The New Path to PCI Liability: 3rd Party Beneficiary Theory
Merchants face a potentially huge liability if they suffer a security breach exposing payment card data. Issuing banks (those banks that issue credit cards to consumers) have filed lawsuits to recover reissuiance costs allegedly ranging from $20-$50 per card (multiplied by thousands or millions of cards depending on the magnitude of the breach). A recent decision from the U.S. Court of Appeals for the Third Circuit ("3rd Circuit" or "Appellate Court") appears to have expanded the potential liability merchants face for payment card security breaches.
In Sovereign Bank v. B.J. Wholesale Club & Fifth Third Bank, No. 06-3392/3405 (3rd Circuit, July 13, 2008)(hereinafter the "BJW Decision"), while the Appellate Court affirmed the lower court's dismissal of most of the claims against B.J. Wholesale Club, it reversed the lower court's dismissal of Sovereign Bank's breach of contract action that was based on a third party beneficiary theory. This article explores how the Appellate Court reached its decision, how the decision could increase the legal risk faced by merchants that suffer security breaches and potential actions merchants can take to better understand and mitigate their legal risk.
The BJW Decision arose out of a payment card security breach suffered by B.J. Wholesale Club ("BJW") that was first reported in March 2004. Criminals were able to steal (and commit crimes using) the magnetic stripe information from payment cards stored by BJW. In reaction to this security breach, Sovereign Bank and the Pennsylvania State Employee's Credit Union (hereinafter "Issuing Banks") incurred costs to reissue the payment cards that were the subject of the BJW breach. Litigation ensued in 2005 when the Issuing Banks separately sued BJW and BJW's merchant bank (Fifth Third Bank) to recover their reissuance costs. The federal lawsuits were eventually consolidated in the U.S. District court for the Middle District of Pennsylvania (the "Lower Court") and alleged the following causes of action: (i) negligence; (ii) breach of contract (Third Party Beneficiary Theory) and (iii) equitable indemnification; (iv) breach of fiduciary duty and (v) promissory estoppel. The Lower Court fully granted the defendants' motion to dismiss and motion for summary judgment, which lead to the plaintiff's to appeal (see Sovereign Bank v. B.J. Wholesale Club, 385 F.Supp.2nd 183 [M.D. Pa. 2005] and Sovereign Bank v. B.J. Wholesale Club, 427 F.Supp.2d 256 [M.D. Pa. 2006]).
Relationship Between the Players in the Payment Card System
In order to understand the Appellate Court's ruling one must first be aware of the relationships (contractual or otherwise) between the players in the payment card system.
In this case, BJW was the merchant that accepted payment cards from consumers (some of whom were issued their cards by the Issuing Banks). In order to accept credit cards and become part of payment card networks such as Visa or Mastercard, merchants must work through and contract with an acquiring bank (a.k.a. "acquirer" or "merchant bank"). In this case Fifth Third acted as BJW's merchant bank and had a "Merchant Agreement" in place with BJW. In turn, moving upstream, Fifth Third had a "Member Agreement" in place with VISA. Pursuant to the Member Agreement, Fifth Third became a "member" of the VISA network and agreed that it would comply with VISA's Cardholder Information Security Program ("CISP") and VISA's Operating Regulations (note that at the time of the breach the PCI Standard was not in effect and each card brand had its own security standard).
Sovereign Bank, was one of the Issuing Banks that had issued payment cards to various consumers that were impacted by the BJW security breach. Sovereign Bank is also a member of the VISA network by virtue of its own Membership Agreement with VISA. However, the Issuing Banks had no direct contractual relationship with Fifth Third or BJW. A graphic representation of the contract chains can be found at this link: BJW Contract Relationship Chart.
Sovereign Bank's Breach of Contract Allegations
Despite not having a direct contractual relationship with Fifth Third, Sovereign Bank alleged a breach of contract claim based on Fifth Third's breach of the Membership Agreement between Fifth Third and VISA. Although it was not a party to the Membership Agreement, Sovereign alleged that it was an intended third party beneficiary of the agreement (see BJW Contract Relationship Chart).
