Refund Fraud Prevention Guide For Merchants

Refund fraud is a fraudulent activity where an individual or group of individuals illegally obtain a refund they don’t deserve. It's a growing problem for businesses, with the National Retail Federation estimating that return fraud costs retailers $17.8 billion annually.

Fraudsters use various methods to commit refund fraud, including friendly fraud (or chargeback fraud) and return fraud.

Friendly fraud is when a cardholder disputes a legitimate transaction for some confabulated reason so they can get their money back. Return fraud, on the other hand, is when a customer returns an item they did not purchase or returns a damaged item for a full refund.

There have been growing cases of cardholders using chargeback threats to bully business owners into issuing refunds. The business owner, wishing to avoid dealing with the chargeback nightmare, will oblige and write off the bill. Case in point:

In this article, we'll go through the many types of refund fraud, standard fraudster techniques, and preventative measures to help you safeguard against refund fraud and protect your business and actual customers.

Understanding Refund Fraud: How Fraudsters Rip off Sellers

Before highlighting the different types of refund fraud that you must know about, let's touch on why refund fraud is pretty easy for fraudsters nowadays.

First, eCommerce business thrives on trust. So refund fraud is easy for fraudsters because companies often struggle to verify whether a refund request is legitimate.

For example, a fraudster buys a product or service and then requests a refund for some reason, like an order not received or merchandise not as described. You know they’re lying, but you may approve the refund request without contesting the claim because you want to provide good customer service and maintain a positive reputation. With that, you inadvertently open a loophole the fraudster will exploit to receive refunds for transactions they never made or items they intentionally damaged themselves. In some cases, the fraudster may even use stolen credit card information to make the purchase.

The rise of online shopping and electronic payment systems has made it easier for fraudsters to commit refund fraud using fake IDs and fathom email addresses. They can quickly request a refund and disappear into thin air without leaving any trace behind, making it challenging for you to track them down.

Watch out for these refund fraud patterns and red flags to avoid being someone’s cheese fries.

Types of Refund Fraud to Look Watch Out for

Business success has a lot to do with pattern recognition. Pay attention to these fraud patterns to stop revenue loss, reputation damage, and potential loss of processing rights before they happen.

#1: Friendly Fraud

As noted earlier, friendly fraud occurs when a customer disputes a valid transaction with their credit card company, often alleging they didn’t approve the bill or that it was fraudulent.

Here are some numbers:

• Friendly fraud is spiking at a rate of ~41%, and 86% of all chargebacks are “probable cases of friendly fraud,” according to Expert Market.
• Merchants say friendly fraud is now the #1 fraud attack source for their businesses, up from #5 in 2019.
• Total losses from friendly fraud in one year reaches $25 billion, according to the NRF.
• Merchants lose up to $375 for every $100 lost to fraud due to fees, increased operating expenses, and other ancillary spends.

These figures show how friendly fraud increasingly and negatively impacts businesses and the need for solid preventative measures.

#2: Return Fraud

What is return fraud? Return Fraud is a subset of refund fraud where a buyer returns a product they did not buy or a broken product for a full refund.

Fraudsters committing return fraud use several dishonest methods, such as altering tags, returning an item they previously acquired for less value, or returning an entirely different product.

While it seems like a fun game for these scammers, return fraud cause business owners significant financial losses and reputational damage.

While honest mistakes happen and equally lead to returns, industry records show that return fraud is becoming quite popular these days. Take a look at the stats:

• Retailers lose $10.40 to return fraud for every $100 of returned merchandise accepted, equating to an estimated $24 billion loss yearly, according to NRF.
• For every 11% of retail products returned, 8% will be sent back to the point of origin fraudulently.
• One-fifth (20%) of participants in Appriss’ study attributed return fraud to organized retail crime.

#3: Wardrobing

Wardrobing is when a scammer purchases a product, uses it for a short period, and then returns it for a full refund. Customers frequently return clothing items after wearing the clothes and complain they were inappropriate or did not fit correctly.

