Current Legal Issues Affecting Central Banks, Volume V
Chapter

Chapter 6 Stored Value Products: A New Legal Challenge

Author(s):
Robert Effros
Published Date:
May 1998
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Author(s)
THOMAS C. BAXTER

Electronic money, or stored value products, is a new frontier for retail payments systems whose technology is rapidly evolving, with new products and developments being announced almost weekly. In comparison, the legal rules governing such products are undeveloped and uncertain. Legal uncertainty is of some concern because monetary history, at least in the United States, suggests that it may undermine public confidence in a payments system, particularly if there are any questions about a system’s ability to deliver good value. In turn, legal uncertainty may stifle development of a desirable payments system—even one that is as economically efficient as electronic money promises to be—if it is too difficult for users of the system to ascertain and appropriately control risks. At the same time, adopting rigid legal rules is not the answer because this too can hamper product development. What is needed then is a happy balance—sufficiently clear legal rules to assess liability and risk, without their being so costly and constraining that they become an iron cage.

Striking the right balance may not be easy. As a starting point, it may be useful for a central bank to review the legal or regulatory rules that apply to payments systems currently operating in its country. In the United States, retail payments systems include cash, checks (including bank, cashier’s, and traveler’s checks), and consumer wire transfers. The rules that apply to these systems serve as a useful reference point for a discussion of electronic money or stored value products. The first part of this chapter briefly describes stored value products and discusses their credit feature. The second part explores the evolution of a stored value product from creation, through its transfer, to final settlement. This part also discusses the importance of adopting a finality rule. The last part examines some issues of particular relevance to central bankers, such as choice of law and the risks associated with cross-border transactions.2

An Overview of Stored Value Products

In the United States, both banks and nonbanks are developing stored value products for a variety of purposes. Understanding how these products work is an important first step in developing an appropriate legal and regulatory structure.

Description of the Products

Models for stored value products vary widely. The simplest model is one issuer supplying cards for a limited purpose, such as purchasing bus transportation. For example, a commuter may purchase a card for $10 from a bus company and $10 of value will be embedded on a magnetic strip on the card. When the commuter rides the bus, he or she will pass this card through a reader, and the reader will debit the amount of the bus fare, resulting in a new card balance. This model poses few legal issues because the issuer, in this case, the bus company, is readily identifiable and is also the one providing the service.

The more sophisticated stored value products operate in a somewhat different fashion. In most cases, the issuer of the “value” will not be the entity providing the goods or service. A single issuer may develop and issue the value on a card but employ other firms as members of its distribution network both to sell the cards and redeem the value embedded on them. These firms act as intermediaries between the issuer and either the purchasers of the cards or the vendors who accept them as a means of payment.

Multiple issuers may also develop stored value products by adopting a common technology for the cards or other access devices, establishing a distribution network, and arranging for a mechanism for settlement. Major credit card companies have been natural developers of the common technology for these types of products because they already have distribution and settlement networks, and are accustomed to the practice of co-branding cards with names and logos of the members of their associations.

Electronic “value” can also be stored and used for transactions on computer networks (or other communications networks). In contrast to stored value cards, which are largely intended to be used for point-of-sale transactions, value stored on computer networks can be used for transactions where the buyer is at a location remote from the seller and the actual place of sale.

Credit as a Distinguishing Feature

One distinguishing feature common to all stored value products is the gap between the time when the user “pays” for the value and the time when that purchased value is redeemed. The temporal gap between the creation of the value and redemption of the value necessarily involves an extension of credit from the purchaser of the card or storage device to the issuer. In effect, when a purchaser buys a card, he or she is exchanging currency for a plastic card embedded with a kind of electronic IOU.3 The purchaser of the stored value card will use the stored obligations embedded on the card to pay for a good or service, thereby transferring this electronic IOU to a merchant who will redeem the IOU from the issuer, usually through an intermediary.

Because these products involve the extension of credit, calling them “money” is a misnomer, if by money one means legal tender. Unlike legal tender, a person is not required to accept a stored value product in payment for a debt. Moreover, tender of a stored value product does not, as a matter of law, discharge the underlying debt obligation. Similar to credit, particularly bank credit, a stored value product may function as the equivalent of money. In the United States, particularly for large transactions, bank credit is the preferred medium of exchange. This is due in part to the presence of a clear regulatory framework that fosters public confidence that bank credit as a payment mechanism delivers good value.

