n March 31, 2006, Global Payments Inc. released a particularly alarming form 8-K. This release pertained to a merchant who was signed by a Global ISO. The merchant processed from October 2005 through January 2006.

During these four months, the merchant, which Global's announcement described as "an online payment system that enables consumers to purchase goods and services from other companies through the Internet," processed $86 million.

To Global's credit, it reserved $47.6 million in cash to protect itself in the event of chargebacks connected to this merchant. Unfortunately, the chargebacks are coming at a rapid pace; the $47.6 million was reduced to $24.1 million as of March 29, 2006.

Global reported that one of the merchant's customers was purportedly operating a multi-level marketing (MLM) scheme targeted at Internet users. In general, MLM merchants are difficult for an acquirer to approve because they have historically high failure rates and/or chargebacks. If they do fail, their chargeback amounts can be exceptionally high.

Let's examine a traditional MLM that sells household consumable items. Many resellers use credit cards for purchases and buy in large quantities for 1) their own supply 2) their down-line and 3) inventory for future sales.

Some unscrupulous MLMs encourage resellers to buy excessive inventories to artificially inflate sales. Resellers do this when they either are getting a residual from the MLM or buying the product in hopes of developing a residual stream. Additionally, many of the resellers are in frequent communication with one another.

Should the MLM encounter financial difficulty, resellers may not be paid. When this occurs, resellers begin charging back (or returning) all the product they purchased for inventory. Worse, the reseller's down-lines begin doing the same. What started out as a financial difficulty quickly moves to a full bankruptcy.

Once this occurs, the resellers are left holding their inventory. Because they have an open communication channel, they are able to "coach" one another on how to successfully process these chargebacks.

Compounding the problem, MLM resellers often have a registration fee. Because payment of this fee bestows lifetime rights to represent the MLM, it too is often charged back. Due to the registration fee's characteristics and card Association rules, the chargebacks can have an excessively long tail.

Suffice it to say, Global is looking at a lot of chargebacks. Further, high chargeback merchants attract unwanted attention. The Associations may get involved and can institute a per chargeback fine. Worse still, the type of merchant described by Global must be properly registered and follow strict guidelines. If this is not done, retroactive and daily fines can apply. In short, Global will likely face increased Association scrutiny as well as potential fees and fines.

While Global does not expect to face a material loss, it estimates its potential uncollateralized loss exposure, in excess of reserves, to be $39.7 million. I suspect this is a worst-case scenario and not likely to take place.

Residuals at risk

Additionally, should a loss occur, Global will pursue recovery through the merchant, the personal guarantee on the account and the ISO that solicited the merchant, which includes a security interest in a separate merchant portfolio of the ISO.

Regardless of the above, Global is a strong, large, publicly traded company. Even if the worst-case scenario is realized, Global will have no difficulty meeting its financial obligations. The ISO, however, may not fare so well.

Further, if the ISO portfolio is tapped by Global, then all entities receiving residuals from that ISO could be at risk of losing residuals. Certainly Global is not in the business of foreclosing on its customers, and I would expect Global to work with any active ISO.

Global's form 8-K also mentions potential litigation, which is typical in situations with this magnitude of fallout. Global thinks the MLM has ceased operations pursuant to a federal court order. A court-appointed receiver has assumed control of the MLM, and the receiver contends that Global must return all of the MLM's reserves to the MLM. Global disagrees with the receiver, and the Judge who appointed the receiver is siding with Global.

Global wrote that it does not know whether the receiver or other interested party will initiate further litigation regarding Global's right to retain all of the cash reserves and apply them against chargebacks in this matter.

Despite the above, Global maintains that its cash reserves will be sufficient to cover any exposure, and there has been a significant decline in weekly chargebacks. Financially, it will likely come out money ahead, and but for some reputation degradation, it will be no worse off and likely a little more savvy.

In pursuit of stability

Regardless of Global's position, the ISO that submitted the merchant may face significant financial obstacles. This does not appear likely, but entities receiving income from this ISO should at least be aware of this issue and consider the stability of their residuals. Certainly this is not a new message within the merchant level salesperson (MLS) community, but sometimes the only time we truly appreciate the stability of our acquirer is when that stability is threatened.

I encourage MLSs to contract directly with a member bank or similarly secured organization. By doing so, they will be better secured against any potential merchant loss, card Association action or member termination.

Ken Musante is President of Humboldt Merchant Services. E-mail him at kmusante@hbms.com .