF THE NEW DODD-FRANK FINANCIAL REFORM ACT ON DEBIT CARDS

By

W. Stephen Cannon and Richard O. Levine
Constantine Cannon LLP

Table of Contents:

The just-enacted “Dodd-Frank Wall Street Reform and Consumer Protection Act” (“Dodd-Frank Act”) has several provisions that should favorably affect the hospitality industry’s costs of accepting debit cards and that grant its members new rights in offering discounts for various types of payment and in routing debit card transactions.  The actual scope and impact of these changes, however, will be crucially dependent on rulemaking proceedings undertaken by the Federal Reserve Board (“Board”) over the next year.  Members of the hospitality industry should monitor these proceedings closely and ensure that the Board is aware of their perspective on the issues at stake.

Overview.  The Dodd-Frank Act broadly expands federal regulatory oversight of the financial services sector of the economy.  Perhaps less well known to members of the hospitality industry, a provision of the Act authored by Sen. Richard Durbin (D.-Ill.) should have a significant impact on merchant acceptance of debit cards, including:  (1) lowering interchange fees deducted by card issuers from amounts due to merchants from card transactions; (2) granting merchants the right to give different discounts to customers for cash, check, debit card or credit card use, and allowing merchants to set a $10 minimum credit card transaction size; and (3) giving merchants greater control over the routing of debit transactions among networks, potentially leading to dual “bugged” debit cards with a choice of routing signature debit transactions over the Visa, MasterCard or Discover networks, or debit cards with multiple PIN debit network choices.*  Finally, rules governing how debit card issuers can claim a “fraud prevention adjustment” to their allowed debit interchange fees may affect issuers’ fraud prevention procedures and technologies.

More specifically, section 1075 of the Act created a new section 920 of the Electronic Fund Transfer Act (“EFTA”), which generally governs consumers’ rights regarding debit card, ATM, and other non-credit electronic transactions. Unlike other sections of the EFTA, which are being transferred to the jurisdiction of a newly created Bureau of Consumer Financial Protection within the Federal Reserve, section 920 will remain under the authority of the Board, itself.  In turn, the Board is to conduct a series of rulemakings over the next year to implement section 920’s mandates.  The major components of section 920 and their implications are discussed below.

Interchange Fees.  Under subsection 920(a), by mid-April 2011, the Board is to promulgate rules to ensure that “interchange fees” collected by a payment network’s card issuers for debit card transactions are “reasonable and proportional” to card issuers’ incremental costs for processing debit card transactions.  These rules are to take effect in July 2011.  In implementing the “reasonable and proportional” interchange fee standard, the Board is to consider both: (1) the functional similarity between electronic debit transactions and checking transactions that are required within the Federal Reserve System to clear at par; and (2) “the incremental cost incurred by an issuer for the role of the issuer in the authorization, clearance, or settlement of a particular electronic debit transaction.” 

The Congressional mandate to the Board to consider both issuer “incremental costs” and the “at-par” check precedent would appear to direct the Board to use its discretionary rulemaking power to converge debit card fees toward at-par clearance.  That is, given the existence of at-par check clearance, the Board could use its discretion in determining allowable “incremental costs” to achieve outcomes that move debit card interchange fees to at-par clearance. 

While the outcome of the Board’s standards rulemaking process will not be known until next year, industry observers expect that the standards will, at a minimum, lead to a reduction in interchange fees.  (On July 16, Bank of America told financial analysts that it expects implementation of the rules will reduce the fees it earns from debit cards between 60 and 80 percent.)  However, debit card issuers with less than $10 billion in assets (including affiliates’ assets) are excluded from interchange fee controls, so the aggregate impact on merchants’ fees may depend on the mix of small and large card-issuers’ cards used by their customers.

Merchants’ Discounting Rights and Minimum Transaction Size Limits.   New EFTA subsection 920(b)(2) prevents payment networks or card issuers from restricting merchants’ ability “to provide a discount or in-kind incentive for payment by the use of cash, checks, debit cards, or credit cards.”  However, the provision does not require that card networks allow merchants to differentiate in their discounts or incentives on the basis of credit or debit card issuers or networks.  The section defines “discount” to be a reduction from “the price that customers are informed is the regular price,” and does not include a means of increasing the price above the regular price (e.g., a surcharge).  Also, the subsection allows merchants to set a $10 minimum for credit card (not debit card) transactions.  The Board may increase this amount by means of a rulemaking proceeding. 

Prohibition on Limiting Debit Card Transactions to One Network.   Subsection 920(b)(1) is intended to inject competition among debit card networks. By mid-July 2011, the Board is to issue regulations prohibiting payment card networks or issuers, as well as their processors and agents, from restricting to only one (or to only one affiliated group) the number of networks on debit cards, over which an electronic debit transaction may be routed. Similarly networks and issuers may not inhibit merchants’ ability to direct the routing of debit transactions “over any payment network that may process such transactions.”

