How a 1978 court case changed the credit card industry and put cards in everyone’s pockets, but erased state laws that limit interest rates.
Have you ever noticed that all your credit card bills seem to get mailed to South Dakota, Nevada or Delaware? Have you ever wondered why national credit card issuers would want to run their businesses in South Dakota, a state where the average temperature in January is 5 degrees?
More importantly, have you wondered why credit card companies can ignore your state’s usury law, which limits the amount of interest that can be charged on a loan, and charge whatever rate they want?
The answer lies in a 1978 Supreme Court ruling, Marquette National Bank of Minneapolis vs. First of Omaha Service Corp. The case not only changed the law, but also became a light-bulb moment for the industry, setting it on a 30-year path that deeply affected state economies and Americans’ debt levels.
“There have been a few seminal events in the industry; this was one of them,” says Scott Crawford, a former analyst in the Congressional Budget Office and for credit card issuer HSBC. He is now CEO of DebtGoal.com. “There was a premium for being in states with lax usury laws. It gave you a strong advantage over operators in other states.”
States, issuers see mutually beneficial deal
The ruling provided a transitionary moment for both the banking industry and a handful of entrepreneurial states — most notably South Dakota and Delaware. The states saw an opportunity to dramatically expand their job bases during a deep recession by luring credit card companies to relocate into their borders. The ruling let credit card issuers “export” nationally whatever interest rate was allowed in the state in which they were headquartered. To induce the companies to relocate, some states simply dropped their usury laws. Several large issuers bit on the deal, relocated and it became anything goes for credit card rates.“A couple of states decided their economic development plan was going to be to attract credit card export industry,” says Kathleen Keest, senior policy analyst at the Washington, D.C.-based Center for Responsible Lending. “They basically deregulated their consumer credit marketplace and said, ‘If you come plop your little headquarters in Delaware or South Dakota, you can export our interest rate cap — look at us, we don’t have any!’ Other states said, ‘They’re getting banks to headquarter there; we should take our interest rate caps off as well to compete for credit card issuance.’ It became a tool to deregulate credit card rates.”
South Dakota was the first to offer what amounted to unlimited interest rates to lure card issuers into relocating their headquarters. A quick look at the membership of the state’s Chamber of Commerce shows how big of an impact the offer made — and continues to make — on the state’s employment base.
Sioux Falls, S.D., alone employs more than 8,000 people in financial services, including credit card issuers, says Amy Smolik with the Sioux Falls Area Chamber of Commerce. “We’ve had a ton of companies come here since Citibank came in 1981,” she says. “It was a strategic move from our governor to get companies to come to South Dakota with our business-friendly laws … They’ve provided a lot of jobs.”
For consumers across the country, the impact was a dramatic increase in the availability of credit cards. According to the American Bankers Association, 38 percent of American households had at least one credit card in 1977, the year before the Marquette ruling. By 1989, the percentage of families with at least one credit card was 56 percent. Today, it’s about 75 percent.
“Back in the day, it was traveling businessmen and wealthy folks who got credit,” says Peter Garuccio, spokesman for the ABA.
The increased availability came at a price. It’s no coincidence that South Dakota is the home state for subprime card issuer First Premier Bank, which gained notoriety for offering a card with an interest rate of 79.9 percent.
See related: CreditCards.com’s Weekly Rate Report
Marquette ruling details
The legal mechanics of Marquette are about as dry as it gets. The case involved two banks: Marquette National Bank of Minneapolis, where the state’s usury law capped interest rates for loans at 12 percent; and the First National Bank of Omaha in Nebraska, where the state laws allowed an interest rate of up to 18 percent. To make up for the low cap in Minnesota, banks in Minnesota could charge an annual fee, which they did. But then, First National Bank of Omaha started marketing its no-annual-fee credit cards to Minnesota residents.
Seeing itself at a disadvantage, Marquette sued, charging that the Omaha bank was violating Minnesota’s usury law. The Supreme Court ruled, essentially, that state usury laws don’t apply to nationally chartered banks based in other states. Plus, nationally chartered banks can “export” the interest rates allowed in their own states to customers throughout the country.
The ruling made a sweeping interpretation of the National Bank Act, a law passed by Congress in 1864 as the United States was three years into the Civil War and in desperate need of financing for the Union’s war effort. Until then, banks were only chartered by states. The National Bank Act created a way for the federal government to charter its own banks, which could issue bank notes backed by government bonds.
See related: Guide to rising credit card interest rates
Smiley case sets stage for high fees
The Marquette ruling also set the stage for another landmark Supreme Court decision regarding the credit card industry, Smiley vs. Citibank. In that case, a California woman, Barbara Smiley, had filed a class action lawsuit against Citibank’s South Dakota-based credit card division, claiming that the $15 late fee she was charged on her credit card bill violated California state law. Citibank responded that the late fee was, in effect, interest and was covered under the National Bank Act. The Supreme Court agreed; the result was an increase of late fees and other fees from $10 or $15 to the $39 fee that credit card customers may see today.
Michael Donovan, one of the attorneys who argued the Smiley case before the Supreme Court, says that the pair of decisions “probably caused terrific abuses in the credit card market. Because they both created such ambiguity as to what law would regulate credit card lending, it was unclear for many, many years who had primary regulatory authority over credit offered in interstate transactions. … It probably stunted the growth of an honest credit card market for over 20 years.” The result, he says, were the kinds of “tricks and traps based on legal gimmickry” that led to the Credit CARD Act of 2009 and the Wall Street reform law that included a Consumer Financial Protection Bureau.
Both of those federal laws are designed to protect consumers — but don’t expect either of them to change the industry practices protected under the Marquette and Smiley decisions.
“I don’t believe the new laws will stop the staggering interest rates charged by lenders for exactly the reason set forth in the Marquette case,” says attorney Margaret C. Jasper, author of “Credit Cards and the Law.” “It seems that all of the credit card companies are located in states with either no usury law or the highest interest rates in the country. Personally, I have been complaining about this and wish Congress would enact some type of federal usury law to stop this predatory lending. This would truly help consumers who are in debt.”
See related: A guide to the Credit CARD Act of 2009, Wall Street reform creates Consumer Financial Protection Bureau, Issuer defends card with an interest rate of 79.9 percent