Developing legal or commercial rules is important to ensure public confidence in these new payments products. In the United States, payments are made by cash, checks (including bank, cashier’s, and traveler’s checks), and consumer wire transfers and, basically, involve one of two payments models: a credit transfer or a debit transfer. In a credit transfer, such as a wire transfer, the originator of the transaction “pushes” credit from its bank account through the payments system ultimately to a beneficiary’s account (see Figure 1). In a debit transfer, such as with personal checks, the drawer delivers an instrument to a payee, who deposits it into its bank account and uses the instrument to “pull” funds from the drawer’s bank account to the account of the payee (see Figure 2). The legal rules in the United States that apply to a credit transfer on the one hand and a debit transfer on the other are clear but quite different.

Figure 1:Funds Transfer

(A Credit Transfer)

Figure 2:Check Collection Process

(A Debit Transfer)

Stored obligations have elements of both a credit transfer and a debit transfer (see Figure 3). At the time of creation, the purchase of a card with value looks like a credit transfer or funds push—the card purchaser is pushing funds out of its account into the account of the issuer. At other times, however, the transaction looks more like a debit transfer or funds pull, as when the vendor redeems a stored obligation from the issuer. (Of course, unlike most debit transfers, the redemption of stored value does not result in funds coming out of the payor’s own account.) The whole-sale application of one set of rules to stored value products, therefore, is not appropriate. Rather, stored value products must be viewed as a new hybrid payments system that is a crossbreed of the debit and credit transfer. As such, existing legal rules—either through contract, regulation, or statute—will not fit them well, and there may be a need to develop specific rules for the new products.

Figure 3:Stored Value Card

(A Credit or a Debit Transfer?)

Source: Reprinted by permission from the Task Force on Stored Value Cards, “A Commercial Lawyer’s Take on Electronic Purse: An Analysis of Commercial Law Issues Associated with Stored Value Cards and Electronic Money,” Business Lawyer, Vol. 52 (February 1997), p. 690. Copyright 1997, American Bar Association. All rights reserved.

The Evolution of a Stored Obligation

To analyze this potential need, it is useful to view a stored obligation as having three distinct phases: the creation of the value; its transfer; and, finally, settlement and discharge. By focusing on each of these stages, it may become clearer when commercial law issues can be resolved by a written contract between parties to the transaction or when a special legal rule is necessary.

Creating the Value

The first stage is the creation of a stored obligation on a device. The analysis that follows assumes that the storage device is a plastic card with the name of the issuer emblazoned across the front, but similar concepts would apply to computer storage devices.

A threshold question is, When is an obligation of an issuer created? Simply manufacturing the cards, even if stamped with the issuer’s name or trademark, will not create an obligation. At this stage, the card is simply a storage device that has marginal financial consequences for the balance sheet of the issuer. One would expect that the creation of the obligation generally will occur when money is exchanged for the stored value and the issuer increases its liability side of its balance sheet. Theft of the plastic cards before they are loaded with value will not create an obligation, but counterfeiting the cards might, particularly if the issuer supplies or controls the encryption technology that determines at the time of transfer whether a stored obligation is authentic.

Another issue concerns the identity of the obligor and the ability to determine whether the obligor is creditworthy. Assume that “A” purchases a stored value card with cash or a bank check. For A’s cash or check, the obligor gives A an IOU in the form of a plastic card embedded with value (see Figure 4). If A uses the plastic card to buy a hat, and the hat seller accepts the card as payment, the card’s obligor then becomes indebted to the hat seller, identified in Figure 3 as “I.O. Presenter.” The only way for A to measure the credit risk associated with purchasing the card and for the hat seller to measure the credit risk associated with accepting the value stored on A’s card as payment is to know the identity of the obligor. However, identifying the obligor may not be so easy. For example, the entity selling the plastic card may not be the entity that issued the value on the card, that is, the obligor. Unless the identity of the actual obligor is disclosed prior to the purchase of the card, the card’s purchaser may never know that its credit risk is ultimately with someone other than the entity that sold the card. To reduce confusion, it would be best if the identity of the entity (or entities) that are liable to pay the stored obligation is disclosed at the time a card is purchased. Absent disclosure, a court could hold any entity identified on a card (or other access device) liable to the card purchaser as the agent of an undisclosed principal, or as a guarantor in much the same way an endorser of a negotiable instrument can be held liable.

