Financial Services Law

Network Rules Occupy Second Circuit, U.S. Supreme Court

Issues surrounding network rules made headlines recently, with the Second Circuit Court of Appeals rejecting a $7.25 billion deal between Visa and MasterCard and approximately 12 million merchants claiming the networks worked together to fix credit and debit interchange fees, as well as the U.S. Supreme Court agreeing to decide whether the companies and their partner banks violated federal antitrust law by conspiring to inflate the prices of ATM fees.

What happened

In 2013, a New York federal court judge signed off on the deal in consolidated actions filed by merchants against Visa, MasterCard, and various issuing and acquiring banks. The estimated 12 million plaintiffs alleged the network rules established by the defendants (such as the default interchange fee and honor-all-cards rule) allowed issuing banks to impose an artificially inflated interchange fee that merchants had little choice but to accept.

Originally filed in 2006, the action spanned years of litigation, including 400 depositions, 17 expert reports, 32 days of expert deposition testimony, and the production of over 80 million pages of documents. After repeated mediation sessions and settlement negotiations, the parties reached a deal in 2012, which was finally approved by the district court on December 13, 2013.

The settlement agreement divided the plaintiffs into two classes: one under Federal Rule of Civil Procedure 23(b)(3) covering merchants that accepted Visa and/or MasterCard from January 1, 2004 to November 28, 2012, and a second class under Rule 23(b)(2) for merchants that accepted or will accept Visa and/or MasterCard from November 28, 2012 and onward.

Members of the (b)(3) class would be eligible for a piece of the $7.25 billion in monetary relief provided by the defendants, while the (b)(2) class would receive injunctive relief in the form of changes to the network rules. Given the differences between the rules, members of the first class who received money damages could opt out, but those in the second class could not.

Despite objections to the deal, the district court approved the settlement as fair and reasonable. Numerous objectors and opt-out plaintiffs appealed and the Second Circuit vacated the district court's certification of the class action and reversed the approval of the settlement.

Class members of the Rule 23(b)(2) class were inadequately represented in violation of Rule 23(a)(4) and the Due Process Clause, the unanimous panel held, because the same attorneys provided representation to both classes of plaintiffs despite the conflict of interest between the two.

"The conflict is clear between merchants of the (b)(3) class, which are pursuing solely monetary relief, and merchants in the (b)(2) class, defined as those seeking only injunctive relief," the court explained. "The former would want to maximize cash compensation for past harm, and the latter would want to maximize restraints on network rules to prevent harm in the future." Such divergent interests, the court held, require separate counsel when it impacts the "essential allocation decisions" of plaintiffs' compensation and defendants' liability.

Class counsel and class representatives were in the position to trade diminution of (b)(2) relief for an increase of (b)(3) relief, the panel said. "Unitary representation of separate classes that claim distinct, competing, and conflicting relief creates unacceptable incentives for counsel to trade benefits to one class for benefits to the other in order somehow to reach a settlement," the court wrote. "Divided loyalties are rarely divided down the middle."

Class counsel "stood to gain enormously if the deal got done," the Second Circuit said, with $544.8 million in fees on the line, calculated based on the amount of monetary compensation to the (b)(3) class but without regard to the value of the injunctive relief to the (b)(2) class. While the court expressly did not impugn the motives or acts of class counsel, it said they were "charged with an inequitable task."

Because the class plaintiffs were inadequately represented, the settlement and release resulting from the representation were nullities, the panel declared, an outcome confirmed by the substance of the deal itself. "[T]he bargain that was struck between relief and release on behalf of absent class members is so unreasonable that it evidences inadequate representation."

For example, merchants in the (b)(2) class that accept American Express (whose network rules prohibit surcharging and include a most-favored-nation clause) or operate in states that prohibit surcharging—California, Florida, New York, and Texas—"gain no appreciable benefit" from the settlement, while merchants that begin business after the termination of the deal on July 20, 2021 gain no benefit at all. Yet, "class counsel forced these merchants to release virtually any claims they would ever have against the defendants."

"This is a matter of class counsel trading the claims of many merchants for relief they cannot use: they actually received nothing," the panel wrote, and remain bound by "an exceptionally broad release."

