Consumers risk losing money through fraud and unauthorised transactions whenever credit card transactions occur. Fortunately, government agencies have passed several laws and regulations since the 1970s to protect consumers. However, when these consumers commit fraud, who protects the merchants?

Sadly, there aren’t explicit laws protecting merchants from consumers who take advantage of a law meant to protect them, allowing them to commit fraud against merchants. This has been an unfortunate regular occurrence, as friendly fraud makes up about 80% of all chargebacks, according to Chargeflow's 2024 Chargeback Report.

Merchants can take several steps to avoid losses and damages from chargebacks and friendly fraud. This article will discuss how chargebacks and friendly fraud work, the legal risks of chargeback fraud, and the steps merchants can take to protect themselves against them. 

What is Chargeback Fraud?

Chargeback fraud, also called friendly fraud, occurs when customers intentionally report a legitimate transaction to their card issuers for a payment reversal while keeping the product or service. In situations like these, the customer deliberately lies that a product is defective or a service is unsatisfactory (when it is not) to receive a refund for what they paid.

In friendly fraud, merchants and payment providers often cannot tell a customer's intent when filing a chargeback. Whether the complaint is legitimate or not, a payment provider will process the chargeback, giving the merchant the burden of refuting it.

Some of the most typical reasons that consumers use to commit chargeback fraud are the following:

1. Claim that an item ordered has not been received.
2. Claim that an item that has been received isn’t as specified or is damaged.
3. Claim that the purchase is an unauthorised transaction.
4. Claim that they have been wrongly charged based on merchant policy lapses.
5. Claim that their credit card and personal information has been stolen and a purchase was made through identity theft.

Laurence Bonicalzi Bridier, CEO at ArtMajeur by YourArt, says, “While there are legitimate reasons for a customer to file for a chargeback, they are often abused to reap double the benefits—keeping the product or service while intentionally receiving a refund, where victims are often e-commerce or online stores.”

How Does Chargeback Fraud Work?

Compared to other types of fraud, a chargeback or friendly fraud is different because it happens not at the point of sale but after the purchase has been made. Consider the following situation:

1. Point of sale: A customer orders 500 customised paper bags through an e-commerce website. They input their credit card information and are prompted to make a successful payment.

2. The merchant processes the order: Upon confirmation of the payment, the merchant processes the order and sends the order for delivery to the customer.

3. Receipt of the goods: The customer receives complete orders in good condition.

4. Initiating the chargeback fraud: With ill intention, a customer finds a flaw in the merchant’s policies and files for a chargeback, claiming that the paper bags were delivered destroyed and wet, rendering them unusable.

5. Receipt of refund: The customer receives the refund and keeps the items for use in good condition.

6. Merchant contests (or loses) the chargeback claims: After a temporary credit has been made to the credit card holder’s account, the merchant can contest the chargeback made by providing evidence that the item has been delivered successfully in good condition. When the merchant loses the case, they lose sales and incur additional charges on chargeback fees.

Legal Risks of Chargeback Fraud

For merchants, chargeback fraud—or any kind of chargeback—is more than lost sales. Here are some legal risks merchants can face when they become too involved with chargeback frauds:

Damaged reputation

The last thing any business would want is a bad reputation, especially regarding financials and defective products and services that harm your credibility. Too many chargeback instances can convey to your customers that you aren’t delivering your products and services satisfactorily. 

With chargeback frauds, it’s double the impact. Not only are you getting a bad image for your chargebacks, but you’re also giving a bad impression to your target market and stakeholders, like banks and card issuers, about the stability and security of your business, which can affect customer loyalty and potential investors.

David Haskins, CEO at WrongfulDeathLawyer.com, says, “Merchants with multiple chargeback cases can be put by card issuers on a chargeback monitoring program where you will be closely monitored to reduce chargebacks at an acceptable level, incurring you monthly or regular fees.”

Lost sales and additional fees

Lost sales are one of the significant impacts of chargebacks. In the case of chargeback frauds, you lose the value of the item that was intentionally kept by the fraudster and the money on the fraudulent chargeback raised against you.