Figure 4:Creation

At the time the obligation is created, the issuer may also want to impose certain conditions on users. For example, an issuer may place an expiration date on the storage device. After this date, the obligations on the card or storage device will no longer be transferable. When the storage device expires, however, the status of the obligation is unclear. The holder of an expired storage device may be able to return the device to the issuer and have the obligations on the device transferred to a new device. Issuers may choose to have the storage device expire in order to update security features on the storage device. The issuer may also want to address through contract whether a card, rather than the obligations on the card, can be transferred to someone other than the original purchaser.

The enforceability of these conditions may depend on whether a court views the contract terms as fair to consumers. This is more likely if the contract language is clear and understandable to a purchaser, particularly given the fact that users will not be able to negotiate the contract terms with the issuers.

Transferring the Value

Once an obligation is loaded onto a storage device, the owner will transfer it, or a part of it, to other users. Unlike other payment products, such as a check or cash, the obligation stored on a stored value card can be divided from one obligation into smaller multiple obligations. Suppose, for example, A purchases from a bank a stored value card with $100 of value loaded onto it and then purchases a hat for $10 from ten different hat sellers. After A completes his purchases, the bank’s obligation to pay A $100 is replaced with ten obligations of the bank to pay $10 to each seller (see Figure 5). While the bank’s liability remains unchanged at $100, its original obligation has grown into ten smaller obligations.

Figure 5:Transfer

When does the issuer’s obligation to pay A effectively transfer to a seller? Transfer can be considered complete or effective either when the sender takes all the steps necessary to effect transfer or when the computer technology makes the obligation available for use by the recipient. Under the latter rule, if a person tries to transfer an obligation from one storage device to another, and the second storage device fails during the operation, the transfer is not effective. Making the transfer effective based on when the computer technology makes the obligation available for the recipient’s use seems to be the better rule, given that encryption and other security protocols will test each transfer to ensure that it is valid after the steps that initiate the transfer are completed. This is roughly equivalent to the rule for cash and wire transfers in the United States. Payment is effective when cash is received or, with a wire transfer, when a beneficiary bank accepts the transfer.

If the transfer is not valid, the obligation should not become available for the recipient’s use. If the effectiveness of transfer relies on computer technology, there is also the possibility that such technology will fail or malfunction. Who then bears the risk of this technological failure? It seems appropriate that damages be apportioned based on whose technology it is that caused the transfer to fail. If a user’s equipment fails because of the user’s own fault (that is, not paying an electric bill), then the user should be responsible for whatever damages were sustained. An issuer, on the other hand, would be responsible if its equipment malfunctions (for example, a card reader, through no fault of its user, causes a stored obligation to be erased rather than transferred) or if there is a systemwide defect in the computer technology, such as a computer virus. At the same time, technological failure, such as an electrical blackout, can be an excuse for nonperformance if the technological interruption or failure is beyond the party’s control, and the party acted reasonably under the circumstances.

Assuming that the technology works and that the transfer from A to a seller is effective, what happens when the issuer does not pay the seller’s claim? Can the seller replevy the hat or require A to pay for the hat again? In other words, has the debt between A and the seller been discharged when the stored obligation is transferred or merely suspended? In the United States, there are different discharge rules, depending on the method of payment. For example, if the transferred obligation is treated like cash, the $10 obligation of A to the seller is discharged when the stored obligation is transferred from A to the seller. If the issuer of the obligation refuses to or cannot pay the seller, then the seller would bear any resulting loss. If the rules governing personal checks apply, however, the $10 obligation between A and the seller is merely suspended when the obligation is transferred until the stored obligation is finally paid by the issuer/obligor.4 If the issuer fails to honor the stored obligation, the $10 obligation between A and the seller would be restored.

