"Credit card fraud is the Net's dirty little secret," reads the deck of an article on credit card fraud written by The Industry Standard's Miguel Helft and posted February 29 on their Web site. "The victims are not consumers," it continues. "They're merchants that have little or no recourse when they're stuck with the bill."
The article itself is a detailed examination of the current state of Internet credit card fraud, with a predictable emphasis on mainstream, rather than adult, businesses. But the underlying theme remains the same both for the sacred and the profane: the merchant has the most to lose. And if fraud and chargebacks "are the Net's dirty little secret," as described by Bill Scheurer, founder and CEO of PocketCard.com (www.pocketcard.com), a Visa card for teens, one can only imagine how cryptic a subject it is for adult Internet, a universe already shrouded in mystery, deception and collusion. Mix credit card fraud, chargebacks and sex, and you have an atmosphere seething with Old Testament passion. Most people have a personal and emotional relationship with credit cards. Having one represents a sort of societal acceptance. Do we even exist without one? And now credit card dependency has followed us onto the Net. Far from not leaving home without them, now we can't even stay home without them.
Today (the day this article is being written) is March 1, 2000, a day like any other in the world of adult Internet but for one ostensibly insignificant event. Effective today, according to a document received by AVN Online and several adult Web masters, "MasterCard will implement an excessive chargeback program for electronic commerce merchants and other selected merchant categories to reduce excessive chargebacks and fraud." That sounds innocuous enough, but the aftershocks of this seemingly small tremor are liable to impact the very infrastructure of adult Internet commerce, though exactly how and for who is extremely difficult to determine, for several reasons: First, the inner workings of the credit card companies are more clandestine than the upper echelons of Scientology. Also, adult Web sites are completely dependent upon credit card merchant accounts, not only for transactions but for age verification. Then, the relationships between merchants, merchant banks and the credit card companies are very complicated and tenuously dependent upon rules and regulations that few people are allowed to see. These combined factors produce opinions and comments much like those of the three blind men describing the elephant by touch - one completely opposite from the next. What is clear, though, is that, from site members and Web masters to third party processors and merchant banks, no one will be immune to the effects of the lowering of chargeback thresholds.
Chargebacks are, of course, credit card refunds, or more accurately, a reversal against a sale that was credited to the merchant's account. They are usually the result of an error made by the credit card's bank, a misunderstanding by the customer, or fraud. As problematic as they may be for mainstream businesses, they are tenfold so for adult sites. "Merchants and industry groups say fraudulent Internet orders tend to fall into two categories," says Miguel Helft in his article. "Items that can easily be exchanged for cash, and transactions that do not require physical shipments of good. The former includes products like consumer electronics, diamonds and gift certificates, the latter downloadable software and subscriptions to adult sites [italics added]." Credit card fraud with respect to adult sites can go both ways, by fraudulently gaining access to sites by crooks with stolen credit cards or by the fraudulent overcharging of credit cards by pay sites.
The Cold Hard Facts
In the document received by AVN Online, the standards of MasterCard's new program were outlined as follows:
"If a merchant engages in electronic commerce transactions or provides services using the Merchant Category Code (MCC) 4816 [Audiotext] or 5967 [Videotext] and has a 1% or higher ratio of chargeback transactions to total sales transactions or a 2.5% or higher ratio of chargeback dollar volume to interchange sales volume in each month for two consecutive calendar months, then MasterCard may, at its sole discretion [italics added], declare the merchant an excessive chargeback special electronic commerce/computer network/inbound telemarketing merchant. If, in the opinion of MasterCard [italics added], the merchant is issuing credits as a substitute for chargebacks to avoid the applicability of this section, then MasterCard may treat the credits as chargebacks to compute the applicable percentages."
Base fines assessed by merchant banks or third party processors may vary, but, according to the document, "Merchants that are found to be excessive for more than two consecutive months will be assessed additional heavy fines by MasterCard according to the following schedule:
"Months 3 through 5, $25,000 fine per month
and an additional $25 per chargeback.
"Months 6 and 7, $50,000 fine per month
and an additional $50 per chargeback.
"Months 8 and 9, $75,000 fine per month
and an additional $75 per chargeback.
"Months 10 and higher, $100,000 fine per month
and an additional $75 per chargeback."
Previous to these new policies, the chargeback threshold level was a 2.5% or higher ration of chargeback transactions to sales. That level has led to problems for some adult sites but was more than attainable for adult sites that were honest in their business practices and vigilant with their customer service. There are, however, few if any sites that will be able to consistently maintain a chargeback ratio at or below 1%. With credits factored in as chargebacks, it will be virtually impossible for most sites to remain compliant.
