History of Free Payment Processing

Retail merchants have not been happy with payment processing fees since the early days of credit cards.  Since the first credit card was run through a ‘knuckle buster’ imprint device, retailers have been trying to find ways to lower fees or pass on these fees to their customers. 

Today, merchants can add credit surcharges (small fee up to 3% is added to a transaction if paid by credit card), offer cash discounts (offering a lower price if paid with cash) and manage dual pricing (posting two prices for an item – cash price vs credit price).  But merchants did not always have these options.  For the 25+ years, these types of surcharges and discounts were not allowed by the card brands.  This allowed large credit card companies to generate huge profits from swipe fees and other transaction-based charges  – while merchants had few options other than pay the merchant fees. 

The tide has changed in the last 10 years, with merchants increasing able to pass fees onto customers.  It light of this, it is interesting to look at the history of card processing and these fees to provide a perspective on the current landscape.

The Early Days of Credit Card Processing

In the early days, credit cards were processed by networks forms by groups of regional banks.  Over time, these small processing networks joined together to create economies of scale.  In the 1950’s, Visa and MasterCard were created from regional associations of banks through the merger or combination of the regional credit card networks that were created in the early years. 

The big obstacle to the adoption of credit cards in the early days was the lack of reliable and affordable technology.  Credit card processing in the early days was a very manual process.  Retail cashiers authorized credit cards by either telephone, or by manually checking the card numbers against a list of invalid card numbers.  This was not very convenient for merchants, so credit card acceptance were not encouraged by retailers.  As a result, credit cards payments represented a very small slice of the total number or dollar volume of retail transactions through the 1970’s. 

In fact, the transaction volume was so small in the early days that the government did not feel the need to step in and regulate the industry – or to set standards.  Instead, the use of the card processing networks and the fees charges for credit cards was governed by various private agreements entered into between card networks, issuer banks, merchants and cardholders.

The Rise of Credit Card Surcharges

As transaction volume increased, some merchants saw their margins squeezed and began assessing their customer fees for paying by credit card – or offered different pricing for cash payments vs credit card purchases – to incentivize consumers to pay with cash and check instead of credit cards.  As you would expect, the card industry did not like this practice and quickly put in place rules and guidelines to limit this practice.

The retailers and consumers complained about the fees to the government, which eventually caused the government to begin regulating the credit card industry.  In particular, the retailers complained about their inability to pass on the fees that they were being charged by the card processors for customers paying by credit cards.  This involvement led to the passage of the Truth in Lending Act (“TILA”), which Congress passed in 1968.  The TILA said that the “card issuer may not, by contract, or otherwise, prohibit any such seller from offering a discount to a cardholder to induce the cardholder to pay by cash, check or similar means rather than use a credit card.”  In other words, the payment processors could no longer prohibit credit card surcharging fees and similar strategies.

The TILA also required lenders and credit card issuers to clearly disclose the cost of credit as an annual percentage rate (APR).  Further, card issuers were required to include any surcharges and price differences in the APR calculation.  The problem with this was that a 5% transaction surcharge on monthly transactions could increase the APR by 60% (5% x 12 mos.).  This disclosure issue made the credit card companies even more motivated to stop merchants from adding surcharge fee to their credit card transactions.

Lawsuits Filed to Protect Credit Card Surcharges

The card networks came up with a solution by adding a new restriction to the credit card networks’ operating rules that prohibited differential pricing and surcharges.  As you would expect, merchants were irate and worked to file an antitrust lawsuit in 1974.  The antitrust lawsuit was filed by Consumers Union against American Express, claiming that Amex’s ban on differential cash vs card pricing was an illegal restraint on trade.  Rather than going to court and risking a huge penalty, Amex settled the lawsuit and agreed to allow retailers accepting Amex to provide consumers with dual pricing for cash vs credit cards.