Acceptance of a stored obligation could also be treated like the acceptance of a cashier’s check.5 In this case, upon acceptance, A’s $10 debt to a seller would be discharged. Absent endorsement liability on the part of A, the seller could only look to the issuer for payment. Finally, a stored obligation might be deemed to be “goods” under Article 2 of the Uniform Commercial Code (UCC), which governs sales transactions, making the exchange of the obligation for the hat a barter transaction. Under Article 2, if the issuer fails to honor the stored obligation, the seller has the right to replevy the hat from A.6

In the United States, arguably, absent an enforceable contract term, a court would apply a rule similar to that governing cashier’s checks to this hat purchase example, and, thus, the seller would bear the risk of loss. The cash analogy is not appropriate because there is no question that there is credit risk involved in the hat purchase. The personal check analogy is also imperfect because the seller probably does not regard A as its debtor. Article 2 is limited to the sale of goods and does not apply to choses in action,7 which is all a stored obligation is. Finally, the applicability of Article 4A of the UCC governing wire transfers seems doubtful because the user of the new payment product is not generally instructing a bank to pay a beneficiary.

Obviously, a rule for determining when transfer is effective is the key to deciding who will ultimately bear the risk of loss. Failing to adopt a finality rule in this context may actually hamper development of stored obligations as a new payments product because users, including merchants, will not be able to judge the risk of using these products and, thus, will be unable to develop mechanisms for reducing this risk. At a minimum, to foster certainty a contract between an issuer and users should include a rule for when transfer is effective.

Discharging the Value and Final Settlement

Turning a stored obligation into value might be characterized as “redemption.” Redemption of an obligation occurs when the holder of a stored obligation presents the storage device (or its information) to the issuer or the issuer’s intermediary and requests money in exchange. In the hat seller example, redemption occurs when sellers one to ten deposit their claims with an intermediary institution that will make presentment on their behalf to the issuer (see Figure 6). At this point in time, A will no longer have any obligations stored on his card. The issuer will most likely respond to the presentment of claims by the sellers by crediting the account of an intermediary on the issuer’s books. The intermediary in turn will credit the accounts of sellers one to ten.

Figure 6:Settlement and Discharge

During this phase, it will be important for all parties to know the status of the credit provided by the issuer and the intermediary, that is, whether the credit is final or provisional and thus subject to the decision to finally pay. If the credit is provisional, the intermediary may be able to charge back sellers one to ten if, because of insolvency or some other reason, the intermediary does not receive good value from the issuer. At some point, however, these provisional credits will firm up, and the intermediary will no longer be able to charge back the sellers. This is referred to as “receiver finality.” If the settlement is final, the intermediary will be left with a loss in the event of an issuer’s insolvency because the intermediary will have paid sellers one to ten and received no payment in turn from the issuer.

One problem that may arise when stored obligations are redeemed is that the issuer may learn about an unanticipated increase in the liability side of its balance sheet. This may happen if the technology malfunctions and obligations “spawn,” that is, a $10 obligation transfers as a $100 obligation (a problem with divisibility), or if a malefactor discovers a method for counterfeiting the issuer’s obligations such that it becomes impossible to distinguish an authentically issued obligation from a counterfeit one. Because the asset side of an issuer’s balance sheet remains the same, the issuer will likely face two successive problems as these claims are presented for payment: the issuer may experience illiquidity if the number of claimants exceeds all reasonable projections, and, if the spawning or counterfeiting reaches a grand scale, the liquidity problem will degenerate into a solvency problem.

Even without spawning or counterfeiting, an issuer still must be prepared to deal with “term structure” risk, the risk that its liabilities—the debt it owes to users or merchants—will mature at a different time than its assets. Banks in the United States manage this risk in part by borrowing from the Federal Reserve Bank’s discount window. Nonbank issuers may, if they choose, manage this risk either by obtaining private insurance or backup lines of credit, or they may be required by law to limit investments to only the most liquid instruments, and maintain reserves.

