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The Green Sheet Online Edition

January 12, 2009 • Issue 09:01:01

How to preserve self-regulation

By Biff Matthews
CardWare International

Federal agencies and regulators in many states have the payments industry in their crosshairs. Bull's-eyes have been leveled on cardholder rights, interchange issues and fraud in all forms.

The Federal Trade Commission is focusing its attention on the operations of ISOs and merchant level salespeople (MLSs) - more the former than the latter. If the stories I read and hear are any indication, there's plenty to focus on:

  • Altered contracts, encouraging MLSs to engage in bait and switch
  • Nondisclosure of terms
  • Additions of terms or insertion of questionable paperwork after contracts have been signed
  • Not providing copies of contracts to merchants

Rogue MLSs have a few additional tricks, including fraudulent lease applications in which commissions are paid upfront for leases never sold. Then there is the oldest trick in the book: MLSs putting stacks of papers in front of merchants for signature; some of the papers are legitimate; others are not.

The gift that keeps giving

The bulk of federal attention is on interchange and what merchants pay to acquiring banks, which, in turn, is paid to card issuers. Terms such as usury and price fixing can be applied to this arrangement. Until recently, Discover Financial Services and American Express Co., with their closed loop systems, were alone in not charging interchange fees.

Now that Discover allows banks, credit unions, and savings and loans to issue Discover cards, it is playing in the same arena as MasterCard Worldwide and Visa Inc. in true open loop systems. For the moment, Discover has avoided inclusion in any federal action or investigation regarding interchange.

In what many believe is a harbinger of things to come, the European Union ruled that the process used by the card brands for establishing interchange fees is anti-competitive and violates antitrust law. The Australia-New Zealand regulatory body drew similar conclusions; both entities have mandated that interchange fees be cut.

Many critics also believe the need to appear transparent - and, in doing so, to stem the tide of lawsuits against them - was a key impetus for decisions by both MasterCard and Visa to go public. The moves will certainly help insulate member banks from billions of dollars in potential damages from antitrust claims initiated by merchants.

A primary challenge for the issue of interchange has always been transparency, along with a lack of consistency in the "spin" surrounding it. Depending on whom you talk to, even within card network leadership, the official line has always been, shall we say, fluid. That's what got the networks in so much hot water. There was no consistent storyline of how interchange rates were calculated and what the components were.

Interchange's origin

At its inception, interchange was established to compensate issuers for the 30-day float on charge accounts. It was also intended to offset cardholder and merchant losses. Subsequently, interchange became a way to incentivize the adoption of new technology, then a tool for getting merchants to pay for cardholder rewards programs.

Other official explanations included the offsetting of fraud losses and chargeoffs on accounts. The only flaw in this argument, of course, was that fraud was going down as exchange rates were rising.

All this aside, interchange became in total what it had always been in part: a source of free money for issuers. If there ever was real value provided to acquirers or merchants, it is no longer the case.

All of this has helped put interchange on the radar at both federal and state levels. All but a handful of state budgets are reportedly in - or approaching - double-digit deficits. The scrambling for revenue sources is in high gear nationwide, particularly since the only alternative - tax hikes - are universally viewed as untenable, politically suicidal, or both.


In good times or bad, though, states often intervene to curb excesses. My favorite example is the state of Arkansas enacting legislation barring exit fees charged to merchants who terminate their processing contracts prematurely.

This is more an ISO issue than one centered on banks. Banks have never had early termination clauses in contracts. If merchants wanted to switch financial institutions, or ceased operation, there was no associated contractual obligation or penalty.

ISOs include early termination clauses and fees in their contracts because there's significant upfront money paid in the form of signing bonuses, plus "free terminal" incentives and other gimmicks.

The plan is to recover these upfront expenses over the life of merchant contracts. But if merchants leave before their contract terms end, ISOs can't usually recover investments from MLSs. The latter group is nothing if not nomadic, and ISOs are stuck with no way to recover initial, fixed costs. Thus, the early termination fee.

The Arkansas limit on fees was minimal - $50 or so was what we heard discussed, which was quite an improvement over the $500 to $2,000 fees that are assessed elsewhere.

Arkansas also caps cardholder rates. All states used to do this, but Delaware and North Dakota removed their caps, thereby creating an instant industry.

In a landmark case, the courts agreed with Citigroup Inc. that outrageous interest rates could be foisted upon residents of all 50 states as long as offending entities were domiciled in states that had no caps. Over time, other states realized this burgeoning new industry had been created at their expense and removed their own usury provisions - or made them so high as to be irrelevant.

In hindsight, early termination was only the start of the fee movement. Here's an industry driven by banks and ex-bankers, and fees fit right in. Arkansas (ever the financial bellwether it seems) moved to protect merchants with prohibitions on exorbitant fees, and retailers developed defensive strategies of their own.

Consumer dissatisfaction

The question of who regulates the acquiring industry can be murky because there are so many potential players. Is it the U.S. Department of the Treasury's Office of the Comptroller of the Currency or its Office of Domestic Finance? Is it the U.S. Department of Commerce or the U.S. Department of Transportation? Is it the FTC or banking regulators? Interestingly, these agencies are all eyeing the acquiring industry. The reason? Complaints.

Federal and state agencies do not go looking for problems. Truly heinous violations - and the substantive and substantial complaints that follow - are what drive government actions. Government agencies are, by nature, reactive entities. The fact that investigations are occurring in noticeable numbers speaks volumes about what is happening in our industry.

ISOs and MLSs have generated enough condemnation to draw regulatory attention. Short-sighted company management and the actions of a small percentage of sales reps are to blame.

The way back

The sales environment was positive for a long while, with residual income from healthy, growing portfolios very much the norm for career salespeople.

Now that sales have slowed and the pool of merchants is smaller because of the poor economy, selling behaviors have changed. To keep revenue streams flowing, illegal things are being done with contracts. Not unethical: illegal.

The regulatory scrutiny we see building is being brought on by this type of behavior. It is time we look inward and realize that the self-regulation we have fought to maintain will only be allowed if we re-establish and adhere to best practices and codes of ethics and force consequences on abusers.

If we do not want official regulatory oversight, we must clean up our act. The alternative is that unscrupulous ISOs will, sooner or later, find themselves in the sights of regulators.

This is not unlike the wonderful folks who brought us predatory lending. It was never right, no matter how it was spun.

The instigators benefited themselves and no one else; least of all, the hapless buyers.

Because business activity has softened, now is the time to adjust and fine-tune policies. The get-rich-quick playbook truly is history. Those who work honestly and ethically will be here tomorrow, and the rest will be bagged by regulators.

In an effort to gain unfair competitive advantage, some will draw attention away from themselves and point the blame at others. Often, these individuals are a mirror image of their unscrupulousness.

The flip side of this is that ISOs may want to dismiss dishonest MLSs, hoping they will go to work for competitors - where they will cause damage. These scenarios can't be tolerated either.

All of us need to consider what's good for our industry and work together to reclaim it. end of article

Biff Matthews is President of Thirteen Inc., the parent company of CardWare International, based in Heath, Ohio. He is one of 12 founding members of the Electronic Transactions Association, serving on its board, advisory board and committees. Call him at 740-522-2150, or e-mail him at mailto:biff@13-inc.com.

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