As a business that processes credit card transactions for merchants, what are your rights when the merchant goes bankrupt? Can you recoup the value of chargebacks from the merchant? Terminate the processing relationship? Take other action to protect yourself from the bankrupt merchant?
Acquirers have been processing card transactions for merchants for a long time, and merchants have been going bankrupt for just as long. So it would seem that the parties' rights would be all figured out by now. Guess again.
As soon as a merchant goes bankrupt, the merchant and its creditors are protected by a whole different set of laws-the U.S. Bankruptcy Code- administered by bankruptcy lawyers, trustees, and judges.
These bankruptcy experts usually do not understand what an acquirer does for the merchant. No firm rules have been established that govern the rights of a processor when its merchant goes bankrupt.
There are some steps an acquirer can take to protect itself when a merchant goes bankrupt.
Liability for chargebacks: When a cardholder rejects a sales transaction on his bill, the issuer may return the transaction to the acquirer as a chargeback. Under card association rules, the acquirer has little choice but to accept the chargeback. Usually, the acquirer recovers chargebacks by offsetting them against incoming transactions.
However, when the merchant's transactions decline precipitously, there may not be sufficient proceeds to cover all of the chargebacks.
Or when the merchant files bankruptcy, the acquirer may not legally be able to process chargebacks that way.
The filing of a bankruptcy creates an "automatic stay" which prohibits a creditor from taking any action to collect from the debtor a debt incurred before the bankruptcy was filed.
Some courts have held that the processing of chargebacks after the filing of a bankruptcy by a merchant is prohibited by the automatic stay.
The acquirer may not learn of the bankruptcy until days, weeks, or sometimes even months after the petition is filed.
Acquirers frequently are not listed on a merchant's bankruptcy schedules, which notify creditors of a bankruptcy.
The principals of the merchant, and their lawyers, do not look at the acquirer as a "creditor."
Many bankruptcy lawyers (as well as bankruptcy judges) are woefully ignorant of the workings of our credit card system and do not recognize the acquirer's claims.
In the meantime, the acquirer has continued to process chargebacks.
The merchant (as a debtor in bankruptcy) or its trustee may try to recover from the acquirer chargebacks processed after the bankruptcy filing because, it will be argued, they were effected in violation of the automatic stay.
Carefully crafted merchant agreements can minimize this risk.
But just as important, you must take care to monitor the financial condition and business operations of your merchants.
If a merchant seems to be facing financial difficulty, as indicated by factors such as a dramatic increase in sales volume or chargebacks, you may take steps to minimize your losses.
First, be sure your merchant agreement allows you to create a reserve account from which you can reimburse yourself for losses. But beware: The reserve account itself may be at risk if a merchant goes bankrupt.
Liability for preferential transfers: Bankruptcy enables the merchant to recover certain payments, ones made within 90 days of filing in payment of a preexisting or overdue debt.
An acquirer which reimburses itself for chargebacks within that 90-day period, either from a reserve account or by offsetting against incoming transactions, may find itself a defendant in a lawsuit initiated by the merchant or its trustee.
The lawsuit will seek to recover the amount of those chargebacks as preferential transfers.
The theory is that the obligation of the merchant to reimburse the acquirer for chargebacks is a "debt" of the merchant to the acquirer; that this debt arose either at the time of the original sales transaction or when the chargeback was first submitted; and that reimbursing the acquirer for the chargeback at a later date (from a reserve account or otherwise) is a payment of a preexisting debt.
An acquirer may have legal rights of offset or recoupment which serve as complete defenses to this type of preference action. You can ensure you have such defenses by correctly drafting your merchant agreement and by properly accounting for chargebacks on your accounting system.
Status of the reserve account: Even though you may hold and control the reserve account, a bankruptcy merchant or its trustee still has the ability to argue that the reserve account belongs to the merchant.
If this argument is successful, the court will require the reserve account to be turned over to the merchant, precluding you from reimbursing yourself for chargebacks from that account.
Although there are few court decisions on any of these issues, courts which have addressed this issue have squarely decided that the reserve account remains the property of the merchant.
Again, whether or not you are able to get reimbursed from the reserve account depends on the language in the merchant agreement.
The assumability of the merchant agreement: A merchant in bankruptcy has a special ability to deal with its existing contracts. The merchant may assume the contract, i.e., continue with it as if bankruptcy had not occurred, or reject it, i.e., terminate it and no longer have any obligations under it.
Merchants may not be able to assume certain types of contracts, such as agreements by banks to advance funds under a revolving line of credit.
These are referred to as agreements of "financial accommodation." In financial accommodation contracts, the nondebtor contracting party may terminate the contract.
It is not yet settled whether merchant agreements may be assumed by a merchant as a debtor in bankruptcy.
If a court believes that they can be assumed, the merchant will have to demonstrate that it can provide to the acquirer adequate assurance of future performance under the contract.
However, a court's idea of adequate assurance may be markedly different from an acquirer's. For example, the merchant may argue that its projections of future sales and profitability demonstrate its ability to reimburse the acquirer for any chargebacks, and therefore this alone is adequate assurance.
To the acquirer, this may be little more than crystal-ball gazing.
If the merchant succeeds in these types of arguments and is able to assume the merchant agreement, the acquirer will find itself obligated to continue processing the transactions in a situation where its ability to receive reimbursements for chargebacks and payment of its ordinary fees may be in jeopardy.
The dynamics of bankruptcy: It is common wisdom among experienced bankruptcy professionals that the creditor able to act promptly and aggressively is the one likely to suffer the least loss.
If you have not analyzed your rights concerning merchant bankruptcy until after a bankruptcy petition has been filed, you will have difficulty matching the pace of the merchant's counsel and the trustee, who may not be experienced in the ways of credit cards, but who are quite experienced in bankruptcy procedures and collections.
Preparing for the worst: You can take steps to minimize your losses in the event of the financial difficulty or bankruptcy of a merchant by doing the following:
Monitoring the financial condition of your merchants.
Including protective language in your merchant agreement to address the particular risks created by the bankruptcy laws.
Obtaining security interests or liens on the property of the merchant to maximize the possibility of reimbursement for any losses and to enhance your leverage.
Securing a reserve account, and drafting the merchant agreement to ensure that it will be available notwithstanding the bankruptcy of a merchant.
Consulting with counsel who have bankruptcy and merchant acquiring experience. Knowledgeable counsel will be able to muster the most effective arguments on your behalf in bankruptcy court and to bankruptcy trustees.
The interplay between bankruptcy and credit card processing has created a wealth of uncertainty regarding an acquirer's rights.
But there are definite steps you can take to minimize your losses. Being cognizant of the bankruptcy laws and carefully drafting your merchant agreement will go a long way when the merchant goes bankrupt. The authors are partners in the Detroit office of the law firm of Jaffe, Raitt, Heuer & Weiss. Mr. Rochkind and Ms. Quasarano concentrate on bankruptcy law, and Ms. Targan on merchant acquiring and electronic banking issues.