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Legal Review: Be Careful Managing the Chargeback Ratio

1 Aug, 2008 By: Bruce Whitman Response

A cautionary tale from the Berkeley Premium Nutraceutical trial.

Virtually all direct response companies with a continuity program have credit card processing issues, but none is more significant than the chargeback ratio. The chargeback ratio is simply the fraction or percentage of the total electronic transactions submitted to the processor that result in consumer chargebacks.

Bruce Whitman
Bruce Whitman

Now that Visa and Mastercard are public companies, their chargeback rules are more readily available to merchants. However, these rules are still complex, and the rules as to what a merchant may not do to keep the chargeback ratio below the required 1 percent of transactions continue to be vague and confusing.

Chargeback Issues in the Berkeley Case

The U.S. government issued a criminal indictment against Berkeley Premium Nutraceutical Inc. (the company marketing and distributing the well-known Enzyte male enhancement product) and five of its executives. Seven other executives plea bargained before trial and became government witnesses.

The indictment alleged that the defendants schemed and conspired to use deceptive advertising and free trial offers to induce consumers to call the call center, which then collected a credit card number for shipping and handling. Then, a salesperson deceptively induced consumers to agree to a continuity program. According to the government, this deceptive method of gaining customers led to chargebacks of more than 1 percent, which led to fines, penalties and threats of revocation of processing by Visa.

Because a large majority of its sales were paid by credit cards over the phone or on the Internet, the threat of revocation of processing caused panic for both the financial and IT managers at Berkeley. According to the government, the managers on trial conspired to commit federal bank fraud, consumer fraud, wire and mail fraud and credit card fraud by artificially increasing transactions to reduce the ratio.

How Not to Manage the Chargeback Ratio

As sales boomed, the chargeback ratio also boomed, and tough refund policies made it difficult to reduce chargebacks by internal customer service. Therefore, Berkeley resorted to several accounting methods to reduce the ratio, including:

› Splitting charges. Berkeley, at times, split one sale into separate charges for the product and for shipping and handling, resulting in two or three electronic transactions (rather than one) to compare against the chargebacks in any particular month. While this method worked to reduce the ratio, the government claimed that the additional charges were "unauthorized transactions," and therefore were criminally fraudulent. The government found it significant that Berkeley only split charges when the ratio was close to 1 percent, but not on all sales.

› Charging executives' credit cards. At times, Berkeley executives actually charged their own credit cards to create thousands of transactions in order to reduce the ratio. The government claimed that although the only apparent loss was to the executive whose card was charged, the intent to deceive the processors and credit card companies constituted conspiracy to commit bank fraud, wire fraud and mail fraud.

› Debit/credit. The most difficult charge to defend in the trial was the allegation that an IT manager had conspired to randomly select credit card numbers from the customer database and charge and then immediately credit them. This "debit/credit" scheme was performed several times, generally on the last day or two of the month, when other methods were no longer available. The charge was conspiracy to commit access device fraud.

Find Out Why You Have Chargebacks

For those who have a chargeback ratio problem, I advise honest analysis of the cause rather than trying to manage the problem on an ad hoc basis. For example, Berkeley realized too late that its ratio problem was solved by combining all of their products into one processing account rather than separate accounts for each product.

You may believe, as did the Berkeley defendants, that managing the chargeback ratio is simply a civil matter between businesses. However, the government believes increasing transactions for that purpose is criminal fraud, so be careful in managing your chargeback ratio.

Bruce Whitman is an attorney and runs the Whitman Law Office in Cincinnati. He can be reached at (513) 321-3940.

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