Pursuant to the Membership Agreement, Fifth Third agreed comply with VISA's Operating Regulations (which included VISA's Cardholder Information Security Program). The version of the Operating Regulations applicable to this case provided the following:
- Fifth Third agreed to ensure that its merchants (BJW in this case) complied with the Operating Regulations
- Fifth Third agreed to enter into a Merchant Agreement with each of its merchants requiring each merchant to comply with VISA's Operating Regulations
- A prohibition against retaining or storing the data encoded on the magnetic stripe on the back of payment cards after a transaction is authorized (this is essentially the same prohibition set forth now in section 3.2 of the PCI Standard), and a duty for Fifth Third to impose this obligation on merchants like BJW
- Provisions concerning dispute resolution between members, including chargeback and representment procedures, and arbitration provisions.
Significantly the Operating Regulations in place at that time did not eliminate any other rights an issuing bank may have to pursue any legal remedy that may otherwise be available. As discussed further below, unless Visa's Operating Regulations have changed, this suggests that there is no real "safe harbor" for PCI compliance.
Sovereign Bank alleged that both BJW's failure to delete the magnetic stripe data, and Fifth Third's failure to ensure BJW's compliance with the deletion requirement constituted a breach of the Operating Regulations by Fifth Third. Sovereign Bank further contended that these contract breaches allowed the unauthorized access to, and use of, payment card data at BJW, and that Sovereign Bank was legally obligated to reimburse cardholders for fraudulent charges that resulted. Moreover, the resulting unauthorized access to payment card data also required Sovereign Bank to incur the expense to reissue the compromised payment cards. Finally, the Issuing Banks alleged that their customer goodwill was adversely impacted by the BJW breach. The Appellate Court was called upon to rule on these issues in a motion to dismiss/summary judgment context.
The Issue to Resolve: 3rd Party Beneficiary Theory.
The Appellate Court considered the following issue:
Was Sovereign Bank an intended third party beneficiary of the Member Agreement between Fifth Third and VISA?
Although Sovereign Bank conceded that it is not an express third party beneficiary of the Member Agreement between Visa and Fifth Third, it based its argument on § 302 of the Restatement (Second) of Contracts (which had been adopted under Pennsylvania law, which governed this case):
Intended and Incidental Beneficiaries
(1) Unless otherwise agreed between promisor and promisee, a beneficiary of a promise is an intended beneficiary if recognition of a right to performance in the beneficiary is appropriate to effectuate the intentions of the parties and either:
(a) the performance of the promise will satisfy an obligation of the promisee to pay money to the beneficiary; or
(b) the circumstances indicate that the promise intends to give the beneficiary the benefit of the promised performance.
(2) An incidental beneficiary is a beneficiary who is not an intended beneficiary.
In the context of § 302, the court framed the issue as follows:
Under § 302, Sovereign's contract claim depends on whether "the recognition of a right to performance" in Sovereign is "appropriate to effectuate the rights of" both Visa and Fifth Third in entering into their Member Agreement and whether "the circumstances indicate that" Visa (the promisee) "intended to give Sovereign the benefit of the promised performance."
To establish whether Visa intended to give issuing banks like Sovereign the ability to rely on Fifth Third's promises in the Member Agreement, Sovereign relied on the deposition testimony of Visa's representative, Alex Miller. Miller testified that he was not aware of any intent on Visa's behalf to create a direct right to benefit third parties, and that no documents existed that allowed issuing banks to "step into [Visa's] shoes" to enforce the Membership Agreement with Fifth Third.
However, Miller also stated:
It's fair to say that the core purposes of the operating regulations is to set up the conditions for participation in the system, to set up rules and standards that apply to that ultimately for the benefit of the Visa payment system, the members that participate in it and other stakeholders such as cardholders, merchants and others who may participate in the system as well.
Miller further testified that the purpose of Visa Operating Rules (including CISP in this case) was to maximize the value of the Visa system as a whole, including "to protect issuers." Fifth Third argued that Miller's statements evidenced that Visa's Operating Regulations were intended not to benefit any individual member or class of members, but the Visa system as a whole.
Sovereign argued that Visa's Operating Rules were specifically intended to benefit issuers. In addition to Miller's testimony, it pointed to an August 1993 memo sent by Visa to its members that specifically alerted members of the (then) new requirements to delete magnetic stripe data (hereinafter referred to as "August 1993 Memo").
That memo started off with the following:
To protect the Visa system and Issuers from potential fraud exposure created by databases of magnetic-stripe information, Section 6.21 has been revised. Effective September 1, 1993, the retention or storage of magnetic stripe data subsequent to the authorization of a transaction is prohibited. Acquirers are obligated to ensure that their merchants do not store the magnetic-stripe information from Visa Cards for any subsequent use.
