In what some are calling the week of Operation Choke Point, four congressional hearings were held over a three-day period in mid-July 2014. The hearings raised serious concerns about the operation's legal authority and unintended impact on legitimate businesses operating within a number of congressional districts.
The Department of Justice-led initiative launched in early 2013 to investigate banks and payment processors suspected of knowingly doing business with fraudulent merchants. The action is a directive of the Consumer Protection Branch of the Financial Fraud Enforcement Task Force. The FFETF coalition of law enforcement, investigatory and regulatory agencies was established in 2009 by President Obama to combat financial fraud.
In February 2013, Michael Blume, Director of the Consumer Protection Branch, sought permission from Stuart Delery, Assistant Attorney General in the DOJ's Civil Division, to authorize issuance of subpoenas under the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (enacted to shore up the Federal Deposit Insurance Corp. system after the savings and loan debacle in the late 1980s). The subpoenas were needed to launch Operation Choke Point investigations directed at seven entities.
In March 2013, FFETF Executive Director Michael Bresnick said in a speech, "We hope to close access to the bank system that mass marketing fraudsters enjoy – effectively putting a chokehold on it – and put a stop to this billion-dollar problem." He also stated that the CPWG had "prioritized the role of financial institutions and payment processors in mass marketing fraud schemes, including payday lenders" and other high-risk merchants identified in a list circulated by the FDIC.
By the end of 2013, the DOJ had issued over 50 subpoenas to banks and payment processors in connection with Operation Choke Point investigations. While none of the entities subpoenaed were publicly identified by regulators, the case of Four Oaks Fincorp Inc. became public in January when the bank agreed to a $1.2 million settlement for allegedly processing payments for fraudulent merchants.
In January 2014, Rep. Darrell Issa, R-Calif., Chairman of the House Committee on Oversight and Government Reform; along with Rep. Jim Jordan, R-Ohio, Chairman of the Subcommittee on Economic Growth, Job Creation and Regulatory Affairs, issued a joint letter to Attorney General Eric Holder Jr. The letter stated that oversight was being conducted on the DOJ enforcement of civil investigative power under FIRREA Section 951(d) to inappropriately target two lawful financial services industries: third-party payment processors and online lenders. Issa and Jordan notified the FDIC, as well.
The letter to Holder referred to a bank under DOJ subpoena that was forced to relinquish nearly all documents in its possession related to payment processors and/or merchant clients that had experienced a return rate, "for any reason," of 3 percent or greater in any one-month period. In fact, only debits returned as "unauthorized" constitute evidence of a fraudulent transaction.
The oversight committee later issued its findings in a May report titled, The Department of Justice's 'Operation Choke Point': Illegally Choking Off Legitimate Businesses? The committee determined that banks had terminated relationships with "a wide variety of entirely lawful and legitimate merchants" and called into question the DOJ's legal authority to execute the initiative.
The House Financial Services Committee opened the discussion on Operation Choke Point in an April hearing, followed by two hearings held July 15. In one of the July hearings titled, "The Department of Justice's 'Operation Choke Point,'" representatives from the DOJ, FDIC, Federal Reserve Board and Office of the Comptroller of the Currency addressed congressional concerns, including massive job losses in classes of merchants where access to payments had been denied.
Committee Chairman Patrick McHenry, R-N.C., acknowledged in his opening statement that members of Congress became aware after Operation Choke Point launched that bank accounts of lawful businesses were being terminated. He said, "When these legitimate enterprises inquired about the sudden termination of their accounts, their banks expressed that it was a result of quote, 'regulatory trends' or 'heightened scrutiny,' and explicitly denied any review of the accountholders' financial risks."
He also noted that the DOJ initially attempted to block congressional oversight in its investigations of Operation Choke Point, but later relinquished 854 pages of internal memoranda, email communications and presentations.
"The initial findings are quite disturbing," McHenry said. "Rather than directly investigate merchants for fraudulent activities, the Department of Justice subpoenaed banks and payment processors of targeted merchants to effectively compel them to choke off businesses from accessing the banking system." These actions may have ultimately led to banks terminating relationships with customers in high-risk categories to avoid potential civil or criminal liability.
