Payment Systems Outline PDF

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Secured Transactions notes payment systems UCC...

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Payment Systems Foundations of a Payment Systems Analysis: 1. How does the system work? 2. How does it finalize payment? 3. How does it deal with fraud and error?

Assignment 21: The Credit-Card System -

Credit card system involves four major participants - 1. Purchaser that holds a credit card - 2. The issuer that issues the credit card - 3. A merchant that makes a sale - 4. An acquirer that collects payment for the merchant

Network

Acquirer

Issuer

Send Transaction Data

Merchant

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Post to card

Complete Transaction

Cardholder

Issuing bank commits to pay for purchases, thus even if the card holders ultimately fail to pay their bills the merchant still gets paid TILA applies only to consumer transactions and only to transactions under $50,000

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Finality of Payment - Credit cards grant a cardholder the right to withhold payment on the basis of any defense that it could assert against the original merchant - Known as a chargeback - Can only assert defenses before cardholder pays the bill - right to withhold payment, not right to a refund - TILA 170(a) imposes a limitation on transactions that occur outside the state where the cardholder resides and more than 100 miles from the cardholder’s billing address.

Assignment 22: Error and Fraud in Credit-Card Transactions -

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Erroneous Charges - To challenge a billing error under TILA, the cardholder must provide written notice to the issuer within 60 days of the date on which the creditor sent the relevant statement to the cardholder. Issuer has 30 days to respond with acknowledgement - Before rejecting the cardholder’s allegation the issuer must first “conduct a reasonable investigation and determining that the property or services were actually delivered as agreed. - If the issuer does not accept the cardholder’s allegation, the issuer must (WITHIN THE TWO-BILLING CYCLE PERIOD) give the cardholder a written explanation of the issuer’s reason for not correcting the charge - Finance charge can accrue against the cardholder if resolved against them Unauthorized Charges - TILA 133 limits cardholder’s liability for unauthorized charges to a maximum of $50 - Even if the cardholder knows the card has been stolen and do not notice the issuer - However if the creditor can prove negligence, the cardholder may be liable for the whole amount - Cardholder can notify the issuer and cut off liability even below $50 - TILA 135 permits any business that issues credit cards to at least ten of its employees to accept liability for unauthorized charges without regard to TILA 133 - Consumer protection provisions of TILA don’t apply to businesses - Issuer bears losses from unauthorized charges as long as the merchant followed the requisite procedures (verifying the signature and obtaining the appropriate

authorization for the transaction)

Assignment 23: Debit Cards -

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Payment with a Debit Card - Feature that distinguishes a debit card is that a debit card serves as an adjunct to a checking (or savings) account - For dual purpose cards, the rule of law that applies is whatever the card is used for (debit or credit) - Replaces the paper check with an electronic impulse that directs the bank to transfer funds to the customer, or transfer funds to a third party Establishing the Debit-Card Relationship - EFTA imposes two procedural requirements to bar banks giving users debit cards - 1. Bank can only send unsolicited debit card to a customer only if the card is sent in an unvalidated condition - 2. Requires the bank to provide the consumer a detailed upfront disclosure of the terms and conditions - Must be in a readily understandable written statement that the consumer may retain Transferring Funds - Two basic uses of a debit card - 1. Depositing and withdrawing money from an account without the burden of going to the bank and waiting to see a teller - Customer uses the card as a substitute for a check - Customer must receive paper receipt of each transaction Collection by the Payee - Merchant enters into a contract either with the bank directly or through a network that processes debit-card transactions - Processed in two different ways - 1. If the customer inputs a PIN, an encrypted transmission goes through the network to the bank. The bank compares the PIN numbers and if there are sufficient funds the bank honors the request, sending a signal back to the merchant - Bank’s obligation for payment becomes final at the moment it transfers the message back to the merchant - 2. If the customer does not input a PIN, the system sends the transmission to the bank, the bank confirms the sufficient funds in the account and places a hold on the funds until they are obtained by the merchant

