A coalition of merchants will argue in federal court Tuesday that regulators must lower debit-card interchange fees by more than they already have in order to comply with the Durbin Amendment.

In a case that banks will be watching closely, Judge Richard J. Leon will hear arguments from retailers that the Federal Reserve Board strayed from the instructions of Congress when it instituted the cap on interchange fees last year. Up for grabs is at least $3 billion in annual revenue for large banks that retailers say is rightfully theirs.

The amendment, authored by Sen. Richard Durbin, D-Ill., was part of the Dodd-Frank Act passed by Congress in 2010. It states that debit interchange fees need to be reasonable and proportional to the cost incurred by the issuer with respect to the transaction. The Fed responded by proposing a 12-cent cap before ultimately raising the allowable charge to 21 cents, plus roughly one to three cents more for fraud expenses. The rule took effect on Oct. 1, 2011 and applies to banks with more than $10 billion of assets.

"What you'll hear from us," says Douglas Kantor, a lawyer at Steptoe & Johnson who is a member of the retailers' legal team, "is that the Fed was true to the law on its proposed rule, and departed from the law, inventing a new interpretation of it, in its final rules. And that's not OK."

"They can't substitute their own policy choices for Congress' policy choices," he adds. "Their job is to implement the law that Congress gave them, and they didn't do that."

The Fed declined to comment on the case, which will take place in Washington. But it has said in court papers that its reading of the law allows it to include certain costs beyond the incremental costs of authorization, clearing and settlement — which, according to the retailers, is all that the law allows.

Financial institutions are not parties to the lawsuit, but they will have a chance to be heard at Tuesday's court hearing. Seth Waxman, a former solicitor general during the Clinton administration, will present an argument on behalf of the Clearing House Association and other bank and credit union industry trade groups.

Waxman, now a lawyer at Wilmer Hale, will not be siding with the Fed. Instead he will make the case that banks should have been allowed to charge more than 21 cents per transaction. Banks were charging 44 cents prior to the law's enactment.

"We think the Fed got it wrong," says Noah Levine, another lawyer at Wilmer Hale who is representing financial institutions. "And we think that what the merchants are asking for in this lawsuit would only make those problems worse."

Durbin, a longtime ally of retailers in their skirmishes with banks, has filed his own court papers arguing that the Fed caved in response to the lobbying efforts of financial institutions.

"Even though a bipartisan majority in Congress had already considered and rejected the arguments of the financial services industry," Durbin's lawyer wrote, "the industry's campaign succeeded in influencing the Board to issue a final rule in June 2011 that deviated from the plain text and intent of the statute that Congress had enacted."

The plaintiffs, led by the National Retail Federation, will also argue Tuesday that the Fed's rule does not meet the requirements of the law in terms of fostering greater competition in the processing of debit-card transactions.

The question here is whether the Fed went far enough when it required that the network processing debit transactions using personal identification numbers be unaffiliated with the network processing signature debit transactions. The retailers argue that the law requires at least two unaffiliated networks for PIN transactions, and at least two unaffiliated networks for signature transactions.

Taken as a whole, the case hinges largely on how much deference the court will give to the Fed in its interpretation of the law.

Judge Leon is a 2001 appointee of President George W. Bush. Retailers have been buoyed by the fact that earlier this year, he overruled the Food and Drug Administration's decision to require graphic warning labels on cigarette packages, because that decision showed a willingness to challenge federal agencies, even though the case involved an unrelated issue.

Legal observers and payments experts were split on the lawsuit's likelihood of success.

"As a strong rule of thumb, courts will defer to the expertise of bank regulators when Congress has specifically assigned to the regulator the duty to interpret and implement a new law," Duncan MacDonald, a payments industry consultant and a former general counsel of Citi's North American and European card division, said in an email.

"Of course, a maverick trial judge might give the retailers an early victory, but on appeal there will be a reversal in favor of the feds."

Eric Grover, a payments industry consultant who does work for a range of financial institutions, argues that the merchants' lawsuit has merit, even though he believes the Durbin Amendment is wrong-headed.

"The hard thing to handicap here is how much deference the court will give to the Fed. But certainly the merchants have plenty of reason to be outraged by the Fed's implementation," Grover says. "I think the whole thing is horrendous. But the dangers of a rogue regulator are far worse than the dangers of a bad law."

Although the lawsuit is still at a pre-trial stage, Tuesday's arguments are expected to be the last word before the judge rules. A written judgment is expected to be issued in the coming months.

At Tuesday's hearing, the merchants will have 30 minutes to make their argument, followed by 30 minutes for the Fed's lawyers. Then the financial institutions will have a chance to offer their view before the plaintiffs and defendants respond to each other's arguments.

Larry Berlin, a payments analyst at First Analysis Corp. in Chicago, analogized the fight between banks and merchants to a football game. He says the merchants have been on offense for several years, and they have moved the ball, but they have not yet reached the end zone.

"And they don't want to settle for the field goal, which is what they have now," Berlin says.

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