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The Green Sheet Online Edition

October 12, 2009 • Issue 09:10:01

The MLS and the ISO:
Cause for concern?

By Brandes Elitch
CrossCheck Inc.

Recently, Cynergy Data LLC filed a Chapter 11 bankruptcy. This company processed roughly $10 billion annually for about 80,000 merchants. It was founded in 1995 and employed about 275 people.

This is the largest ISO bankruptcy since CardSystems Solutions Inc. filed Chapter 11 in 2007 (caused by an information technology breach that compromised data on 40 million cardholders).

Under the FAQ section of Cynergy's Web site, the company states its rationale for the filing: "This step is necessary due to a weak economy, an unsustainable capital structure and restricted access to capital markets." I would like to explore these three elements in more detail, to arrive at some recommendations for merchant level salespeople (MLSs).

Capital markets

First, what happened to the capital markets? We know now that financial institutions need more and better capital, limits on leverage and more authoritative plans for dealing with bank failure. But just as with previous bubbles: the dot-com bubble, the hedge fund Long-Term Capital Management's implosion in 2000, and the savings and loan crisis of the early 1990s - we didn't see it at the time.

As Warren Buffet said, "When the tide goes out, you learn who's been swimming naked." An organization called the Financial Literacy Group identified some of these "naked truths":

  • The idea that capital markets always operate rationally and efficiently (efficient market theory)
  • The belief that the capital market can perform acceptable self-discipline and self-regulation
  • The premise that new forms of securitization would benefit the overall economy
  • The promise that financial innovation based on "financial engineering" or "quantitative modeling" using derivatives-based leverage (overtrading) would add value to society

Depression-era legislation created a wall between commercial and investment banking (The Glass-Steagall Act of 1933), but this was dismantled in 1999 as part of a "financial reform" approach to making markets more efficient.

Now, banks can mix deposits from low-risk commercial banking and high-risk investment banking. Banks can act on both sides of a financial transaction. They can provide financing for their clients, and they can offer banking services to the providers of capital (corporate finance and underwriting, investor advice and proprietary trading).

After dealing with the aftershocks of Lehman Brothers, AIG, bank failures, a bear market and the shutoff of credit for corporate borrowers, we need a fully functional capital market, an effective market economy and, of course, the requisite degree of political stability. How soon we will get all these things is a matter of some speculation.

Many financial observers have opined that we have successfully "muddled through" the crises of last year and that the recession is over. Certainly, we have dodged a bullet - a big one. But we still have restricted access to capital markets and the lingering concern that a bubble remains in financial markets.

The economist Charles Kindleberger identified the stages of a bubble: first, an economic event that justifies an increase in asset prices; second, the expansion of bank credit (even though banks appear to be hoarding it rather than lending it); and third, positive feedback, where investors think there is easy money to be made and re-invest. Then comes euphoria, followed by the inevitable crash.

It does seem that the banks, which provide the liquidity that lubricates the financial system, are placing funds at central banks, in government obligations and into other secure investments rather than loaning money to corporate borrowers.

Meanwhile, corporations with debts to manage are having difficulty finding any kind of credit line or borrowing facility. And when an overleveraged company meets declining sales and decreasing revenues, it runs out of operating capital.

ISO practices

A few trends among ISOs may have precipitated this situation. For a few years now, many ISOs have given away free terminals to merchants. Where I work, we just "gave away" a few hundred terminals to one merchant, and this was an expensive proposition; we are not anxious to do it again.

Someone booking 1,000 new merchants a month can get overextended quickly with this gimmick.

Then there is the trend toward paying out up to 70 percent of the residual to the MLS or cashing the MLS out immediately once the merchant signs the contract. The money has to come from somewhere. The MLS might get cashed out, but the deal is predicated on a certain revenue stream over the next few years from the merchant, which may or may not manifest.

