How Pay-Pal Squeezes Merchants with Unfair and Likely Illegal Business Practices

A class-action suit charges Pay-Pal with some shady practices that leave small businesses in a jam.

By Simon Waxman, AlterNet
Posted on December 18, 2011

When Andrew Sauter decided to start taking online credit card payments for his small business, he didn’t think twice about PayPal, the dominant Web-based money transmitter in the United States.

A subsidiary of the auction giant eBay, PayPal bills itself as “the faster, safer way to pay and get paid online” and “the world’s most loved way to pay and get paid.” There are 103 million active PayPal accounts, and in the third quarter of 2011 alone the company processed $29.3 billion in payments. According to a February Reuters report, 59 of the top-100 American e-commerce sites use PayPal.

With PayPal, Sauter was able to process credit card transactions quickly and at reasonable rates. And it was easy to sign up for, perfect for his growing company, which designs Facebook marketing campaigns. More importantly, customers demanded it.

In exchange for the service, Sauter paid 2.2 percent of each transaction to PayPal, along with a $30-per-month fee, totaling about $5,400 over the life of the account. For four years, everything worked.

But when he checked his account on September 3, he found an unwelcome surprise. Instead of the nearly $2,600 he expected, his available balance was only $192, with $2,399 listed as “pending.” PayPal was reserving 30 percent of the value of each of his transactions for 90 days. The reserve was applied retroactively, creating a sudden cash-flow problem that threatened to shut him down or force him to take on expensive and otherwise-unnecessary loans.

What followed for Sauter mirrors the experiences of many other merchants who rely on, and reward, PayPal to make their businesses function: a battle with an opaque corporate bureaucracy marked by frustration, desperation and dead-ends. With the help of the Illinois Department of Financial and Professional Regulation, Sauter, who lives in Chicago, would eventually get his money and compel PayPal to withdraw its reserve permanently. He also joined Zepeda v. PayPal, an ongoing class-action lawsuit representing, according to one of the principle litigants, more than 1,800 plaintiffs in similar situations.

PayPal insists that its reserves policy is a risk-management tool that benefits consumers, an untold number of whom will use the company’s payment tools to buy gifts this holiday season. By zealously policing merchant activity, PayPal hopes to retain its most vital resource: shoppers’ trust. As long as shoppers want to use PayPal, merchants feel they have little choice but to offer it.

Their stories reveal how PayPal takes advantage of its indispensability and its customers—and how a legal apparatus that ignores real harm empowers it to do so. Backed by finely crafted disclaimers, the “faster, safer” online transactions company seizes merchants’ funds and refuses to tell them why.On the basis of eBay's 2010 Annual Report and statements from PayPal representatives, there is good reason to suspect that the company not only protects itself with that money, but also invests it for its own gain. And in the process, it may violate state laws.

PayPal didn’t invent seller holds and reserves. As the company describes them, they serve a purpose much like escrow; a way to ensure fair dealing between buyers and sellers. And credit card processors routinely withhold portions of some merchants’ funds in order to protect themselves from chargebacks.

Say you’re in Michigan, and you use your credit card to buy a gold coin from an online seller in Florida. He sends you a nickel, or he sends you nothing at all. You’ll want your money back, and if the seller refuses, you can request a refund through the credit card processor. If the processor agrees that fraud has occurred, it will initiate a chargeback, hounding the seller for the refund by imposing penalties and taking legal action against it.

But if the seller lacks sufficient funds to refund a customer, skips town, or has gone bankrupt—an increasingly likely possibility in the economic downturn—the processor is on the hook. Though PayPal isn’t strictly a processor, it too faces such liabilities and understandably tries to mitigate them.

So it places “rolling reserves” like Sauter’s on the accounts of merchants it deems risky. It may also hold the entire contents of accounts for up to 180 days.

It’s not clear how many accounts are affected. In a June 2009 post on PayPal’s official blog—the only public communication from the company about merchant reserves and holds outside its user agreement—a former PayPal risk analyst writes, “We’re requiring reserves for a very small percentage of our sellers—currently less than 1%.” Assuming that figure has held stable, there could be tens of thousands of merchant accounts held or reserved at any given time, receiving millions of dollars withheld by PayPal.