For the time being, these new policies are applicable only to MasterCard accounts, but they are global in impact. Visa was scheduled to convene their annual meeting in March, with any newly enacted policies going into effect in or around June. It is expected that they will follow MasterCard's lead with similar chargeback threshold levels - though we have heard rumors of a .5% threshold. Our sources tell us that that any new Visa policy will only be with the Visa USA division, not Visa International. This has led to speculation that several companies will move their merchant processing offshore.
On February 8, AVN Online posted a story regarding this matter on the AVN Web site, requesting readers to send in any comments that they had, on or off the record. We also E-mailed our advertisers and others for feedback. We did receive responses, though not nearly as many as we expected. AVN Online also left several messages with representatives of MasterCard, the FTC, and merchant banks, none of which were returned. It became immediately apparent that the impact of these new policies would be more like a subterranean nuclear detonation than a surface explosion. The threat as perceived to the continuing viability of adult Internet is so real for so many that a "circle the wagons" mentality seems to have taken hold. In fact, the response of individuals or companies appears more often than not proportionate to their sense of security within the industry as well as with their relationship to the credit card companies.
Though even the most secure, if pushed, will betray dissatisfaction with the current situation.
"Yes, we are worried," said JoeE of Cyber Entertainment Network (www.cencash.com), an industry E-commerce player. "In fact, we're trying to form our own version of Mothers against Drunk Drivers, but for the adult Internet industry. We need to fight Visa/MasterCard. We need a very strong lobby. Between the seven largest [adult] companies, we do a billion dollars a year on the Internet. We have our own customer service, plus we use PayCom, which used to be Epoch, which has their own customer service also. So we try to fight the chargeback off before it becomes a chargeback. The banks aren't working with us, neither are Visa or MasterCard. If somebody doesn't like the site or wants their money back and they call us, we give them their money back instantly."
"We have voiced our concerns to MasterCard and we are scheduling a meeting with them in a few weeks to further discuss the issues at hand," said Kjell Petridis, V.P. for Business Development for Jettis.com (www.jettis.com), a leading third-party processor. "MasterCard's position that the excessive issuance of credits as an effort to control chargebacks may be attributed toward a merchant's chargeback is a shock to everyone. In many ways, it seems inconsistent. When you fill out a merchant account application, you are asked what your return policy is. Everyone answers that they have a "no question policy" towards disputed charges and yet that very practice is being singled out in this case. My sense is that some of the aggressive marketing practices that are out there have been identified and this new policy addresses the problem directly."
Craig Tant of CCBill (www.ccbill.com), another leading third-party processor, was much more sanguine. "There's a lot of talk on this issue and the E-mail that [MasterCard] sent out, and everyone's overreacting to it. They just want to take control of chargebacks. In order to do that, they've got to have some leverage to make sure that people realize that if they are going to have situations where there are chargebacks, double-billing, or the other goofy things that you can do, that they can control the situation by penalizing them for doing so. I think they're going to use [the new policies] accordingly, and I'm not worried in any way about it.
"I think maybe someone is going to hedge the numbers, do all the wrong things, and they [MasterCard] want the ability to go, 'No, we don't want to work with this.' A few bad apples will make it hard for everybody. I know of a company out there, a multi-million dollar company a month, that is doing free trials and makes it next to impossible to cancel. If you don't cancel within three days, you're billed sixty dollars a month. Yes, they will gladly refund, but how long are they holding that money until they refund it, and is that acceptable? They're playing the game. What's the interest on a million dollars a month? That's a profit margin right there. Do you think MasterCard likes that situation? MasterCard is right for saying that they want to have some control over that."
In a similar vein, Steph from Janey's Web Service (www.janey.net) wrote us, "[MasterCard] is lowering the threshold because of the increased fraud that occurs on the Net. Any good businessperson would do the same. This is an issue that is created by surfers to the adult Web sites primarily. So, in effect, we caused this ourselves... What does concern me is that the increased cost of doing business forces many of the smaller Web sites out of business... simply because the 1% level at the smaller numbers really hits these smaller Web sites harder."
Macey Montgomery (www.maceysplace.com) runs a small Web site that specializes in phone sex. She wrote us, "I received the memo... regarding this new policy implementation. It is ridiculous. The fines begin at $25,000 and go up from there. This could seriously put many adult businesses out of business. I own two phone sex services and beginning March 1, we will no longer be accepting MasterCard until there is a resolution to this. This new policy is too stringent and I hope that other services that have told me that they are not accepting MC, will do so. Maybe this will get [MasterCard] to open their eyes and see how harsh of a policy this is."