In his Senate floor comments prior to final passage of the Dodd-Frank Act, Sen. Durbin stated that the routing provision is to be interpreted broadly by the Board in drafting the implementing regulations:

This paragraph is intended to enable each and every electronic debit transaction—no matter whether that transaction is authorized by a signature, PIN, or otherwise—to be run over at least two unaffiliated networks, and the Board's regulations should ensure that networks or issuers do not try to evade the intent of this amendment by having cards that may run on only two unaffiliated networks where one of those networks is limited and cannot be used for many types of transactions.

If issued in this manner, the Board’s regulations may bring about a significant change in the nature of payment card networks.  Indeed, it is possible that the Board might not just prevent payment networks from entering into exclusive relationships with issuers for debit cards, but require card issuers affirmatively to seek interconnection with multiple payment networks for their debit cards.  If so, it is possible that debit cards could be “bugged” with multiple network logos for both PIN and signature authorization at the merchant’s discretion.  This could give merchants a much greater ability to control the cost of debit card transactions.  And it could force Visa and MasterCard to open up exclusive arrangements that they have with numerous debit issuers. 

The “Fraud Prevention Adjustment” Rulemaking.  By mid-April 2011, the Board also must complete a rulemaking establishing standards by which card issuers may seek to adjust their allowed interchange fees to take into consideration their “fraud prevention” costs.  EFTA subsection 920(a)(5) authorizes the Board to make “adjustments” to interchange fee amounts received by an issuer if “such adjustment is reasonably necessary to make allowance for costs incurred by the issuer in preventing fraud in relation to” debit card transactions involving the issuer.  However, such adjustments are allowed only if the issuer complies with fraud standards developed in a Board rulemaking that is part of (or concurrent with) the fee standard rulemaking. 

Significantly, in setting adjustments, the Board is to take into consideration the effect of authorization type (e.g., PIN vs. signature) on fraud levels and to require issuers to “take effective steps” to reduce fraud “including through development and implementation of cost-effective fraud prevention technology.”  Further, in developing the standards, the Board is to consider: (1) the nature and type of fraud in electronic debit transactions; (2) the extent to which fraud depends on the form of authorization, including PIN, signature, or other means; (3) available and economic means by which fraud on electronic debit transactions may be reduced; (4) the fraud prevention and data security costs expended by each party to an electronic debit transaction, including by consumers and retailers; (5) the cost of fraud absorbed by each party to a transaction, including by consumers and retailers; (6) the extent to which interchange fees have reduced or increased incentives for parties in electronic debit transactions to reduce fraud; and (7) such other factors as the Board considers appropriate.  Further, any adjustment allowed must take into account any fraud-related reimbursement received by issuers, such as charge-backs.

The fraud adjustment rulemaking thus provides the Board with the opportunity to assess how card networks’ authorization choices and fraud procedures both burden the merchant community and potentially increase, rather than reduce, the volume of debit card fraud, and to assess claimed issuer fraud prevention costs in light of the costs imposed on merchants by the PCI security standards and their enforcement and penalty mechanisms adopted by the card systems.**  In so doing, the Board could quantify the proportion of fraud costs borne by merchants through fraud-related charge-backs, penalties and fines, and assessments passed through to merchants by indemnification provisions in merchants’ agreements with their card-processing banks.  The rulemaking also gives the Board the opportunity to promote use of the fraud adjustment mechanism as a means of creating financial incentives for issuers and merchants to migrate to more effective authentication methods.

Conclusion.  Over the next year, Federal Reserve Board proceedings to implement the debit card provisions of the Dodd-Frank Act will be the key forum for implementing provisions of the Act that have the potential to affect significantly the cost to members of the hospitality industry of accepting debit cards, as well as rights regarding their use.  These proceedings may also affect the pace at which card issuers introduce new card fraud prevention technologies.  Thus, the hospitality industry should not only “stay tuned” to forthcoming changes in debit card acceptance, but also remain aware of opportunities to facilitate the Board’s understanding of the impact of its decisions on industry members.

W. Stephen Cannon is Chairman, and Richard O. Levine is Of Counsel, at Constantine Cannon LLP, a law firm based in New York and Washington, D.C.  Mr. Cannon can be reached at 202-204-3502, scannon@constantinecannon.com.  Mr. Levine can be reached at 202-204-3511, rlevine@constantinecannon.com.

HospitalityLawyer.com
P.O. Box 22888
Houston, Texas 77227
(713) 963-8800