In Depth April 30, 2009, 5:00PM EST

About That New, "Friendly" Consumer Contract

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Former Citibank lawyer MacDonald opposed harsh penalties for late payments Chris Casaburi

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The credit-card industry expanded rapidly in the 1990s as mainstream banks such as Citi, now a unit of Citigroup, competed with nonbank financial firms including Providian and Capital One (COF) for customers who historically would have been denied cards because of their shaky credit histories. More companies offered rock-bottom introductory rates that were replaced with much higher ones. Banks and financial firms began relying on fine-print provisions that allowed them to change terms at will, says MacDonald, now an independent bank consultant.

In a November 1997 memo, MacDonald, then one of Citi's most senior lawyers, warned against adopting Providian's strategy of "penalty pricing," which involved charging consumers who made late payments steep fees and hiking their rates. "I was asked to resign three days later," he recalls. Penalty pricing became standard throughout the industry. Citigroup declined to comment. Providian was acquired by Washington Mutual in 2005. JPMorgan Chase (JPM) bought Washington Mutual after its collapse in September 2008.

Open-ended change-in-terms provisions—which typically read, "All terms may change...for any reason"—spread to other industries, says Matthew S. Melius, a former chief operating officer at the subprime credit-card company Metris, which was acquired by HSBC in 2005. Currently a principal at FG Companies (HBC), a finance consulting firm, Melius observes that terms for cell-phone, satellite TV, and Internet service, as well as frequent-flier programs, all can shift at the whim of companies, which causes considerable consumer frustration. "You will find [change-in-term provisions] anywhere there is a long-term relationship with the consumer," Melius says. "Generally, they result in higher prices."

Sprint Nextel (S), the wireless titan, uses its change-in-terms provision to extend customers' two-year phone agreements without asking them. Or at least that's the allegation in a pending civil suit filed in 2007 by Minnesota Attorney General Lori Swanson. The company unilaterally renewed contracts whenever customers disputed bills, purchased new phones, or received "courtesy discounts," the state AG alleges. If customers tried to cancel, they were hit with hefty fees. "Essentially what [Sprint] is doing is changing terms [as if there weren't] any contract at all," says Swanson.

Arguing that the AG's suit lacks any merit, Sprint says its practices are appropriate. None of the complaints by 14 consumers and a small business cited in the state lawsuit "indicated an early termination fee was improperly charged," Sprint said in a statement.

FREQUENT IRE PROGRAMS

Frequent-flier programs, once a source of consumer delight, have become common targets for litigation as financially strapped airlines use change-in-terms provisions to cut back on benefits. Ohio resident David Simon sued Continental Airlines (CAL) in March in federal court in Cleveland for adding a $75 fee and increasing the miles required to fly from Los Angeles to Cleveland. The suit alleges that when Simon joined the OnePass mileage program about 10 years ago, there was no fee, and such a flight required only 25,000 miles, not the 50,000 currently required. The suit accuses Continental of breach of contract. Simon's OnePass contract does state, however, that "Continental Airlines reserves the right to modify or discontinue the OnePass program." Continental declined to comment.