Chargebacks are a forced transaction reversal initiated by the cardholder’s bank. They are meant as a consumer protection mechanism, but are often overutilized.
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What Are Chargebacks? What Do They Mean for Your Business?
What is a chargeback? In simple terms, it's the reversal of a credit card payment that comes directly from the bank.
If you're a merchant, chargebacks can be a frustrating threat to your livelihood. If you're a consumer, chargebacks represent a shield between you and dishonest merchants. If those two things seem at odds, well, that was never the way it was intended.
To understand how chargebacks work (and how they don't), it helps to have some background on the rationale behind chargebacks, and the impact they have on those involved.
The Purpose of Chargebacks
On the outside, chargebacks can appear very similar to traditional refunds, yet there is one very relevant difference: rather than contact the business for a refund, the consumer is asking the bank to forcibly take money from the business’s account. An investigation follows, and if the bank feels the cardholder’s request is valid, funds are removed from the merchant’s account and returned to the consumer; the consumer, on the other hand, is in no way obligated to return whatever was purchased.
The merchant has no say in this. In fact, merchants likely won't even know it happened until after the fact. As a consumer protection, the chargeback process is naturally skewed towards the cardholder’s safety, in multiple ways:
Chargebacks are designed to keep customers feeling secure. The risk of a forced reversal of funds keeps merchants focused on providing exceptional customer service.
Chargebacks also serve as a deterrent to merchants who might be tempted to sell sub-par products or services. Cardholders will claim the products or services were not as described, setting the stage for a chargeback situation.
The threat of chargebacks helps merchants stay transparent. Customers can’t be expected to pay for something that was never delivered, charges that shouldn’t have been made in the first place, or refunds that never got issued.
Chargebacks help protect cardholders from the effects of criminal fraud. In a world where even players like Equifax suffer data breaches, many cardholders aren’t even surprised when they learn unauthorized transactions have been made on their account. The ability to file chargebacks on fraudulent credit card transactions helps innocent victims recoup their money.
How Did the Chargeback System Originate?
First, let’s delve into a little bit of the history of chargebacks.
In the early 1970s, bank credit cards had not yet gained widespread acceptance in the US. This was partially because of consumer fear: people worried that the card could be lost or stolen, then used for unauthorized transactions ... with the original owner getting stuck with the bill.
There were also complaints of unscrupulous merchants taking advantage of the consumer--for example, using the credit card number to add fraudulent charges. The Fair Credit Billing Act of 1974 attempted to address the second issue by creating what is called a chargeback.
As originally conceived, chargebacks were a form of cardholder protection, a "safety net" of sorts that meant the cardholder’s money was safe, no matter what. An argument with a merchant, for example, could easily come to a stalemate: "I say you owe me the money, and there's nothing you can do about it because the bank has already paid me!"
But using a chargeback, the cardholder could effectively go over the merchant's head and secure a refund from the bank itself. The bank, in turn, could void a credit card transaction, then withdraw funds that were previously deposited into the merchant’s bank account and slap the merchant with a hefty fee (or in extreme cases, revoke the merchant's card processing permissions).
The new regulations were an effort to alleviate consumer fear, and it worked: bank credit card use exploded in the 1970s … and until relatively recently, chargebacks served the system well.
When Can Consumers Legally Use Chargebacks?
Today, credit cards are such a ubiquitous part of life that many users don't even realize they have chargeback protection. Those who do know often misunderstand how the chargeback is supposed to work. They don't comprehend what isn't--and what is--a chargeback situation.
For example, consumers who are the victims of identity theft have every right to file a chargeback if fraudulent purchases are made. Cardholders should contact the bank immediately, both to recoup stolen money and to prevent additional losses.
It's important to note, however, that this is the only situation where the consumer should call the bank first; in every other circumstance, the cardholder needs to communicate directly with the merchant.
And of course, the goal is to resolve the issue without the banks getting involved at all. Sometimes, the perceived fraud might be an accident. Perhaps the consumer has forgotten about the purchase or the merchant made an innocent mistake. The situation might be able to be quickly and easily settled to everyone's satisfaction. Plus, while many consumers don't realize it, a refund usually puts money back in the consumer’s account much quicker than a chargeback.
If the merchant isn't able--or willing--to work toward a mutually agreeable solution, a chargeback may be in order. But even if a customer is unsatisfied with a purchase, simply filing a chargeback without first seeking a traditional refund is the equivalent of cyber shoplifting.
