Contingent liability is a term often used by financial institution underwriters and sales representatives to properly identify a situation created when merchants process credit card transactions ahead of the date that cardholder customers can expect to receive the goods or services that they originally purchased.
Companies like timeshare rentals and travel agencies pose an obvious contingent liability risk because they have sold something that is a future service. Of course, all MOTO merchants – companies that sell tangible goods or services through mail order, online methods, or in telephone order environments, use software or conventional terminals, and always key in their transactions – pose a contingent liability risks to the bank.
There is, effectively, an inherent liability or risk placed upon an
acquiring bank that must pay the credit card-issuing bank when a
merchant is unable to pay a sizeable chargeback.
Issuing banks too have often been forced to cover substantial chargebacks when merchants have either become bankrupt or sometimes have committed fraud. In many of these cases, the merchant has engaged in misleading or deceptive practices in the course of their business, either privately or publicly.
The overall contingent liability can span up to several months of the merchant’s entire sales volume because customer credit card holders retain inherent rights to dispute a charge and, in turn, the chargeback process. Although consumers can indeed file chargebacks for up to several months after their purchase, the effective term of the contingent liability produced by each credit card transaction (which will determine the overall damages wrought) is usually measured in just a few days. Additionally, merchant acquirers review most of their merchant accounts at least once a year. The probability of default is affected, in part, by the time between periodic account reviews, so the loss rarely represents more than a few days’ worth of total processing volume at any one given time.
Since the merchant acquirer is at risk if the merchant can’t cover a chargeback, the acquiring institution must both carefully evaluate the credit quality of merchants seeking to use the institution’s services and also closely monitor the credit quality of its current merchants. The acquirer usually considers industry effects, company-specific effects and even the nature of individual credit card transactions. It is true that merchant acquirers regularly charge different fees, depending upon whether or not a merchant has followed correct procedures for a credit card transaction.
Within individual industries, businesses that are susceptible to buyer’s remorse present a much higher risk to a merchant acquirer. Consider a business that often sells annual memberships – such as a yacht club – at a discount rate relative to their regular monthly fee in order to encourage new clients to commit for a lengthier period. Some customers may regret their commitment within the first few weeks. Although buyer’s remorse alone is not sufficient to win a chargeback dispute, it does provide incentives for the buyer to exploit the process. A new client may make a questionable claim that the facilities are not appropriately nautical, or that the service is seasonally compromised. Since these are entirely subjective points of view and involve matters of degree, the cardholder has a chance to win the chargeback dispute, placing the acquirer at some risk. The same thing applies to merchants that sell items of high-value collectibles. Customers can be disappointed in artwork, rare coins, or stamps for any of several reasons. Also, fraud is frequently involved in these types of businesses because the goods may indeed not be genuine or their condition may be exaggerated. These reasons are amongst many that drive some businesses to prevent credit cards purchases and instead require cash purchases.
The second type of contingency liability is a company type risk. Just as insurers and banks evaluate the credit risk of individual merchants, so do merchant acquirers. Acquiring institutions study standard measures of financial strength, such as financial ratios of an individual company against companies of its same type. For small unincorporated businesses – such as individuals with DBAs – financial statements are often unaudited, so acquiring institutions might use business tax returns to supplement the unaudited statements.
Acquiring institutions even proceed beyond the company level and use information about the owners and managers of such companies, especially for unincorporated businesses. Acquirers can utilize FICO credit scores, at the personal level, as well as at the operational level. Acquiring institutions also use credit report information and the number of years that a potential client has been in business to gauge their risk.
Both traditional lenders and merchant acquirers use information that others have already generated about specific companies, such as whether a merchant retains existing banking relationships. Of course, companies headquartered abroad will receive more scrutiny than domestic companies. The processing history of a company that already has a relationship with a merchant acquirer is always important, particularly fraud and chargeback rates.
If a company’s financial status is not particularly strong, a merchant acquiring institution may require the merchant owner to offer a personal guarantee. An acquirer might impose conditions, such as creating a processing limit, which corresponds to a commercial bank’s lending limits. Similar to a bank, an acquiring institution may require lesser-qualified merchants to provide collateral, usually in the form of cash, a certificate of deposit or even a letter of credit. If the merchant cannot provide such collateral, then the acquiring institution might institute a holdback, or a delayed-payment arrangement. Under such an arrangement, the merchant acquirer withholds payment to the merchant for a predetermined length of time after processing. The duration of the payment delay is usually a function of the delivery delay and, less frequently, the chargeback ratio.
The final and third type of contingency liability is a transaction risk. If merchants follow procedures during a card-present point of sale, then nearly all risks -excepting fraud and delayed delivery – drop significantly. Swiping a credit card instead of manually keying in a credit card number reduces error to nearly zero. While a credit card in card-present transactions may have been stolen, swiping is at least one step toward insuring legitimacy.
More and more transactions in recent times, however, are those in which the cardholder and the card are both not present. As a result, merchants and merchant acquirers have developed new procedures for limiting risk.
MOTO transactions and online transactions have presented special issues for payment card companies. The most popular approach has been for merchants to access truly unique pieces of information during credit card authorization, some of which confirm that the purchaser has possession of the card itself and not just the card number. Credit card companies have long encoded a verification number into the magnetic stripe on the back of the card, such as the Verification Value (CW or CWl) or the Card Validation Code (CVC or CVCl). This code, read during the swipe, confirms that the card is actually present at the point of sale. The problem is that this approach cannot help for internet or MOTO transactions because the card is not present and a swipe is impossible. For MOTO transactions and online transactions, address verification, requesting the CVC, and other such information is required in lieu of these card and the cardholder present scenarios.