With chargeback fraud, you also enter the normal chargeback process—from the card issuer to the credit card network. During the chargeback process, the merchant also pays chargeback fees for every chargeback raised by each customer per transaction. For example, Mastercard estimates that a merchant charges $15 to $70 for every dispute.

Operational costs

When a customer initiates a chargeback, a part of the chargeback process is for merchants to dispute the chargeback by providing evidence, documentation, and all necessary information to contest the claim and release the temporary debit of the chargeback from the merchant. 

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This process can be costly for businesses, either because of the manpower and resources required to collate evidence or because of the opportunity cost that could have otherwise been allocated to value-adding activities. This is especially true during peak times, such as Black Friday sales, when businesses need to allocate even more resources to handle the influx of customers and manage sales data, further straining their capabilities.

Risk of account closure

The acquiring bank or the financial institution that processes card transactions can close your merchant account for many reasons, including suspicious merchant activity, fraud, or if your account is about to breach card network chargeback thresholds, either through legitimate or chargeback fraud. 

For example, Visa considers a 0.65% chargeback ratio and 75 monthly chargebacks as an early warning for breaching chargeback thresholds, while a 1.8% chargeback ratio and 1,000 chargebacks are excessive.

How Merchants Can Protect Themselves Against Chargeback Fraud

With chargeback fraud constantly threatening merchants with financial losses and account closures, there are still practical options you can take to protect yourself against chargeback fraud.

Monitor and flag unusual transactions

Most fraudster activity lies in repeated and similar transactions fraudsters make in a short period to gain profit or file chargebacks for them later in the guise of flagging them for unauthorized purchases despite them being legitimate transactions to commit chargeback fraud.

Merchants can protect themselves by monitoring and flagging unusual daily transactions, using monitoring tools like fraud analytics to detect suspicious activity, or learning techniques on how to crawl a website without getting blocked. These tools and activities help conduct market research on chargeback fraud, tactics, and chargeback fraud occurrence in the industry to help prepare merchants for potentially fraudulent activities. 

Have clear return and refund policies—and make them known

Prevention is better than cure, and the most effective defense for merchants from chargeback claims and chargeback fraud is by implementing a robust and clear action plan and policies on returns and refunds.

When a merchant’s refund and return policies are unclear or ambiguous and cannot be easily seen, customers are more likely to file a chargeback rather than communicate directly with the merchant about other possible return options. 

Maintain good customer service

Open communication, good service, and customer relationships are key to resolving disputes, including avoiding chargeback fraud. 

Lev Peker, CEO at CARiD, says, “When merchants show active efforts and solutions to address customer concerns, especially post-sale concerns, customers are less likely to take advantage of return and refund policy loopholes to commit chargeback fraud.” 

Implement customer and card verification systems

Some customers commit chargeback fraud on purpose and as a habit, and even the best customer service cannot reduce the risk of merchants falling for chargeback fraud. In these cases, implementing robust customer and card verification systems can help protect merchants from chargeback fraud, including:

1. Have fraud-prevention tools to identify and avoid fraudulent transactions before they result in chargebacks.
2. Employ multi-factor authentication processes to verify the identity of customers to avoid transactions committed by fraudsters in someone else’s accounts.
3. Authentication steps like CVV or 3DS to authenticate transactions as extra layers of verification.

Grant Aldrich, Founder of Preppy, says, “Fraudsters target businesses with weak internal IT systems to commit fraud like chargeback fraud, especially in the absence of strong transaction verification systems. Professionals like Certified Ethical Hackers can help identify loopholes, vulnerabilities, and weaknesses in a business’s systems to reduce the risk of fraud in the organisation.”

Wrapping Up: Protecting Your Business Against Chargeback Frauds 

Merchants face many legal risks because of the lack of protection from the law regarding the chargeback process, including damaged reputation, lost sales, added operational costs, and worst of all — risk account closure. However, merchants can still protect themselves against chargeback fraud through robust protection systems, proactive monitoring, transparent policies, and effective customer management.