According to the company, there must have been something dicey about Sauter’s business, though PayPal is unwilling to disclose the nature of its risk analysis. In an email spokesperson Jennifer Hakes said the company considers a number of factors when deciding to place a hold or reserve, such as the seller’s credit rating, the number and frequency of customer disputes, the type of business a seller runs, and average delivery timeframes.

In his four years doing business with PayPal, Sauter had never had a chargeback or customer complaint; he’d never made a late payment to PayPal or violated the user agreement. His business was expanding steadily, not fluctuating wildly, a possible red flag. When he attempted to figure out which risk factors applied in his case, he was stonewalled. “I didn’t get very far” with customer service, he said, “I talked with one 'supervisor.' His name was Chris.”

Hakes offered that PayPal does “communicate with sellers when they may experience a hold or reserve, to the extent we can without revealing proprietary risk modeling information.” In practice that communication is extremely limited and, in the cases of the merchants interviewed for this article, amounted to little more than “canned responses,” as Brian Pattee, a Georgia-based eBay seller and participant in the class action suit, described it.

Sauter emailed PayPal’s accounts vetting department, vice president of operations, chief financial officer, office of executive escalations (a kind of advanced customer service), senior director of accounts protection, appeals department, communications department, and others at the company. When his complaint at last reached the office handling reserves, he was told to try again in a year, though there was no guarantee the account would be reviewed. Even at this stage he was told nothing about why the account had been reserved or why PayPal intended to keep it that way.

It was much the same story for Jamie Pflughoeft, a Seattle-based photographer who specializes in pet portraits. When asked about her experience with PayPal, she said she “can’t talk about it without getting bitter or angry.”

Pflughoeft (pronounced “flew-hoff”) wasn’t always so disgruntled. For six years, she happily used PayPal without incident. She ventures that, on top of her photography business, the 12 workshops she and her partner have run for aspiring shutterbugs grossed an average of $40,000 each, every dollar transacted through PayPal and subject to its fees. “They’ve made a good chunk of change off my business, for sure,” she said.

On May 26, 2010 Pflughoeft noticed that her account had been hit with its own 30 percent, 90-day reserve, resulting in an inaccessible pending balance of $1,567.33. PayPal’s rationale—protecting itself against chargebacks for unshipped or unsatisfactory merchandise—made little sense to Pflughoeft, whose business provides services at the point of sale. “There are no refunds on a service once it’s performed,” she explained, “it’s very straightforward.”

She called PayPal’s toll-free number and “spoke to a very, very friendly customer service representative who was entirely unhelpful.” He “kept repeating what I already knew,” she said. Pflughoeft asked to speak to a supervisor and was told that no one could change anything or give her any information.

With standard channels proving fruitless, Pflughoeft turned to the Washington State Department of Financial Institutions, which forwarded her complaint to PayPal. Two months after implementing a rolling reserve with no apparent end date, days after receiving the complaint, PayPal gave Pflughoeft her money and ended the reserve. In October the same happened to Sauter, who retrieved his funds only after complaining through the state of Illinois. Neither was offered interest on the reserved funds.

But PayPal didn’t just give Sauter and Pflughoeft their money. While the reserves were in effect, every payment they received was accompanied by a line-item deduction showing the amount withheld from individual transactions and the date on which it would be released. After the reserves were withdrawn, each payment was suddenly presented as though it had been transferred in full at the time of posting.

Looking at their accounts now, it would be impossible to tell that there had been deductions or waiting periods, though both kept their own records of the reserves, including screenshots of account statements that back up their claims. As Pflughoeft put it, PayPal “wiped the slate clean.”

As far as anyone can tell, the reserves and holds are legal. PayPal has been sued numerous times for a variety of alleged infringements, and has typically settled and avoided adjudication in court.

Zepeda vs. PayPal, filed in California Northern District Court in June 2010, appears to be heading in the same direction. If the parties settle—as court documents and one litigant, who requested anonymity for fear of jeopardizing the plaintiffs’ position, suggest they will—PayPal’s business methods will once again escape legal scrutiny.