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Erroneous Transactions - Errors in the transaction are rare as the merchant will likely refuse payment if there is an issue with the card, thus leading to very few problems Fraudulent Transactions - Several features of the system operate to minimize losses from fraud - Rules preventing unsolicited mailing of activated debit cards should limit fraud from stolen cards - Both the authorization request and the bank’s reply are encrypted - PIN pads at the merchant include software designed to prevent theft by destroying the encryption protocol if tampered with - Two questions arise from false authorizations on debit cards - 1. Who bears a loss as between the merchant that accepts payment based on a stolen debit card and the bank on which the card draws? - Determined by the details of the individual contracts, but typically the loss goes to the bank as they are in a much better position to mitigate those losses as opposed to the merchant - 2. Who bears the loss as between the bank on which the card draws and the customer whose card has been stolen? - Two protections for consumers - 1. Card must have minimal security features for confirming transactions, and in the absence of such a feature, the EFTA bars any imposition on the consumer for liability for unauthorized use - 2. EFTA 909 establishes rules limiting the customer’s loss from each unauthorized transfer (Has been held to be a series of transfers as well) - 1. Allows the banks to hold the customer responsible for up to 50 dollars in losses that occur before the financial institution learns of the consumer’s loss of the card - 2. Allows the bank to charge the customer up to 500 dollars (including the 50) if the consumer discovers the card has been lost and does not promptly notify the bank - 3. Bank Statement Rule- Consumer has 60 days to review their statements to identify unauthorized transactions - If they fail to report, they are liable for all

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future erroneous transactions (plus the earlier 500) EFTA framework for dispute resolution concerning transactions - Customer must give oral or written notice of claimed unauthorized transactions within 60 days of notice of transaction - Bank must provide customer with a written explanation and respond within ten business days or give the customer a provisional recredit - Bank must complete investigation within 90 days after receive the customer’s 60 day notice

Assignment 24: Prepaid Cards -

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Mechanics - Functions similar to a debit card with the difference that it is not linked to a bank account - The issuer keeps track of the funds from the cardholder so it can tell how much is on the card - the “value” that “resides” on the card - Indicator of value can be carried directly on the card, thus the transaction could be completed directly between the merchant’s terminal and the card itself - Cards can be “host-based” or “non-host-based” - Host-based - where a record for the value of the card is maintained at a “host”, with databases that verify the individual transactions, if card is stolen, the value is not lost - Non-host based - value is on the card, if stolen and used, the value is gone - Some cards have a chip in the card which keeps track of the value of the card Smart Card Legal Issues - EFTA - Do the transactions that use the card involve an “electronic fund transfer” governed by the EFTA? (EFTA 903) - 1. Electronic fund transfer - “any transfer of funds which is initiated through an electronic terminal… so as to order, instruct or authorize a financial institution to debit an account - 2. Account - “a demand deposit (checking), savings or other consumer asset account held directly or indirectly by a financial

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institution” - 3. Financial institution - “State or National bank, a State or Federal savings and loan association, or any other person who directly or indirectly holds an account belonging to a consumer” For host-based cards, the card sponsor could be a financial institution, and each transaction correlates with the account held by the host , thus making it an electronic fund transfer Currently governed by Reg E 1005.2 (b)(2), and 1005.18(a)

Assignment 26: Internet Payments -

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Credit Cards on the Internet - Processing the Transaction - With respect to unauthorized transactions, the cardholder that purchases on the Internet, and verifies his identity solely by asking for the card number and billing address has not identified the customer adequately - Reg Z - cardholders have no responsibility at all in unauthorized transactions that are conducted based solely on card numbers - Problems - Fraud - Internet merchants bear the losses from fraud Debit Cards on the Internet - Internet merchants are motivated to accept debit cards - Smaller interchange fee - The finality of debit cards - Security of the debit card Mobile Payments - In-band - Payments for information or content delivered directly to the telephone - Out-of-band- Purchases in which a telephone is used to purchase something that cannot be delivered to the telephone (starbucks)

