House of Cards
Illustrations by Michael Morgenstern
Note: This month’s CLE, “Challenging the Rules for the Credit Industry,” is Wednesday, March 17.
When it comes to credit cards, we have a tendency to compare things like promotional interest rates, frequent flier points and cash back offers while skimming over the fine print on the back of the contract that generally reads something like this: “We reserve the right to change the APRs, fees and other terms of the account at any time.”
The risks of ignorance about the fine print might not have been so damaging during flush times, but since the 2008 financial meltdown, millions of Americans have been coming to grips with the ramifications of the terms in their cardholder agreements. Already staggering under the onslaught of a recession, cardholders have opened their mail only to learn that financial institutions hiked interest rates, pumped up minimum payments, applied a smorgasbord of fees, cut credit lines or closed accounts altogether—in some cases even for people who never missed a payment.
During the second half of 2009, banks and other credit card issuers were in a race against time to lock cardholders in to still higher interest rates and impose other fees before restrictions kicked in under the Credit Card Accountability, Responsibility and Disclosure Act—dubbed the CARD Act—that Congress passed last spring.
President Barack Obama signed the CARD Act into law on May 22, 2009, and most of its provisions were scheduled to go into effect on Feb. 22. A White House fact sheet said the act was “marking a turning point for American consumers and ending the days of unfair rate hikes and hidden fees.”
The CARD Act outlaws double-cycle billing, which can result in higher finance charges for those who carry a credit card balance from one month to the next; universal default provisions, under which a late payment to any creditor can trigger interest rate increases; and interest rate hikes on existing balances in accounts that have fixed rates and are not more than 60 days late in payments. The act also requires banks to notify customers 45 days before implementing changes in interest rates or any other “significant” terms in the cardholder agreement.
Other provisions mandate more disclosure about costs and cardholder rights, require banks to mail out statements at least 21 days before payment due dates (compared to the current 14 days), impose restrictions on over-the-limit fees, and require applicants under age 21 to have a co-signer unless they can prove they are able to make payments independently. The act calls for late charges and other fees generally to be “reasonable.” (Some of these practices already had been prohibited under rules issued in December 2008 by the Federal Reserve Board in conjunction with the Office of Thrift Supervision and the National Credit Union Administration.)
But during the interregnum, the credit card industry did what it could to get a jump on the new restrictions. Banks replaced fixed-interest rates on many of their cards with variable rates, pegged those variable rates to the maximum prime rate over a 90-day period rather than a single monthly billing cycle, lowered balances to which maximum late fees would apply, and even started charging inactivity fees for cards getting minimal use. In November, half the people responding to a survey by the polling service Rasmussen Reports said their credit interest rates had gone up within the past six months.
(The House of Representatives hurriedly passed a bill in November that would have frozen interest rates until the new law went into effect, but a similar bill died in the Senate.)
The banking industry lobbied fiercely against the CARD Act, warning that it would trigger higher interest rates, even for creditworthy customers.
“At the precise time when credit needs to be flowing to American consumers, Congress has passed a bill that will clearly have the impact of restricting credit, especially to those with less than perfect credit,” says Richard P. Eckman, a partner in the Wilmington, Del., office of Pepper Hamilton who chairs the firm’s financial services practice group and represents companies in that field. “A year or two from now, Congress will be asking why consumer credit is so expensive and why there isn’t more of it.”
But advocates of the law say it was long overdue. They contend that, after at least 30 years of federal court decisions and rule-making that always seemed to favor the financial services industry, it was time for Congress to win one for the consumer. And even then, the law hardly represents a total victory for consumers.
“In terms of what the act actually does, it is rather limited, frankly,” says Adam J. Levitin, a professor at the Georgetown University Law Center in Washington, D.C., who also is special counsel on mortgage affairs to the Congressional Oversight Panel. “It doesn’t impose a usury cap and it doesn’t require anyone to be given credit. What it does is target a few very abusive billing practices.”
The real significance of the act is political, Levitin asserts. “The last time Congress did any kind of major regulation of the industry was in 1968,” he says. “The fact that they lost one is kind of shocking and puts a little dent in their aura of invincibility.”
There may be more changes to come in how the government regulates the credit card industry.
In December, the House passed a bill that would create a Consumer Financial Protection Agency with consolidated oversight authority for companies that issue credit cards and other financial products to consumers. Among its duties, the agency would issue rules interpreting and enforcing the CARD Act. A Senate version of the bill still was stalled as Congress returned to work in January after its holiday break.
But even if Congress does not enact a new round of legislation, “the landscape for credit cards is going to shift,” says Ben Woolsey, director of marketing and consumer research at CreditCards.com, an online service that reports on developments in the credit card market and provides information to consumers.
THE DEATH OF USURY
Illustration by Michael Morgenstern
Credit cards are so firmly entrenched in modern life that it’s easy to forget what a recent innovation they are.