Merchants in the (b)(2) class that cannot surcharge "suffer an unreasonable tradeoff between relief and release that demonstrates their representation did not comply with due process," the Second Circuit said. The court recognized that broad class action settlements are common, particularly when a defendant's ability to limit future liability is an important factor in the willingness to settle. "But the benefits of litigation peace do not outweigh class members' due process right to adequate representation," the court concluded.

A concurring opinion went one step further with regard to the release, calling the deal "not a settlement [but] a confiscation," with one class of plaintiffs receiving money and in return giving up the future rights of others.

Network rules were also at the heart of a new case added to the U.S. Supreme Court's docket for the coming term. The eight Justices agreed to weigh in on whether Visa, MasterCard, and affiliated banks conspired to inflate the prices of ATM access fees in violation of federal antitrust law.

The trio of consolidated cases (two filed by consumers and a third filed by independent ATM operators) alleged that the defendants adopted rules blocking ATM operators from charging less when transactions were processed by competing networks. Visa and MasterCard profited from the fees, as did the banks, the plaintiffs argued, because they owned equity in the companies before they went public.

The defendants countered that the plaintiffs lacked standing, the rules were created prior to the companies going public, and that membership in a business association alone (in this case, being part of the Visa and MasterCard networks) is not sufficient to demonstrate a conspiracy under antitrust law.

A federal district court agreed, tossing the suit in 2013. The judge found the injury alleged by the plaintiffs too speculative and said they failed to demonstrate that membership in the association amounted to collusion under federal antitrust law.

But last August the D.C. Circuit Court of Appeals reversed, reinstating the cases. The plaintiffs "alleged that the member banks used the bankcard associations to adopt and enforce a supracompetitive pricing regime for ATM access fees," the panel said. "That is enough to satisfy the plausibility standard."

Noting a split between the D.C. Circuit and the Third, Fourth, and Ninth Circuits, the defendants filed a writ of certiorari. "If firms that participate in business associations must incur the burden of defending costly antitrust litigation and discovery on mere allegations like these, the antitrust laws will become a substantial deterrent to the use of this precompetitive form of business organization," the petitioners argued.

Granting the writ, the Justices agreed to answer the question of "[w]hether allegations that members of a business association agreed to adhere to the association's rules and possess governance rights in the association, without more, are sufficient to plead the element of conspiracy in violation of Section 1 of the Sherman Act."

Oral argument will be heard next term.

To read the opinion in In re Payment Card Interchange Fee and Merchant Discount Antitrust Litigation, click here. Link: I sent PDF

To read the petition for writ of certiorari in Visa v. Stoumbos, click here.

Why it matters

The $7.25 billion deal in the merchant case was the largest-ever cash settlement in an antitrust class action, and the Second Circuit opinion sends the parties back to the drawing board for a new agreement. The panel did note that (b)(3) and (b)(2) classes can be combined in a single case (and may not always require separate representation), but made it clear that structural defects in the class action created a fundamental conflict between the classes and "sapped class counsel of the incentive to zealously represent the latter."

The legal issues for Visa and MasterCard will continue not just on remand but in the separate antitrust action set to be heard by the Justices of the U.S. Supreme Court next term.

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State Money Transmitter Laws Update: Then There Was One

South Carolina became the 49th state to enact a money transmitter licensing statute, leaving Montana as the lone jurisdiction in the United States not to require money transmitters to be licensed to offer services to residents of its state. (Massachusetts still requires licensing only for international transmissions.) The new South Carolina statute, which will become effective in June 2017, is very similar to the statutes already in place in a number of states. Although virtual currencies have not been expressly addressed in the statute, the term "monetary value" has been defined broadly enough to permit the regulator to require those involved in the transmission of virtual currencies to be licensed. This definition has been the basis for other states to determine that virtual currencies are covered by the statute. No exemption is provided for payment processors other than those processing transactions between banks or other entities exempt from the licensing requirements.

North Carolina Addresses Payment Processors and Virtual Currency

Within days of the enactment of the new South Carolina law, the North Carolina governor signed into law an amendment making a number of significant modifications to the state's Money Transmitters Act. Although much of the press coverage has focused on the legislature's decision to incorporate virtual currencies expressly into the statute, we believe the significance of this action has been blown out of proportion.