Sovereign also relied on a May 2003 article printed online by Visa entitled "Issuers and Acquirers Are At Risk When Magnetic-Stripe Data Is Stored," which indicated that magnetic stripe data compromises "impact Issuers" (hereinafter referred to as "May 1993 Memo).
The Appellate Court's Decision and Reasoning
The Appellate Court considered the arguments by both sides and ultimately held that genuine issues of material fact did exist as to whether Sovereign was an intended beneficiary of the Member Agreement between Fifth Third and Visa, and therefore the case should be remanded for further proceedings (e.g. trial) rather than decided on a summary judgment motion.
The Appellate Court rejected Sovereign's reliance on the May 2003 Memo, indicating that it simply stated the reason for the prohibition against retention of magnetic stripe data. However, the Appellate Court agreed that the August 1993 Memo and Miller's "core purpose" testimony (referenced above), raised genuine issues of fact.
The court noted that Sovereign is a Visa member and that the core purpose the Operating Regulations according to Miller was to benefit members that participate in the Visa system. Just because Miller also indicated the Operating Rules were to benefit other stakeholders (such as cardholders, merchants and others who may participate in the system), the possibility that Visa intended to benefit individual users such as Sovereign was not negated.
Moreover, the Appellate Court held that the August 1993 Memo clearly stated that acquirers (such as Fifth Third) must act to protect Issuing Banks (like Sovereign) by ensuring that merchants (like BJW) do not retain magnetic stripe data. The Appellate Court held that this piece of evidence alone was sufficient to get Sovereign past summary judgment. Based on the foregoing, the Appellate Court remanded Sovereign's breach of contract claim for further proceedings (e.g. trial in front of a judge or jury).
Analysis -- Increased Merchant PCI Liability
Similar to Minnesota's Plastic Card Protection Act (discussed at this LINK), this decision has the potential to significantly increase the liability risk faced by merchants that are not compliant with PCI and that suffer a security breach.
First, although the Appellate Court's breach of contract decision only involved the acquirer and the issuing bank, merchants such as BJW may ultimately be liable for the issuing bank's costs. The source of this liability will also be contractual. However the contract at issue in this case is the direct contract between the merchant bank and the merchant (hereinafter "Merchant Agreement" -- see BJW Contract Relationship Chart). As the court ruled, this case will now be remanded to the lower court. A judge or jury could find Fifth Third liable to Sovereign for reissuance costs, or Fifth Third and Sovereign may settle the case based on the strength of Sovereign's breach of contract claim. If Fifth Third wanted to recover the damages it paid to Sovereign, it may be able to rely on language in the Merchant Agreement between it and BJW to recover directly from BJW.
It is not atypical for a merchant to enter into a very one-sided Merchant Agreement with an acquiring bank (or the acquiring bank's processor). Such Merchant Agreements often require the merchant to comply with the card association's operating rules, security program and/or PCI. A sample of how such language may read is as follows:
Merchant agrees to comply with all security standards and guidelines that may be published from time to time by Visa or MasterCard and any other applicable industry security standards, including, without limitation, the Visa U.S.A. Cardholder Information Security Program ("CISP"), the MasterCard Site Data Protection ("SDP"), and the Payment Card Industry Data Security Standard (the "Security Requirements").
If BJW agreed to comply with Visa's Operating Rules and/or CISP, Fifth Third may have a right to recover any damages paid to Sovereign under a breach of contract theory (BJW having breached the Merchant Agreement).
In fact, merchant banks may have an explicitly contractual right to recover reissuance costs they are forced to pay issuing banks. It is likely that the Merchant Agreement requires the merchant to indemnify the merchant bank for liability it incurs because the merchant allowed a security breach. A sample of how such language might read is as follows:
Merchant agrees to indemnify Acquiring Bank, Member, the Associations, affiliates, officers, directors, employees, agents and issuing banks from any losses, expenses, costs, liabilities, and damages of any and every kind (including, without limitation, our costs, expenses, and reasonable legal fees) arising out of any claim, complaint, or chargeback caused by the merchant's noncompliance with this Agreement, any Security Requirements or the Association Rules.
If similar language exists in the Merchant Agreement between BJW and Fifth Third, Fifth Third may demand that BJW indemnify it for any issuing costs that Fifth Third is required to pay to Sovereign. Of course, if BJW refuses, Fifth Third will again need to file a claim against BJW for breach of the Merchant Agreement. In short, by allowing an issuing bank to use the Visa Member Agreement to go after the merchant bank, the Appellate Court opened a path to merchant liability for the costs incurred by the issuing bank to reissue credit cards. The path starts with the Member Agreement, goes through the Merchant Agreement and ends up at the merchant.
