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Stock Strategist Industry Reports

Litigation Risk Rises for Payment Networks

But Morningstar's fair value estimates for Visa and MasterCard are unchanged.

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The 2nd U.S. Circuit Court of Appeals in New York has overturned a 2013 $7.25 billion settlement between payment networks  Visa (V) and  MasterCard (MA) and a group of retailers. Essentially, the court ruled that barring the ability to challenge certain network rules in perpetuity was unfair, the interests of past and future merchants were in conflict, and representation was inadequate given differing interests of the plaintiffs.

In the initial lawsuit leading to the network settlement, merchants alleged that network rules establishing default interchange rates, requiring merchants to accept all branded cards (for example, both high-cost rewards products and lower-cost basic cards), and preventing merchants from influencing customer payment preferences were anti-competitive. In addition to the monetary payment, networks agreed to change certain controversial practices. The settlement also prevented merchants from challenging the networks on a wide range of other practices. Two classes of plaintiffs were included--those that accepted cards between 2004 and 2012 and merchants accepting card payments thereafter. Those in the first class received the monetary judgment and were able to opt out of the settlement; those in the second received changes in network rules and were unable to opt out.

Last week’s court action opens the door to more litigation costs and monetary damages for the payment networks and furthers the ambitions of merchants to drive their customers to low-cost payment methods. However, we still think card-issuing banks are more at risk than the networks as costs are negotiated or regulated downward, given their weaker economic moats and larger share of transaction costs.

Disputes have also arisen over the use of personal identification numbers versus signatures at the point of sale. Merchants argue that PINs are far more secure, while networks prefer to give customers a choice between the two methods. Signature debit processing can also be more profitable for the payment networks than PIN processing--another key point of contention.

Overall, we think these items support our thesis that merchants are exercising more power than they have in the past. That said, the handful of high-margin basis points retained by Visa and MasterCard pales in comparison with the larger fees paid to merchant acquirers and card issuers. Furthermore, security technology is changing fast, and the signature versus PIN debate may soon be obsolete. Regulatory and structural changes (network initial public offerings and the Visa/Visa Europe merger) have already increased competition considerably since the initial bouts of litigation more than a decade ago. Finally, we think the growing value of the data gathered by the networks offers upside potential that offsets the risks of further regulatory and legal actions. We are maintaining our fair value estimates for Visa and MasterCard.

Jim Sinegal does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.