Wardrobing is a first-party fraud that results in financial losses and strains the retail supply chain, as businesses cannot readily resell returned items at the total price.

Here are some numbers:

• 28% of Gen Z and Zennial respondents in one study say they’ve worn an item with the tags attached and returned it.
• NRF says acts of wardrobing amount to $12.6 billion in lost sales for retailers.
• 50% retailers in one study say returns of used, non-defective merchandise are the most types of refund fraud they experienced in the past year.

#4: Refund Fraud by Employee

Refund fraud by employees is when an employee of a company abuses their access to the company's refund or return system for personal gain. That can involve several deceptive tactics, such as creating fraudulent refunds or manipulating the system to process returns without authorization.

According to a report by Hiscox, employee theft and fraud cost businesses an average of $114,000 per year, with refund fraud being one of the most common types of employee fraud. In addition, the Association of Certified Fraud Examiners (ACFE) found that businesses lost an average of 5% of their annual revenue to employee fraud, with refund fraud being one of the most significant contributors.

#5: Item Swapping

Item swapping is another aspect of return fraud where a customer purchases an item, switches it with a cheaper or older one, and then returns the swapped object to the store for a full refund. The fraudster may keep or sell the more expensive or newer item for profit.

For example, a scammer may purchase a new item, replace it with an identical older item they already own, and then return the older item in the new item's packaging. The fraudster may also purchase a different but similar-looking item and swap the tags or packaging with the original item, confusing the seller.

In some cases, fraudsters even purchase a new item, take it home, use it, and then swap it with a cheaper or older item before returning it to the store for a refund. Such practices are standard with products like electronics, where the original packaging can be challenging to reproduce.

Item swapping can be challenging for businesses to detect, especially if the swapped item is of a similar size and weight as the original. And they’re costly for businesses, as the company will have to sell the exchanged item at a discounted price or incur additional costs to dispose of useless items properly.

How Does Refund Fraud Impact Businesses?

Refund fraud can cause businesses significant financial losses, harm their brand and result in operational challenges.

Fraudulent refunds deplete a company's resources and lower its profitability, especially for SMEs operating on thin budgets. Frequent refund fraud also erodes customers' trust in the business, resulting in a loss of future sales.

Refund fraud also leads to harsher return rules, longer wait times for returns and other inconveniences for honest customers.

Additionally, refund fraud increases costs and restricts consumer access to goods and services, as businesses pass on refund fraud costs to customers through higher prices or decreased product availability. That, in turn, impacts consumer purchasing power, reducing their ability to buy goods and services – or forcing them to seek alternative, less desirable options.

On a larger scale, the overall purchasing power of customers is negatively affected, reducing their ability to consume and contribute to the economy. Furthermore, refund fraud has a significant impact on the ecosystem as well in that it:

• reduces market efficiency,
• disrupts supply networks, and
• results in the loss of employment and taxes.

Preventing refund fraud is tricky, as we’ve observed. Retailers often face a backlash when they force the hammer. Case in point, Asos made international headlines in early April 2019 for tightening its return policy too hard. Many customers felt offended when Asos notified them, "if we notice an unusual pattern, we might investigate and take action." The following passage will unveil relevant preventive measures you apply right away.

Tips for Preventing Refund Fraud

The standard checklists for preventing refund fraud are:

1. Verify customer identities
2. Train employees on fraud patterns
3. Establish transparent order refund policies
4. Develop a comprehensive fraud prevention plan
5. Use advanced fraud detection & mitigation technologies
6. Use reverse logistics to quality-assure transaction processes

And then, having done all that necessary due diligence, you’ve got to also automate your disputes with Chargeflow to ensure you can automatically recover any chargeback the scammer can force on you.

Chargeflow provides businesses with essential tools and resources to help them avoid refunding legitimate transactions due to the fear of chargebacks. With Chargeflow, you can quickly conduct a thorough risk assessment on transactions, identify potential fraud risks and take proactive measures as required.

Give it a spin today – with the success-based pricing, you only pay when you win, which is a win-win!