PCI Compliance as a Defense - Existence of "Safe Harbor?"
Despite the existence of this contractual path to liability, the question arises whether a merchant's compliance with the PCI and card association operating regulations will insulate the merchant from liability if it suffers a payment card security breach. Unfortunately, from the issuing bank's point of view the merchant's PCI compliance status is irrelevant - the issuing bank still must pay to reissue payment cards after a security breach of a PCI-compliant merchant. There are several points which may illuminate whether PCI compliance provides an automatic "safe harbor" from liability.
First, at least under the version in effect during the BJW case, according to the Appellate Court, issuing banks were not precluded by Visa Operating Rules from pursuing any available remedies at law. Thus, even if a merchant had fully complied with PCI and the applicable operating rules, an issuing bank's status as a member of Visa or Mastercard does not block it from going after merchants. In fact, even if an issuing bank had agreed with Visa to refrain from pursuing merchants that were PCI compliant, the only party that could enforce that agreement would be Visa (unless, ironically, the merchant could be argued to be a third party beneficiary of the Member Agreement between Visa and the Issuing bank). Significantly, while compliance with the industry standard for protecting cardholder information will offer merchants a strong defense, it is still possible that a merchant could be liable under other theories of liability (e.g. negligence) if a court finds that the PCI standard itself is inadequate (see e.g. T.J. Hooper case).
Second, a PCI-compliant merchant's liability will be largely contingent on the language set forth in the Member Agreement between the acquiring bank and the card association, and the Merchant Agreement between the acquiring bank and the merchant itself. If the Member Agreement makes the acquiring bank responsible for merchants' security breaches in general (regardless of PCI compliance) and the Merchant Agreement requires the merchant to indemnify the acquiring bank for any losses, then the path to liability described above could apply. In such a case, in order to "block" the path from issuing bank through the Member Agreement, the Member Agreement would have to contain specific language providing a PCI "safe harbor" (alternatively, as discussed further below, the merchant may be able to negotiate a "safe harbor" in the Merchant Agreement to block the liability path).
Significantly, gaining access to the card associations' operating rules and Membership Agreements has been notoriously difficult. Without the ability to read to those documents it may be hard to ascertain the scope of the liability risk under this theory since the merchant will not be aware of the merchant bank's obligations to the card association in the event of a merchant security breach.
Variations in the terms and conditions of Member Agreements and card association operating rules may also impact the path to merchant liability. As such, the holding in the BJW may not apply if there have been changes in subsequent versions of these documents. For example, if the current versions of Visa's Member Agreement specifically precludes enforcement of the Merchant Agreement by third parties, then the issuing banks would not be able to use employ the 3rd party beneficiary theory used by Sovereign. However, if the Member Agreement between the card association and acquirer bank remains silent, then the same rationale in the BJW decision could apply.
With respect to Visa's Member Agreements, where intent is unclear, issuing banks may be able to rely on Mr. Miller's deposition testimony in the BJW decision. As such, cases brought in jurisdictions that follow section 302 of the Restatement (Second) of Contracts may be prone to agree with the Appellate Court's decision. Again, unfortunately, merchants will not be able to ascertain the full extent of their risk unless they can get access to the acquiring bank's Member Agreement or be informed of whether it prohibits third party beneficiaries.
Merchant Actions to Potentially Reduce the Risk of Liability
There may be some steps that merchants can take to reduce their risk of liability for a payment card security breach. The BJW path to liability is a two step process. First the issuing bank must successfully sue the acquirer for breach of the Member Agreement between the card association and the acquirer, then the acquirer must pursue the merchant under the Merchant Agreement. Thus, merchants should consider both steps to determine the extent of their potential liability and for purposes of cutting off the path.
- Attempt to Determine Existence of 3rd Party Beneficiary Prohibition in Member Agreement
The first step on the path to liability under the 3rd party beneficiary theory is whether the Member Agreement between the card association and acquirer bank precludes third party enforcement of the Member Agreement. Merchants should ask their acquirer banks if they can examine their Member Agreement. It is likely, however, that the acquirer bank will be unwilling to provide the agreement itself. If not, the merchant should at least attempt seek assurances that there is a prohibition against third party beneficiaries. If the Merchant Agreement does not contain such a prohibition, then it is possible that the first step on the BJW liability path is open. Therefore, the merchant should seek to cut off the second step on the path, the Merchant Agreement.