Another ISO "innovation" is the merchant cash advance. Sometimes this is called factoring, although technically factoring means transferring the right to the accounts receivable. This is a risky business, which is why factors typically charge around 30 percent for these short-term loans. Lenders can justify this because the borrowing companies are not bankable: They lack acceptable cash flow, a secondary source of repayment or solid financials.

Cash advance companies are guessing that a given merchant's revenues and profit margins will be the same in three months as they are today.

Have you taken a look at the retail sector recently? Many malls look like ghost towns; predictions are that hundreds of them will be liquidated in the next couple of years. I would not bet on cash flow from merchants in the retail space anytime soon.

This affects the second parameter of the Cynergy Data insolvency: capital structure. To fund cash outlays, some ISOs have borrowed money, on the theory that their future return will be higher than their cost of debt.

Bankers like to see an optimal capital structure (the percentage of debt to equity on the balance sheet), but instead, the money to pay for free terminals, cashouts and cash advances came from debt.

The economy

The last element mentioned in Cynergy's filing was a weak economy. This is where the bubble comes in. Are we in a recovery, and if so, what kind of recovery is it, and are there other bubbles we need to concern ourselves with if we are to avoid another liquidity crisis?

I remember attending a presentation a couple of years ago; the two guest speakers were Steve Forbes and Allan Greenspan. Greenspan was treated as an icon; Forbes caused a commotion when he said that what was then considered to be just a "subprime problem" was a bigger problem caused by the Federal Reserve creating far too much liquidity in the financial markets.

Back then everybody thought that Forbes was being impertinent, but now it is obvious that he was completely correct.

When the economy goes south, all kinds of unexpected things happen. One example is the bankruptcy of Frontier Airlines.

As Frontier's business slowed, the company cancelled flights. Frontier's processor, First Data Corp., decided this would engender chargebacks and informed the airline, with virtually no notice, that it would withhold 50 percent of Frontier's revenues as a "holdback." Ultimately, First Data ratcheted back this number, but whatever number it chose was enough to precipitate bankruptcy.

Another example is an Internet firm called Angie's List. Its processor, Elavon, summarily decided to hold back $2.5 million on this firm, which had $35 million in annual revenues.

Fortunately, Angie's List was able to change processors and get its money back in three weeks; otherwise it might have filed bankruptcy too. Imagine how you would feel if you were the MLS that signed these accounts: euphoria, followed by the crash.

One more important point for MLSs to consider: When an ISO gets into financial trouble, the portfolio can be sold to another ISO. In some cases, the selling ISO sells 100 percent of its future cash flow, even though it may be obligated to pay the MLS a significant percentage of this. This is why MLSs need to be intimately familiar with the clause in their contracts about "assignment of rights" - and know how to enforce them.

For many years, the ISO world has been characterized by MLSs being relieved of their residuals when their ISOs are sold or reconstituted. Sometimes, this is just a ploy to discontinue residuals. There is no excuse for this, even a bad economy.

Pay attention to these things, be aware of your rights, enforce them and, before you choose an ISO, do your homework.

This is not necessarily easy. Most ISOs are small and privately held. MLSs will not likely have access to financials, but there is one thing you will have access to: reputation.

People in the ISO community talk to each other, and they have long memories. At a minimum, do your due diligence on the reputation of the principals. If they have a reputation for fair and honest dealing, that will go a long way toward alleviating concerns about their financials.

Companies that always need to get that next deal to fix the problems of the past are ones to stay away from, particularly if those problems stemmed from someone not keeping his or her word in the first place. end of article

Brandes Elitch, Director of Partner Acquisition for CrossCheck Inc., has been a cash management practitioner for several Fortune 500 companies, sold cash management services for major banks and served as a consultant to bankcard acquirers. A Certified Cash Manager and Accredited ACH Professional, Brandes has a Master's in Business Administration from New York University and a Juris Doctor from Santa Clara University. He can be reached at brandese@cross-check.com.

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