Merchants for a long time offered customers open-ended credit lines, but it wasn’t until the 1960s that financial institutions came up with the idea of a general purpose credit card with a revolving balance that could be used at a number of different outlets to purchase a variety of goods and services.
These new credit cards were fundamentally very different from the credit arrangements that individual stores offered to customers. While store cards were meant to facilitate the sale of merchandise, “for the banks it was about lending money,” says James L. Brown, director of the Center for Consumer Affairs at the University of Wisconsin-Milwaukee. Revenues came from transaction fees charged to merchants, fees charged to cardholders and from interest on outstanding balances. The ideal customer was the one who used the card regularly and paid part of the card balance every month, but let some of the balance carry over, producing interest income for the bank.
Still, the profitability of credit cards was limited by usury laws that in most states put caps on the interest rates a lender was allowed to charge.
Then came Marquette.
The U.S. Supreme Court decided Marquette National Bank v. First of Omaha Service Corp. in 1978. The case arose when a Minnesota bank sued to force the credit card subsidiary of a Nebraska competitor to abide by Minnesota’s usury laws when operating in Minnesota. The Supreme Court based its decision on a provision in the National Bank Act of 1864 that permitted a national bank to charge interest “at the rate allowed by the laws of the state, territory or district where the bank is located,” even if that rate was prohibited in another state where the bank was doing business. So, the court concluded, the bank could charge interest rates permitted by its home state, Nebraska, in any other state where it did business.
National banks chartered by the federal government responded to Marquette by setting up subsidiaries in bank-friendly states willing to scale back or repeal their usury laws—South Dakota, Delaware and Utah among them—that gave the banks free rein to charge whatever interest rates they wanted anywhere in the country they did business.
But Marquette also resulted in state and locally chartered banks being squeezed out of the credit card market, at least until Congress added provisions to the Depository Institutions Deregulation and Monetary Control Act of 1980 that allowed them to charge the same interest rates in their states that were being charged by national banks doing business there. State legislatures followed that lead by passing “wild-card,” or “parity,” statutes.
“Essentially, these statutes said that if there was an out-of-state bank operating in a state’s jurisdiction, the locally chartered banks could do whatever the out-of-state bank did,” says Christopher Peterson, a professor and associate dean for academic affairs at S.J. Quinney College of Law at the University of Utah in Salt Lake City. “This meant that no interest rate cap applied to any bank anywhere in the United States.”
In effect, Marquette had largely done away with usury, one of the oldest legal principles in human history. As far back as the 18th century B.C., the Code of Hammurabi prohibited usury by capping interest rates for grain at 331⁄3 percent and 20 percent for silver. “Before we had invented money, we had interest caps on loans,” Peterson notes.
Marquette also made it possible for financial institutions to fine-tune their credit card marketing strategies. With the ceiling on interest rates essentially blown away, card companies could tailor rates to various segments of customers. It even made sense to give credit cards to riskier customers—albeit at higher interest rates.
In 1996, a second Supreme Court decision, Smiley v. Citibank, expanded the reach of Marquette by ruling that the word interest as referred to in section 85 of the 1864 National Bank Act included fees—and thus these fees were not subject to state regulation. As a result, says Brown, the fees charged to cardholders were limited “only by the imagination of the people in the credit card business.”
A cornucopia of fees descended on cardholders, and in 2009 fees accounted for an estimated 47 percent of revenues that came into financial institutions from their credit card operations, according to R.K. Hammer, a market research group.
DEBT EXPLOSION
Illustration by Michael Morgenstern
Credit card debt in the U.S. has exploded in the decades since Marquette, with revolving credit growing from $48 billion in 1978 to $131 billion in 1985 and reaching a high of $992 billion at the end of 2008, according to the Federal Reserve. In the survey conducted by Rasmussen Reports in November, 45 percent of respondents said they “sometimes” carry a balance on their cards. CreditCards.com estimates that balances average about $10,000 in households that run up balances.
Servicing this debt takes a toll on both families and the nation’s economy, according to a report, titled Vicious Cycle (PDF), which was issued last May by the congressional Joint Economic Committee.
“A growing share of consumers’ disposable income, which largely determines consumer spending,” is being diverted to service credit card debt rather than to help economic recovery,” states the report. “As of March 2009, U.S. revolving consumer debt (almost entirely credit card debt) was about $950 billion. In the fourth quarter of 2008, 13.9 percent of consumer disposable income went to service this debt.”
The report maintains that credit card companies have followed the same kinds of policies that brought down the real estate market. “As with subprime lenders, credit card issuers have been seeking to maximize their profits by lending to those who are economically vulnerable and then spreading their risk by securitizing the debt,” the report states. “In addition, credit card companies have spread risk to other credit cardholders by raising interest rates to all borrowers, effectively charging creditworthy borrowers to make up for growing defaults.”
