Consumers are furious about tricks and traps in credit-card contracts. Most infuriating of all is when issuers lure customers with attractive terms and then unilaterally change them a few months—or weeks—later. Congress and the White House can no longer ignore the fury. President Barack Obama has placed credit-card practices squarely in his sights and on Apr. 30 the Credit Cardholders' Bill of Rights, sponsored by Representatives Carolyn Maloney (D-N.Y.) and Barney Frank (D-Mass.), passed the House by an overwhelming majority. The Senate is gearing up for action on parallel legislation sponsored by Senator Chris Dodd (D-Conn.).
The proposed reforms would limit, but not eliminate, the ability of card issuers to unilaterally change the terms of card contracts. The bills presume that Congress can identify bad changes and ban them once and for all. But there is reason to doubt Congress' ability to effectively distinguish good changes from bad ones, especially since the fairness and efficiency of rates, fees, and other contractual terms can change with economic circumstances. Moreover, a term change that hurts one cardholder may help another cardholder. For example, while an increase in the interest rate is detrimental to many consumers, others can gain access to credit cards with reasonable interest rates only if issuers retain the option to increase rates when the risk of default increases. The "flat prohibitions" approach gives too much credit to Congress and excessively discounts the benefits of flexibility.
We propose a middle ground. Our proposal balances flexibility and responsibility. It recognizes that in a dynamic environment, some changes to terms are beneficial for both card issuers and consumers. It also recognizes that, left to their own devices, issuers make changes that benefit only themselves.
Mandate a Change Approval Board
We would enlist the aid of market forces and specialized bodies to police the modification of credit-card contracts. At the heart of our proposal are contracts that require changes to be approved and certified by a third party called a Change Approval Board, or CAB.
Here's how it would work: The issuer and cardholder would add the CAB as a party to their contract. The CAB would not scrutinize the initial contract, but it would have to approve any changes the issuer proposes to make to the initial contract. Since contracts can be modified only with the consent of all parties to the contract, the CAB would be able to prevent any unjustified term change simply by withholding consent.
The CAB would provide fair-minded issuers a means of ensuring customers that only mutually beneficial term changes will be made. It would allow issuers to offer credit-card contracts that retain the benefits of flexibility while substantially reducing the costs of unfettered discretion.
The CAB could be a government-sponsored body appointed by the Federal Reserve Board, the Federal Trade Commission, or the proposed Financial Products Safety Commission. Its members should include both industry and consumer representatives. But there need not be only one CAB. In addition to the government-sponsored CAB, we envision the creation of multiple private CABs, each applying different certification standards.
There could be a strict CAB that would deny all—or virtually all—term changes, and there could be more lenient CABs. Risk-averse cardholders who care deeply about their peace of mind would choose a contract with a higher initial interest rate and a CAB that imposes stricter conditions on changes. Cardholders who prefer a lower interest rate but are willing to accept the risk of rate hikes if they miss a payment, or if their credit rating falls, would choose a more lenient CAB. In short, market forces can play a significant role in shaping the system.
No Legislation Needed for Private CABs
Card issuers will pay for the CABs, though the cost will likely be passed through to cardholders. Cardholders who don't want to bear the cost can opt for a contract with no CAB.
Strictly speaking, no new legislation is required to create CABs, or at least privately sponsored ones. Ideally, the market would create the system on its own. In reality, coordination problems and perhaps even antitrust concerns require government intervention. After the system is in place, we expect issuers would opt into it voluntarily by entering into binding commitments to make only certified changes to their credit-card terms.
Similar mechanisms already are used to police term changes by powerful sellers and service providers. For example, insurance companies often cannot increase their rates without first obtaining the approval of a state regulator. The CAB system extends this model and creates a market for the approval bodies themselves.
The CAB system promises to deter abusive term changes while retaining the flexibility to change credit-card contracts when change is justified. We encourage Congress and regulators to consider this solution as they move to address credit-card rage.
Professor Oren Bar-Gill teaches contract law at New York University School of Law. Professor Kevin Davis teaches contract law at New York University School of Law.