Manipulating Overdrafts is Perfectly Legal?

Between 2005 and 2007, Wells Fargo earned over $1.4 billion in overdraft penalties. To realize these profits, the bank devised a clever way to maximize the number of overdraft fees—it reordered the chronology of transactions that occurred in any given day. For example, Wells Fargo would debit consumers first for their largest expenditures, even if, on that same day, consumers had made a smaller purchase prior to the largest. The likelihood of incurring overdraft penalties on larger expenditures is greater than the likelihood of incurring one on smaller purchases. Thus, Wells Fargo was able to hit customers with more overdraft fees by manipulating the order of purchases. 

As an example:

Jon Doe has $1,000 in his checking account. At 8:00 a.m. he uses his Wells Fargo debit card to purchase a $2 cup of coffee. At 12:00 p.m., he buys a $10 lunch. At 3:00 p.m. he purchases a $1,100 refrigerator. With his final purchase, Jon overdrafted his account and, as a result, should be charged an overdraft fee. Logically, the bank should charge him one overdraft fee because he only over-drafted once—when he purchased the refrigerator. However, by changing the chronological order of Jon’s daily purchases—debiting his account for the $1,100 purchase first, the $10 purchase second, and the $2 purchase third, Wells Fargo can charge Jon three overdraft fees instead of one.  

Wells Fargo was not the only bank doing this. Bank of America, Chase, and many other banks, big and small, engaged in this practice. Obviously this behavior seems unfair and unethical, and common sense says that such schemes should be illegal.

In 2010, a class action lawsuit was filed against Wells Fargo (Gutierrez v. Wells Fargo Bank). According to the plaintiffs, over 1 million customers were charged these unfair overdraft fees, and the bank made hundreds of millions of dollars from this practice. The U.S. District Court of Northern California ruled that Wells Fargo had to return $203 million to customers and enjoined the unfair overdraft practice. According to the court:

Well Fargo … devised a bookkeeping device to turn what would ordinarily be one overdraft into as many as ten overdrafts, thereby dramatically multiplying the number of fees the bank can extract from a single mistake…These neat tricks generated colossal sums per year in additional overdraft fees, just as the internal bank memos had predicted. The bank went to considerable effort to hide these manipulations while constructing a facade of phony disclosure.

Wells Fargo appealed the district court's decision to the U.S. Court of Appeals, which held that the question of ethics and fairness was irrelevant. Specifically, the appellate court ruled that the National Banking Act does not prohibit this practice and, therefore, under federal regulation this practice is perfectly legal. Furthermore, the court stated that any law put in place to prohibit this practice on a local or state level would be invalid because the National Banking Act would also preempt such a law. 

Despite the appellate court’s decision, in order for preemption to apply, it must pass the test established by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under Dodd-Frank, state banking laws may be preempted by federal law only if such laws (1) discriminate against national banks; (2) “prevent or significantly interfere with the exercise by [a] national bank of its powers,” as stated in the Barnett Bank case; or (3) are preempted by another federal law. 

According to the appellate court’s decision, California’s Unfair Competition Law was preempted because it prevented and significantly interfered with a national bank’s federally authorized power to choose a posting order. The court stated: “[A] federal court cannot mandate the order in which Wells Fargo posts its transactions. Therefore, we vacate the permanent injunction and the $203 million restitution award.” 

Unfortunately, the court’s rational for ruling in favor of federal preemption does not comply with Dodd-Frank’s requirements. The appellate court failed to explain how or why prohibiting the reordering of transactions prevents or significantly interferes with a national bank’s exercise of its powers under the National Banking Act. Instead, the decision seems to imply that because the National Banking Act doesn’t prohibit this practice, any state law that limits such powers is automatically deemed to prevent or significantly interfere with a national bank’s powers. This interpretation completely disregards Dodd-Frank’s requirements. 

The preemption test set forth in Dodd-Frank was intended to prevent broad preemption of state consumer protection laws, since previously federal banking regulators preempted most state consumer protection laws yet did nothing to protect such consumers on the federal level. Case in point: between 2000 and 2008, at a time when subprime mortgages and other mortgage abuses were proliferating, the Office of the Comptroller of the Currency took only two public enforcement actions against banks for unfair and deceptive mortgage practices. To remedy this, under the new Dodd-Frank test, only those state laws that significantly impact federally authorized bank powers can be preempted. Unfortunately, it appears that Dodd-Frank’s preemption provisions are widely being ignored.

The appellate court’s decision is problematic not only for states’ attempts to regulate overdrafts, but also for states’ efforts to provide consumer protections in banking laws in general. History tells us that federal regulators rarely take enforcement action against financial institutions for such practices. Disregarding Dodd-Frank’s preemption provisions and leaving all financial regulation in the hands of federal regulators, who did not protect consumers in the past, means that very little will continue be accomplished in the realm of consumer protection. Court decisions, such as the Ninth Circuit’s, cannot be allowed to stand. Such precedents imply that states cannot implement stricter and more comprehensive consumer protections than the federal government, which is exactly what Dodd-Frank attempted to prevent. Courts, like banks, must be held accountable for following the law.

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