We had to ask ourselves that question. Don’t get me wrong. We have experience with disputes and chargebacks. Our dispute management software would be useless if we didn’t have it. But the question to what is a chargeback can offer a simple or complex answer. It really depends on the chargeback and the reason code that issued it. Let’s first look at the definition. And then we’ll build it up the answer, step-by-step:
What is a chargeback?
- A chargeback is a transaction reversal meant to serve as a form of consumer protection from fraudulent activity committed by both merchants and individuals.
- A demand by a credit-card provider for a retailer to make good the loss on a fraudulent or disputed transaction.
Cardholders occasionally file disputes with their issuing bank. These banks are often called “issuers”. A dispute is filed, the acquirer will debit the transaction amount from the merchant’s account. The merchant will then need to gather compelling evidence. This will help strengthen her response and prove her innocence from fraudulent activity. The funds will return to the merchant. That is, if the evidence favors an overturn of the cardholder’s dispute.
Please note that a cardholder can issue a second chargeback. This is scenario is called pre-arbitration. And cardholders may issue arbitration if, for example, they are determined to prove they were fraud victims.
The Origins of Chargeback
To understand a bit more about what is a chargeback, let’s take a quick look at where chargebacks originally came from.
Back during the 1970s, credit cards were still somewhat rare. Many people didn’t trust that little piece of plastic over fears of it getting lost or stolen. Some were even concerned merchants would enact fake charges to the card as well. Due to these concerns, the government passed the Fair Credit Billing Act of 1974, which created the concept of chargebacks among other provisions. With this item in place, consumer confidence in credit cards grew and with it the popularity of credit cards in general.
In this post, we’re going to dive deep in order to explain a chargeback beyond the dictionary chargeback meaning. This includes explaining the parties that are involved in the chargeback process. Yes, we already have a post that explains this process. But we’re using this opportunity to explore different areas that extend the chargeback’s definition. Here, we’ll explain the role of chargebacks as a lagging indicator. Then we’ll explain the different types of fraud affiliated to a chargeback. Afterwards, we’ll provide a (simplified) version of the chargeback the process. We’ll end this post with a look on chargeback prevention and chargeback resolution. Enjoy!
Table of Contents
Parties in the Chargeback Process
The customer is a cardholder who made a purchase with a merchant. There are several reasons that a cardholder will file a dispute. He may have seen an unrecognizable transaction on his billing statement. Or he may recognize the transaction. But he may not recognize the merchant descriptor. Each card network guarantees zero-fraud liability to its cardholders.
The issuer provides payment cards to the cardholder. Some examples include credit and debit cards. The issuer is ‘the underwriter’ of the account. That means it's responsible to disburse funds from the customer to the merchant.
Note: The customer’s balance and authorization is managed by the issuer’s processor.
Issuing Bank Processor
The issuer’s processor verifies the customers’ account balances. It’ll either authorize or deny transaction requests that are received through the card network.
Visa, MasterCard, American Express, and Discover are the four major card networks. Each network provides a pipeline that transfers payments between issuers and acquirers. The card networks also manage the settlement process between both parties. Basically, these networks provide the data connection between both parties. And they flow the funds through FedWire.
Note: American Express and Discover have a unique role. These card networks are also issuers and acquirers. That means the customer and the merchant are their clients. Visa and MasterCard are strictly card networks.
The acquirer is the institution responsible for acquiring authorization through the card network. It receives funds on the merchant’s behalf from the customer’s issuing bank. At this time, the acquirer settles the funds collected from the processing fees, network fees, and interchange fees.
Merchant Account Processor
The merchant account processor is a company that partners with an acquirer. It does so in order to process payments on the merchant's behalf. Merchants typically have a closer relationship with their account processor than their acquirer. But a merchant’s processor and acquirer are often the same institution.
Merchant Commercial Bank Account
The acquirer receives the funds from the issuer through the card network’s settlement process. The funds will be deposited to the merchant commercial bank account. The merchant commercial bank account is the ultimate destination of funds. These funds were transferred from a cardholder.
However, the transferred funds can be used for chargebacks. When that happens, the acquirer automatically withdraws the funds from the merchant commercial bank account. And the funds are moved back to the issuer/cardholder’s account. It's quick and painless—for the cardholder.
The payment gateway does the complex work. It builds secure connections to merchant account processors. Think of this as a “virtual” credit card terminal. It allows a merchant to submit payments to a processor through the internet. Payment gateways also provide fraud filters, recurring billing payments, and other valuable functions to assist ecommerce companies.
A business, company, brand or other relevant party who provides a good or service in exchange for payment.
