The Legal Jungle: 
What
Constitutes Fraud?


UNDERSTANDING THE DEFINITION OF FRAUD,
AND THE CIRCUMSTANCES UNDER WHICH IT
CAN OCCUR, IS AN IMPORTANT PART OF RISK
MANAGEMENT FOR ALL ISOs, CREDIT CARD
PROCESSORS AND SALES AGENTS.
by Paul Rianda

    Many Agent Agreements contain provisions that provide that a sales agent will lose its residual if it commits fraud. However, a definition of what actually constitutes fraud is rarely set forth in the Agent Agreement. As a consequence, the legal definition of “fraud” is the standard used to determine if the agent has violated the provisions of the Agent Agreement and therefore should lose its residual. In this article, I will discuss the legal definition of the term “fraud” and also its application to the potential termination of a sales agent’s residual under an Agent Agreement.

   Definition of Fraud

    Under the “common law” of all states, there is a body of definitions, including the definition of fraud, that have been developed and refined by judges and lawyers over the years. As more cases about fraud have been adjudicated, the definition of what constitutes fraud has become more precise. Fraud has a specific legal meaning. The following essential elements must be present before an actual finding of fraud will occur:
    Misrepresentation of a material fact consisting of a false representation, concealment or non-disclosure;    

  • Knowledge of the falsity (scienter);
  • Intent to deceive and induce reliance;
  • Justifiable and actual reliance on the misrepresentation; and
  • Resulting damages.


    As with most legal definitions, the definition of fraud leaves a lot to be desired as far as the clarity of the definition and its application in day-to-day circumstances. For a layperson or even an attorney, just reading the definition above can be confusing, unless one looks at the elements of the definition one at a time. Below, I will attempt to provide some more explanation as to each of the elements of the legal definition of fraud, along with examples to help explain its application.

Material Fact

    In order for an action to constitute a fraud, the misrepresentation must go to a material fact and not to an insignificant issue. For instance, if the sales agent made a representation to an ISO that caused the ISO no monetary or any other type of harm, the ISO would be hard pressed to show that this was material and therefore a fraudulent statement. An agent for instance could misrepresent its owner’s age, which likely would be of little significance, even though the representation was untrue. However, misrepresenting the owner’s social security number could be a misrepresentation rising to the level of fraud if it were done to conceal the fact the owner has a criminal past. Not all misrepresentations constitute fraud, only those serious enough to be deemed material to the Agent Agreement.

Knowledge of the Falsity

In order to constitute fraud, the false representation, concealment or non-disclosure must have been known to the sales agent at the time it was made. For instance, if a sales agent submits an application to an ISO that contains false information about the merchant, this does not necessarily constitute a fraud on the part of the sales agent. If the merchant provided the information to the sales agent, and the sales agent did not know the information was false, no fraud by the sales agent has been committed. However, if the sales agent was complicit with the merchant in providing the false information, then the sales agent has in fact committed a fraud assuming that all the other elements of the legal definition have been satisfied    

Intent to Deceive and Induce Reliance

In addition to having knowledge of the falsity of the representation, the sales agent must also have the intent to deceive and induce reliance of the ISO. This can be one of the more difficult elements to prove, given the fact that it requires proof of the sales agent’s state of mind when the representation was made. The easiest way to prove this intent is to have the sales agent admit its intent to deceive and induce reliance as part of its plan in providing the false information. However, persons committing fraud rarely make such an admission. Instead, it generally becomes necessary to show this intent through circumstantial evidence. For instance, if a sales agent realizes an economic gain from the transaction, this can be evidence of an intent to defraud    

Reliance

The next element required to establish fraud is justifiable and actual reliance on the misrepresentation. The question to be asked is whether the entity that has been defrauded was diligent in trying to discover facts that could have brought to light the misrepresentation it said it relied on. For instance, a sales agent could submit an application for a merchant stating that the merchant has an outstanding credit history. In our industry it is standard operating procedure for a credit card processor to run a credit check to see if the merchant is credit worthy. Given the standard in the industry to run the credit report, it would be unjustified for a credit card processor to rely upon a representation by a sales agent regarding the good credit of the merchant. In these circumstances, a sales agent could potentially avoid any liability for fraud even though it had made a misrepresentation because the credit card processor was not justified in its reliance upon the representation.    

Damages

    The last element required to establish fraud is damages. Damages can be of a monetary nature such as a charge back that occurs because of the fraudulent merchant transaction. In addition, damages can be non-monetary to the extent that a credit card processor’s reputation is damaged or it is subject to continuing damage that can be enjoined through an injunction. Sales agents need to be very cognizant that they are liable not only for their own fraud but for the fraud of their agents and employees. Often sales agents have sub-agents that submit application through them. These sub-agents and the employees of the sales agent can also be a source of fraudulent conduct that could cause the sales agent to lose its right to a residual stream. Most Agent Agreements have provisions that state that the sales agent is responsible for any conduct of its sub-agents and its employees. Therefore, a sales agent needs to be very careful in determining the sub-agents it will allow to submit business through it and in screening its employees. Fraud is an issue that does not come up very often in our industry but when it does it is usually one of the largest sources of merchant losses. For that reason, understanding the definition of fraud, and the circumstances under which it can occur, is an important part of risk management for all ISOs, credit card processors and sales agents.

** The information contained herein is for informational purposes only and should not be relied upon in reaching a conclusion in a particular area. The legal principles discussed herein were accurate at the time this article was authored but are subject to change. Please consult an attorney before making a decision using only the information provided in this article.