During his testimony, Delery said that by following the flow of money from fraudulent transactions, the DOJ had determined that some third-party payment processors knowingly processed transactions for merchants engaged in fraud in violation of federal law. "As a result, in November 2012, attorneys proposed a concentrated effort to pursue the fraud committed by banks and payment processors," he stated.
In a memorandum dated Nov. 5, 2012, issued to Delery by Assistant U.S. Attorney Joel Sweet titled, "Operation Choke Point: A proposal to reduce dramatically mass market consumer fraud within 180 days," Sweet outlined the multi-agency plan to combat fraud perpetrated against consumers by focusing on payment systems.
Before that, Sweet served as lead prosecutor in United States v. Payment Processing Center LLC, which led to shuttering of PPC for an alleged telemarketing scam that processed unsigned bank drafts for payment. For its relationship with PPC, Wachovia Bank N.A. eventually agreed to a $160 million settlement in 2010.
During the July 15 hearing, Reps. Michael Fitzpatrick, R-Pa., and Ann Wagner, R-Mo., referenced an Operation Choke Point status report dated Sept. 9, 2013, entered as evidence in committee investigations. "In that memo the Department [of Justice] stated that 'in the event that a legitimate business was innocently harmed by Operation Choke Point, it should be left to the legitimate lenders themselves to prove that they're innocent,'" Fitzpatrick said, and followed with, "Does this mean that you're guilty until proven innocent?"
Reading from the same report, Wagner added, "Although we recognize the possibility that banks may have decided to stop doing business with legitimate lenders, we do not believe that such decisions should alter our investigative plan." She then said, "Mr. Delery, clearly the DOJ's public statements to Congress do not match with its internal communications. What will you do to restore the integrity of your office and ensure that no more legitimate jobs or businesses become collateral damage, so to speak, of Operation Choke Point?"
Delery then stated, "I think what I will do is what I have done since these concerns have been raised, which is to rearticulate the policy to the public and to the industry and internally to make clear that our investigations are focused on evidence of specific, unlawful conduct that we are investigating based on evidence that consumers are being defrauded, not entire industries."
Rep. Blaine Luetkemeyer, R-Mo., a former bank examiner and vocal opponent of the operation's tactics, stated in his testimony, "I've taken a step in trying to solve the problem by offering a bill, End Operation Choke Point Act, under which financial institutions are granted the safe harbor necessary to serve legally operating customers." His bill, H.R. 4986, was introduced on June 26 and had nine cosponsors as of July 17.
When regulators present were asked whether they would support his bill, most agreed to examine it further. FDIC Acting General Counsel Richard Osterman, who was more familiar with the bill, said "We have concerns. Frankly, there are difficulties in trying to create a safe harbor in terms of avoiding unintended consequences." Luetkemeyer then said, "It tells me you're not willing to give up Choke Point."
On July 17, the Electronic Transactions Association testified before a House Judiciary Subcommittee on Regulatory Reform, Commercial and Antitrust hearing titled, "Guilty until Proven Innocent? A Study of the Propriety and Legal Authority for the Justice Department's Operation Choke Point." Operation Choke Point was also discussed during a Small Business Committee hearing held the previous day.
ETA Senior Vice President of Government Affairs Scott Talbott stated in his testimony, "Although ETA strongly supports increased law enforcement aimed at preventing mass frauds, it has serious concerns about the Operation Choke Point approach. In ETA's view, Operation Choke Point employs the wrong legal tools, is unnecessarily confrontational, and creates serious risks to law abiding processors and merchants without producing any benefits to consumers beyond those which could be obtained with a more focused and collaborative approach."
He said in testimony that ETA members had reported a sharp increase in information requests and investigative demands from the FTC and also expressed concern over how new restrictions on access to payment systems might impede high-tech startup and Internet commerce segments of the economy.
He also agreed with Luetkemeyer on use of safe harbor. "A far better approach would be to establish a reasonable safe harbor that would allow payments companies, which were not directly involved in the fraudulent activities of a merchant, to work with regulators without any risk of triggering an enforcement action," Talbott stated.