The lawsuit names eight plaintiffs with held and reserved accounts totaling around $92,000. They accuse PayPal of unjustly enriching itself by refusing to turn over interest on withheld funds and of deceptively marketing its services as fast and secure. The suit further asserts that, contrary to PayPal’s claim that it carefully assesses the risks associated with each account it holds or reserves, the company withholds payments arbitrarily.

Pattee, one of the named plaintiffs, believes there was no good reason to hold his account. He points out that even though his funds were released in February 2010—his account now shows “no record of the holds whatsoever”—he still doesn’t know why his entire balance was held for 180 days. “They pretty much said, ‘We’re not telling you,’” he explained, and was told, “If you want to know why, get a subpoena.”

In 10 years as an eBay seller, Pattee had faced only one complaint, and PayPal had ruled in his favor after he proved the customer’s grievance was without merit. The 180-day hold was doubly mystifying to Pattee given that PayPal allows buyers only a 45-day window in which to dispute a transaction.

In a brief responding to the class action, PayPal never denies that plaintiffs such as Pattee were harmed or attempts to justify that harm. It does not demonstrate diligence in holding only the riskiest transactions or show that it is withholding only funds it needs to cover chargeback liabilities.

Instead, the company’s lawyers point to PayPal’s user agreement, which authorizes PayPal to place holds and reserves at its sole discretion and does not require it to inform users of its reasons for doing so. Users also “agree that [they] will not receive interest” and that “[they] irrevocably transfer and assign to PayPal any ownership right that [they] may have in any interest that may accrue.”

The brief also does not deny that plaintiffs were deceived by PayPal’s marketing, but argues that the alleged deception does not meet the standard necessary for legal accountability.
Lawyers representing both the plaintiffs and PayPal did not respond to requests for comment. Hakes refused to comment on the litigation.

If the parties settle, it will likely be because PayPal’s user agreement is airtight. The company says it places holds and reserves exclusively on risky accounts, but the agreement allows it to withhold funds for any reason, and there is no way to test those reasons, which PayPal never reveals in individual cases. The reasons might include even signing up for PayPal’s own products—Sauter’s and Pflughoeft’s accounts were reserved soon after they registered for PayPal’s “virtual terminal,” which allowed them to take credit card payments over the phone.

Only if a court finds the terms of the agreement “unconscionable” would the company be forced to change its practices. As long as PayPal can settle with the litigants, the courts won’t get a chance to make that evaluation.

PayPal could, however, be breaking state laws designed to prevent wire services from hanging on to money.

PayPal isn’t a bank or an escrow service, both of which are expected to hold money for potentially lengthy periods. Instead, per its user agreement, “PayPal is Only a Payment Service Provider.” It transmits money between parties and collects fees on the transmissions. It’s a bit like Western Union, but nothing like Wells Fargo.

As such, PayPal needs to obtain money transmitter licenses in order to operate in most states. PayPal has a license for every state that requires one.

In its 2010 annual report, eBay acknowledges that this licensing scheme creates potential legal risks. “As a licensed money transmitter, PayPal is subject to restrictions,” the report says. “If PayPal were found to be in violation of money services laws or regulations, PayPal could be subject to liability”—up to and including the closure of its business in certain states.

One of these restrictions concerns how long a transmitter can hold onto money before forwarding it to the intended recipients. For instance, the Illinois statute governing licensed money transmitters allows three business days. On its face, this provision prohibits PayPal from holding portions of Sauter’s money for 90 days. A spokesperson for the Illinois Department of Financial and Professional Regulation, tasked with enforcing the statute, acknowledged that the Department has never taken action against a transmitter for violating the three-day provision.

The analogous Washington state law allows the transmitter 10 days to deposit funds in the recipient’s account. However, Washington’s law allows the transmitter to withhold money if it “has reason to believe that a crime has occurred, is occurring, or may occur as a result of transmitting the money.”

Did PayPal have reason to suspect that Pflughoeft, a Washington resident, was involved in crime or that transmitting her full payments to her would facilitate crime? Again, there is no way to know, since PayPal refuses to reveal why it places holds and reserves on individual accounts, even to the accountholders themselves.

However, given that PayPal returned Pflughoeft’s money within days of receiving her complaint via the Washington Department of Financial Institutions—the agency that licensed PayPal as a money transmitter in that state—it's hard to believe that Paypal suspected her of any involvement in criminal activity.

