Chargeback: What is Payment Fraud and How to Prevent It
By Joe Vignolo /
1 Jun 2021
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 chargeback is also defined as a demand by a credit-card provider for a retailer to make good the loss on a fraudulent or disputed transaction.
The Origins of the Chargeback
To understand a bit more about what a chargeback is, 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.
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.
Merchants often have to deal with chargeback fraud. The primary purpose of risk analysis is to detect and prevent false chargeback operations. The ability to discover the details behind a chargeback scam is invaluable for merchants. This involves discovering whether a suspicious order was placed by a legitimate authorized cardholder or a fraudster who used stolen cardholder information.
By definition, payment fraud is criminal deception meant to bring personal or financial gain to the fraudster. Fraud is very easy to comprehend on its own, but when paired with words like friendly, true, and chargeback, it takes on a whole new meaning, especially for merchants.
What is Chargeback Fraud?
When a cardholder disputes a transaction with their bank or credit card company with the intent to get something for free, they’re committing chargeback fraud. Also known as friendly fraud, it represents a way of abusing the chargeback process to obtain a secure refund without notifying the merchant.
There are many reasons for a fraudulent chargeback. Some of the most common include:
- The cardholder was hoping to get something for free
- The cardholder didn’t understand the purchasing process
- The cardholder regrets ordering the product or service but doesn’t want to inform the merchant about it
- A family member (family fraud) used the cardholder’s information to purchase something without notifying the card holder
Despite the numerous and often creative excuses, statistics say that dishonest chargeback claims are constantly on the rise.
Chargeback Fraud Detection: Chargebacks and other 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 is 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 were rendered. There are thousands of stories illustrating instances of chargeback fraud. It could be Twitter users bragging about getting free Domino’s pizza 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 e-commerce 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.
Friendly fraud and chargeback fraud, which we will use interchangeably going forward, are a type of chargeback most merchants face.
When a cardholder expresses friendly fraud concerns and files for a dispute, it’s important to consider various types of fraud, including:
- Actual fraud: When a fraudster uses another cardholder’s information to purchase an item. Then the merchant unknowingly sends the item to the fraudster.
- Friendly/Chargeback fraud: Friendly fraud is a type of fraud that occurs when cardholders dispute legitimate purchases. For instance, a family member purchases items without notifying the authorized cardholder, or when the purchaser themselves want something for free.
- Merchant error or negligence: This happens when the merchant fails to ship the order, ships a damaged item, or refuses to provide quality customer service (a refund or store credit). Therefore, the chargeback falls under merchant error or negligence.
The Challenges of Fighting Friendly Fraud
Now that you know what friendly fraud is, you should also know it is difficult to combat.
Banks assign predefined codes to disputes based on the customer’s reason for a chargeback. Very often, merchants simply accept the reason code as legitimate and fail to investigate the truth. This can be due to limited resources to contest chargebacks to begin with or compounded by a buyer’s insistence they should be refunded for a given charge.
Sadly, chargeback acceptance without proof leaves the merchant defenseless against this form of fraudulent activity. Ironically, fraud chargebacks are often submitted by regular or trusted customers so the merchant never suspects their customer is lying.
False chargebacks are also on the rise because chargeback regulations were set before the Internet era. This means these regulations have yet to adapt to today’s Internet-based marketplace. Prosecutors also often don’t have the political will or resources to deal with this crime.
Because it is so hard to fight fraud, it’s important to stop this crime before it even happens. Sift offers comprehensive fraud prevention products to keep your business safe.
Chargeback Fraud Prevention
Reducing fraud is an absolute necessity for merchants. But before you try to fight fraud, you should first make sure your business is as close to being chargeback-proof as possible. Familiarize yourself with the minor mistakes or missteps that may encourage chargeback fraud.
The most effective way to prevent fraud is to utilize a platform that allows you to manage everything about fraud detection in one place. Sift is the leader in Digital Trust & Safety.
Our dispute management solutions effectively and proactively combat online fraud and abuse. Through fraud detection and prevention, we streamline operations and drive revenue growth.
To learn more about the ways we prevent fraud and chargeback operations, check out these recent posts:
Joe Vignolo is the Director of Content Marketing at Sift, specializing in authentic storytelling that connects and converts. Before joining Sift, he ran content at Outreach and Datanyze and was an award-winning broadcast journalist in the San Francisco Bay Area. He also believes Point Break (the original) is a shining example of American cinema.