In fact, while some have touted the decision to expressly address virtual currencies in the Act as a positive effort to eliminate uncertainty around whether virtual currency businesses require licenses, the amendments will potentially require more companies to get licenses and make it harder to obtain them.

What happened

The amendments to the North Carolina Money Transmitters Act updated a number of provisions of the Act. Possibly the most significant of the changes is a clear exemption from the licensing requirements for a number of different payment processors including those processing payroll and payments as the bona fide agents of payees. In addition, the scope of the statute has been limited to requiring licensing for transmissions "primarily for personal, family or household purposes" thereby eliminating the need for licenses to conduct business-to-business transactions.

The amended law also now reflects the same position as many other states: no person can "solicit[] or advertise[] money transmission services from a Website that North Carolina citizens may access in order to enter into those transactions by electronic means" without a money transmitter license.

Like the new South Carolina law, the term "monetary value" has been defined to be a "medium of exchange, whether or not redeemable in money." Although a number of states have already determined that such a definition is broad enough to require virtual currency businesses to obtain licenses, the North Carolina legislature went a step further to expressly reference "virtual currency" several places in the statute, including in the definition of "money transmission" which now includes "engaging in the business" of "maintaining control of virtual currency on behalf of others."

The newly amended law is considered by many to be more business friendly than the New York Department of Financial Services Virtual Currency Regulation. However, absent action by the North Carolina regulator, the bar for new entrants is significantly higher as there is no "on-ramp" like the one provided by the New York DFS. The minimum net worth requirement has been increased from $100,000 to $250,000 for all applicants—including virtual currency businesses. The baseline for the surety bond requirement remains at $150,000 as long as the transactional level is below $1 million. The bonding requirement increases incrementally to $250,000 when transactions exceed $50 million.

The Commissioner also has been given "discretion to require applicants to obtain additional insurance coverage to address related cybersecurity risks inherent in the applicant's business model as it relates to virtual currency transmission and to the extent such risks are not within the scope of the required surety bond."

The statute addresses several issues that have been somewhat problematic for other states adapting their licensing requirements to virtual currency businesses. One key area is the permissible investment requirement which now allows virtual currencies to be counted now as permissible investments but only limitedly. The term "virtual currency" has also been defined as "[a] digital representation of value that can be digitally traded and functions as a medium of exchange, a unit of account, or a store of value … but does not have legal tender status as recognized by the United States Government."

The Act is retroactively effective to October 1, 2015.

To read the North Carolina Money Transmitters Act, click here.

Why it matters

Regulation continues to tighten not only around virtual currency businesses but all money services businesses. South Carolina, one of the last holdouts in regulating the industry, will add a little more to this increasing regulatory burden when its statute becomes effective in 2017. And, despite praises for being a more business-friendly effort to regulate virtual currency businesses, the amended North Carolina statute raises the regulatory bar immediately not just for such businesses but all money services businesses. This tightening will continue as the Uniform Law Commission completes the drafting of a model uniform code for virtual currencies and other states—including California, Pennsylvania, Tennessee, and Wyoming—consider how to regulate virtual currency businesses.

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A Different Approach to Regulatory Relief

Community banks indeed need regulatory relief. Regulators generally agree, but their hands are tied as a decadelong enforcement environment drags on. Meanwhile, financial technology (fintech) firms assert they should not be subject to banking-type regulatory supervision as long as they are not banks or until they partner with banks. Both groups need to be more realistic about what regulatory relief is actually possible.

Sorry for this spoiler alert, but neither banks nor fintech firms will be relieved of the core priorities and concerns of financial industry regulators. There will be no relief from the obligation to comply with those laws and regulations deemed critical to preserving the safety and soundness of the U.S. banking and financial system, protecting it from abuse and providing consumer protection. These include fair lending and abuses of customers in products and practices, stress tests, enterprise risk management, BSA/AML and privacy and cybersecurity protection. The long-coming new "fifth pillar" rule from the Financial Crimes Enforcement Network reinforcing what banks have already been expected to do—to identify and monitor the beneficial ownership of their customers—is fresh evidence that broad relief from compliance is not at hand for banks or fintech. And as banks venture into new niches and assume/undertake new risks (such as marketplace lending, auto finance or investment advisory services), they will be closely scrutinized until compliance becomes standardized for each new trend.

