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Federal Reserve
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B. F e l d b e r g
V ic e
P r e s id e n t
December 14, 1993
To the Chief Executive Officer of Each State
Member Bank, Bank Holding Company and Branch
or Agency of a Foreign Bank in the Second
Federal Reserve District:
The staffs of the federal financial institutions
regulatory agencies and the Federal Trade Commission have
recently been investigating deceptive practices in regard to
credit card-related merchant activities at insured depository
institutions. We want to alert you regarding this problem
because a bank has already failed as a result of improper credit
card-related merchant activities, and we have recently learned
that some individuals and companies, who were associated with
that failure, are attempting to sell arrangements similar to
those that caused the bank failure.
The attached Interagency Advisory describes some
questionable credit card-related activities and offers some
suggestions on how best to avoid any difficulties in this area.
The Interagency Advisory is being issued by the Board of
Governors of the Federal Reserve System, Office of the
Comptroller of the Currency, Federal Deposit Insurance
Corporation, Office of Thrift Supervision, and National Credit
Union Administration.
Please direct any questions regarding this matter to
Kevin J. Clarke, Domestic Banking Department, at (212) 720-2181.
Sincerely,
Attachment
Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
National Credit Union Administration
Office of the Comptroller of the Currency
Office of Thrift Supervision
November 15, 1993
Interagency Advisory
CREDIT CARD-RELATED MERCHANT ACTIVITIES
The enforcement staffs of the federal financial institutions supervisory agencies,
as well as the staff of the Federal Trade Commission, have received reports that some
individuals and companies are engaging in deceptive practices in regard to credit card-related
merchant activities at financial institutions. These matters are being actively investigated by
the staffs of several of the agencies. This advisory alerts you to possible suspect merchant
and credit card agent activities and requests that you communicate with your staff about
possible problems that may arise as a result of such activities.1
Merchant credit card activities basically involve the acceptance of credit card
sales drafts for clearing by a financial institution (the "Clearing Institution"). For the Clearing
Institution, these activities are generally characterized by thin profit margins amidst high
transactional and sales volumes. Typically, a merchant’s customer will charge an item on a
credit card, and the Clearing Institution will give credit to the merchant’s account. Should the
customer dispute a charge transaction, the Clearing Institution is obligated to honor the
customer’s legitimate request to reverse the transaction. The Clearing Institution must then
seek reimbursement from the merchant. Problems arise when a merchant is not creditworthy
and is unable, or unwilling, to reimburse the Clearing Institution. In these instances, the
Clearing Institution will incur a loss.
Clearly, in order to avoid losses and to ensure the safe and profitable operation
of a Clearing Institution’s credit card activities, the merchants with whom they contract for
clearing services should be financially sound and honestly operated. To this end, safe and
sound merchant credit card activities should include clear and detailed acceptance standards
for merchants. A Clearing Institution should scrutinize prospective merchants with the same
care and diligence that it uses in evaluating prospective borrowers. Also, financial institutions
engaging in credit card clearing operations must closely monitor their merchants. Controls
should be in place to ensure that early warning signs are recognized so that problem
merchants can be removed from a Clearing Institution’s program promptly to minimize loss
exposure. In cases of merchants clearing large dollar volumes, a Clearing Institution should
establish an account administration program that, at a minimum, incorporates periodic reviews
of the merchants’ financial statements and business activities. In addition, a Clearing
Institution should establish an internal periodic reporting system of merchant account
1
This is not the first time that such activities have been identified. In 1990, the OCC
issued an advisory to its national banks alerting them to many of these same activities.
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2
activities, regardless of the amount or number of transactions cleared, and these reports should
be reviewed for irregularities so that the Clearing Institution alerts itself quickly to
problematic merchant activity. Also, Clearing Institutions should, of course, follow the
guidelines that are established by the card issuing networks.
Another recent problem with merchant activities involves Clearing Institutions
that sometimes engage the services of agents, such as an independent sales organization
("ISO"), in their merchant programs. ISOs solicit merchants’ credit card transactions for a
Clearing Institution. In some cases, the ISOs actually contract with merchants on behalf of
Clearing Institutions.- Some o f these contracts are entered into by the ISOs-without the
review and approval of the Clearing Institutions. At times, Clearing Institutions unfortunately
rely too much on the ISOs to oversee account activity. Federal regulators have found several
instances in which Clearing Institutions have not properly monitored the activities of ISOs.
In these cases, Clearing Institutions have permitted ISOs to contract with disreputable
merchants, such as some telemarket businesses that engage in fraudulent transactions. These
problem merchants later experience high charge-back activity due to questionable sales
schemes and other improper practices. Because of the poor financial condition of the
merchant, or ISO, or both, these Clearing Institutions ultimately incurred heavy losses. At
least one bank has failed as a direct result of such activity.
A financial institution with credit card clearing activities that engages an ISO
should develop its own internal controls and procedures to ensure sound agent selection
standards. ISOs that seek to be compensated solely on the basis of the volume of signed-up
merchants should be carefully scrutinized. When engaging the services of a third party, such
as an ISO, in connection with any aspect of its operations, a Clearing Institution should
adequately supervise the ISO’s activities; and it should, of course, reserve the right to ratify
or reject any merchant contract that is initiated by an ISO.
@FedFRASER