Here's why: with a chargeback, the cardholder keeps the purchased item and gets the cost of the item refunded; essentially, the merchant has to pay twice for the same item or service. Legitimately, consumers are "required" to request a traditional return/refund from the merchant first … and should only file a chargeback in extreme situations. Otherwise, the consumer is taking something for free—the very definition of stealing.
How did Chargebacks Become "Friendly Fraud"?
If you're asking the question, “What is a chargeback?” you'd better ask another: “What is friendly fraud?” Friendly fraud--often called chargeback fraud because consumers are abusing the chargeback process--refers to customers deliberately stealing from merchants by claiming legitimate purchases are fraudulent.
As we've seen, chargebacks were designed as a form of consumer protection. But industry regulations have not kept pace with rapid changes in technology and payment options, and this has allowed chargebacks to become weapons consumers can use against merchants.
Cardholders might file a chargeback for any of a number of wrong reasons:
- The consumer uses a chargeback to avoid a restocking or handling fee.
- The consumer has “buyer’s remorse.”
- The return process seems too cumbersome.
- The consumer wasn’t patient enough to wait for (or didn’t understand) the delivery schedule.
- The consumer didn’t act promptly and the return time limit has expired.
- A family member made the purchase but the cardholder doesn’t want to pay the bill.
- The cardholder forgot about or didn’t recognize the transaction.
- The cardholder wants to make some extra money and/or wants something for free.
According to consumer claims at the time of filing, nearly half of all chargebacks are supposedly in response to unauthorized transactions. A recent survey, however, found that over 80% of cardholders filed a chargeback simply because they didn’t have time to request a refund from the merchant.
The consumer might think a single incident of chargeback fraud is no big deal, but that mentality is clearly creating a very substantial problem. Financial losses from credit card fraud exceeded $100 billion in fees, false positives, and lost merchandise and revenue for eCommerce merchants in 2013 alone. Of that, experts estimate that at least $4 billion is caused by friendly fraud ... but in reality, the costs are much higher.
In order to fully understand the repercussions of their actions, consumers need to be made aware of the effect chargebacks have on merchants. At the same time, it is absolutely essential for merchants themselves to understand how a chargeback affects their bottom line.
Chargeback Costs & Consequences: Merchants
Chargebacks have both short and long-term ramifications for merchants.
Each time a consumer files a chargeback, the merchant is hit with a fee (this can range from $20 to $100 per transaction). Even if the consumer later cancels the chargeback (for example, if it was filed because of non-delivery, but the item shows up a few days later), the merchant will still have to pay fees and administrative costs associated with the process.
If the consumer files a chargeback and simply keeps the merchandise, the merchant loses that revenue and any future potential for profit.
If monthly chargeback rates exceed a predetermined threshold, excessive fines (in the ballpark of $10,000) will be levied against the business.
If chargeback rates remain above the acceptable threshold, the acquiring bank could simply terminate the merchant account. This means a frozen merchant account, with the ability to process credit card payments revoked. Merchants are unable to accept cards so long as they have a closed merchant account.
If the merchant’s account is terminated, that business will be placed on the MATCH list. This means the business has been black-balled and is unable to secure a new account with a different processor for at least five years.
Even if the bank doesn't close the account, businesses that experience significant chargebacks could be forced to obtain high risk merchant accounts. These accounts come with steep processing fees and revenue-stealing rolling reserves.
Acquirers often create a merchant account reserve for businesses that regularly receive chargebacks. This non-interest-bearing bank account is used to protect the bank’s assets should the business sustain too many profit losses. Restricted access to revenue usually creates cash flow issues that the struggling merchant is unable to overcome.
While merchants have the right to dispute illegitimate chargebacks, crafting an effective dispute takes significant amounts of valuable resources—resources the merchant should be using to grow the business. Plus, without professional help, these chargeback disputes rarely end with a win for the merchant.
Winning a chargeback dispute doesn’t improve the merchant’s chargeback-to-transaction ratio; the merchant can regain profits but will not reduce the risk of a terminated merchant account.
What Is a Chargeback Cycle?
As you can see, chargebacks represent a serious danger to a business’s longevity and sustainability. Prevention and risk management should be high priorities, but stemming the flow of chargebacks is challenging due to the number of players involved and number of moving parts.
As an example, let's look at the basic life cycle of a chargeback:
- The cardholder files a chargeback. A dissatisfied customer contacts the bank (issuer) and asks for a refund.