SHARPENING THEIR CLAUSES
When consumer groups squawked about these policies, banks invoked the “unilateral change of terms” clauses embedded in most cardholder agreements that reserve for the issuer the right to change the terms at any time and for any reason.
Banks need the flexibility to adjust the terms of the contract, says Nessa Feddis, a senior counsel to the government relations division of the American Bankers Association. “The customer already has a lot of flexibility,” Feddis says. “He or she can choose when to borrow, when to pay it off and when to close the account. An open-end credit is a long-term relationship, and the banks need to be able to adjust to the market.”
But these clauses are ridiculous in the view of Lauren K. Saunders, managing attorney of the Washington, D.C., office of the National Consumer Law Center.
“It makes the whole agreement illusory,” Saunders says. “Isn’t that what we’re taught in contract law? If one side doesn’t agree to the terms of the contract, it’s an illusory contract. Another basic contract law notion is the idea of a liquidated damages provision. A penalty provision can be enforced only if it fairly reflects the reasonable cost of the violation to the other party.”
But the high interest rates, late fees and overdraft fees that banks apply to cardholders go far beyond the actual burden on the banks of delinquent payments, says Saunders. They are, she adds, the sorts of unfair and deceptive practices that would be subject to state regulation—if that power had not been pre-empted by the federal government.
The 1864 Bank Act designated the Office of the Comptroller of the Currency to oversee and regulate national banks. Since most credit cards are issued by national banks, the OCC has become the primary regulator of credit cards as well.
But many consumer advocates are not happy with the way the comptroller’s office has carried out this responsibility. “The OCC doesn’t want to enforce any kind of consumer protection law, and they don’t want anyone else enforcing it, either,” says Georgetown’s Levitin. He contends that because the OCC is funded partly through fees from the banks it regulates, it is reluctant to take significant enforcement actions against them. And the office has repeatedly intervened to keep states from regulating these banks too.
The Supreme Court’s 1996 ruling in Smiley, which largely pre-empted states from regulating fees and penalties im-posed by banks against credit card customers, relied heavily on the OCC’s interpretation of section 85 of the National Bank Act. In 2002, the office filed an amicus brief in American Bankers Association v. Lockyer that supported the association’s efforts to block a California law requiring banks to disclose to customers the costs of making only minimum payments on their credit cards. A federal district court issued a permanent injunction against the law’s enforcement, holding that any state law that impairs the efficiency of national banks is unenforceable.
And in 2007, the Supreme Court decided in Watters v. Wachovia Bank (PDF) that rules adopted by the OCC in 2004, which bar states from regulating national banks and their subsidiaries on a series of operational matters, should also be extended to state-chartered subsidiaries of national banks.
“It’s gotten to the point that there’s almost nothing that a credit card issuer does that [the issuer] will not feel comfortable arguing that it is pre-emptive of state law,” says Kathleen Keest, who is senior policy counsel for the Center for Responsible Lending in Durham, N.C. “And this is all compounded by the fact that the OCC doesn’t really want to slap anyone’s hands.”
The OCC’s regulatory approach was not a matter of coincidence, but rather part of a general push by the second Bush administration toward deregulation, argues former Maine Attorney General James Tierney, who now is director of the National State Attorneys General Program at Columbia Law School in New York City. “These things don’t just happen,” says Tierney. “It was a deliberate policy to essen-tially become unregulated.”
In 2007, when profits for the credit card industry reached an all-time high of $40 billion, deregulation seemed to be working OK, at least for the financial institutions.
But a scant year later, as the subprime mortgage collapse threatened to bring down the entire economy, Congress and even some federal regulators began to have second thoughts.
ANGER ONLINE
Cardholders, too, were getting restive. When the Federal Reserve posted some proposed new rules relating to credit cards on its website, a record 60,000 comments were posted. Many were from angry cardholders complaining about unfair treatment by credit card issuers. One message opened this way: “Hello! I have been ripped off by the credit card company!”
And when Chase Bank announced that customers who had taken advantage of an offer to transfer balances from other cards as a way of consolidating debts at low interest rates would now have to double their minimum required payments and pay additional fees, a number of cardholders sued. Some 25 separate cardholder complaints were consolidated into a class action suit that is now moving into discovery, says Robert S. Green, a partner at Green Welling in San Francisco, which represents a number of cardholders.
“One client of mine saw her minimum payment raised from $400 to $1,000 a month,” Green says. “That makes a difference in your household income.”
Ordinarily, Chase would have been shielded from lawsuits under the “change terms” clause in its agreement with cardholders. But, Green says, the bank’s initial offer-ing promised that the terms of the balance transfer would last for the “life” of the loan. “If they say it’s guaranteed for the life of the loan, it’s hard to change it,” says Green.