- Negotiate a "Safe Harbor" in the Merchant Agreement
Obviously, the merchant has little control over what third party beneficiary terms its acquirer may have agreed to in the Member Agreement. However, a merchant does have some control over the terms it agrees to in its Merchant Agreement with its acquirer. It may be possible for a merchant to cut-off liability even if the issuing bank has been successful as a third party beneficiary of the Member Agreement. When entering into negotiations with acquirers (or their payment processors) merchants should attempt to negotiate a "safe harbor" into their Merchant Agreement. In essence, the safe harbor language would indicate that in the event of a security breach involving payment card information, if at the time of the breach the merchant was compliant with PCI and/or the card association's operating rules, the acquirer would have no right to indemnification or any other recourse against the merchant. Rather than relying on (mostly likely) illusory safe harbors identified by the card associations, this would provide a direct right to avoid contractual liability if the merchant has done everything it promised with respect to PCI.
The parameters of the safe harbor should be defined to protect the merchant. First, the merchant agreement should identify a truly independent third party responsible for performing a post-breach PCI/operating rules audit, and set-up a process for the audit itself (note that one issue to consider is that the auditors findings will not be protected by attorney-client privilege, so caution is warranted). This third party would be the last word on whether the merchant was PCI-compliant at the time of the breach. Currently this post-incident response is performed by auditors hand-picked by the card associations, and some believe, because of close relationships these auditors have with the card associations, they could be less than "neutral" when performing these audits. Second, the standard for compliance should not be strict compliance. Rather, the merchant should be deemed to be compliant unless it is in material non-compliance with PCI. Finding technical non-compliance with some section of PCI or card association rules, as any security expert can tell you, is not difficult. Even better would be language requiring the non-compliance with PCI to be the actual cause of the security breach at issue - if the non-compliance was not in anyway relevant to the breach the merchant would not be liable. Last, if possible, the Safe Harbor should include indemnification from the acquiring bank if the merchant is PCI-compliant at the time of the breach. This would allow the merchant to cut off direct suits from other stakeholders (consumers, issuing banks, card associations). Admittedly, however, it will likely be difficult to convince an acquiring bank to go this far.
Whether a merchant will be able to negotiation a safe harbor or any other term of the Merchant Agreement will depend a large part on negotiating leverage. Larger merchants with clout, or any merchant willing to "shop around" between multiple acquiring banks, will be in the best position to negotiate favorable terms. Some of the same negotiating leverage issues apply for this route as well.
- Limitation of Liability
In addition, merchants should consider a limitation of liability that caps the merchant's potential liability in the event of a security breach exposing credit card data. Merchants that have expended significant resources in becoming PCI compliant may be able to justify the cap more easily.
- Insure Against Payment Card Security Breaches
The insurance market has created information security and privacy liability policies which may cover liability arising out of a payment card breach. Since the risk of a security breach can never be 100% eliminated, insurance may be a good risk management tool to transfer unwanted risk. The key for utilizing insurance is to make sure the risk the merchant desires to transfer is actually transferred in light of the terms, conditions and exclusions in the insurance policy.
Merchants can no longer afford to treat PCI compliance as a pure security issue. Merchants should carefully analyze their PCI liability risk and determine ways to mitigate that risk. Laws like Minnesota's Plastic Card Protection Act and the BJW decision have likely increased the risk significantly. The potential for huge damage is great - issuing banks have alleged that the costs of reissuing payment cards range from $20-$50 per card (multiplied by thousands or even millions of cards). For smaller and medium companies highly reliant on payment cards, the failure to address this risk ahead of time can mean bankruptcy. For larger retailers, the prospect of spending tens of millions of dollars defending and settling lawsuits against issuing banks and merchants should spur on a careful examination of all merchant agreements, and the possible shopping around for merchant banks and payment processors that provide reasonable terms.
As such, more than ever, merchants must work with their legal counsel and risk managers to understand and mitigate the risk. Merchant lawyers must analyze their clients' current contractual relationships with acquiring banks and assist in negotiating favorable terms with payment processors and merchant banks. Since the risk is somewhat unpredictable and may be difficult to eliminate, information security and privacy risk insurance should also be considered. Lawyers should carefully analyze the scope of information security liability coverage to make sure their PCI risk is being transferred to the insurers. If the proper steps are taken, merchants may be able to avoid or mitigate significant losses in the event of a security breach.