- The issuer reviews /assigns a reason code to the case. These reason codes offer an explanation as to why the consumer is disputing the transaction (for example, “goods or services not as described”). Each code has its own set of rules (filing time limits, necessary documentation, etc.).
- The issuer investigates and takes action. At this point, the issuer should fully investigate the cardholder’s chargeback claim, making sure all the regulations have been addressed and that the complaint has merit. If the cardholder has a valid claim, the funds will be removed from the merchant’s bank account and credited to the cardholder’s. Notification of the chargeback will be sent to the merchant’s bank. (If the cardholder doesn’t have a valid claim, the chargeback will simply be voided.)
- The acquirer reviews the chargeback and takes action. The credit card networks (Visa, Mastercard) have created various merchant's rights, including the right to dispute an illegitimate chargeback. If inaccurate claims are made, the merchant can try to regain profits that were fraudulently removed.
If the acquiring bank has access to compelling evidence that would invalidate the chargeback, it will act on the merchant’s behalf. Otherwise, the acquirer will pass the chargeback along to the merchant.
- The merchant reviews the chargeback and takes action. If the chargeback is justified, the merchant must accept the losses. However, if the business has sufficient compelling evidence--such as documentation to prove the chargeback is invalid--the merchant can re-present the chargeback for the issuer’s review.
- The acquirer re-presents the chargeback. The acquirer takes evidence provided by the merchant and disputes the chargeback--a process called representment--on behalf of the merchant.
- The issuer reviews the evidence and makes a final decision. If the merchant’s evidence is compelling enough to refute the cardholder’s claim, the transaction will be posted to the cardholder’s account a second time. The funds that were originally deposited into the merchant’s account--then removed through the chargeback--will be deposited once again. Any chargeback fees or administrative costs, however, will not be repaid to the merchant.
If, on the other hand, the merchant’s evidence doesn’t refute the cardholder’s claim, the chargeback stands. The transaction amount is permanently removed from the merchant’s bank account and applied to the consumer’s credit card statement.
As you can see, there is much at stake for the merchant. But they are not the only ones getting hurt through the process.
Chargeback Costs & Consequences: Consumers
Considering the very definition of chargebacks clearly labels them a form of consumer protection, it might seem like merchants are the only individuals who can be victimized by illegitimate chargebacks and friendly fraud. In the end, however, consumers suffer as well:
Filing a chargeback means the cardholder won't get a refund for several months (a traditional refund, by comparison, usually returns money to the consumer’s account within a few days).
If a consumer files a chargeback and the bank discovers it is a case of friendly fraud, the credit card account can be closed. Losing a credit card account can negatively impact a consumer’s credit score.
If a merchant successfully disputes an illegitimate chargeback, the consumer might have to pay the accompanying chargeback fees.
Cardholders who "cry wolf" too often won’t get the help they need in cases of legitimate fraud.
Finally, in an effort to compensate for predictable chargeback fraud, merchants raise their prices.
Accepting Responsibility on Both Sides
For long-term change, both merchants and consumers need to be able to answer the question: What is a chargeback? And both parties need to accept responsibility for their actions in the process.
Merchants must work to reduce the risk of chargebacks, both legitimate and illegitimate. If merchants ensure they are offering prompt and attentive customer service, providing high quality products and services, and attending to transaction details, consumers won’t have a valid reason to file a chargeback against the establishment. Friendly fraud will decrease.
By taking the necessary steps to detect fraud, merchants can identify more of the transactions that could potentially lead to chargebacks. Preventing these fraudsters from making purchases reduces the risk of a resulting chargeback.
Fighting chargebacks is the last major responsibility merchants must face in this arena. Banks allow fewer chargebacks to be filed against merchants who regularly dispute these claims. Not only does chargeback representment ensure the business retains more profits, it also helps educate consumers about what isn't--and what is--a chargeback … and when it should correctly be used.
Cardholders need to remember that owning a credit card is a privilege, not a right. Certain responsibilities come with that privilege; one is understanding what chargebacks are and when they can ethically and legally be used.
Chargebacks should only be filed in extreme situations; they are the last resort, not the first action to take when seeking a refund. Chargebacks shouldn’t be used frivolously, as the ramifications for the merchant are quite severe.
Hopefully, with proper education about chargebacks, both merchants and consumers can see a decline in the number of fraudulent chargeback claims.