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Tuesday, August 19, 2014

Report says DOJ knew Operation Choke Point negatively affected legitimate businesses

The Federal Deposit Insurance Corp. eliminated from its documentation lists of what has been termed "high-risk" merchant types. The move is seen as a response to the controversy over the U.S. federal government's Operation Choke Point program that allegedly targeted businesses unfairly by denying them the ability to process transactions electronically.

On July 28, 2014, the FDIC said it was clarifying its role in supervising relationships between merchants and their payment processors. (This FDIC action was mentioned briefly in a sidebar to our lead article, "Operation Choke Point draws fire from Congress, industry," published Aug. 11, 2014, issue 14:08:01, which was going to press when this news broke. This follow-up story provides further details.)

"FDIC guidance and an informational article contained lists of examples of merchant categories that had been associated by the payments industry with higher-risk activity when the guidance and article were released," the agency said. "The lists of examples of merchant categories have led to misunderstandings regarding the FDIC's supervisory approach to TPPPs [third-party payment processors], creating the misperception that the listed examples of merchant categories were prohibited or discouraged."

The FDIC stated that the list contained various types of telemarketing or e-commerce categories, with businesses in those categories associated with higher-risk activity. The agency defined higher-risk activity as that which could be subject to "complex or varying legal and regulatory environments, such as those that may be legal only in certain states; those that may be prohibited for certain consumers, such as minors; those that may be subject to varying state and federal licensing and reporting regimes; and those that may result in higher levels of complaints, returns, or chargebacks."

Additionally, the FDIC claimed the lists were "incidental to the primary purpose of the guidance, which was to describe the risks associated with financial institutions’ relationships with TPPPs, and to provide guidance to insured institutions on appropriate risk management for relationships with TPPPs." The FDIC's lists of "high-risk" merchant categories reportedly included firearms and ammunition, adult entertainment, check cashing, and payday lending businesses.

A 'no choking' matter

Operation Choke Point was launched by the U.S. Department of Justice in the spring of 2013. The program seeks to "choke off" high-risk businesses' access to electronic payments by mandating that payment processors terminate that access; by year's end the DOJ reportedly issued over 50 subpoenas to banks and payment processors to force them to terminate processing relationships with certain businesses.

In May 2014, the House Committee on Oversight and Government Reform headed by Rep. Darrell Issa, R-Calif., released a report entitled The Department of Justice's "Operation Choke Point": Illegally Choking Off Legitimate Businesses? that characterizes the program as a strong-arm tactic against financial service providers – comply or be investigated themselves.

"The initiative is predicated on the claim that providing normal banking services to certain merchants creates a 'reputational risk' sufficient to trigger a federal investigation," the report said. "Acting in coordination with Operation Choke Point, bank regulators labeled a wide range of lawful merchants as 'high-risk' – including coin dealers, firearms and ammunition sales, and short-term lending. Operation Choke Point effectively transformed this guidance into an implicit threat of a federal investigation."

The report also charges that the DOJ is aware that its program is negatively impacting legitimate, legally operating businesses. "Internal memoranda on Operation Choke Point acknowledge the program’s impact on legitimate merchants," the report said. "Senior officials informed Attorney General Eric Holder that as a consequence of Operation Choke Point, banks are exiting entire lines of business deemed 'high risk' by the government."

According to the report, the DOJ does not have the legal authority to force processors to comply with Operation Choke Point dictates. By law, the subpoena power is for use in pursuing "civil penalties against entities that commit fraud against banks, not private companies doing legal business," the report said. In fact, the report alleges that the DOJ has "radically and unjustifiably expanded" its authority to target high-risk businesses via processors.

Operation Choke Point apparently used the FDIC's high-risk merchant lists as a way to force processors to comply or face federal probes."Suddenly, doing business with a 'high-risk' merchant is sufficient to trigger a subpoena by the Department of Justice," the report said. "Banks are put in an unenviable position: discontinue longstanding, profitable relationships with fully licensed and legal businesses, or face a potentially ruinous lawsuit by the Department of Justice."

Vicarious liability

The Electronic Transactions Association sponsored a July 2014 report by the NERA Economic Consulting firm that advocates for industry self regulation as the most effective and efficient means of weeding out fraudulent merchants. In Economic Effects of Imposing Third-Party Liability on Payment Processors, Jeffrey A. Eisenach Ph.D. argued that the financial services industry already has a strong economic incentive to ensure against fraudulent activity.

Eisenach stated that the cost of chargebacks have caused processors to "internalize" fraud risk management. "Thus, processors already have strong incentives to monitor merchant conduct and to reflect the costs of high levels of consumer dissatisfaction back onto the responsible merchants through higher reserve accounts or the threat of termination," he wrote.

Eisenach believes that the DOJ is undermining its own efforts by imposing third-party liability, also called "vicarious liablity," on payment processors. He said the "imposition of vicarious liability on payment processors through Operation Choke Point is generating significant economic costs while generating little or no apparent benefits."

Eisenach added that federal regulators and processors are ultimately in alignment about the need to eliminate "bad actors" from the economy. But he believes industry self-regulation is a more effective means to that end, as it doesn't throw the proverbial baby out with the bath water.

"Industry self-regulation avoids the additional costs of third-party liability to processors and therefore does not distort the market or reduce competition by driving out important lawful merchants," Eisenach said. end of article

Editor's Note:

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