Assignment 28: The Basic Checking Relationship -

The Basic Relationship - A checking account is basically a two-step arrangement between the bank and the customer, under which the customer deposits money with the bank and the bank then disposes of the money in accordance with the customer’s directions - If the payor(drawer/issuer) writes (issues) a check to the payee, the check is drawn on the payor’s account at the payor bank (also called the “drawee”). The payee deposits the check at his bank (the “depository bank”). If other banks handle the check before it gets from the depositary bank to the payor bank, all of

Intermediary Bank

Payor’s Bank

Payee’s Bank

(Drawee)

Payor

Payee

(Drawer)

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those banks are “intermediary banks” - When going t The Bank’s Right to Pay - When is it proper for the bank to pay? - It is proper for a bank to charge a customer’s account for “any item that was properly payable” - UCC 4-401 - Item is properly payable “if the customer authorized the payment” - Ex. Payor writes a check and Payee cashes it at Payor’s bank - In most cases the payee does not take the check to the payor bank, but instead goes through an intermediary; payee’s own bank or a check-cashing service - As long as the payee properly transfers the check to the intermediary, the intermediary becomes “a person entitled to enforce” (UCC 3-301)

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Overdrafts - Customer authorizes payment by writing a check, but the account does not have enough funds to cover the check when it arrives at the payor bank - Bank is free to honor and overdraft the account or to dishonor the check as it wishes - When there are multiple check against an account that has insufficient funds to pay all of them, the bank pay out the largest checks first and smaller checks later - Leads to more bounced checks, but justified that the largest checks are usually the most important Stopping Payment - Customer’s decision to pay does not become final at the time the customer issues the check; customer has right to “stop” payment - Customer must give the payor bank timely and adequate notice of the customer’s desire - Three major issues - 1. The customer must act promptly as a stop-payment notice is only valid if it is “received at a time and in a manner that affords the bank a reasonable opportunity to act on it before any final action by the bank with respect to the item” - 2. A stop-payment order is only valid for six months. - 3. When somebody pays with a check, the payee has two separate rights to payment; Right to enforce the check and the right to pursue the check writer on the underlying transaction. - UCC 3-310 lays down rules governing rights of payee - 1. UCC suspends the payee’s right to pursue the customer on the underlying transaction when the payee accepts the customer’s check - To prevent the payee from collecting double payment - 2. Suspension ends if the check is dishonored - To ensure that the payee is not

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prejudiced by accepting a check that goes unpaid - Termination of suspension leaves the payee where it started with the right to pursue the check writer on the transaction - Remedies for Improper Payment - Most likely problems - 1. The customer in fact did not write the check - 2. The payment was made after a forged indorsement - 3. Bank failed to comply with a valid order to stop payment - Basic remedy is for the bank to reverse the improper transaction - Bank must recredit customer’s account, and also must pay any damages to the customer that follow proximately from the dishonor (UCC 4-402) - However UCC 4-407 subrogates the bank to the rights of the payee of the check - Bank can assert the payee’s rights against the drawer as a defense to the bank’s obligation to recredit the account The Bank’s Obligation to Pay - When are funds available for payment? - Bank has an affirmative obligation to pay the item when the account has funds “available” to cover the item - Only runs to the customer of the bank - Payee has no claim against bank if the bank customer prevents the bank from paying (withdrawal of funds or stop-payment order) - EFAA and Reg CC establish a framework of deadlines within which a depositary bank must release funds that its customers deposit by check. - Deadlines apply even if the depositary bank does not determine by the deadline if the payor bank will honor the check in question - Most important distinction in assessing funds availability is whether the customer wishes to use those funds indirectly (by writing checks against them) or directly (by withdrawing cash) - Noncash Withdrawals - Bank must make 100 dollars available on the first business day after the banking day on which the funds are deposited (Reg CC 229.10(c)(1)(vii)). - The rest of the funds must be available for withdrawal no later than the second business day

