By Theodore F. Monroe, Bradley O. Cebeci, and Eugene Rome as seen in The Green Sheet, September 2006.
The day has finally arrived: The federal government has decided to make payment processors and ISOs completely (and ridiculously) responsible for the “sins” of their merchants.
Early this year, the U.S. government filed a civil action against Payment Processing Center LLC, a Pennsylvania-based payment processing company. The action pertains to PPC’s work for outbound telemarketers (the ones who place calls soliciting business) and other high-risk merchants.
Card Associations categorize many types of merchants as high-risk, for example, offshore merchants, travel services, direct marketers, escort services, adult-oriented and gambling Web sites, and Internet pharmacies.
Notably, the government does not allege that PPC engaged in fraud. Instead, it seeks to hold PPC liable for allegedly enabling its telemarketing clients to engage in fraud. The government asserts that PPC continued to process transactions for certain accounts despite facing return rates exceeding 60% for those accounts.
Red flag or red herring?
The government asserts that a 60% return rate should have raised red flags for PPC of potential telemarketing fraud. It therefore seeks to hold PPC liable for the alleged fraud perpetrated by these merchants. The theory is that PPC either knew or remained intentionally ignorant of the fact that it was enabling them to engage in massive fraud.
Within days of the action’s filing, the presiding judge issued a temporary restraining order against PPC containing a host of onerous (and downright bizarre) prohibitions against processing various categories of transactions.
For instance, the order bars PPC from processing bank drafts in which the return rate for a merchant telemarketer exceeds 2% in any given week. Anyone out there have a merchant with a return rate lower than 2% the week after Christmas?
The order also bars PPC from processing bank drafts for all merchants who are, or have been within the past two years, under investigation by any state or federal regulatory agency. For some businesses in the industry, investigations are customary. Yet this order flatly prohibits PPC from processing for such merchants. Further, how is PPC or its merchants supposed to know whether a merchant is being investigated?
Frozen solid, locked out
What should truly send a collective shudder down the spine of processors and ISOs everywhere is how the government goes about obtaining these orders. Also chilling is the immediate asset freezes that accompany the orders.
In PPC’s case, the government obtained the order in secret before any of the defendants were even aware of the lawsuit. Typically, the first time processors or ISOs are aware that the government objects to their business methods is when federal marshals arrive, papers in hand, to shut them down or limit their activities and seize their assets.
This order immediately froze the bank accounts of PPC and its principals, prohibiting them from transferring funds or opening new accounts. It also required them to disclose all assets and bank accounts embodying funds derived from telemarketing or payment processing. As an attorney with expertise in this area, I have seen the horror these orders cause.
An increasing number of legitimate businesses (and their principals) are being sued by the Federal Trade Commission for acts of their affiliates, merchants and even customers. My clients are generally shocked by such suits. Often, they can only look on in dismay as a federal receiver changes the locks on their business doors.
Paying the piper
Such businesses face astronomical legal fees. Yet because their assets are frozen, they usually have no way to pay for a defense absent permission from the court to release funds from their own bank accounts. The government typically challenges these requests, arguing for a number far below the market rate.
For example, in a fairly typical enforcement case filed by the FTC against one of my clients, I estimated the minimum cost of defense fees at approximately $100,000; the FTC was only willing to stipulate to $15,000 in fees.
Deconstructing return rates
Notwithstanding all this, the government’s claim of a 60% return rate seems overstated in PPC’s case. PPC claims, for example, that at least 17.5% of the returns reflected in the government’s return-rate figure represent nonsufficient funds returns; another 7.4% represent returns due to closed consumer accounts; and still another 5.6% represent returns where the consumer account could not be located.
Based on these and several other categories of returns that it deems legitimate, PPC contends the percentage of returns potentially attributable to fraudulent activity is about 1.67%. That’s a heck of lot lower than 60%.
If the defendants’ numbers are anywhere near accurate, the persuasive force of the government’s red flags argument is significantly deflated, and the government’s actions of requesting a temporary restraining order and an asset freeze are way out of bounds. This is particularly so because any real “bad guys” are conspicuously absent from this lawsuit.
Up a creek, without an income
Indeed, a striking point in this case is that the government has not sued any of the 13 PPC merchants specifically alleged to have perpetrated the underlying acts of fraud. This may be because many of them appear to have operated outside the United States. PPC and its principals are the only defendants in the government’s action. Thus, they alone face the burden of paying obscene legal fees, redress to consumers and the prospect of a permanent injunction restricting their future processing activities.
Keep the PPC case in mind next time you accept an application from a high-risk merchant. In addition to the risk you always carry with respect to chargebacks and card Association fines, these days you just may find the government looking to hold you responsible for the far worse sins of your merchants.
The information contained in this article is for informational purposes only. Please consult an attorney before relying on it for your specific legal needs. Theodore F. Monroe is an Attorney whose practice focuses on the electronic payment and direct marketing industries. For more information about this article or any other matter, please e-mail Mr. Monroe at firstname.lastname@example.org or call him at 213-622-7509.