"David," who asked that his Web site not be named because "I do not need any more problems," is also very troubled. "As an adult Web master I am highly concerned with my livelihood. I do not know what to do. I have been in this business for a little over two years. I was hit pretty hard with the DMR/ WEB800 problems. Fortunately, I have had my own merchant accounts for the last year. So, I wasn't hit as hard as others. What I don't understand is this. If MasterCard is charging us 2.5% to process our initial transactions, then if we get a chargeback they hit us with a penalty between $10 and $35 on top of the original credit for the disputed charge. How can they possibly get away with major penalties? I am beyond worried and concerned. What do I do from here? Looks as if I will be getting a job at a local fast food restaurant."
But not everyone believed the story in the first place. We received this response from Steve at Membership+ (www.membershipplus.net); "...MasterCard does not impose "fines" on merchants... banks impose fines. That right there tells you that a certain bank is behind this, not MasterCard. MasterCard has no risk involved in chargebacks, why would they impose such huge fine? In my opinion, you did poor research and only contributed to RUMORS that should never have been started if you did your homework first and reported later."
And then there were the "no comments." One notable one was from AdultCheck (www.adultcheck.com), a leading Age Verification Service, whose in-house counsel Tim Umbright responded tersely, "We don't have any desire to discuss it [chargebacks] in the media in any way, shape or form. We have a pretty hard policy in that way."
The Middle Men
ISO is an acronym for Independent Sales Organization. They are the middlemen situated between the merchants and the merchant, or acquiring, banks. In the adult world, they are particularly important because there are so few banks that will accept adult clients, considering them too large a risk, so those businesses are forced to go through an ISO to obtain merchant status. AVN Online spoke with a few prominent ISO merchant sales representatives (MSR), who prefer to remain anonymous because of delicate relationships with the credit card companies that make them particularly vulnerable to retribution. One told us that if MasterCard or Visa found out that he had spoken with us, they would tell the merchant banks with which he did business not to accept any of his clients' applications, in effect blacklisting him.
"I probably do as much adult as anyone else in the world," he said. "The MasterCard program is so prohibitive that either they are going to have to change it or they're just going to drive all the traffic to Visa. My phone has not stopped ringing since this thing broke, and I process for just about all the big guys. Visa's program is going to be different. MasterCard's program counts credits for chargebacks, and I think that's a critical mistake. That just makes it flat impossible to comply with."
Would Visa likely follow suit with the 1% threshold? "Yes, but I do have people who are able to maintain in the very low 1%. I just don't know how some guys are going to qualify for the new percentages. Visa and MasterCard's position, very simply, is that the adult business is bogging down the system by creating the chargebacks, costing the issuers money, and they don't like it.
"It would be politically disastrous for Visa/MasterCard to just outright stop accepting credit cards for adult sites," the rep continued. "I really think it does come down to something as simple as they don't want so many chargebacks running through their system. You have to understand how the revenue is split up in the card association. Visa and MasterCard themselves make very little money on every transaction, and they make nothing on the chargebacks. All that money is going to either the issuing or acquiring banks. But they also lose revenue, or they have to give it back, every time a credit takes place. The charge to handle a chargeback is right up there in the ten to twenty dollar range, and then when you calculate what it costs the card issuer to go find another card holder when he loses a card holder allegedly over somebody going into an adult site, now they say it costs them up to a hundred dollars. That's how they're justifying the fines. They don't consider them punitive, but compensatory."
"I think that the nature of the business is going to change, the nature of recurring billing is going to change, the anonymity issues are going to change, and the disclosure issues are going to change, in order to satisfy the card association," said another rep. "Either that or somebody is going to come up with most incredible new distributable quasi-cash payment system that enables these Web site operators to continue. There is no other option in my mind, and I have thought this through. The fact is that I have watched over the past couple of years the card association squeezing, and now they're downright emotional about it."
The Conspiracy Theories
AVN Online also spoke with several attorneys from firms who represent many of the leading adult Internet companies. Their opinions on the subject couldn't have been more different from everyone else we spoke with. To a one, they were convinced, or could easily believe, that political forces were at work behind the scenes, brokering deals the impact of which goes far beyond the relatively limited world of Internet porn. Because of the sensitive nature of these comments, the attorneys, like the ISO reps, agreed to speak on condition of anonymity.
