A merchant agreement is a contract between a business, as merchant, and a financial institution governing the terms and conditions of electronic payment processing services provided by the financial institution to the business. The typical merchant agreement requires the business to pay service fees to the financial institution in exchange for the ability to accept electronic payments from its customers. When a customer makes an electronic payment to the business, the financial institution credits the business’s account. But when a customer’s transaction is canceled or declined after the financial institution credits the business’s account for the purchase, the financial institution refunds the money to the customer and charges the business for the refund plus a “chargeback” fee.
In a favorable ruling for financial institutions, the Sixth Circuit recently held in Electronic Merchant Systems LLC v. Gaal[1] that “chargeback debts” are contingent debts that accrue at the time of the customer’s transaction with the merchant, rather than at the time of the chargeback itself. The decision had the effect of reviving a significant breach-of-contract claim against the personal guarantor of the obligations owed by the merchant to the financial institution providing electronic payment processing services under a merchant agreement.
In 2014, plaintiff Electronic Merchant Systems LLC (EMS) entered into a merchant agreement with a business, “Procom,” which was owned by defendant Peter Gaal. Under the 2014 agreement, EMS and an associated bank provided payment-processing services to Procom in exchange for Procom’s payment of certain fees. One of the fees for which Procom was liable was on account of chargebacks, which occurred when a customer’s transaction was declined or canceled after EMS had already credited Procom’s account for the purchase. The relevant provision of the 2014 agreement stated:
[A]n authorized sale does not constitute a guarantee of payment, only available credit, and may be subject to dispute or chargeback . . . . EMS shall have the right to debit the Merchant’s Designated Account, incoming transactions or any other funds of the Merchant in . . . EMS’s direct or indirect control by reason of . . . EMS’s security interest granted by Merchant . . . for the face amount of any transaction and to chargeback such transaction . . . .
Included within the 2014 agreement was a personal guaranty provision, which was signed by Gaal. The guaranty stated:
The undersigned . . . in consideration of BANK and EMS entering into this Merchant Agreement (“Agreement”) with [Procom], hereby absolutely and unconditionally guarantee the full and prompt payment of any and all amounts owed to BANK and EMS and the performance of all MERCHANT’S obligations under this Agreement as may be subsequently amended from time to time, whether before or after termination or expiration of the Agreement . . . . This Guaranty is continuing, binding upon heirs and successors and may not be changed except in writing and signed by BANK and EMS.
In 2019, a second merchant agreement was entered into by ESM and Procom. Procom’s obligations under the 2019 agreement were the subject of a personal guaranty, but not by Gaal. In addition, the 2019 agreement contained an integration clause.
During the COVID-19 pandemic, many of Procom’s customers canceled their credit card purchases. EMS claimed that this resulted in over $10M in chargebacks. Some of the chargebacks related to transactions occurring prior to the execution of the 2019 agreement, and some of the chargebacks related to transactions occurring after that date. The chargeback debts went unpaid. Procom subsequently filed a petition for relief under chapter 7 of the Bankruptcy Code, and EMS filed a proof of claim in Procom’s chapter 7 case.
EMS sued Gaal for breach of guaranty, unjust enrichment and fraud. The district court granted Gaal’s motion to dismiss, finding, among other things, that the 2019 agreement superseded the 2014 agreement, including replacing the guaranty provision set forth in the 2014 agreement, which was signed by Gaal, with the guaranty provision set forth in the 2019 agreement, which was signed by a different party. The court also held that the chargebacks in question occurred after the execution of the 2019 agreement and arose solely under that agreement. Because Gaal was only a guarantor of obligations under the 2014 agreement, the district court held that Gaal was not liable for any chargeback debt.
On appeal, the Sixth Circuit affirmed the district court’s finding that the 2019 agreement replaced the 2014 agreement. However, the court reversed the district court’s finding that the chargebacks in question — including those relating to transactions occurring prior to the execution of the 2019 agreement — arose under the 2019 agreement rather than the 2014 agreement. The court stated that under the plain language of the guaranty, Gaal guaranteed the “full and prompt payment of any and all amounts owed to BANK and EMS and the performance of all MERCHANT’S obligations under this Agreement” — i.e., the 2014 agreement. So, the issue was whether any of the chargeback debt accrued under the 2014 agreement.
The Sixth Circuit held that “any chargeback debt related to transactions which occurred prior to the execution of the 2019 Agreement constitutes an obligation arising under the 2014 Agreement, for which Gaal may be liable under his guaranty.” In other words, Gaal may be liable for transactions that were (1) processed after Gaal personally guaranteed the 2014 agreement but before the 2019 agreement was consummated, and (2) eventually charged back.
Although the issue was one of first impression, the Sixth Circuit relied on bankruptcy case law holding that a contingent debt “accrues” when the debtor has an obligation to pay it. The court also relied on the Fifth Circuit’s decision in In re United Sciences of America, Inc.,[2] which specifically holds in the context of chargeback debt that “[the] right to payment, and hence [the debtor’s] debt to [the creditor], arose not later than when the charged back item was initially credited to [the debtor’s] account, regardless of when the issuing banks actually asserted their chargeback claims.”[3] Finding these cases persuasive, the Sixth Circuit held that “EMS thus had a right to repayment when the transactions were made and Procom’s account was credited by EMS, even if that right to repayment was contingent upon a future event (the chargebacks).”
Next, the court agreed with the district court that the plain language of the 2019 agreement superseded and terminated the 2014 agreement. However, the court held that this did not necessarily extinguish Gaal’s liability under the 2014 agreement for debts that had accrued thereunder. As the court explained, “[t]o extinguish liabilities already accrued, then, more than an agreement to terminate is needed: there must be an intentional agreement between the parties to eliminate accrued obligations.” The court remanded to the district court to determine whether the 2019 agreement was a novation of the 2014 agreement.
The decision in Electronic Merchant Systems restates a familiar concept in bankruptcy law: A contingent debt “accrues” when the debtor becomes legally obligated to pay it. The decision was also based on the specific language of the merchant agreement. Because merchant agreements can vary greatly, it is important for financial institutions to carefully review (and, if necessary, update) the terms and conditions of their agreements to ensure that their rights and obligations are adequately protected in the event of a default.