Opponents of federal pre-emption of all state regulatory authority were cheered by the Supreme Court’s decision on June 29, 2009. By a 5-4 vote, the court declined to give the OCC near complete pre-emption of any state authority over national banks and held that a state may seek to enforce its fair lending laws against those banks.
KEEPING AN EYE ON CONGRESS
Despite some movement in the courts and regulatory agencies, however, most eyes are watching Capitol Hill to see what Congress might do next to bolster regulation of financial institutions that issue credit cards.
Some members of Congress have attempted to resurrect federal usury laws relating to credit cards. But in May, the Senate voted down a bill proposed by Sen. Bernard Sanders, I-Vt., to cap interest rates at 15 percent, and a proposal by Sen. Richard J. Durbin, D-Ill., to cap interest rates at 36 percent is languishing in committee. A House bill that would cap rates at 16 percent also has been referred to committee.
Levitin, for one, is skeptical of interest rate caps. “You don’t know if you’re going to set the cap at the right level,” he says. Instead, Levitin favors “flipping the current model upside down” by making lenders vet new fees and practices with a federal regulatory agency. His idea is that this agency, instead of telling banks, “You can do anything you want except A, B and C,” would instead say, “You can only do X, Y and Z—and if you want to do E and F, you have to ask for permission.”
On Dec. 11, the House of Representatives passed the Wall Street Reform and Consumer Protection Act (H.R. 4173) by a vote of 223-202. A key provision in the bill would create a Consumer Financial Protection Agency. The agency would be empowered to issue rules and enforce consumer protection laws, including the CARD Act. Those responsibilities currently are scattered among a number of different agencies.
Consumer advocates generally support the bill even as they point out some flaws.
The measure does not represent a sea change in federal regulation, Levitin says. In his view, the initial effect would be to consolidate regulatory responsibility in a single agency. The legislation is fairly open-ended, however, about operations and specific powers of the agency. The agency would not be empowered to ban financial services products outright, but its broad rule-making powers would include the ability to impose restrictions on products.
The bill carves out an enforcement role for the states, in response to concerns that they would be squeezed out of the process by federal pre-emption. But federal regulators, including the OCC, would still be able to pre-empt state laws on a case-by-case basis if they determine the laws would interfere with a financial institution’s ability to conduct business.
And Saunders at the National Consumer Law Center decries a provision that specifically strips consumers of a private right of action to enforce rules issued by the new agency. “So Congress has specifically said that consumers can’t enforce these rules,” she says. “What good are they if they are not enforceable?”
But while H.R. 4173 has passed, a companion bill, the Restoring American Financial Stability Act, faces a tough fight in the Senate. The U.S. Chamber of Commerce and the American Bankers Association already have lined up against it. And the bill’s future became more uncertain after the special election Jan. 19 of Republican Scott Brown to fill out the Senate term of the late Edward M. Kennedy. Brown’s election took away the filibuster-proof super-majority that the Democrats held before Kennedy died in August.
(The American Bar Association, in correspondence to members of Congress, has expressed concerns about any provisions in the House or Senate measures that would expand federal power to regulate lawyers engaged in the practice of law. The ABA would not object, however, to consolidating existing federal regulatory power in a single agency.)
The key will be to strike a new balance between the interests of financial institutions and consumers, but few experts, if any, think that will be easy.
In a more closely regulated environment, card issuers will try to “figure out a way to make money off of all customers, not just the ones who pay interest,” says Woolsey of CreditCards.com. “Consumers have been spoiled over time to think that a credit card is something that could and should be free, and ought to be free,” he says. “The industry can’t afford to give it away.”
But Brown at the University of Wisconsin-Milwaukee says the days when banks can set whatever rules they want are over as well. “I’m old enough to ascribe to the pendulum idea,” he says. “When we’ve swung to the point that a credit card issuer can change any and all terms of an agreement, I think the pendulum has swung too far. And it will swing back. We’ll see if it swings too far the other way.”
ABA Connection offers three easy ways to get low cost/no cost CLE credit
Live Call-in Teleconferences
This month’s CLE, “Challenging the Rules for the Credit Industry,” is from 1-2 p.m. ET on Wednesday, March 17.
To register, call 1-800-285-2221 between 8:30 a.m. and 6:30 p.m. (ET) weekdays starting Feb. 17, or go to abanet.org/cle/connection.html. Multiple participants may listen via speakerphone, but each individual who wants CLE credit must register separately.
Co-Sponsors: Section of Administrative Law and Regulatory Practice; General Practice, SOlo and Small Firm Division
Online Access—At No Cost
Online Streaming Audio, available starting March 22. To register, go to abanet.org/cle. Past programs are available here.
CLE on Podcast
Podcast downloads are available starting March 22.
COMING IN APRIL—Litigation v. Arbitration in International Business Diputes
Kristin Choo is a freelance writer in New York City.
