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Recently, Frontier Airlines Holdings Inc. grabbed headlines by filing for bankruptcy protection to prevent its transaction processor First Data Corp. from withholding more funds to cover potential payment card losses at the Denver-based airline. That action should have signaled ISOs to talk to their banks about any merchants that may need a reserve account or should have an established account adjusted, says Mike McCormack, executive vice president at Noblett & Associates LLC, a Fort Lauderdale, Fla.-based payments consulting firm. "It's important that ISOs have a dialogue with their banks on reserve requirements, where reserves are already taken or could be taken," McCormack says. "ISOs should work in advance to know if banks want to change reserve. Banks want to move quickly and may catch ISOs flat-footed."
Merchant contracts usually contain boilerplate language that stipulates that banks can decide to demand ISOs set up reserve accounts at any time, most often with no notice to the merchant, McCormack says, noting that the contracts always favor the bank. ISOs can avoid being blindsided by a bank's decision to open or increase a reserve account by talking with the bank in advance, he says.
If a bank demands that the ISO create a reserve account, a merchant simply could walk away or blame the ISO for the bank's decision, McCormack says. "If the bank plays rough with the merchant, the merchant is likely to pick up and walk out the door and start depositing elsewhere," McCormack says.
Accept No Substitute
At North American Bancard, a Troy, Mich.-based ISO, Randy Lobban, director of risk management and credit policy, says reserve accounts are no substitute for good underwriting–the process of evaluating a merchant's business plan and practices and determining the potential for successful sales. "If there is a no legitimate product or the marketing is suspect, we will decline," Lobban says. "Reserves will never offset the losses from fraud or just bad marketing."
Lobban cites the example of a merchant selling bibles. In business for 20 years, with a slew of processing statements, this merchant likely will not require a reserve account, Lobban says. The merchant has proven he knows how to run the business, almost never encounters fraud and seldom has charge-backs. Suppose another merchant sells diamond rings and watches instead of bibles. Fraudsters may find the nature of the jewelry more enticing than bibles, which could dictate setting up a reserve account, Lobban. "We look at the business and break it down where the risk points are," he says.
Donna Embry, senior vice president of product strategy at Payment Alliance International, a Louisville, Ky.-based ISO, likens an ISO's underwriting policies to those of a commercial lender, especially one seeking collateral. "It is, for the most part, to cover charge-backs," Embry says.
Reserve accounts came about because banks were liable for card transactions in the days before the card associations became publicly held companies, she says. When a merchant or ISO went out of business, the bank was responsible for charge-backs that ensued. Typically, ISOs deposit the funds from a reserve account in a certificate of deposit in either the merchant's or ISO's name, Embry says. As the opportunities for charge-backs decrease, the need for an account decreases.
Whether the reserve account is funded upfront or with a portion of each transaction is up to the ISO's sponsoring bank, Embry says. "It really is situational," she adds. "There is no general model." Usually, executives set up reserves as a risk-control device of last resort, says Jim Aviles, chief operating officer at Merchant e-Solutions Inc., a Redwood City, Calif.-based merchant services provider. Aviles prefers to review a merchant's balance sheet to gain insight into the merchant's financial condition.
In his experience, reserve accounts have provided little aid when a merchant goes under, though they can be of value if fraudulent activity starts to appear in a merchant account, he says.
Merchant e-Solutions uses risk-management systems to limit exposure to fraudulent transactions, Aviles says. That effort is aided by the company's decision to delay merchant funding for as many as three days to provide the time needed to spot bad transactions. "The key to good risk management is not holding reserves," Aviles says, "but identifying the bad guys when they go bad, very quickly."
That can limit his firm's financial exposure to one or two days. Merchant e-Solutions may lose $7,000, for example, instead of $50,000 or $60,000 if the company is slow to catch on to the fraudulent scheme, Aviles says. "When we look at a merchant, we want to see that their financial condition will support their business model," he says. If not, the immediate next step is to ask several questions of the merchant. Can the company improve? Is its cash flow positive? Can it add liquidity to its balance sheet?
If Merchant e-Solutions believes the merchant is viable, the processor sets up the payment card account but insists upon delayed funding. Generally, Aviles' company uses reserves for merchants that are at risk but have healthy financials and a good chance of success.
Merchant e-Solutions's early fraud-detection strategy is working, Aviles says. In 2007, the company's two largest losses came from merchants that filed for bankruptcy. In each case, the bankruptcy court quickly took over reserves held against those merchant accounts. "Our approach to managing risk is not so much on the merchant, but we do build a system than can effectively gauge the financial stress a merchant may be under," Aviles says. "We're really looking to protect ourselves from the guy who is going out of business."