Despite this loss, the card issuers kept pushing back on these regulations in order to protect margins.  Issuers added new operating restrictions and invested heavily in lobbying efforts.  These efforts paid off.  In 1976, the federal government issued a temporary ban on surcharging.  The legislation prohibited a seller in a sales transaction from imposing a surcharge on a cardholder that pays by credit card.  As this ban was not permanent, it needed to be renewed by Congress.  Congress renewed the ban in 1981, but in 1984 Congress allowed the ban to expire.

Despite the ban expiring, the card issuers continued its battle in a couple of ways. First, the card companies retained the prohibition on card surcharge in the contracts that a merchant is required to sign in order to accept the issuers’ credit cards.  Second, credit card companies moved their lobbying efforts from the Federal level to the state level.  Across the Country, State legislators introduced surcharge bans for their State is response to the lobbying efforts of the card issuers. Through this lobbying pressure, ten states banned credit card surcharges, including California , New York, Texas and Florida.  This was very effective as these are many of the largest states in the US.

For the next 25 years, the credit card processors benefited from their advantageous position.  The combination of the restrictions on credit card surcharging in the operating agreements, State-wide bans on surcharging in the most populous States and a virtual oligopoly in the card processing market allows allowed processors to charge retailers high fees, with the retailers pretty much having no alternatives.  This enabled the card networks to generate excess profits for almost three decades.  The card companies grew to be multi-billion dollar businesses, making their executives very rich.

Retailer Win a Court Case on Credit Card Surcharging

Retailers finally won a huge concession on credit card surcharging in 2013.  What’s interesting is that this was not led by a large national retailer, but rather by a small pet company located in Atlanta, Georgia named Animal Land.  In 2005, Animal Land sued Visa claiming that its no-surcharge rule violated antitrust laws by preventing Animal Land and other merchants from assessing a small charge to customers for using credit cards. Animal Land accused the credit card issuers of illegal price-fixing.

This led to other national retailers and retail trade associations filing lawsuits against the major credit card networks claiming that the card networks were colluding to ban retailers from providing incentives to consumers to use less expensive payment methods (such as cash or debit cards). These parties also claimed that the card networks were engaging in illegal price-fixing practices in violation of the federal antitrust laws. 

In 2013, after eight years of litigation Visa and MasterCard agreed to a national class action settlement and agreed to modify their operating rules to allow merchants to impose surcharges on credit-card transactions.  For the first time in almost thirty years, merchants became entitled to add a surcharge for credit card transactions.

The class action litigation settlement applied primarily to the 40 States that had no restrictions or laws against credit cards surcharging. However, the other states with state-level bans soon started removing these restrictions on credit card processing as well.  In October 2013, a federal judge in New York declared the state’s ban on assessing a surcharge to be unconstitutional and in violation of the right to commercial free speech. A federal court in California followed suit in March 2015, striking down a similar Californian prohibition on surcharges.

2024 Status of Credit Card Surcharges

While a few States still have restrictions in 2024 – and the payment industry continues to fight against surcharges and discounts – the momentum has clearly shifted in the favor of retail merchants.

There are several strategies that merchants are currently using to defray the cost of accepting credit cards.  All these are used to effectively pass on the cost of processing credit cards to the consumer.  There are credit surcharges (adding a small fee of up to 3% to a transaction if paid by credit card), cash discounts (offering a discounted or lower price if paid with cash) and dual pricing (posting two prices for an item – cash price vs credit price).  The card issuers and card networks do not like any of these strategies, as it makes it seem more expensive to pay by credit card and incentivizes consumers to use lower cost (and less profitable) payment methods – such as cash and debit cards.  At of the time of writing, the card industry is continuing to push back against these market trends by adding rules and regulations to their operating agreements that will make it more difficult or costly for merchants to offer strategies to shift usage to lower cost payment methods.  We will cover that in our next paper.

Note: Some content and facts included in this post were based on data and other information published in ‘A History of Credit Card Transaction Costs and the Suppliers Newly Minted Right to Surcharge to Make Credit Cards a More Competitive Payment Channel’.  This paper was published by Scott Blakeley, Esq. & Ruth Fagan, Esq

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