Chargeback 1st Party Fraud - What You Need to Know as a Merchant

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The ability to return goods to a merchant and receive a refund has been a standard component of commerce for decades. The refund process is typically based on communication between the merchant and its customer.

With credit card purchases, a customer who is dissatisfied with a transaction may contact the merchant to discuss the problem and come to a resolution, such as refunding the purchase amount to the credit card by returning the goods purchased. Some customers choose instead to skip this step and go directly to the credit card issuer to file a chargeback dispute. A chargeback reverses the sale and returns the funds to the credit card account, so customers think it is a faster resolution for a refund than contacting the merchant. Although the result is the same for them, it can be quite different for merchants.

One of the reasons the credit card chargeback process was created was to provide a safety net for customers. If a transaction goes badly and the merchant is unable or unwilling to resolve the matter, the customer can file a chargeback dispute with the bank that issued the credit card. Once a chargeback is initiated, the issuing bank retracts the funds in question from the merchant’s account, and the cardholder’s account is provisionally credited. The chargeback process essentially reverses the sale, and the funds are withheld from the merchant’s account pending resolution of the matter.

The issuing bank investigates the dispute. If it deems it is appropriate, it forwards the matter via the credit card network to the merchant’s bank. If the issuing bank determines the dispute is invalid, the chargeback dispute is denied and the customer must pay for the transaction. When the claim is considered valid, the funds from the transaction are returned to the cardholder’s account and a chargeback is initiated to the merchant’s account.

At this point the merchant’s acquirer takes over to investigate the dispute. If they find the dispute is invalid, they reverse the chargeback and provide the issuing bank with documentation as to why the chargeback is invalid. If the merchant’s acquirer determines that the issuer followed all appropriate requirements, then it is up to the merchant to prove that the dispute is not valid.

The cardholder, after receiving and reviewing the documentation, has the right to state that the evidence provided by the merchant does not resolve the issue. In this case, the entire process repeats and the merchant has a chance to provide additional documentation to refute the chargeback. If the cardholder disagrees again, then the dispute moves into the arbitration phase. At this point the merchant or issuer can request arbitration from the card network. This is basically a final ruling on the case and is no longer disputable through this process by the cardholder, issuer, acquirer, or merchant. If the dispute reaches this stage and the merchant continues to contest the dispute, the merchant may be responsible for paying for the arbitration process, which can cost up to several hundred dollars. Regardless of whether the merchant loses or wins, the merchant is obligated to pay some or all of the arbitration costs.

Investigating a chargeback is labor-intensive and tedious, so most¹ businesses choose not to take this step. This is particularly true for low-cost merchandise/service providers. If the dispute is won by the customer, the merchant loses the revenue from the sale, the cost of chargeback fees, and the time and effort devoted to investigating the complaint. Understandably, most² merchants simply cut their losses and pay the fees rather than take the time to investigate.

1st Party Fraudulent Chargebacks

This type of fraud is termed “friendly fraud” and results in substantial losses each year for merchants. With friendly fraud, a customer who may not have started out with malicious intent makes a purchase and receives the product, but then files for a chargeback though they have not returned the good. In the case of a merchant who provides a non-tangible good, this would be a dispute surrounding a service which was consumed knowingly either in full or partially by the consumer where the cardholder is then requesting a full refund.

Friendly fraud is one of the most challenging types of chargebacks for merchants to deal with, but there are steps they can take to mitigate the fraud and ways to respond to chargeback disputes that may help eliminate or lessen the headache. If a merchant can prove that the customer actually did make a purchase and the merchandise was received or consumed, friendly fraud chargebacks may be easier to reverse. In general, there are several things merchants can do to reduce this type of chargeback:

  • Clearly post return policies and specify the amount of time allotted for returning items. For expensive items being returned by the customer, the merchant should require that the customer obtain proof of mailing, such as a certificate of mailing or a receipt provided at the time of mailing from the courier they use.
  • Obtain a card verification code, which helps to ensure that the person making a purchase has the physical card in hand and is not using a stolen card number.
  • For online purchases and in accordance with applicable laws, recording the digital footprint information can help identify the location and characteristics of the device used to place the order, as well as information about the customer using the device. If a customer claims in the future that they did not place an order, the merchant will have evidence that the computer used for the transaction is tied to the cardholder. Keep a record of all communications with customers who make purchases online or by telephone, including e-mails received from and sent to customers. These records can help prove that a customer did actually make the purchase they are disputing.
  • For expensive items, require a signature upon delivery to prevent unscrupulous customers from claiming that a product was never delivered. In addition, the merchant could also ship only to AVS-verified addresses to minimize the risk of product losses.
  • Digital purchases can be particularly troublesome for merchants, because goods are delivered immediately online and there are no shipping records. It is essential for merchants selling digital products to require customer-specific account information and record IP addresses and device identifications for purchases in accordance with applicable law. They should also keep a record showing that the product was downloaded, accessed or used.

These are important steps for merchants to consider, but seeking outside help can also be useful. Fraud detection services can block suspicious transactions based on numerous factors that help to identify not only organized fraud but also friendly fraud and the individuals who commit it. These services come in many different forms, from standalone software as a service (SaaS) solutions, additional services from your gateway provider, or even third parties that manage your risk for you. Unfortunately, today chargebacks and friendly fraud are a risk for merchants who accept credit card payments, but the risk can be tempered by taking proactive steps to protect your business.

¹, ²Managing the Challenge of Merchant Chargebacks by JAVELIN, a Greenwich Associates LLC company