Another issue is who bears the risk of loss if an issuer becomes insolvent after a stored obligation has been presented to the issuer but before final payment has occurred. The extent of the intermediary’s or holder’s loss will depend on the manner in which the issuer holds the funds used to purchase the obligations. If the funds are held in an insured account for the benefit of holders of stored obligations, the holders will be guaranteed some amount of money. If the funds are held in a fiduciary or trust account for the benefit of holders of the stored obligations, the issuer’s creditors should not be able to reach the funds. Absent an insured or fiduciary account, an intermediary or holder will be a general creditor of an issuer and may not be able to be made whole.

If the intermediary (or redeemer, if the intermediary has charged back the redeemer’s account) cannot recover from the insolvent issuer’s estate, it will likely look to other entities that can be held accountable for the obligation, including other entities identified on the storage device. In a multiple issuer system, an intermediary may look to any solvent issuer.

Miscellaneous Issues

In addition to the issues identified above, there are a myriad of other unresolved legal issues concerning stored obligations. Some issues that may be of particular concern to central banks are examined below.

Choice of Law

It is anticipated that most new payment products will rely on choice of law provisions in contracts to establish the law that governs the duties and rights of users and issuers. Because there is a possibility that the parties’ choice of law may not be given effect, it may be appropriate to have a uniform choice of law rule governing the new payments products, particularly for products that are designed to be used cross border. The rule could allow parties to select the governing law in a contract and could provide a default rule for cases where such a contractual provision does not exist.

Lost or Stolen Obligations

If a stored obligation is lost, stolen, or destroyed, there are two possible analogies that can be used to resolve the question of who bears the risk of loss: the stored obligation can be treated like currency or like a check. When currency is lost, the person who lost it bears the risk of loss and is not able to obtain replacement currency. With a cashier’s check, however, the holder who has lost possession can demand payment from the issuer by filing an affidavit of loss that provides reasonable identification of the check and is received sufficiently in advance of the time when the bank must decide to pay or dishonor.8 Similarly, with a personal check, the payor is able to stop payment on the lost check if the stop payment order is received by the payor bank in time to act.9

There are a number of practical difficulties, however, with adopting the stop payment approach to the new payment products. To stop payment on a lost, stolen, or destroyed obligation, the holder who has suffered the loss must be able to reasonably identify the obligation. Most of the new payment products will not allow a holder to identify uniquely the stored obligation. Even if the obligation is identified uniquely, the issuer may not be able to stop the transfer of the obligation if the issuer is unable to notify others using the products, either at the point of sale or transfer, of the stop payment. Even presuming that the issuer can effect the stop payment, there may be no easy way for the holder that has lost possession of a stored obligation to establish the amount of the issuer’s outstanding obligation to the holder at the time the stored obligation was lost.

Foreign Exchange Risk

Stored value products denominated in a foreign currency may also pose additional risks, including the risk that a currency will be devalued or a counterparty will fail. Devaluation risk can be managed, to some degree, through hedging. The risk that a counterparty to a foreign exchange transaction will fail, however, may not be so manageable.

For example, in order to settle an obligation denominated in a foreign currency, the issuer may need to convert the obligation into another currency. In these cases, settlement risk is increased because of the cross-border nature of the settlement. Typically, in cross-border transactions, because of timing differences, one side of the transaction may settle before the other side. During this time, the nonperforming party could fail. If the nonperforming party is in a foreign jurisdiction, the insolvency will be governed by that country’s laws. This adds another layer of legal risk to the settlement if the insolvency laws of the foreign country are less favorable to creditors than the insolvency laws in the issuer’s country. The risk of devaluation and counterparty failure are normal risks involved in a foreign exchange transaction. There is, however, greater risk that, in the context of stored obligations, the redeemer of the stored obligation—who is the party that will likely bear the risk of loss—will not realize that redemption involves a foreign exchange transaction or, if the redeemer is a consumer, may not understand these special settlement risks.

Conclusion

Stored value products are being tested in different markets around the world from small towns to the major financial centers in Asia, the United States, and the United Kingdom. As these products become more widely used, many issues raised in this chapter may be resolved through contract or customary use, while other issues may warrant regulatory intervention. As a new retail payments system, stored value products deserve careful attention to ensure that appropriate rules are adopted. Central banks can help foster the development of such rules, thereby permitting these products to act as an efficient payment mechanism for consumers without unnecessary or uncontrollable risk.

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