By Adam Atlas
Attorney at Law
Once upon a time, ISOs that wanted to board merchants more quickly than their acquirers could underwrite them would illegally aggregate processing for multiple merchants under a single merchant identification number. In recent years, the Payment Facilitator (Payfac) model has created a legitimate way to aggregate processing of multiple merchants. Payfacs assume liability for losses incurred by their sub-merchants or sponsored merchants.
A Payfac can be thought of as a high-end merchant that processes for multiple merchants, or a low-end, with-liability ISO that assumes liability for all its sub-merchants. Today, ISOs are flocking to this increasingly popular model. It favors technologically savvy ISOs that can deliver the systems necessary to deal directly with merchants. Large platforms like Square and Stripe resemble the Payfac model.
When a Payfac or ISO (hereinafter referred to as ISO/Payfac) assumes liability for merchant losses, it's likely going to be asked to maintain a reserve with the processor or acquirer to protect it from losses stemming from chargebacks or other merchant liabilities. In this article, I will discuss certain legal considerations concerning ISO/Payfac reserve accounts.
Important distinctions exist between an ISO/Payfac reserve and a merchant reserve. Both are generally maintained to protect against merchant losses – but they are assessed according to different criteria. The merchant reserve is established as a function of the risk of the merchant. The ISO/Payfac reserve is established as a function of the risk of the overall portfolio of the ISO/Payfac and its merchants, combined. The ISO/Payfac agreement should distinguish between these two types of reserves and the rules applicable to each.
A major difference exists between allowing an acquiring bank to hold an amount always equal to 3 percent of monthly settlements and allowing the acquiring bank to withhold 3 percent of all settlements to an ISO. In the former, the reserve amount should vary in proportion to the processing volume of the ISO and its merchants. In the latter, the reserve amount appears to grow infinitely by an amount equal to 3 percent of each settlement to the ISO.
Given that reserve accounts do not usually accrue interest for the ISO, and for obvious commercial reasons, it's important to see whether the reserve is a true hedge against ISO losses or simply an investment tool for the acquirer. ISOs/Payfacs should review their agreements and look for clarity on how the reserve is funded and whether the formula is logical.
Generally, reserve funds belong to the entity from which they are withheld. Usually, ISO/Payfac reserves belong to the ISO/Payfac, and merchant reserves belong to the merchant. This is so because they are typically funded by payments from the entity required to form the reserve account.
It's important to clarify title in reserve funds because they would be subject to seizure should a bankruptcy occur, and the owner of the funds would want a successor on a bankruptcy to release the reserve account funds to the rightful owner or at least use them to fund a new reserve account.
When a liability arises for which the reserve account was created, the reserve funds are not necessarily used immediately. An ISO/Payfac's acquiring bank may, for example, call on the merchant and then the ISO/Payfac to fund the loss. If neither is able or willing to do so, it will draw on the reserve funds.
When an acquiring bank has to draw on reserve account funds, the relationship between it and the corresponding ISO/Payfac is usually not strong. Whether an ISO/Payfac is legally required or not, its acquiring bank will typically expect the ISO/Payfac to defray its liabilities before drawing on the reserve account. The reserve account is often viewed as a fire-extinguisher used once for a critical purpose for which no funds are available.
At the end of the ISO/Payfac relationship with a processor or acquirer, the ISO/Payfac will want its reserve funds returned. If the business has been sold, the successor will be expected to post an equivalent reserve account, at which time the ISO/Payfac will be entitled to receive its funds. Alternatively, the funds on reserve could simply be made an asset sold as part of the sale of the business.
If the business isn't sold, the ISO/Payfac will want the reserve account to be paid back, ideally within no more than six months following termination of the ISO agreement. This payback window is customary, as chargebacks and other losses are likely to occur after the termination.
It's important for ISOs/Payfacs to request and obtain regular reporting regarding reserve amounts so they can track them through the process to a post-termination release. If liabilities arise after termination for which the ISO/Payfac doesn't provide payment, the reserve account will be drawn upon and will be correspondingly smaller once released.
What would you do with $10 million of someone else's money in your bank account? Processors and acquirers face that question every day. Sometimes the temptation to use that money for purposes other than those intended is simply too great – and they steal it. This has occurred over the years – sometimes on a grand scale.
Thus ISOs/Payfacs should monitor the financial condition of their sponsors and also determine if their integrity is acceptable. Processors and acquirers that mislead ISOs/Payfacs on small items are perhaps likely to do so with large items, as well. If an ISO/Payfac has doubts about the solvency or integrity of its acquirer or processor, it should shop for alternative relationships. There may be more at stake than merchant accounts. The cash on reserve may also be in play.
Once an ISO/Payfac has zeroed in on its key considerations concerning reserves, it should make sure the wording of its agreement reflects the positions it has taken. If the language isn't clear, it should be clarified. Ambiguities can be interpreted against the ISO/Payfac or lead to absurd outcomes from courts that are not versed in the merchant services industry.
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, email Adam Atlas, Attorney at Law, at atlas@adamatlas.com or call him at 514-842-0886.
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