What Happens When Merchant Reserves are Used to Cover Losses?

What happens when a risk reserve gets used for the purpose for which it was intended, that is, to cover losses?

Here’s an example.

My company, ABC Payments has a merchant services agreement with Fun Excursions. Fun Excursions provides exactly what its name describes to travelers visiting a popular vacation destination.

Fun collects payments up to 3 months in advance of the date they provide their services. They process $100,000 a month in card volume and have been doing business with ABC for the past several months, in which they’ve accumulated a $50,000 reserve balance.

A natural disaster wipes out Fun’s excursion fleet, and suddenly they are unable to deliver any of their services. They’ve collected $250,000 in payments for services they have not yet delivered. They start issuing refunds, but Fun has never been great at managing cash flow or their insurance policies, and after a while, there’s no money left in the bank to cover the returns. ABC terminates Fun’s payment processing account for failure to cover its obligations.

Fun customers are still reaching out for refunds, but the number is disconnected. Customers start contacting their credit card issuer to initiate a chargeback.

Fun continues to run up a chargeback tab, but Fun and its owners are nowhere to be found to cover this debt.

ABC can use the $50,000 reserve balance that it collected from Fun, but it finds itself with an additional $70,000 of uncovered chargebacks. Not to mention, it is also stuck covering the fees associated with processing these chargebacks.

Just when ABC thinks it’s done with covering the losses associated with Fun, a year later, more chargebacks trickle in. These have been initiated not by the cardholder, but by the issuing bank that is holding the balance for a delinquent cardholder. The issuing bank is doing what it can to minimize its own write-off debt.

All in all, ABC incurs a bad debt loss of $90,000. Even though ABC thought it was mitigating its risk by implementing a risk reserve, it wasn’t enough.

ABC can pursue Fun to collect this balance, but the chances of collection are slim.

What happens if ABC can’t cover this debt? The liability falls to the next party in line, the last of which is the sponsor bank. That is why the acquiring sponsor bank has the ultimate say in whether a merchant can stay or must go.

This scenario might seem far-fetched, but in the payments world, particularly for providers that frequently dabble in high risk, it happens more often than they’d like to admit.