Some relief is on the horizon. Heavily capitalized community banks will get relief from the provisions of Dodd-Frank that never applied to many anyway (Volcker trading and derivative activities) and will get some reporting, privacy notice and examination frequency relief. Meanwhile, compliance should receive more emphasis than license avoidance within the diverse collection of innovators and disruptors that is fintech. Another spoiler alert! Regulators and most politicians will still demand competency, transparency and decency at a minimum from all sectors of the expanding financial services industry.

Is there another approach that may accomplish the goals of regulators, politicians, banks and fintech alike? What if banks could operate with assurance that they were within the boundaries of publicly available compliance standards and could rely on vendors and consultants that had been publicly vetted by the regulators? What if mistakes and unintentional oversights could become agreed corrective actions instead of being disproportionately elevated to enforcement actions with public recrimination of banks and their boards of directors? A similar environment would be advantageous to fintech as well.

Might we build upon the evolving trend towards information sharing in the Cybersecurity Information Sharing Act and the open source concept from blockchain and make core compliance requirements a more "open architecture" and shared-expertise foundation for all firms in the financial services industry? Just as there is no crying in baseball, there should be no competition in compliance. Bankers, regulators, vendors and fintech innovators should be able to openly agree on what compliance is necessary at a minimum to meet the risks to their mutual industries and to customers and consumers, work together on implementation and move on. Acceptable approaches, minimum systems standards and resources could be shared and updated online and through webcasts and interactive blogs. This "Regtech" approach to compliance should include more real-time disclosure and access to most cybersecurity intelligence and the information in SARs filed with FinCEN that could be used by others to prevent more money laundering.

Bank trade association networks, online and on-call compliance firms, bank and technology partnerships and cooperative industry compliance efforts such as the Financial Services Information Sharing and Analysis Center (FS-ISAC) and new guidance from the Bank of International Settlements and regulatory agencies encouraging intraindustry cooperation are moves towards an open compliance culture. However, the regulators are the missing piece to the compliance puzzle. Critical to this new approach would be expanding regulators' roles from supervisors to collegial participants in establishing compliance approaches in a format accessible to all. This would relieve banks from the uncertainty of not knowing whether their compliance efforts are sufficient until examination exit meetings. Compliance need not be pursued by banks in silos but should be based on consultation and cooperation among all interested parties, including the regulators.

Here are some benefits this new approach could spawn for banking:

  • Bank board meetings could again concentrate on banking and growth instead of compliance and enforcement actions.
  • Pressure on compliance officers to perform "or else" would be relaxed and the costs of establishing a compliance system could be reduced by making more expertise openly available.
  • New compliance developments and new issues could be openly communicated to all, much the way no-action and advisory and interpretive letters have long served as guides for compliance and permissible activities and practices.
  • The role and image of examiners could change from "gotcha" finders to validators and advisers on compliance improvements where shortcomings are identified.
  • We could hopefully do away with the practice of placing all banks in the enforcement action "penalty box" unable to engage in M&A or any other expansionary activities for 2-3 examination cycles upon the finding of noncompliance in examinations.

Of course, good governance and a top-down culture of compliance would still be expected from banks and, yes, fintech firms as well. However, banks could focus on banking and fintech on innovations if there were a public open-forum and shared information database for all things compliance. Customer privacy would still be tightly protected. And bankers will still find ways to distinguish themselves from competitors by their products and services delivery, reputation and strategy.

This approach would likely be a game changer for vendors of compliance tools and systems, who usually target customers one by one with turnkey or tailored compliance and operations solutions. Instead, they would have to market themselves openly to the industry and to the regulators and compete as participants in establishing a menu of acceptable generic and less-customized compliance solutions that all could tap and share.

So who might be first to step forward and endorse a new cooperative and kinder, gentler open-forum approach to compliance? Comptroller Thomas Curry? FDIC Vice Chairman Thomas Hoenig? Or perhaps Senator Warren?

This article originally appeared on on July 7, 2016. Click here to read the original article.

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