Seal of the Board of Governors of the Federal Reserve System
BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM

WASHINGTON, D. C.  20551

DIVISION OF BANKING
SUPERVISION AND REGULATION


 SR 93-64 (FIS)
November 18, 1993

TO THE OFFICER IN CHARGE OF SUPERVISION
          AT EACH FEDERAL RESERVE BANK


SUBJECT: 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 regards to credit card-related merchant activities at financial institutions.  These matters are being actively investigated by the staffs of the agencies.  The attached Interagency Advisory alerts financial institutions to possible suspect merchant and credit card agent activities.  

                         Because we are aware that some individuals and firms are actively contacting financial institutions to solicit questionable credit card-related business, we request that you forward the attached Interagency Advisory to all of the state member banks, bank holding companies, and foreign banking organizations with credit card operations in your District.   A suggested transmittal letter is attached.  The Interagency Advisory was issued jointly by the Federal Reserve, Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and National Credit Union Administration on November 15, 1993.

                        Last, we note that Division staff is in the process of developing new credit card-related examination procedures.   We anticipate that the new procedures will be completed by the Spring of 1994.  The new procedures will address, inter alia, the subject of merchant credit card activities and our examination efforts in this regard in greater detail than those set forth in the attached Interagency Advisory.  

                        Please direct any questions on merchant activities to Mark Leemon, Senior Attorney, Division of Banking Supervision and Regulation, at (202) 452-5206.

Herbert A. Biern
Deputy Associate Director

ATTACHMENTS TRANSMITTED ELECTRONICALLY BELOW


Suggested Letter

Dear ______________________:

Subject:    Credit Card-Related Merchant Activities

                        The staffs of some of the federal financial institutions regulatory agencies and the Federal Trade Commission have recently been investigating deceptive practices in regards to credit card-related merchant activities at insured depository institutions.  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, we want to alert you regarding this problem.  

                        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 [Reserve Bank Contact] _______________________________.

Sincerely,

Attachment


                    
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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 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 of 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.


Footnotes

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.  Return to text


SR letters | 1993