Chargebacks as a Lagging Indicator
No one likes getting chargebacks. But it does provide valuable insights. You'd be surprised how much you can improve your business operations. Every processed chargeback is assigned an appropriate reason code that most accurately represents the cardholder’s dispute. Merchants will see some breakdown of reason codes unique to their own business. But we found our own breakdown based on the millions processed chargebacks.
These reason code categories might not translate into actionable insights. But a large frequency of reason codes should raise red flags to improve your business. A pie chart and histograms can provide a great stepping stone for more in-depth research. For instance, you should view the categories above as its own ‘bucket’. And you should focus in learning how so many chargebacks were issued.
Overwhelming Amount of Fraud / No Authorization Reason Codes?
This is where you step on the stepping stone. Let’s say you experienced a disproportionate amount of chargebacks coded under Fraud or No Authorization. This tells you to look at your front-end fraud prevention solutions. Do you have enough safeguards in place to stop transactions that are obviously fraudulent?
You need to start with the basic safeguards, including CVV and AVS. But there are other things you can consider. For example, there's automated transaction scoring. You can also use rules-based filters and geolocation. And don't forget device ID, device fingerprinting, and 3D secure tools. Your front-end fraud prevention should be strong enough to protect your business. That’ll reduce the risk of ‘large-scale’ attacks from fraudulent activity.
Absolutely ZERO Fraud / No Authorization Reason Codes?
There is a thing of having too many safeguards. If there are too many, it may block legitimate transactions and alienate real customers. And there is a problem when you don't see any problems with your prevention solutions. If that happens, try to understand how rigorous is your front-end fraud protection. It’s acceptable to let some fraud pass through. You can still respond to fraudulent chargebacks and recover lost revenue.
This a perfect challenge to adopt a Goldilocks approach for fraud-related reason codes. Your fraud prevention solutions shouldn’t be not too much. It shouldn’t be too little. You have just the right amount of solutions.
Lots of Cancel Recurring Billing Chargebacks?
A lot of merchants use recurring billing as the preferred method of payment collection. This approach is great to guarantee a customer lifetime duration. It'll also works well in producing an ongoing revenue stream. However, merchants can frustrate a lot of customers if they use recurring billing incorrectly.
This frustration appears to merchants as Cancel Recurring Billing reason codes. But there is a positive to this frustration. After all, it’s a good indicator that your customer communication needs attention. For example, is it clear to customers that they’ll be billed monthly for a product? Are you emailing users to remind them of invoice dates? A rule of thumb is that over-communication is preferred when it comes to recurring billing.
Mostly Product / Services Related Reason Codes?
Product or service-related reason codes have a few different subsets. Each subset important to monitor as lagging indicators. That means somewhere within your operations is ‘lagging’. And a correction needs to be made. Here are some questions merchants should ask themselves if shipping is the lagging indicator:
- Are you sending tracking information to the customer?
- Are there problems with a particular shipping provider?
You can improve your business by answering these questions. It’ll also help you know where to place your resources in order to prevent future lagging. However, shipping is only one lagging indicator. Another subset deals with product expectations. This often points to inadequate, insufficient, or downright incorrect product descriptions on the website. You should look at your product descriptors if you received a lot of product-not-as-described reason codes. Try to answer these questions when this occurs:
- Did I not provide detailed specifications to the customer?
- Are there enough photos and views to contextualize the product?
- Can I incorporate customer reviews onto the product page to help set expectations?
Reason codes are often overlooked. You need to know that reason codes are a goldmine for merchants. Especially if you’re thinking of improving your overall business operations. The reason codes are helpful to let you know there's a problem. And we can offer a solution.
This is a good time to download your free copy of the Chargeback Reason Code Encyclopedia. Keep it handy. It contains every single reason code from MasterCard, Visa, Discover, and American Express. That includes their definition, additional insight, and real world examples of dispute resolution.
Chargebacks and Types of Fraud
Chargebacks are a natural part of doing business. And every merchant will have a portion of legitimate chargebacks filed under valid reason codes. And yes. Cardholders are entitled to a refund. But almost 80% of chargebacks are proven to be chargeback fraud or friendly fraud. Let’s explain the different types of chargebacks.
True Fraud (Unauthorized Use)
Unauthorized use of a card is a result of compromised payment information. This could originate from card skimming and other nefarious scams used by fraudsters. The fraudulent purchase may be caught by the issuer. But there are times where it is disputed by the cardholder. That enables the issuer to close her account and issue a new account number and card.
