COMMENTARY: How Faulty Merchant Agreements Sink ISOs

By Eugene Rome

Merchant-service providers of all shapes and sizes learn the hard way that cutting corners by using cut-and-paste tactics to create a merchant agreement can end up in costly litigation. Independent sales organizations, third-party processors, and payment facilitators must have a merchant agreement that is tailored to their particular business model, the types of merchants they service, and their potential exposure based on risk.

Many service providers use outdated merchant agreements, many of which read like they have been cut-and-pasted from terms and conditions drafted for brick-and-mortar merchants using card-imprinting machines back in the 1990s. Not surprisingly, such cut-and-paste jobs are often missing contractual terms important to protecting the service provider in connection with high-risk merchants operating in a card-not-present environment.

Such key items include appropriately drafted indemnity, security, and reserves provisions. An outdated agreement may fail to comply with card-brand requirements for merchant (or submerchant/sponsored merchant) agreements, and may also fail to adequately account for other issues associated with the service provider’s particular business model as an ISO, a third-party processor, or any type of payment facilitator.

Many merchant agreements include a generic indemnity provision that fails to adequately protect the service provider against potential liabilities associated with high-risk merchants. Such generic indemnity provisions may fail to protect the service provider against the cost of responding to a government investigation into the merchant’s activities, or against the risk of chargebacks in the event of merchant fraud.

Many merchant agreements depend on deficiently drafted security-interest and reserves provisions that fail to protect the service provider when the Federal Trade Commission files a complaint under seal and obtains a preliminary injunction and asset freeze, and accompanying order for turnover of merchant funds (including reserves) to the receiver for purposes of consumer redress.

Many merchant agreements include poorly drafted early-termination fee clauses. Such clauses frequently fail to include appropriate language regarding the basis for calculating the early-termination fee and its reasonableness as liquidated damages, thereby rendering the clause vulnerable to challenge as an unenforceable penalty provision. Of course, such poor drafting may easily cost the service provider hundreds of thousands of dollars in early-termination fees it would have otherwise recovered under the contract.

Many merchant agreements include poorly drafted guarantees. Such agreements may fail to provide for personal jurisdiction over the guarantor so that the service provider must file separate lawsuits in different jurisdictions against the merchant and the guarantor. Such agreements may fail to include a corporate resolution approving a cross-corporate guaranty, thereby rendering the guaranty ineffective and leaving the service provider alone on the hook for the merchant losses.

Many service providers get it wrong from the very start of the merchant relationship through shoddy contract-management practices. Bad practices include incorporating terms and conditions by reference in the merchant application, but failing to provide the terms and conditions and accompanying fee schedule until after the merchant has already been approved as part of the “welcome package,” without ever procuring the merchant’s signature on the actual terms and conditions; or, almost equally as bad, faxing the terms and conditions in an unreadable 8-point font, and obtaining the merchant’s signature via an even more illegible return fax.

Such shortcomings may prove fatal to a service provider’s ability to prove “mutuality” (i.e., that the parties had a “meeting of the minds” regarding the basic substance and terms of the contract) as necessary to prove the existence of an enforceable contract with the merchant. Of course, that means no contractual right to early-termination fees, indemnity, or prevailing-party attorneys’ fees, and no enforceable guaranty.

Best practices include: (i) printing the terms and conditions in an easy-to-read format (larger font, shorter paragraphs, and adequate spacing between the text); (ii) sending the complete terms and conditions (and any associated fee schedules and appendices) to the merchant contemporaneously with the merchant application; (iii) obtaining the merchant’s initials on each page of the merchant package, and obtaining the merchant’s signature on both the merchant application and the terms and conditions; and (iv) using an electronic document-management and signature service (such as EchoSign or DocuSign) for all merchant agreements.

The foregoing describes just a few of the most common deficiencies associated with merchant agreements. Of course, the devil is in the details, which is why ISOs, third-party processors, and payment facilitators should have merchant agreements thoroughly reviewed and examined to identify the key issues and potential risks.

—Eugene Rome is the principal and founder of the Los Angeles-based law firm Rome & Associates. Reach him at erome@romeandassociates.com.