Chargebacks: Everything you need to know
Kshitiz Moktan, Compliance
What is a Chargeback?
A chargeback is a reversal of an ACH or a card transaction that happens when a user disputes that the transaction is not authorized by them or claims that it was fraudulent. It is also known as payment disputes, which can occur when a cardholder sees a transaction on their debit or credit card that they don’t believe they have made, or if they were charged the incorrect amount.
In such cases, they can dispute that transaction with their bank or financial institution. The bank will review their request and reverse the disputed amount from the merchant’s account, returning the money to the cardholder without needing the merchant’s approval.
Types of Chargebacks
Chargebacks in general can be classified into three different types: True fraud/criminal fraud, friendly fraud, and merchant error.
True Fraud or Criminal Fraud
Criminal Fraud also known as true fraud occurs when a fraudster uses a stolen identity or card information to process an unauthorized transaction without the cardholder’s prior knowledge. When the legitimate owner of the card realizes that they have been charged for the transaction they have not made, they file a chargeback regarding the transaction.
Friendly fraud chargebacks refer to customers who abuse the chargebacks procedure by reporting valid transactions as being fraudulent to get a refund. Customers can do this on purpose, or they might do it by mistake or due to confusion. There are instances where a member of a family might have used the family credit card without other members being aware of it, causing them to file for a chargeback.
Merchant Error Chargebacks
Merchant error chargebacks happen when the chargeback is due to an error made by the merchant. These could be caused due to system errors, unwanted recurring payments, authorization errors, and so on. This type of chargeback is not very common.
Why is managing chargebacks important?
Chargebacks can mainly affect merchants in three different ways.
Merchants directly lose revenue from the transactions caused by chargebacks. Along with financial loss, disputing a chargeback case takes time and effort. It takes resources to gather evidence and go through all the chargeback processes to increase the chances of winning.
High Service fee
Each chargeback incurs a service fee which might cost between $20 - $100 depending on the merchant's agreement with their acquirer. Regardless of whether it is resolved in your favor or not, the merchant needs to bear that cost. Along with the chargeback fees, there are various hidden costs factored in, due to which the merchants often lose more than twice the transaction amount for each chargeback.
When a chargeback ratio exceeds 1% of your total transaction, it creates additional problems for the merchant. A chargeback ratio is a number comparing the total transaction a merchant processes each month with the number of chargebacks the merchant received during the period in question. Each card brand calculates merchants’ chargeback ratios differently. If your chargeback-to-transaction ratio sits above the acceptable threshold, you could be labeled a “high-risk merchant”. You’d be required to join a chargeback monitoring regime, like the Visa Dispute Monitoring Program (VDMP). This typically involves higher processing costs while you attempt to resolve the situation.
Here is how the basic chargeback management process works:
A chargeback process begins when a cardholder (user) contacts the issuing bank to dispute a transaction and reverse it. The cardholder has up to 120 days from the settlement date to file a chargeback request.
The Provisional Refund
Cardholders will be issued a conditional refund. The issuer then reimburses the funds from the acquirer to the cardholder's account. The acquirer will debit the amount of the original transaction from the Merchant's account along with any applicable fees.
* A card issuer offers payment cards to consumers on behalf of card networks such as Visa, MasterCard, or American Express.
** An acquirer is a financial institution that processes credit and debit card transactions for a company or merchant.
The Reason Code/ Exception code
The issuing bank then assigns a numeric reason code for the chargeback which helps to understand the reason and determine the way to validate the original transaction. The chargeback information is then sent to the acquirer and the acquirer provides the information to the merchant.
A merchant has the option to either accept the chargeback or fight it if the claim is invalid. The merchant can dispute chargebacks by uploading relevant evidence (based on the exception code). This evidence is submitted to the networks in a process known as representment.
Time frames vary by network, but merchants typically need to submit evidence within 20 calendar days of the exception date. If a merchant takes no action and does not dispute, the case will close 30 days after the exception date and there will be no further movement of funds.
Bank Review and Decision
The issuing bank reviews the information. One of three things happen:
- Merchant Win The merchant’s representment case validates the original transaction. The transaction amount is re-charged to the cardholder’s account, and the funds go back into the merchant’s bank account. It takes around 70 days for the confirmation and provisional credit is given to the merchant until this time.
- Cardholder Win In case the evidence provided by the merchant did not convince the bank to reverse the chargeback, the cardholder wins If the dispute is decided in the cardholder’s favor, provisional credit will be reversed (except for Visa 10.4 cases).
- Merchant Win but the cardholder files for Second Chargeback The cardholder can still file for a second chargeback for the same transaction if their claim is valid.