"What we've found out is that the FTC and Visa seem to communicate with one another pretty regularly," said one attorney. "In fact, Visa, according to one of my FTC contacts, allegedly reports instances of high chargebacks to the FTC. We recently found out that one of the reasons why the FTC was so interested in this area was because of a credit card scam that allegedly was perpetrated by one particular person who allegedly had obtained credit card database lists from Charter Pacific Bank. This was alleged to have occurred in 1998. He allegedly paid (name withheld) off at Charter Pacific Bank and acquired a large amount of database information on credit cards and credit card users, and then proceeded to bill them bogusly.
"We now think Visa got wind of the chargebacks and notified the FTC, who commenced action against this party and others in the adult industry. (Name withheld) was arrested last year. The FTC charged him with 48 million dollars of allegedly bogus credit card charges. Once the FTC had their target focused on the adult industry, what they realized was that there are huge amounts of money here, and that's when they began to investigate a lot of other adult entities.
"It was clear to us that Visa/MasterCard and then the FTC confused a lot of legitimate Web masters with (name withheld)," continued the attorney. "And there's a reason for that. The credit cards came from a bank doing processing on those cards for legitimate Web sites. So it's possible they figured that the entire industry, or at least a good part of it, was engaged in this un- lawful activity, when at the time that was not the case. There were only a handful of big Internet adult sites to begin with. So this gave the industry a black eye almost from the beginning with regulators: the FTC, the Justice Department and Congress."
"Supposedly there are two rumored theories behind where we are today, building on the fact that there was this start-off with this humongous alleged credit card fraud that Visa and the FTC became aware of," said another attorney.
"One, the credit card industry has been trying for years to get changes in the bankruptcy laws to make it very difficult for consumers to discharge credit card debt. Right now it is very easy for consumers to rack up very large amounts of credit card debt and then walk away from it. Year after year the credit card and banking industries have not been able to get this legislation through.
"What supposedly happened is that the Senate banking committee was approached by the credit card companies, maybe particularly Visa, and they said to the banking committee, 'We know the conservatives and the religious right would like to curtail the adult Internet. What we can do is we can help you do it by pulling the plug on the money source. If you give us better bankruptcy legislation to make it more difficult for people to discharge their bankruptcy debt, we'll assist you by making it tougher for this industry to exist online.' While I can't confirm that conversation, and maybe the day will come when my source will reveal himself publicly, if you check right now, the toughest revisions to the bankruptcy law have been introduced in congress as we speak.
"There is another theory that what Visa and MasterCard are trying to do - because they are seriously concerned about the fact that the nature of E-commerce is that you can do things like get a hold of a database and charge 200,000 people in an hour and then disappear - is to concentrate the industry around a very few processors. Concentrated into a few hands so that they can get their hands around the data so that they know just how to regulate this. So what they're allegedly trying to do by this is make it extremely difficult for a very large number of adult Web sites to profitably exist.
"They clearly know that a 1% total chargeback rate is impossible for this industry. I think they know this and that they have the data already. And this plays into both theories. There may be a reason why this is happening now. This current crisis started last fall. It may not be coincidental that for the very first time the greater amount of dollars that was being spent on the Internet was on non-adult sales rather than adult. Non-adult sales are big enough that Visa and MasterCard can now do what they've been alleged to have done many times before, like in audiotext. Now that there are enough dollars coming in from sales of other goods and services on the Internet, they can start to move away from adult. And if the rumor is true about this little deal about bankruptcy, they can start to deliver on their part of the deal because now they've got all the dollars coming in from other things. The two theories are not mutually exclusive."
As should be obvious from the scope of opinion that this issue incites, there may never be an official ending to this story, at least not until age-verifiable alternative methods of Internet billing are developed and widely distributed. Almost everyone who AVN Online spoke with said that they were currently developing such methods, but no one was ready to go on the record with what. There are already several alternative billing systems on the market (see sidebar), but all are hampered by as yet unsolved limitations of one kind or another.
The credit card companies themselves are hard at work on ways to shore up the flaws of online credit card processing, such as utilizing methods of identification that are already present on the cards. Time will tell, but experts in the industry say that no alternative system will ever fully replace the efficacy and convenience of credit cards.
There are also many rumors concerning possible legal action against the credit card companies and/or the merchant banks. There is talk of grass roots appeals and organized lobbying efforts. In fact, one such lobbying group already exists, the Global Internet Alliance (GIA), a confederation of key members of the adult Internet industry formed to collectively address problems affecting adult consumers and merchants around the world.
More to come as it develops...
[Also in this issue is the first installment of a multi-part Legal Commentary by Clyde Dewitt discussing the credit card industry's impact on the Internet and adult sites in particular. Part One is entitled "How This All Came About," and makes a very nice companion piece to this article, if we don't mind saying so ourselves. - Ed.]