For example, most of the cards stolen from Home Depot and Target resulted in thousands of fraudulent purchases. This only produced fear (and some presence) of chargebacks.
Don’t let the word ‘friendly’ fool you. This expression is used for cardholders who file disputes with no malicious intent. Some causes of friendly fraud include forgetfulness, family members making unknown purchases, and misunderstandings of merchant return policies.
For example, a son asks his Mom if he can use the card to buy some Nike’s. But it’s not just any pair of shoes. It’s a limited edition pair that is only available at a boutique retailer. Dad reviews the bill a month later. But he doesn’t recognize the retailer’s name or the transaction. Dad thinks that this fraud, and he disputes the charge.
Chargeback fraud is the fraudulent request for a return or refund in the form of a chargeback. In this case, the transaction passed fraud prevention. But what fraud prevention didn’t pick up was the motive of the dispute. It turns out the cardholder filed the dispute in order to regain the transaction dollar amount.
And here’s where the cardholder becomes a little malicious. He wants his money back. But he plans to keep the product or services that was rendered. There are thousands of stories illustrating instances of chargeback fraud. It could be Twitter users bragging about getting free Domino’s pizza by by filing disputes. Or it could be travelers who use chargebacks to refund any ‘no-show’ reservations.
According to LexisNexis True Cost of Fraud study, these three types of fraud represent roughly 75% of total fraud losses. This specifically affects ecommerce merchants. Lost or stolen merchandise accounts for the remaining 25%. Friendly fraud and chargeback fraud are responsible for 56% of a merchant’s fraud losses.
The Chargeback Process - Simplified
The chargeback process is similar to legal proceedings. The cardholder and the merchant will offer evidence that supports their claims. The cardholder is filing a dispute to issue a chargeback. And the merchant is the defendant that is proving his innocence in the transaction. Retrieval requests sometimes precede an actual chargeback. Here, the merchant is asked to provide basic documentation that’ll quickly validate or disprove the dispute. This is to prove whether the dispute is fraudulent.
Full disclosure: The chargeback process is skewed in favor of the cardholder. There’s no doubt about that. But merchants make their case with the right response and the relevant compelling evidence. This will help them win cases of friendly fraud and chargeback fraud. It will also build better models to bolster front-end fraud protection. Let’s take a look at the simplified version of the chargeback process.
A cardholder files a dispute by contacting the issuer about a particular transaction. These disputes are typically submitted on a smartphone or on an online form.
The issuer reviews the dispute. This is where it decides whether this dispute should be forwarded to the card network. The dispute will be deemed as either valid or invalid. Here's what happens in both scenarios:
- Invalid dispute: The cardholder’s dispute is reject, and the chargeback process ends.
- Valid dispute: The chargeback process continues to the card network. The dispute is now transformed into a chargeback?
The issuer provides an immediate credit to the customer for the disputed amount. And the networks initiate the flow of funds from the merchant commercial bank account back to the issuer.
The issuer submits the chargeback to the card network, who then passes it to the acquirer. Fees are incurred here. But it’s eventually passed to the merchant.
The acquirer receives the chargeback and passes it to the merchant. It typically contains instructions to gather compelling evidence that directly relates to the chargeback reason code. This communication occurs on the merchant account processor’s online portal. It can also occur in an offline letter.
The merchant chooses whether or not to respond to the chargeback. Here’s what happens in both scenarios:
- The merchant decides to respond: He’ll need to gather compelling evidence that is related to the transaction and cardholder. This includes, but certainly not limited to:
- Date/time stamp
- Device usage
- Shipping verification
- Address verification
- CVV match
- Device fingerprinting
- Past transactional history
- Any subsequent transactions from the customer
- Any communication with customer
- Other data that is related to the transaction
- The merchant decides not to respond: The chargeback process is complete. And it has been ruled in favor of the customer.
The acquirer reviews the compelling evidence. Then it passes the information to the card network. Afterwards, the network passes it to the issuer on behalf of the merchant. Here’s what can happen in this step:
- The compelling evidence proves an invalid chargeback: The issuer will decline the chargeback. It will return the funds from the issuer into the merchant commercial bank account (via the acquirer). This merchant won after spending many days to prove her innocence.
- The compelling evidence proves an valid chargeback: The compelling evidence does not prove the transactions validity. Therefore, the chargeback process ends and funds remain with the issuer/customer. E.g., The merchant lost.
Conditional Additional Steps Following Step 7
The customer is given the option to chargeback the transaction again. Visa refers to this as pre-arbitration. And MasterCard calls it a second chargeback. The entire process will start again. This happens if the cardholder lost the original chargeback case. It can also happen if the merchant was at fault.