Illinois and Washington aren’t the only states that impose time limits on money transmitters. Minnesota, for instance, allows five days, and Hawaii allows 10. Hakes said, “PayPal works closely with state regulators to ensure that it satisfies consumer protection requirements, including the timing required to transmit payments.” Despite repeated phone calls and emails, PayPal’s senior manager for North American compliance, Christopher Chen—who is named on the Arkansas, South Dakota, and Hawaii licenses—could not be reached for comment.

What does PayPal do with the money it withholds? Beyond furnishing legitimate refunds, the high reserve percentages and long withholding periods provide the company capital it could build on, and money transmitter licensing laws are no obstacle to investment.

There is ample reason to believe that this is precisely what PayPal is doing. Alongside fees that customers know about, eBay’s “other revenues are derived principally from interest earned on certain PayPal customer account balances” and two unrelated sources, according to the annual report.

The report does not elaborate on which account balances are invested, and Hakes neither confirmed nor denied whether PayPal invests the earnings it denies merchants. However, since merchants are required by the user agreement to turn over interest on held accounts, it is fair to assume that their accounts are among the “certain” few.

In addition to boosting PayPal’s revenue, the refusal to pay interest to merchants may encourage PayPal to crack down on accounts less carefully than it otherwise would. “If PayPal had to pay a rate of interest that was not trivial, that would also give it an incentive to not impose a reserve except in cases where it really thought a substantial risk existed,” said Todd Rakoff, a contracts and administrative law expert at Harvard Law School.

Yet even if PayPal is not exploiting merchants for its own gain, many sellers are undeservedly and negatively affected by the company’s hold and reserve policies.

“This is just [PayPal] abusing their position of power,” Sauter said, echoing a message found on countless blogs and Web sites, such as paypalsucks.com, aboutpaypal.org, and the official PayPal and eBay forums. Pattee is convinced that “the ones who made them who they are are getting stomped on.”

Lack of transparency and any meaningful internal appeals process forces accountholders to seek redress through government agencies and the law. But the law, at least, seems to be no ally. PayPal’s user agreement protects the company in a manner that subjects even merchants who play by the rules to a range of real harms that the law ignores.

PayPal’s brief responding to the plaintiffs in Zepeda is a stark indictment of the law’s capacity to respond to injury. The company deflects every charge without disputing the substance of plaintiffs’ complaints. For example, no credence is given to the accusation of deceptive marketing, even though PayPal’s product descriptions are intended to convince merchants to sign up for services that frequently turn out to be vastly different from those advertised. PayPal argues as though the actual experience of harm is of secondary importance to a legal system swayed not by real events, but by legalistic interpretations of them.

Given that the plaintiffs’ lawyers chose not to respond to PayPal’s brief and have instead entered into settlement talks, it appears PayPal’s understanding of how the law works—call it cynical, call it realistic—is on safer ground than its customers’ accounts.

Correction: A previous version of this article stated that PayPal has been operating with an expired license in Tennessee since April 15, 2011. PayPal's Tennessee license expired in April and was retroactively renewed in October.

Tyranny of the Merchant Class

Maximizing Profits on the Backs of the Powerless
By RALPH NADER

There is a reason why, so many centuries ago, every major religion warned its adherents not to give too much power to the “merchant class.” That reason is still here – the commercial drive knows few self-imposed boundaries, especially when it resides in large corporations.

A cruel manifestation of this singular drive for maximizing profit is how companies treat those who are most powerless, most vulnerable or most preoccupied.

Here are some illustrations that highlight the serious failures of law enforcement:

1. Pre-teen children. The direct marketing to children knows no limits of decency. Undermining parental authority with penetrating marketing schemes and temptations, companies deceptively excite youngsters to buy massive amounts of products that are bad for their safety, health and minds. Think junk food – loaded with fat, salt and sugar, that increases obesity, diabetes and predisposition for high blood pressure. (See http://www.cspinet.org.)

Obesity produces sickness, death, disability and large medical bills.

Marketers are selling ever more violent entertainment, and soft porn with delivery systems that escape parental review or supervision. Television is no longer the only route to children. Our fourteen year-old, then-startling book—Children First: A Parent’s Guide to Corporate Predators—now reads as an understatement.