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Cash withdrawals - Regulations permit the bank to defer for still another day the availability of all sums beyond the first 500 - Bank must still make 100 available on the first business day and must make an additional 400 available on the second business day, but the bank can defer the availability of any remaining funds until the 3rd business day - Low-risk items - Reg CC includes a group of low risk items, and the bank must make the entire amount of funds from such items available on the first business day after the banking day on which the funds are deposited - Banking Days v Business Days - Banking days - subset of business days, specifically business days on which the bank is open for “carrying on substantially all of its banking functions” - Business Days - All calendar days other than Saturdays, Sundays, and federal holidays Wrongful Dishonor - Wrongful dishonor is when a bank violates its agreement with a customer by failing to pay a check that it was obligated to pay - Customer is entitled to all of the damages proximately caused by the wrongful dishonor

Assignment 29: Risk of Loss in the Checking System -

The Basic Framework - Nonpayment - Indorsements - signature by the person who is giving the check - Indorser liability is the principal statutory mechanism for allocating losses between the bank and the payee/payor - Blank indorsement - signature only indorsement - has the legal effect of making the check “bearer paper” so that any party that is in possession of the check (even a thief) would be entitled to enforce it - Special indorsement - signature and statement identifying the party the check is payable to - Makes the check “order paper”, which can be enforced only by the identified party - Restrictive indorsement - signature and “for deposit only” or “for

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collection” - Restrict the rights of later parties to transfer the check except in accordance with the indorsement - Under UCC 3-415, each party that indorses a check makes an implied contract with subsequent parties that acquire the check - Only runs to the person entitled to enforce the instrument - Excludes thieves or similar misconduct - Contract obligates the indorser to pay the check if the payor bank dishonors it - Because each party that indorses the check is liable on its indorsement and because each party’s liability runs to all subsequent owners of the check, the rule results in a chain of liability under which each party can pass a dishonored check back up the chain to the last person in the chain (earliest indorser) that is able to pay - UCC 4-214 allows a collecting bank to which a dishonored item is returned to recover any funds it advanced to its customer - Indorser liability is not mandatory - Only an implied contract, the indorser may add the phrase “without recourse” to the indorsement - If added, subsequent owners of the check cannot sue the indorser even if the check is dishonored Forged Signatures - Where a theft is involved and cannot be identified, the problem the parties face is to determine who among the innocent parties should bear the loss - Transaction is presumed to have been conducted without negligence on the part of any of the parties, if negligence is present, different rules apply - Forged Drawers’ Signatures - Liability when a thief steals a blank check and purchases things, or creates forged checks depends on whether the payor bank is duped into paying the check or notices the forgery and dishonors the check - Payor Bank Pays the Check - Payor bank bears the loss if it fails to notice the forgery and

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honors the check - Three exceptions - 1. Allows the bank to seek recovery from “the person to whom or for whose benefit payment was made” - Does not apply against a person that took the instrument in good faith and for value - 2. Bank can claim breach of a presentment warranty - If any of the warranties is false, the payor bank can recover from the party that presented the check to the payor bank or from any previous transferor in the chain of collection - 3. Imposes warranty liability if the transferor had “knowledge” that the signature of the drawer w.as unauthorized - Requires actual knowledge Payor Bank Dishonors the Forged Check - If the payor bank notices the forgery and dishonors the check, the collecting bank is left holding the check - Presenting bank seeks to pass its loss onto an earlier party in the transaction - UCC contains 2 rules upon which the presenting bank can rely - 1. Indorser liability system - pass the loss up the chain to the earliest solvent party that indorsed the check without disclaiming liability - 2. It creates a special set of warranties that limit claims about forged drawer’s signatures, and it limits payor banks to pursuing that limited set of warranties - Payor bank can complain only if the warrantor had “knowledge” that the drawer’s signature was unauthorized - Payor bank can only pursue transfer warranties against parties to whom an

instrument has been transferred - Instrument is presented to the payor bank, not transferred to it, payor bank cannot pursue the...