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Whose Pal is PayPal?

W hen is a bank not a bank? It's a question that seems to come up whenever a crafty businessperson (or more likely their lawyer) figures out how to circumnavigate prevailing banking law. Often the allure for the non-bank is the banking industry's access to the payments system. That seems to be the draw for PayPal, the e-payments processor that claims in excess of 15 million users of its online, person-to-person (P2P) payments service.

The company shook off legal challenges in February to mount the first successful stock offering of the new year for an Internet company. But questions still dog PayPal. Such as: Is PayPal a bank? If not, then who is responsible for ensuring PayPal's compliance with consumer-protection laws? Is the company playing fast and loose with folks' money?

The Federal Deposit Insurance Corp. (Uncle Sam's insurance fund for bank deposits) has weighed in on the first question. Responding to a letter of inquiry from PayPal, the FDIC's legal staff said that because PayPal does not actually accept deposits from customers - but rather acts as an "agent," moving money between payees, payers and banks - it is not a bank under federal law. But because it is an agent (not a depositor in and of itself), funds left on deposit with PayPal by individual PayPal customers (and aggregated by PayPal into master accounts at banks) are insured up to $100,000 per customer, the FDIC wrote. This is called "pass-through" deposit insurance coverage.

A spokesman for the FDIC reiterated the agency's point during a recent telephone interview. Asked if the FDIC had entertained any challenges to PayPal's "non-bank bank" status, the spokesman said none have been lodged.

Considering the scope of its business, it's a bit surprising that bankers haven't been complaining about PayPal to the Feds. As of the end of last year, the company was servicing more than 12 million accounts and was handling 189,000 payment transactions a day on behalf of consumers and small businesses. (It characterized 2.6 million customers as small businesses.)

The value of daily transactions handled by PayPal averaged $9.6 million last year and continues to grow by leaps and bounds. PayPal also issues a credit card, co-branded with Providian Bank, and an ATM/debit card that customers can use to access funds from their PayPal accounts.

PayPal's standing under state law is a different story. Banking regulators in at least three states (including New York and California) are investigating whether PayPal should be considered a bank and regulated as such. PayPal recently anted up for a money-transmitter's license from Louisiana after regulators there ordered the company to otherwise stop doing business with online customers in the state.

In its first quarterly earnings report as a public company, released April 17, PayPal revealed that it has applied for money-transmitter licenses from 23 states and that seven states have issued those licenses. The company said it also is preparing applications for money-transmitter licenses from four other states.

Meanwhile, scores of complaints have been lodged against PayPal with the Better Business Bureau, state consumer-protection agencies, in state and federal courts, and by way of a Web site (http://www.paypalwarning.com/) hosted by a disgruntled merchant turned Paul Revere.

Even Visa and MasterCard, the bank-owned payment card brands, have entered the fray, reassessing rules on transaction aggregation practices.

MasterCard has "clarified" that its rules require direct agreements between member banks and each merchant on whose behalf the bank acquires and settles MasterCard transactions, a spokesman explained. In other words, aggregating transactions from multiple sellers and processing through one master merchant account is taboo.

Transaction aggregation is currently permissible under Visa rules, an executive there explained, although he adds that the position is under review. The current view at Visa goes something like this: Aggregation occurs most typically in Internet commerce, where multiple merchants are showcased on a single Web site. Visa enforces specific rules and procedures for these accounts, including a requirement that individual merchants be differentiated using special identification numbers.

[Aggregation differs from factoring, at least in Visa's view. Factoring - bundling card transactions from multiple merchants that appear on the customers' records as though they all involved the same merchant - is banned by Visa rules, according to the exec we spoke with.]

Visa and MasterCard rules preclude discussing specific cases. In filings earlier this year with the Securities Exchange Commission, however, PayPal discussed problems raised by Visa and MasterCard and the possibility that one or both organizations might yank PayPal's merchant card acceptance privileges.

Nancy Bennett is a Los Angeles-based credit card guru who has received dozens of calls from folks who believe they have been victimized by PayPal. Typically, the complaints involve small-time players in online auctioning whose funds have been frozen by PayPal, sometimes for indefinite periods, often because of vague suspicions of fraud.

