DAVID S. EVANS: Hi, this is David Evans. PYMNTS.com asked me to talk to Richard Epstein today about the complaint that was recently filed, I guess, yesterday, by TCF, claiming that the Durbin Amendment, Section 1075 of the Dodd-Frank Act is unconstitutional. Richard, as I understand it, you are a legal advisor to TCF in that matter. Is that right?
RICHARD EPSTEIN: I’m actually one of their lawyers on the complaint, yes.
EVANS: And Richard, just to remind our audience in case they don’t know your background, Richard is a very well-known law professor at University of Chicago, who is now also teaching at New York University, has many years of experience in appellate and Supreme Court litigation and is obviously very well-known in legal circles.So Richard, why don’t we get right into this.
Why do you believe, why does your client, TCF, believe that the Durbin Amendment, and I’m going to keep calling it the Durbin Amendment, is unconstitutional?
EPSTEIN: Well, my first acquaintance with the Durbin Amendment actually came at a Federal Reserve Board meeting in Chicago. And when I first saw it, long before I heard of TCF, my eyes popped out of my head. Essentially what this amendment tries to do is to give the company which supplies a huge portion of the essential services to this complicated two-side industries a tiny sliver of its actual cost. And essentially, it works a one-two punch, which makes it impossible to sustain a business in a rational way.
The first thing it does is it takes your normal cost of business and probably allows you to recover at most about 15% to 20% of those. In addition, if you try to raise your rates to your consumer customers, your banking customers, because you can’t get it from the retailers, the statute also contains an exemption for banks that are under $10 billion. So the moment you raise your fees to your customers, you lose them to the exempt banks. If you try to service the business without raising it, you will lose, essentially in TCF’s case, about $80 million out of $100 million, so income stream.
The debit card today is essentially the checking account. Checks are down in use, cash is stagnant, the debit card has now overtaken the credit card. If you cannot, in effect, recover your costs on a project of this sort and this magnitude, it becomes a taking.
Now the slightly more technical –
EVANS: Richard, let me just interrupt you there. So that all sounds horrible. Assuming all that is true, the government does nasty things all the time. So why is that unconstitutional?
EPSTEIN: Well, it’s interesting. The government does many nasty things, and in many cases it is, in fact, OK,. But in the financial industry, the rules have always been different. Rate regulation is perhaps one of the areas in which the constitutional safeguards have been most systematically observed. And what you see out of these safeguards is as follows: The standard rationale for regulation in most industries is that the industry is a national monopoly with monopoly power. And the function of the government is to lower the monopoly rate of return to a competitive rate of return. On the other hand, since governments do nasty things all the time, they’re not allowed to lower to a confiscatory rate where you cannot get enough returns so as to attract and to maintain capital. That’s the current standard.
In our case, we don’t even have a great difficulty on this issue. This is not a monopoly industry. The only monopoly elements, and this is disputable, is whether or not Visa and MasterCard, by virtue of being in the middle of the system, have some kind of dominant market power. But the Durbin Amendment doesn’t shoot at them, it hits us. And what it says, in effect, is that somebody who’s in an intensely competitive part of the industry has to compete with other people under a huge cost disadvantage which will make it impossible to recover its costs.
And let me stress what the magnitude of this is. If you’ll look at the way in which the amendment is drafted, it’s a bait and switch operation. At the beginning, the amendment says that you’re entitled to recover costs that are only reasonable and proportionate. That’s actually the way the system is today. But this second part of the provision is very different, and it defines these costs in very narrow ways as to cover only the costs of authorizing, clearing, and settling a transaction in terms of the electronics. Those turn out to be, in a typical transaction, about 7¢ or 8¢, and the revenues from that transaction are on the order of 47¢. So it’s gone.
What Senator Durbin has said is that you’re free to charge your customers. But this is an industry in which customers turn over with immense rapidity. The TCF Bank probably has to sign up about 300,000 or 400,000 customers a year to maintain its base of about 1.6 million customers, because it loses that number… very sensitive market and things switch over all the time. You try to put on a working-class population $100 in fees, and they’re out the door. So you can’t raise it from that source, and if you look at the amendment, it is so tightly drafted that the Federal Reserve Board, which has responsibility for its implementation has essentially no wiggle room.
So what you do is you have a competitive market in which you already earn a competitive rate of return, and they’re telling you that you have to go below competition and have increased costs, to boot, and they’re saying that the only offset that you get is from your ability to raise prices to your customers, and then they effectively shut that off by the $10 billion exemption. So there’s a vicious one-two punch under these circumstances.
What makes it so extraordinary is that it’s very clear Senator Durbin does not understand the contents of his own amendment. He wrote something in response to our complaint yesterday which is a complete source of disinformation in terms of the way this has gone. He basically says in this particular case, the true ogre is VISA and MasterCard because they have power to set rates in whatever way they see fit.