Speaking on behalf of the Community Financial Services Association of America, David Thompson, Managing Partner at Cooper & Kirk PLLC, testified at the July 17 hearing that the DOJ had undertaken this operation without any congressional authorization. He added, "To make matters worse, DOJ and the banking agencies have failed to provide these law-abiding companies, including short-term credit providers, with any opportunity to be heard and to defend themselves against these scurrilous accusations and slanders."
Following the hearing, Talbott reemphasized the ETA's position on the matter. "We think that a collaborative approach, including the new [ETA] guidelines, is the better way to approach fraud," he said. "We each bring different skills to the table. We bring our knowledge and experience in risk management, and they bring subpoena power."
Earlier in 2014, the ETA released a 114-page document titled Guidelines on Merchant and ISO Underwriting and Risk Monitoring, which was developed by risk professionals to provide comprehensive tools for underwriting merchants and mitigating risk. As evidence that such measures are effective, an ETA member survey revealed that more than 10,000 fraudulent merchants were discharged by acquirers over the past year due to effective fraud detection programs already in place.
Two ETA-commissioned economic studies supported assertions made during the hearing. In one study, Economic Effects of Imposing Third-Party Liability on Payment Processors, NERA Economic Consulting concluded that the DOJ focus on payment companies was misplaced and ineffectual when compared with industry self-regulation efforts.
In the second study, The FTC's Potential Impact on the Merchant Acquiring Industry, author Raymond Carter, Principal at First Annapolis Consulting Inc., reached a more disconcerting conclusion. "The position paper that I wrote is about how the FTC's proposed actions are very different from the way that the industry is designed and operates today in that they're potentially going to consider holding merchant acquirers responsible for the liability of all transactions processed by a merchant that has done something that the FTC believes is illegal," Carter noted.
As Congress prepared to take an August recess, it appeared unlikely any bill to curtail Operation Choke Point would be enacted into law this year. However, the payments industry must remain vigilant, and ETA has setup a petition drive online, which can be viewed at www.change.org/petitions/u-s-house-of-representatives-tell-congress-operation-chokepoint-is-choking-off-legitimate-commerce.
"My hope is that federal agencies like the DOJ and the FTC and others will see the payments industry as a better partner than a target in their investigation of fraud, and that public outcry over what Operation Choke Point is doing will result in a change of policy at these federal agencies to one that pursues fraudulent merchants instead of innocent payments companies," said Jason Oxman, ETA Chief Executive Officer.
Attorney Michael Thurman, of Thurman Legal, agreed with Oxman that efforts should focus on enhancing rules for merchant categories under question, which has been effective elsewhere. "To me, that is the perfect model for this situation, where if the regulators would lay out the rules and, rather than legislate by threatened enforcement, actually provide stringent guidelines that are the result of rulemaking and the industry and public having the opportunity to weigh in," Thurman said.
Also worth noting is that neither the FTC nor the DOJ carry rule-making authority. "It reminds me of the old adage that 'when all you have is a hammer, everything looks like a nail,'" Thurman said. "That's my sense of what's going on with Operation Choke Point. You have two agencies that only have a hammer available to them, and so they're using it." But legislators must exercise caution. "What we don't want is some drastic law that will be so burdensome that it will interfere in commerce," said payments attorney Adam Atlas. "We're already carrying some of the burden of the wrongdoing that's being perpetrated by folks through processing. But what Operation Choke Point appears to be doing is to engage the liability of the processors for more than just the commercial value of the transaction."
In the worst case scenario, legitimate high-risk merchants might be driven offshore to less scrupulous processors, which is why self-regulation remains a critical component. "That is why, prudently, ETA came up with the industry self-regulation guidelines," Atlas said. "What I think you can probably expect is major processors and acquirers to roll these principles into their own underwriting practices. These are then echoed down in the ISOs that have to live by those sets of rules."
Looking ahead, Atlas sees plenty of opportunity for specialization in high-risk merchants for a handful of acquirers and ISOs that are willing to comply with new rules of engagement. "For the right price, there is lots of processing to be done out there," Atlas said. "I think, fortunately, that the laws of supply and demand will intervene to give a new life to high-risk processing, perhaps with better controls, to see that true criminals are not involved."
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