If the issuing and acquiring banks are unable to settle on an outcome, arbitration places the dispute decision and final say in the hands of an impartial third party – the card network. The card network’s decision will be final. Only 2% of disputes make it to arbitration. Arbitration is rarely used because the costs are high, the outcome is uncertain, and the process is opaque.
Chargeback Reversal Strategies
Below are the two ways a merchant can get reversals:
Communicate with the User
Most chargebacks can be avoided if communication with the users is proper. This is a very significant process as this can help resolve the dispute without going through all the hassle.
At Machnet, this is the first step taken when receiving a chargeback return. We request the clients to communicate with the user and investigate the case. In most cases, we have found that the users have filed for chargeback due to misunderstanding or misinformation.
Friendly fraud can be one of the main reasons. In such scenarios, we ask the client to communicate with the user and request resettlement. This saves the merchant a lot of time, resources, and unnecessary fees.
Chargeback Representment (Dispute Filing)
The initial thought behind chargebacks is to protect the cardholder in case of suspected fraud. That makes it that much more difficult to overturn it since the process will be in favor of the cardholder. Chargebacks are won or lost through a process called representment. During this process, you literally ‘re-present’ the transaction to the bank for a second review.
Below is the list of the process a merchant can follow when a Chargeback occurs:
- Understanding the Process: In case communicating with the user did not work, merchants are required to dispute a file against the chargeback and this is the first process we need to understand. It is useful to review how a chargeback moves through the different stages of the dispute process. This can help merchants determine the best strategy for disputing a case.
- Identify the Reason Code: Each chargeback has a Reason code that indicates why the transaction is being disputed. Not only does it provide information about why the customer filed for a dispute, but also informs you about the chargeback type and the list of the necessary evidence for overturning a dispute.
- Know the time limits: Merchants have limited time to respond to incoming chargebacks. It is usually 20-30 business days depending on the card scheme and reason code. You will automatically forfeit the case if you submit your representment package past the deadline, so you must respond within the allowed timeframe.
- Assemble Compelling Evidence: To win a chargeback dispute as a merchant, you must have evidence that is compelling enough to persuade the cardholder’s bank to reevaluate the case. The evidence provided needs to prove the following:
- Identified and verified the user
- Processed the transaction correctly as per the information provided by the user
- Delivered the transaction to the correct recipient mentioned by the user and also sent a confirmation to the user’s email and phone
- Transaction processed with the user's consent and they accepted the merchant user agreement
- The supporting documents that need to be included are proof of delivery from the payout partners and transaction confirmation page where the user agreed to send the transaction.
- Write a Rebuttal Letter: A chargeback rebuttal letter is a type of cover letter that should include a concise summary of your evidence, clearly explaining how the cardholder’s dispute is invalid. It should present the facts professionally and dispassionately, avoiding emotions and overblown explanations.
- Compile & Submit Your Representment: After preparing and compiling all the evidence and the rebuttal letter, you need to submit the representment to the acquiring bank. The documents are then reviewed and sent to the cardholder’s issuing bank for a final decision.
Risk Mitigation Strategies to avoid Chargebacks
The more proactively we seek to shut down chargebacks before they happen, the less we have to worry about its reversal process. A well-managed chargeback program can be a strategic business advantage for any fintech company.
Merchants and business owners need to take proper risk mitigation approaches. Proper risk assessment helps the firm reduce the chances of financial fraud and avoid a chargeback. Some important risk mitigation strategies could be the following:
Know your customer (KYC) and Enhanced Due Diligence (EDD) is a control procedure that can be applied to identify the users and avoid risks. KYC should be done for all onboarding users while EDD should be done for high-risk users and high-volume transactions. KYC and EDD help the merchants identify the users and check the accuracy of the information and documents provided while processing any transaction.
Automated risk profiling of Individuals
Merchants should have automated risk assessment tools in their system which can intelligently use risk data available internally and externally to assess risks. Some of these service providers are SIFT Science, Maxmind, and Sardine.
Automated and Manual Transaction Monitoring
Automated and Manual Transaction Monitoring helps flag any suspicious transactions from an individual. Transaction monitoring means checking the sending patterns of the users, flagging multiple transactions, checking if the user has been splitting large volume transactions (smurfing), sending multiple transactions to single or multiple beneficiaries, and so on.
Each individual in the organization who is responsible for compliance checks should be provided with proper training. Training should be exhaustive and should include rules and regulations for KYC/EDD, AML CTF Risks and Risk Assessment, Identifying PEPs, and how adverse media screening works. It should also include the risk rating of Suspicious Transactions, the risk score of any risky users, transaction monitoring and current regulations, and all other factors involved to help mitigate the number of fraud transactions.
At Machnet, we make sure to implement all the above-listed risk mitigation strategies in order to avoid chargebacks. To learn more about our process schedule a call with our sales team at firstname.lastname@example.org