If they had that power, you would expect that they would keep all the money and give only dribs and drabs to the banks like TCF, which are on the other end of this transaction. But if you look at the splits in the money, approximately they run as follows: About 10% or so of the money, give or take, goes to the merchant bank – that is the bank of the retailer, who initiates the transaction. About another 10% or so goes to VISA or MasterCard for running it, and the rest of the money goes on the other side of the market to the issuing bank. It’s only earning an ordinary rate of return. Why is that? Because it has a huge number of services that it has to supply, and the amendment is explicit to say that all those costs are disallowed. So when you disallow costs, force a business to operate at a loss, give it a safety valve which is essentially worthless because of the peculiar distribution that you have between the exempt and the non-exempt banks, we think this adds up to an unconstitutional situation.
EVANS: Well, Richard, what are you seeking to accomplish with the lawsuit? What do you want the courts to do?
EPSTEIN: OK, well the first thing we want to have them to do is to say, look, these amendments cannot go into effect until we get our day in court. And what we mean by that is we believe the constitutional challenges are quite strong, and it would be disastrous to impose this thing upon a bank, have it suffer serious runs on revenue, and then declare it unconstitutional when there’s no chance of recoupment.
So we want to get a fair shot at it. And then once we get that fair shot at it, we want the standard remedy that you give in all rate cases where the government oversteps the line, that is, a permanent injunction against the enforcement of this particular act. And if you start looking at the rate cases on lots of other cases of economic regulation, courts are relatively willing to do this if, in fact, they look at a scheme and understand from its basic structure that the cost recovery that is constitutionally guaranteed is not going to be obtainable.
That’s the basic gist of this case. And we’re in it for the count. This is not the kind of case in which there’s anything you can do to compromise. This is not a suit against the Federal Reserve Board on the grounds that it’s done something. It’s a suit which essentially responds to the simple observation that they are told very explicitly what they have to do and they will do it. So at this point, the case is ripe for adjudication because all the administrative details are essentially on matters that have nothing to do with the Constitutionality of the statute.
EVANS: Richard, question for you. How long – assuming you got a preliminary injunction, how quickly do you believe you could get that from the court, assuming the court went along with you?
EPSTEIN: I think we could get it relatively quickly. Doing litigation with the government is always turning square corners, because they’re given procedural advantage that private parties don’t have. But the regulations here will be announced in preliminary form on November 9th, and at that point, I think we’ll start to see numbers which are far below those which are need to guarantee to the rate of return.
At that point, the case is one which you may as well put forward. The statute itself requires that there be final regulations on April 21st of next year, and that they’re supposed to go into effect on July 21st. So clearly the preliminary injunction has to come sometime within the next six or seven months in order for this to make any sense at all. And I also think, by the way, it’s in the government’s interest that this thing be resolved very quickly. There are massive conversion costs that will have to be borne by everybody, particularly VISA and MasterCard, to put this thing into place, and why in the world would one want them to incur costs when there’s a serious challenge to this particular statute?
I mean, I’m quite confident on the legal on this one. I’ve done a lot of the research on the recent cases, and I’ve seen cases – in rate cases, for example, in which preliminary injunctions have been granted where the stated objective of the regulation is to simply to allow somebody to recover costs, and not to make a profit. This is a situation where, on this entire debit card business, you can’t even recover anything more than say 15% of your costs. That’s simply not a sustainable model for any long-going business, and what happened is Senator Durbin does not understand this. He thinks that he’s getting at VISA and MasterCard. He believes that they set everything according to whim. If they did that, of course, they would never turn over all this money to us. Presumably they’re doing it to keep us in the system, and as you well know, in any kind of a complicated two-sided market, the only way you keep people in the system is to give them a revenue stream which covers their costs. If, in fact, you don’t get a revenue stream to cover your costs, you either exist the system or you exit the banking business altogether. And what Senator Durbin has done has essentially imputed mythical powers of monopoly to TCF Banks and others in its market niche, when in fact they have no place to go.
I might add, they don’t have credit cards because very few banks carry those, and so they couldn’t try to shift their customers from debit to credit card. And it’s also taking dead aim at the most rapidly growing segment of the payments industry. Debit cards today exceed both in numbers of transactions and in total dollars, credit card transactions. Credit charge transactions in the last year went down by $100 million or so, and now they start to be going up.
So all of this, in effect, gives you a sense that this a piece of massive and unnecessary disruption. And the only way to prevent that disruption is for the courts to intervene quickly and firmly on a matter of such great importance.
EVANS: Richard, are there other examples of the government passing legislation and imposing regulation that prevent firms from recovering a fair return on capital?
