By Adam Atlas
Attorney at Law
The ISO and payment processing industry has seen bankruptcies. For example, back in 2009, Cynergy Data went through bankruptcy, and ISOs and merchants muddled through for the most part.
Bank failures, such as those of Silicon Valley Bank, Signature Bank and Silvergate Bank are, however, different and present new risks for the processing industry. The purpose of this article is to consider bank failures from the legal point of view of the ISO and payment processing industry.
At any given moment in time, an ISO or payment processor has a number of "buckets" of money in play; each one answers to its own legal paradigm.
A retail ISO customarily does not assume liability for merchant losses, is not party to merchant agreements and does not take possession of merchant face-value of funds.
In most retail ISO scenarios, merchant settlement funds are held in a single bank-owned aggregated account of the acquiring bank that is swept to merchants on a daily basis. In this scenario, the ISO is party to a merchant agreement with the acquiring bank and is an unsecured creditor for their settlement funds.
To be clear, the merchant does not typically have the benefit of a single sweep account. Instead, funds of multiple merchants are commingled, and no single merchant can be said to be an account holder of the account. The settlement account of an acquiring bank belongs to the bank and is on the balance sheet of the bank. Merchants have a contractual claim versus the bank for the funds.
Merchants are not likely to benefit from FDIC insurance on the funds held in an acquiring bank settlement account because the account is not a bank account belonging to the merchants.
If an acquiring bank goes bankrupt, merchants are at risk of losing all funds not yet settled to them by the acquiring bank. Fortunately, merchants are usually waiting for only a day or so of settlements, so loss of those funds should hopefully not be fatal to the merchant.
Wholesale ISOs and payment facilitators (payfac) customarily take liability for merchant losses, are parties to merchant agreements and sometimes take possession of merchant face-value of funds.
Bankruptcy of the acquiring bank of a wholesale ISO or payfac puts the ISO or payfac in the front seat with the bank for the wreck.
If the merchants or sub-merchants have contracts with the acquiring bank, they will be making the same unsecured creditor claims as merchants of retail ISOs discussed above. When the merchants or sub-merchants realize there is nothing to be had from the acquiring bank, if they have direct terms with the ISO or payfac, then they will start making claims for the face-value of unsettled funds versus the ISO or payfac.
In simple terms, a wholesale ISO or payfac often back-stops the solvency of its acquiring bank. This could result in substantial claims versus the ISO or payfac that—ironically—might be more solvent than its own acquiring bank.
It’s not a waste of time for wholesale ISOs and payfacs to reflect on what would happen if their acquiring bank went under—together with all merchant funds in process.
Reserve accounts consist of often a substantial sum of funds held by an acquirer under a merchant agreement to protect the processor against potential losses on account of merchant chargebacks or other losses.
Some merchants process without having given reserves, but others must post reserves before a single transaction is processed. The amount of reserves for any given merchant is a commercial matter based on the acquirer's credit assessment of the merchant, the track record of the merchant and other factors. In any case, many thousands of merchants post reserve accounts to all acquirers.
Most merchants and ISOs perceive reserve account funds to be the "property" of merchants. Indeed, many ISO and merchant agreements use language that suggest the same.
Despite perceptions, however, the most likely legal characterization of reserve funds is the same as unsettled merchant processing funds. Specifically, if an acquiring bank holding reserves goes bankrupt, merchants are likely to be unsecured creditors with claims for their funds.
There is, perhaps, a slightly better claim for FDIC insurance on merchant reserves, as these funds are perceived as an account—a reserve account—held by the acquirer for the merchant. I am not aware of whether the FDIC has ruled on this issue, however.
No surprises here, dear reader. ISOs with unpaid residuals on a bankruptcy would have to get in line like other unsecured creditors. ISOs do, however, have some ammunition in the form of their relationships with merchants. In processor bankruptcy scenarios, I have seen the bankrupt processor honor the duty to pay residuals as a means of protecting the value of the assets of the bankrupt processor, namely, the merchant portfolio.
If the bankrupt acquirer sees its assets sold to a new bank, the new bank might make a business decision to pay residuals that the bankrupt acquirer was unable to pay so as to secure loyalty of ISOs and downstream agents and preserve the value of the portfolio it bought out of the bankruptcy.
Perhaps the most interesting situation for a bankrupt acquirer is for merchants to reverse all their pending transactions. This raises complicated questions of competing interests of the bankrupt estate and merchants. I am not aware of this ever having been attempted, but I suspect many merchants will try it if they learn their acquirer is going under.
This column considers a number of fact patterns in general terms, and the risk assessment of any given pattern will vary greatly from one ISO or processor scenario to another. The analysis herein will most likely not apply to any single reader’s business and must not be taken as legal advice or a prediction of outcomes on bankruptcy of a bank. This is not financial advice; I don’t know anything about CDs, T-bills and the like. 
In publishing The Green Sheet, neither the author nor the publisher is engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional should be sought. For further information on this article, please contact Adam Atlas, Attorney at Law by email at atlas@adamatlas.com or by phone at 514-842-0886.
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