Her assessment of the situation: "Most of these folks don't need merchant accounts." They're only doing a few hundred dollars a month in sales. Checks and money orders will work just fine for these folks.

And what about the money to which PayPal customers have been denied access? A close reading of the service agreement that all customers (both senders and receivers of money) are obliged to accept reveals that PayPal customers sign away their rights to sue. Customers agree to indemnify PayPal and hold it blameless for anything or everything that could possibly go wrong with or as a result of a PayPal transaction. Customers also grant PayPal a right of set-off against their accounts for amounts PayPal deems they owe, and the right to restrict access to funds on deposit with PayPal and/or their financial institutions.

"Unfortunately, I think many of these folks never bothered to read the agreement before clicking the 'Accept' button," says Bennett.

I e-mailed the agreement to a friend I'll call Counselor (yes, she's a lawyer), asking what she thought of it as a service contract. "I'm on page 27 and I'm still scrolling," Counselor called to tell me a few moments later. "This is why nobody reads these agreements."

An attorney familiar with a pending lawsuit against PayPal says the complainants will argue that provisions of the contract are unenforceable, notably a provision that insists all legal disputes be settled by arbitration. The lawsuit also contends that PayPal violates the EFT Act and that it engages in unfair and deceptive business practices. The suit, which is awaiting a judicial review for status as a class action, potentially could include as plaintiffs millions of current and past users of PayPal.

The Federal Reserve and other bank regulators are responsible for ensuring that financial institutions abide by the consumer-protection dictates of laws such as the EFT Act. The Federal Trade Commission (FTC) oversees enforcement among non-banks, such as retailers and oil companies that issue credit and debit cards. The FTC's main charge: to work on behalf of consumers by identifying and pursuing legal action against fraudulent, deceptive and unfair business practices.

A few months ago, the FTC filed charges against an ISO - Certified Merchant Services, Ltd. (see Green Sheet issue 02:02:02, Feb. 28, 2002) - alleging unfair and deceptive practices in the marketing of merchant accounts to small businesses. It was the first time the FTC had ever leveled charges at an ISO. If the FTC gets its way, CMS will be shut down.

I contacted the FTC several times while preparing this column, inquiring about any investigations under way that might involve PayPal or other non-banks in the payments business. No response. Several messages left with PayPal also remain unanswered.

In its 10-K filing with the SEC, PayPal makes a big deal about the risks inherent in the business of acquiring and processing Internet payment transactions. "Striking the optimal balance between the dual objectives of controlling fraud and providing a user-friendly system will remain a key challenge," the company wrote.

The company also noted that Chase Merchant Services, the card-servicing venture that JP Morgan Chase operates in conjunction with First Data Corp, was holding about $15 million in funds owed PayPal to cover anticipated liabilities from potential transaction chargebacks. Chase had been processing credit card transactions for PayPal until December 1, 2001; no explanation was given for the bank's pullout.

PayPal, in its 10-K report, notes that it accesses the credit card system through an agreement with Electronic Payment Exchange (EPX). Its credit card merchant banks these days are First Union National Bank and TheBancorp.com. Wells Fargo Bank provides PayPal with access to the automated clearinghouse (ACH) and helps with fraud control, according to PayPal.

The ACH relationship is necessary because PayPal offers customers the option to fund payments from their bank accounts. PayPay also reserves the right to initiate debits against customer bank accounts, which is why it's subject to the EFT Act. Customers provide a bank account number that can be accessed by PayPal during the signup process.

Payments is a business fraught with risks. That's why financial institutions - among the most tightly regulated businesses in America - have been designated the gatekeepers to the payments system. Banks take on these risks because, among other things, they enjoy special privileges and access to the federal money trough. When the going gets tough, the government steps in and makes sure nobody loses too much money.

The same isn't true for non-banks. Too often non-banks are blinded by the allure of the money that flows through the payments system, only to be blindsided by the back-end risks. We've witnessed this already among payment card issuers. Remember the Sears Discover Card? (Discover is still around, yes, but it's no longer backed by Sears.)

Can PayPal buck the trend and survive long term in the payments space? Maybe, if it sticks with P2P payments. But as PayPal continues to creep into merchant services - facilitating transactions between online buyers of goods and services - it confronts a morass of regulatory and legal issues that is bound to stymie growth.