2. The poor. Whether white, African-American, Hispanic or Native American, merchants make the poor pay more. Loan sharks, shoddy merchandise, sub-standard food products and inadequate medical care have plagued the poor and been the subject of many studies and too few prosecutions.

3. People preoccupied by their bereavement are often preyed upon by the funeral industry. The Federal Trade Commission has an ample file on overcharges and deceptive practices from the unscrupulous merchants in that trade.

4. People with rare diseases often require so called “orphan drugs.” Under a 1983 law, drug companies receive a seven year monopoly with no price restraints on these drugs. Drug companies are also given huge tax credits for research and development costs associated with orphan drugs.

The Wall Street Journal (“How Drugs for Rare Diseases Became Lifeline for Companies”, Nov 15, 2005) called these drugs “lucrative niches.” With no competition, these monopoly drugs come with staggering prices for desperate patients.

Here is one story of how your tax dollars are being used for hyperprofit corporate profits. Henry Blair was working on an experimental enzyme under government contract as a researcher at Tufts University Medical School. Working with scientists at the National Institutes of Health, they and he made the enzyme work as a treatment for Gaucher disease, which swells organs and deteriorates bones.

In 1981, Mr. Blair started the Genzyme company, got the government contract to make the enzyme which he brought to market in 1991. The average price was—get this—$200,000 a year per patient!

In 1992, the Congressional Office of Technology Assessment (OTA) (banished by Newt Gingrich in 1995) reported that Genzyme spent $29.4 million on the drug, with much of the initial research funded and done by government scientists at the National Institutes of Health.

Two years later, Genzyme found a much cheaper way of making the drug. In 2005, the Wall Street Journal wrote that the Gaucher drug was still priced at $200,000 per patient each year. The company says it gives the drug at no cost to about 10% of the patients. For the rest, either rely on the insurance companies (good luck), or otherwise pay or die.

5. The Health Uninsured are charged by hospitals full price, which The Wall Street Journal reported “is far more than the prices typically paid by insurance companies.” This is the case, the Journal added, in spite of an annual taxpayer subsidy of $22 billion to hospitals “to care for the uninsured.”

6. Amputees who need prosthetic devices find that the devices in the United States are very highly priced (by comparison with other western countries.) Health insurance companies make these products leading candidates for rising co-payments. This can mean tens of thousands of dollars from the patients or they go without. These shocking co-payment requirements are often in the fine print.

Many of these devices also come about with taxpayer funded research and development. Profit margins are large because of the users’ dire necessity to have them for mobility, for work, for human dignity.

7. Low-credit-score credit card holders. The relentless credit card economy requiring plastic to buy more and more things and services. The credit score becomes the hammer. A story recounted by MSNBC’s Bob Sullivan in his engrossing new book Stop Getting Ripped Off describes: “the card promised an attractive 9.9% interest rate.

But there was a catch buried in the fine print: account setup fee: $29; program fee: $95; annual fee: $48; monthly servicing fee: $84 annually; additional card fee: $20 annually.” Then this clincher sentence: “If you are assigned the minimum credit limit of $250, your initial available credit will be $71 ($51 if you select the additional-card option).”

No wonder the vendors call them “fee-harvesting” cards. Who needs loan-sharks? These credit card vendors fleece the poor wearing a three-piece suit and sitting in air conditioned skyscrapers.

Such is the fate of the poor or the vulnerable under the boot of commercial avarice.

The Myths of Financial Innovation

What is It Good For?

By DEAN BAKER

Brookings economist Robert Litan picked up the gauntlet thrown down by Paul Volcker and others and put out a lengthy paper defending the major financial innovations of the last four decades. Litan surveys the field and pronounces most of what he sees to be good.

While there is certainly some merit to many of the points that Litan makes, he presents a very incomplete picture. A fuller discussion is likely to be more critical of recent innovations.

Credit cards are a good place to start. Litan notes the explosion of credit card use over the last three decades and sees this as a great advance. He notes the enormous convenience of credit card use over cash or checks. Litan dismisses the idea that credit cards increased consumer indebtedness, noting that the ratio of credit card debt to mortgage debt did not rise over this period. He even claims that credit cards have helped foster growth by providing financing to many small businesses in their start-up phase.

