By Adam Atlas
Attorney at Law
My clients have been asking questions lately about the fundamental architecture of our payment system. They want to assess the possible outcomes of various processor disaster scenarios.
This article presents some basic building blocks of the payment system so that you, as ISOs and merchant level salespeople (MLSs) can make informed decisions about how to manage your business in difficult, risky times.
Of utmost importance in our industry is the ability to correctly allocate risk. Beginning with credit card issuers, which have the difficult underwriting duty of deciding how much credit to extend to cardholders, and continuing to credit card acquirers, which are tasked with deciding the amount of funds to release to merchants, the most valuable expertise is the ability to correctly allocate risk.
In every relationship - from the cardholder to issuing banks, card companies, acquiring banks, merchants, acquiring processors, ISOs and MLSs - parties negotiate the allocation of risk.
A payment professional's relationship with his or her acquiring organization is but one of several relationships carrying the risk for any single merchant or transaction. Everyone wants to avoid being the fall guy.
However, for the right price and with the right underwriting ability and expertise, an ISO can assume the risk of merchant chargebacks, fraud and other losses.
When entering into an ISO or MLS agreement, reflect on which part of the risk you are assuming. You should never be surprised to pay for liability you've agreed to carry.
Effective underwriting means a lot more than defining who you're doing business with. It also requires you to decide how much credit you are willing to extend your business partner. For example, what percentage of a merchant's daily settlements will be held back for reserve in a reserve account?
All funds sent to merchants are credit for that merchant until the risk of chargebacks on the underlying transactions is extinguished. That risk can extend as much as six months or more in some cases.
Experience and history have caused the current market to inherit an architecture that includes reserve accounts in many relationships.
Reserve accounts are customarily maintained as a fixed percentage of the aggregate volume going through the relationship; however, some unreasonable reserve accounts set aside a certain percentage of each transaction settlement.
This kind of reserve account grows exponentially and eventually bears no real connection to the volume of processing between the parties.
If a reserve account like this is maintained for you, enter into a discussion with the party maintaining this reserve in order to adjust it so that it becomes a floating amount tied to the relationship's aggregate volume.
A processor, meaning a super ISO that has been delegated high-level responsibilities by the acquiring bank, including capturing transactions, authorizing transactions and settlement of transactions to merchants, is required by its acquiring bank to maintain a well-stocked reserve account with the acquiring bank.
This reserve account is usually created at the genesis of the relationship between the processor and the bank. A reserve account at this level, like all other reserve accounts, is a function of the volume of the transactions processed and the level of risk the bank attributes to merchants the processor is boarding.
Except in extremely high-risk processing relationships, the reserve account is always, at most, a small percentage of the aggregate volume the processor processes through the bank. The processor reserve is drawn upon when the processor has liabilities to the bank that the processor is unable to fulfill.
If the processor goes bankrupt, the bank will likely seize the reserve because it will probably have a security interest or lien on the reserve account. The bank will likely make sure that its lien on the reserve account ranks ahead of the liens that may have been created by other creditors of the processor such as lenders, investors and shareholders.
The purpose of a reserve held by a processor out of ISO residuals is the same as that of the reserve held by the acquiring bank from processor receipts.
The processor needs to have a bare minimum of "insurance" against a scenario in which the ISO incurs a large liability to the processor that it is unable to fulfill on account of bankruptcy or some other financial problem.
The existence of ISO reserves is attributed primarily to processors' fears that ISOs will run into financial difficulty. In today's economy, however, ISOs are worried that their processors may go bankrupt, which may place their reserve accounts in jeopardy.
A processor's dipping into its ISO reserves to finance its day-to-day expenses would be extremely risky, if not downright suicidal. However, some processors might not be able to survive without taking on excessive, even self-destructive risk.
Like other reserves, the merchant reserve is maintained to mitigate the risk of merchants causing losses by, intentionally or unintentionally, processing transactions that result in losses to the acquiring organization that the merchant is unable to cover with cash on hand.
An important distinction exists between the ISO reserve maintained by a processor and the merchant reserve maintained by the acquiring bank.
In the custom of our industry, the funds in the merchant reserve account belong to the merchant and must, provided the merchant has no liabilities to the acquiring bank, be paid out to the merchant no later than 180 days following termination of the merchant agreement.
When a merchant terminates his or her relationship with an acquiring bank, provided that the risk on the account has been mild, the bank often remits as much as half of the original reserve less than 160 days following the termination.
The card brands have strict rules concerning who may, at various points in time, be in possession of merchant funds relating to payment processing. Those rules often prohibit any party other than the acquiring bank from being in possession of those funds.
In contrast, the rules do not require ISO reserves to be maintained under any particular regime. Consequently, and distinct from the merchant account scenario, ISO reserves may be in control of unregulated and intrinsically less secure entities than the acquiring bank; namely, the processor.
ISOs should take serious interest in the size and location of their own and their merchants' reserve accounts. Without infringing on the privacy of an acquiring organization, an ISO may, for example, request an acquiring processor or bank to provide independent assessment of the reserve funds relating to the ISO and its merchants, as well as the general condition of the processor reserve compared with its overall volume.
In a perfect world, ISOs would see these digits live on their desktops through a widget or other application. Reading the amount of the reserve on a monthly statement is comfort to some, but not to all.
In publishing The Green Sheet, neither the author nor the publisher is engaged in rendering legal, accounting or other professional services. If you require legal advice or other expert assistance, seek the services of a competent professional. For further information on this article, e-mail Adam Atlas, Attorney at Law, at email@example.com or call him at 514-842-0886.
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