But pre-arbitration/second chargeback is recommended only if you have strong evidence and a strong argument. More time on the chargeback process translates to more money being at stake. Before any merchant decides to send a chargeback to pre-arbitration/second chargeback, ask yourselves, ‘Is it worth it?’.
The cardholder lost and the merchant won pre-arbitration/second chargeback. The issuer can push to arbitration. That automatically incurs a $250 fee for the merchant. She’ll receive that money back if she wins the chargeback, again. However, the merchant is assessed an additional $250 fee if she loses this round.
The duration of the chargeback process is dependent on whichever Visa, MasterCard, American Express or Discover reason code was used. On average, the process can last one month or as long as six months. However, Visa just made efforts to have disputes resolved within 31 days. You can learn more about the new VCR Dispute Reason Codes right here.
Potential Outcomes of a Chargeback
Every chargeback ends in one of three outcomes. The chargeback was either actual fraud, chargeback/friendly fraud, or product/service issues.
When you receive a chargeback, it’s either coded under a fraud reason code or a non-fraud reason code. However, some chargebacks will be coded as fraud even though it’s often proved to be anything else. Chargeback fraud or friendly fraud was the source under these circumstances.
And it’s an unfortunate circumstance. Fraud-coded chargebacks lead many merchants to simply ignore it. They may write it off as un-winnable cases of fraud. That couldn’t be further from the truth! It’s revealed that more than three-quarters of chargebacks are really chargeback fraud or friendly fraud. And that can only be revealed with a response.
The Difference Between a Chargeback and a Refund
It should be noted that a chargeback isn’t simply a refund. Yes, a chargeback could end up returning a cardholder’s funds, but there may be added chargeback fees to that amount. Plus, a chargeback is started by the cardholder. A refund, on the other hand, is started by the merchant and relates to a single transaction with a card. The amount returned to the cardholder can be all or only part of the total payment.
Merchant Losses to Chargebacks
The only thing worse than a chargeback is losing to a chargeback. Merchants just don’t lose the dollars that were disputed. They also lose money from the chargeback fees and (possibly) the product. Merchants also lose the time and money from selling, ordering, packaging and delivering the product. In 2016, ecommerce merchants were expected to lose a combined total of nearly $7 billion in revenue from chargebacks. Individually, that represents to 1.47% of total revenue.
And there are other ways to lose money from chargebacks. For instance, your chargeback ratio will be affected when you receive a chargeback. If that ratio is over 1%, processors can increase fees for chargeback occurrences. They can even refuse to process payments for the merchant’s account. Unfortunately, this scenario pings these merchants as being “too risky” for future business. The credit card processors simply don’t want to deal with the amount of chargebacks that are common with high-risk merchants.
That’s why it’s important for these merchants to control their chargeback ratio. But of course, is easier said than done! You ratio is impacted every time the chargeback reaches the card network. And a merchant may not know about receiving a chargeback until weeks after the disputed transaction. It’s no surprise that high-risk merchants can feel particularly helpless.
Chargeback Alerts can keep you ahead of any variable that’ll affect your chargeback ratio. It gives you the opportunity to prevent fees, immediately blacklist a customer, and take action to remedy the situation. A dispute will have a difficult time turning into a chargeback with this feature. And you’ll reduce your chances of having a damaging record with payment processors and card networks. A good alert feature includes all participating issuers. Fortunately, Chargeback Alerts is the feature that does just that.
Is There a Difference Between Chargebacks for Debit and Credit Cards?
A debit card chargeback can differ from credit card chargebacks in that a transaction with a debit card takes money out of a cardholder’s account directly. This may mean cardholders are much more determined to get their money back since the transaction has directly affected their bank account. Debit cards may also have a different cardholder liability cap, where the amount the cardholder is liable may increase after only a couple of days. The liability can even increase to the full transaction amount after 60 days. This can also make the timeline for disputing a charge go by faster.
Be an honest merchant. That's the first thing everyone should implement. This requires producing quality products. You'll need to accurately describe what you’re selling. And you must strive to provide the best customer service in your industry. Merchants should consider the following in order to prevent chargebacks:
- Excellent customer service
- A customer centric return policy
- Detailed and accurate product descriptions
- Set realistic expectations of the product/service results
- Easy to find shipping/tracking information
- Document conversations with customers
Responding to Chargebacks
Prepare yourself to receive a chargeback. It will happen. So you should take time to understand the possible reasons for a dispute. After all, there are currently over 130 different chargeback reason codes among the top four networks. And they have plans for how you should respond to the reasons for each code.