EPSTEIN: Sure. There have been a number of cases of this particular sort that have come down. Let me just mention two of them to you, of a recent vintage. One of them, there is a case called Jersey Central, and this took place about 1987 or so before the recent Duquesne Light case, and what happened is, this was the time at which they decided to cut out all new nuclear reactors. And the question was, who had to eat the cost of putting down these reactors when they were now going to be wasted. And what the Jersey Central regulatory authority did was say to this particular utility, you have to eat these costs, and you’re going to run your business so you get no profit. And that statute and an opinion by Judge Bork at the time, struck this down on the grounds that it didn’t meet the rate regulation mandates. This was 1987.
A couple of years later, there’s a case called Calfarm Ins. Co. v. Deukmejian, who was then the governor of California, there was a proposition with respect to the automobile industry which essentially just wanted to roll back rates to the point where it could no longer earn a acceptable rate of return on that line of business. And the California Supreme Court, no conservative body, struck that statute down on the grounds that it, too, systematically and on its face, denied an industry a reasonable rate of return. What’s instructive about it is they took the automobile line of insurance separate from the rest of the companies and they followed a rule which has been in place for a very long time, which is that you cannot tell a regulated industry that you’re just fine by requiring them to set off their profits from an unrelated business against their losses in the regulated industry. That goes back to a case called Brooks-Scanlon in 1920, and even that case cites many cases from the 19th century.
So there are pretty solid precedents on this particular point. The most recent case from the year 2000 involved a utility in Michigan which is a telephone company, and again, it was exactly same thing. The form of regulation there, which was called TSLRIC – Total System Long Run Increment Cost essentially required you to constantly reduce your rate base to take into account new technological improvements. And the court issued a preliminary injunction on the statute on the grounds that it unconstitutional because it did not allow you to recover your fixed costs and a profit.
So there are a lot of precedents out there. This not, like many areas of economic regulation, where a rational basis test simply applies so that nobody has any particular chance of winning. There’s a very different climate of opinion in rate making cases. The only discretion that is given to the government is in the choice of methodologies by which it computes rates. But there’s a strict obligation, not a discretionary one, that the bottom line must meet an appropriate rate of return which is the competitive rate of return.
That’s where a bank like TCF is right now, at the competitive rate of return. And if you try and knock it any lower than it currently is, you’re already in confiscation land. So the test here is very tough.
EVANS: Well, Richard, this is a wonderful introduction to the complaint that I’m sure we’re going to hear a lot more about it. Before we close today, I gave a quick introduction to you, but I’d like to actually finish our conversation by having you tell our audience a little bit more about yourself.
You’re obviously a very well know academic scholar in the law, but I guess maybe if you could spend just a minute maybe describing other experience you have in this kind of litigation where you weren’t trying to get something to be overturned by the courts, just to give a flavor to the audience of the kind of stuff you do for a living.
EPSTEIN: Well, I’m basically a jack of all trades and some people would say a master of none, but I’ve taught over the years something like 35 or 40 different subjects, and I’ve litigated on another bunch of them. So my basic specialty is working in areas where there’s no clear precedent and there’s a sort of crisis need for some kind crisis management intervention.
And the kinds of cases that I’ve worked on, I’ve worked on banking cases associated with VISA and the interchange market. I’ve worked on – privately on other areas of the Dodd-Frank bill. I dealt with regulation of the electrical power industry and submitted various papers on behalf of various trades associations. I do a large amount of large tort litigation, dealing with such things as oil spills and so forth. I am very extensively involved in land use regulation and control. I wrote a book recently on the labor statute, the Employee Free Choice Act. And my two latest books are completely unrelated to this. They’ll both be coming, probably from Harvard Press. One of them is on the rule of law and private property, and the other turns out to be a long history of American constitutional law.
In terms of my own background that is most salient to this particular stuff, I wrote a book in 1985 called Takings: Private Property and the Power of Eminent Domain which had, as one of its minor theorems that the New Deal was entirely unconstitutional if you understood the way in which the first principles operated. And that book, essentially, became the guideline for most people who had a fairly strong property protective approach on these subjects.
So I’ve been in this teaching business now for 42 years. And this is about as strong a case and as clean a set-up as I’ve ever seen in constitutional law.
EVANS: Richard, thank you very much for your time today. We really appreciate your insights, and I’m sure we’ll be hearing from you and probably the opponents of this lawsuit as well over the next few months and perhaps few years. So thanks again for your time.
TCF Bank Files Lawsuit Challenging The Durbin Amendment of the Dodd-Frank Act
The Economics of Payment Card Interchange Fees and the Limits of Regulation
Tick Tock Goes the Durbin Clock- Eight Months to go on Debit Card Regulation
Dealing with Durbin Briefing Room
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