There is a lot here to chew on.

Certainly credit cards do facilitate payments. However, it used to be verycommon for businesses to accept personal checks. Don't try that one today. For the vast majority of people who do have credit cards, they certainly are easier to use than checks; however those with mixed credit histories, who can't get credit cards, don't stand to gain from their convenience.

Of course almost anyone with a bank account can now get a debit card, so this should leave them as well off as when they could pay with a check (unless they hoped to use a bad one). But in the post-credit card, pre-debit card era, credit cards did not unambiguously increase access and convenience for everyone.

There is also the obvious point that banks have found ways to slip fees into credit and debit card bills that many people would probably not pay if they were fully aware of them. The most notorious of these fees is the overdraft fee attached to debit cards, which can often be several times the size of the purchase being made. While new legislation is limiting the ability of banks to impose such fees and requiring greater transparency, any assessment of the merits of credit cards should acknowledge these costs.

This raises another important issue with credit cards - their cost structure. The industry imposes a fee that averages close to 2.0 percent per transaction on credit card purchases. (It's worth noting that these fees are about half as large in most other countries.) Since the credit card companies generally prohibit retailers from offering cash discounts, this means that cash-paying customers must subsidize those who pay with credit cards. (Fees are somewhat lower on debit card purchases.) If lower-income customers are more likely to pay with cash or debit cards, then the banking industry has effectively created a sales tax, the proceeds of which go to subsidize the purchases of higher-income consumers.

The issue of cross-subsidies also comes up in reference to the fees that the industry charges. In the debate over increased regulation, the industry claimed that if they could not charge high late payment fees and were limited in their ability to jack up interest rates, then they would have to curtail the frequent flyer miles and other bonuses that they offer to their customers. It remains to be seen whether the industry will follow through with this threat, but if they do, it implies that another way in which their credit card innovation might have been used to subsidize higher-income households at the expense of lower-income households.

In examining whether credit card debt has led to lower savings, Litan picks a very low bar. Mortgage borrowing exploded, as homeowners were eager to borrow against bubble-inflated house prices. They got a further push from lenders anxious to have mortgages to sell in the secondary market. The fact that the growth rate in credit card debt didn't exceed the growth in mortgage debt over this period can hardly be seen as a compelling argument that credit cards did not negatively affect savings.

In fact, the ratio of credit card debt to disposable income nearly tripled from 1980 to 2008, rising from 2.7 percent of income in 1980 to 8.9 percent by the end of 2008. Of course, this doesn't prove that access to credit card borrowing led to a lower savings rate, but we may not want to cross it off the list of suspects as quickly as Litan. Credit card borrowing is no doubt a mixed picture. In some cases it gives households an opportunity to sustain their standard of living through bad economic times. However, many families do have problems managing their money and easy access to credit cards could make their situation worse.

This brings up one final issue with credit cards. Litan gives credit cards an unambiguous plus for their impact on growth because many small businesses have been financed through credit cards. This one requires a bit more reflection.

More than half of small businesses fail in their first four years. A small business that is only open for a year or two is probably not benefiting the economy. The resources that are diverted into this business could likely have been better used elsewhere in the economy. Instead of making capital and labor available for a viable business, the failed small business owner has diverted it to some hare-brained scheme - just as a pointed headed government bureaucrat might do.

Obviously, all small business start-ups do not provide a benefit to the economy. Now, let's take the subset of small businesses that are turned down for bank loans by our highly innovative financial sector and which therefore must rely on high cost credit card borrowing. Presumably a much higher share of these businesses fail than small businesses in general.

If credit cards make it easier for people with harebrained schemes to start small businesses can we say that they have helped foster economic growth? That seems a bit of a leap. I don't have the data on this and neither does Litan, but until one of us does, we better take away the plus that he gives credit cards for their impact on economic growth.

In sum, the story of one financial innovation, credit cards, is much more mixed than Litan claims in his assessment. They certainly have increased convenience but at a considerable cost. It is noteworthy that the credit card transaction fees are much lower in Old Europe than in the United States. Also, East Asia is far more advanced in allowing the use of electric money transfers from cell phones. So, we may want to hold off on the celebration for the U.S. financial industry's development and promotion of credit cards.