April proved to be a difficult month for Visa and MasterCard. Both associations entered into agreements in principle to avoid a trial in a class action antitrust lawsuit brought by Wal-Mart and a number of other merchants, large and small. Under those agreements, MasterCard will pay approximately $1 billion and Visa will pay approximately $2 billion to the merchant class over the next ten years. Both associations also agreed that they will modify their "Honor All Cards" rules to eliminate the requirement that merchants accept offline MasterCard and Visa debit card transactions.
The widely publicized settlement of the Wal-Mart class action lawsuit, however, represents only the beginning of the story. On April 21, 2003, just days prior to the settlement agreements in the Wal-Mart litigation, Visa and MasterCard received word that a federal court in California had refused to dismiss another class action antitrust lawsuit pending against the associations. This second lawsuit challenges the legality of uniform interchange fees under the antitrust laws and could have a substantially greater impact on the bankcard acquiring industry than the likely effects of the settlement agreements in the Wal-Mart litigation.
The Wal-Mart Litigation Settlement
In the Wal-Mart litigation, merchants took issue with MasterCard and Visa charging the same interchange fee for credit card transactions and offline debit card transactions. According to the merchants, offline debit card transactions posed a significantly smaller risk of loss to issuers than credit card transactions because debit card transactions result in an immediate charge to a consumer bank account. The plaintiffs argued that competition would have driven down the interchange fee for debit card transactions had those fees not been propped up by Visa and MasterCard through their "Honor All Cards" rules. As evidence of their position, Plaintiffs pointed to the substantially lower charges associated with PIN online debit transactions.
Visa and MasterCard responded to these arguments by claiming that the gap between the cost of offline debit card transactions and online debit transactions reflected the additional benefits consumers and merchants received from their standardized card systems. The federal trial court, however, found that plaintiffs had uncovered sufficient evidence to dispute this claim and that the issue would have to be resolved by a jury. The court also concluded that sufficient evidence existed to allow a jury to decide whether Visa and MasterCard were engaged in a conspiracy to monopolize the debit card market, that other forms of payment (i.e., debit cards, cash, and checks) do not compete with credit cards, and that Visa has monopoly power in the credit card services market. The court even went so far as to suggest that credit cards may not compete with charge cards but did not make its decision contingent on this finding.
Given these rulings and the prospect of a damage award reaching the hundreds of billions of dollars, Visa and MasterCard had little choice but to reach a settlement. The settlement requires Visa and MasterCard to give merchants the choice of whether to accept offline debit transactions. Additionally, Visa and MasterCard have agreed to unilaterally lower their interchange rates by at least one-third and to encode their debit cards with magnetic strips which will notify merchants at the point-of-sale that the card is a debit card. There appears to be near unanimous agreement among commentators and industry analysts that these settlement terms will lead to declines in the interchange fees for debit transactions beyond those agreed to in the settlement. Others also predict that issuing banks may reintroduce or increase consumer charges and that credit cards may become balkanized under numerous different trademarks.
What is clear is that acquiring firms should anticipate a reduction in revenue from merchant discount fees. Visa and MasterCard have not announced how they intend to prevent acquiring firms from pocketing reductions in the interchange fee for offline debit transactions and may face significant legal hurdles if they attempt to pass on those cost savings directly to merchants over the objections of acquiring firms. However, even if Visa and MasterCard take no action to pass on the reduction in interchange fees to merchants, competition among acquiring firms will ultimately lead to the renegotiation of offline debit transactions. These negotiations likely will not stop with merely passing on the savings produced by a reduction in interchange fees. Rather, acquiring firms will likely see merchants demand a similar reduction in the balance of the merchant discount fee. Merchants will argue that acquiring firms will earn
higher margins on lower cost offline debit transactions absent such a reduction.
Over time the decline in discount fees for offline debit transactions also will likely lead to declines in the discount fees for credit card transactions. In an internal memorandum prepared in 1990 and released in the Wal-Mart litigation, Visa termed expansion into the online debit market a "business necessity" because development of a mature online debit network could cost Visa members $813 million due to a "downward pressure" on credit card interchange. (Memorandum from Ron Hodges, Visa Debit Market Development, dated November 29, 1990). Reductions in the credit card interchange fee also will likely lead to reductions in the balance of the merchant discount fee which is retained by acquiring firms as their profit for each transaction.
An argument can be made that reductions in interchange fees should not lead to reductions in the balance of a discount fee because the transaction costs for acquiring firms are the same regardless of the interchange fee. Although it has equitable appeal, acquiring firms must be prepared to modify their business plans and cost structures to meet the new competition posed by online debit networks and debit cards generally. On the other hand, acquiring firms should recognize that the changing structure of the market also provides significant opportunity to expand merchant portfolios for those firms which offer superior service at low cost. The resulting increased volume should more than offset lower per transaction revenue.
The California Litigation
Visa and MasterCard face a different set of problems in California. In that case, merchants have brought a class action alleging that the member-banks of Visa and MasterCard have agreed to uniform interchange fees for different classes of merchants and that the absence of negotiated interchange fees has resulted in inflated merchant discount rates.
Visa and MasterCard faced a similar lawsuit nearly twenty years ago in Georgia. In that case, National Bancard Corporation ("Nabanco") complained that it could not compete effectively with member banks in the acquisition of merchants. Nabanco argued that member banks could offer lower merchant discount rates because they did not pay interchange fees for "on-us" transactions (i.e., where the card issuing bank and acquiring bank were the same). A federal appeals court affirmed a verdict in favor of Visa and MasterCard, concluding that the interchange fee was necessary to establish a universal payment card system.
Visa and MasterCard moved to dismiss the California litigation relying on the Nabanco decision. The trial court declined, distinguishing its case from Nabanco on the grounds that Nabanco (unlike the plaintiffs before it) had not alleged the complete absence of negotiated interchange fees. The trial court, however, provided Visa and MasterCard with some relief. It concluded, among other things, that the absence of negotiated interchange fees was not per se unlawful and that Visa and MasterCard were entitled to an opportunity to demonstrate their claim that uniform interchange rates were procompetitive and essential to their services.
The California litigation is obviously a long way from over and no one can predict the ultimate outcome or its impact on the industry. Nonetheless, the plaintiffs have overcome an important hurdle in their case and the lawsuit raises the possibility that the current payment card system could be completely overhauled. In a credit card payment system without uniform interchange fees, acquiring institutions would negotiate interchange fees directly with issuers, leading to increased information costs for all parties and significant price fluctuations in the marketplace. On the other hand, like the Wal-Mart litigation settlement, a new market structure would present significant new opportunities for acquiring institutions which have planned ahead.
In the current legal climate, acquiring institutions would be well served to monitor closely the lawsuits pending against the associations. Further, although merchants generally have not attacked acquiring firms in their current round of lawsuits, the acquiring side of the bankcard industry could be the next target for merchant plaintiffs. As such, acquiring firms should regularly consult their antitrust counsel to identify and mitigate their antitrust exposure. By undertaking these preventive steps, acquiring firms will put themselves in the best position possible to respond to the always changing competitive conditions of the marketplace.