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What is Chargeback Fraud?

Fraud Knowledge & Training

Chargeback fraud occurs when a customer submits a transaction dispute with their payment provider for illegitimate – even dishonest – reasons. The consequences of fraudulent chargebacks can include unnecessary costs to firms, as well as enabling certain forms of illicit financial activity. This activity can then feed into money laundering and further financial crime, creating further risk and cost implications.

With this in mind, how do illegitimate chargebacks differ from legitimate ones, and what can firms do about it?

Legitimate and Fraudulent Chargebacks: Key Differences

Before classifying any illegitimate chargeback as fraudulent, firms should be aware that intent is often required to legally prove an event as fraud. But regardless of intent, illegitimate chargebacks involve the same kinds of behaviors and consequences, leading the industry to commonly refer to illegitimate and fraudulent chargebacks interchangeably. 

Beyond this, proving intent can be elusive. For practical purposes, then, this article will only consider two chargeback categories: legitimate and fraudulent. Nonetheless, firms should consult their legal and compliance departments to ensure their official classifications are appropriate.

Legitimate Chargebacks

The chargeback process is intended to protect customers from unauthorized or unfulfilled transactions. Generally, chargebacks can be submitted legitimately in several key situations. Under the Fair Credit Billing Act (FCBA), customers are supported in disputes with creditors under conditions that include:

  • Billing errors
  • Unauthorized charges
  • Charges for goods that weren’t delivered

According to the FCBA, a customer has 60 days to dispute an unauthorized or incorrect charge in writing. For bank and debit accounts, the Electronic Funds Transfer Act (EFTA) provides similar protections for unauthorized EFTs. To qualify under the Act, a transaction must:

  • Not have been made by the customer
  • Be made by someone without authority to do so
  • Be of no benefit to the customer

Under the EFTA, a transaction does not count as unauthorized if the customer knowingly gave the third party access to their card or account. However, customers remain protected if they were deceived as to the identity of the perpetrator or had already contacted their financial institution to revoke permission before the transaction occurred.

Friendly Fraud

Fraudulent chargebacks, sometimes known as friendly fraud, occur because a customer falsely claims a legitimate dispute reason. This might include claiming:

  • A legitimate charge was unauthorized
  • Received goods never arrived
  • A billing error occurred when it did not 

Generally, firms must undergo a process that requires demonstrating legitimate grounds for a chargeback in order to win the case. If merchants have grounds to believe a chargeback was initiated for misleading or illegitimate reasons, they may challenge the process. So it’s important for firms to ensure they understand legitimate and illegitimate grounds for chargebacks to avoid unnecessary resource drain.

What are the Business Consequences of Chargeback Fraud?

Chargebacks can lead to significant business costs, from revenue losses to chargeback fees – up to $50 per chargeback, and sometimes more. Beyond this, some firms may feel compelled to blacklist merchants that receive too many chargebacks – or in some other way decline to do business with them, further impacting profits.

Outside direct costs to firms, fraudulent chargebacks can fuel further criminal activity, including money laundering and related financial crimes. This, in turn, contributes to the rising compliance risks firms around the world are facing.

According to one report, 90 percent of surveyed firms reported being impacted by chargeback abuse, and only a minority felt they effectively managed it. But effective fraud risk management is essential to firms wishing to stay at the forefront of the fight against financial crime. 

How Can Firms Detect and Prevent Chargeback Fraud?

The measures that help firms prevent chargeback fraud are part of a broader, robust risk management system. They include proper customer documentation and onboarding – especially customer screening, including KYC measures – enabling firms to know who they are doing business with in the first place. Connected with this, robust customer and transaction documentation will help firms compare dispute claims with the records on hand.

Still, some fraud will always slip through the cracks, and for that purpose, a solid transaction monitoring system is indispensable. Many perpetrators of fraudulent chargebacks are repeat offenders, so the use of machine learning and artificial intelligence can pinpoint patterns invisible to the naked eye. For example, thanks to identity clustering, an artificial intelligence overlay can detect subtle red flags which might slip under a human radar – but add up to pinpoint a fraudster’s concealed identity.

Fraud risks will always be a part of the landscape for financial services providers, but with proper tools and knowledge, firms can stop illicit activity in its tracks.

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Originally published 21 March 2023, updated 22 March 2023

Disclaimer: This is for general information only. The information presented does not constitute legal advice. ComplyAdvantage accepts no responsibility for any information contained herein and disclaims and excludes any liability in respect of the contents or for action taken based on this information.

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