Easterbrook: Banks Free to Gouge Consumers (at least for now)

Yesterday the Seventh Circuit upheld a district court decision permitting the retroactive application of penalty credit card interest rates to existing balances.  Writing for the court, Judge Frank Easterbrook noted that (1) the plaintiff's state law claims were preempted by the National Bank Act and (2) the plaintiff's Truth-in-Lending Act/Reg Z claim that she did not receive proper notice of the repricing was not tenable. 

Most of the opinion addresses the TILA claim.  It's very technical, but Judge Easterbrook recognized that the applicable Reg Z language as well as the Federal Reserve Staff's comment on Reg Z are ambiguous.  Easterbrook resolves the ambiguity by playing economic equivalence: 

"It would be lawful for a bank to impose an over-limit fee (say, $75) in the first month, then increase the periodic rate of interest only for successive months. As the Bank’s actual practice of back-dating the penalty rate has the same economic effect as a fee in the initial month, it is hard to see why one method should be allowed and the other prohibited.... Structuring penalty interest to have the same effect as a penalty fee in the initial month therefore does not undermine the goal of advance-notice requirements. Swanson and others in her position still can shop for better rates for future months."

Two problems with this statement. 

First, even though a penalty fee and an retroactive interest rate application may be mathematically equivalent, they might not be economically equivalent; a consumer might react differently to a contract that lists one than a contract that lists another.  A bank that listed a late fee of $75 might scare off customers.  So the bank will list a low late fee and then just retroactively reprice (to an undisclosed interest rate of its choosing) for the same effect.  The later practice snookers the consumer; the former is clearly disclosed up-front.

Not only does Easterbrook ignore that behavioral economics says these are not equivalent costs, but he also ignores that Congress and the Fed conside them distinct.  The Schumer box has them disclosed separately. The mere fact that Easterbrook finds their equivalence should be irrelevant, as Congress considered them distinct.  Easterbrook's decision blesses the card industry's game of three-card-monte in which costs are disguised by shifting to equivalent, but poorly disclosed terms.

Second, Easterbrook seems to have forgotten a basic principle of contract law:  penalty provisions are not enforceable.  Liquidated damages are enforceable only if reasonable in light of actual and anticipated harm.  It's hard to imagine that a $75 (or more realistic $45) "penalty fee" has any relation to the risks posed to the bank by an overlimit transaction (which the bank choose to allow).  For goodness sakes, it's called a "penalty fee." 

Easterbrook also took the Fed's propspectively applicable amendments to Reg Z as proof that Reg Z does not currently cover retroactive repricing.  Logically this is suspect, however.  The Fed might have wanted to clarify rather than change Reg Z because of courts' misinterpretation.

In fairness, I think Judge Easterbrook was trying to decide this case as fairly as he could based on the regulatory language.  Were Easterbrook writing policy on a blank canvas, the results might well be different.  But in the end he was having to interpret an ambiguous position, and the interpretation he choose was hardly the necessary outcome.  A little more sensitivity to the pervasive abusiveness of the card industry's billing tricks and traps (which the Fed and Congress have picked up on) would argue for a contrary interpretation. 

Of note, in my state, Maryland, a bill just passed the House of Delegates that would prohibit retroactive repricing (and universal cross default) in all consumer contracts.  Because this is a generally applicable law, banks' preemption defense is much weaker; banks are subject to generally applicable laws on contracts, torts, debt collection, etc.  (Indeed, OCC and OTS regs are explicit about this, and another recent 7th Circuit opinion by Judge Posner agrees.)  Proudly, the Maryland bill's lead sponsor is my state representative WIlliam Frick. 

[Update:  On March 16, three days before Judge Easterbrook's decision came out, the Ninth Circuit issued a published opinion on the same issue with the opposite holding.  The Ninth Circuit held that as a matter of law, the Truth in Lending Act requires advance notice of an increase in interest rates if the increase is "because of the consumer’s delinquency or default” or if the cardholder agreement permits the issuer to "increase the rate at its discretion but does not include the specific terms for an increase."]