Porn in the USA

Internet smut peddlers reaped millions from unsuspecting credit-card holders. Their partner in slime was right here in the heartland.

HPS, following standard procedure, had checked the Xpics site before opening the company's account. HPS's only suggestion was the removal of nudity from homepages so children wouldn't be inadvertently exposed to the likes of Wendy Wett, "goo gobblers" and the erotic adventures of teenage babysitters (Carr says HPS drew the line at bestiality and child porn). When Visa and Mastercard started asking questions about Xpics, HPS defended the pornographers, telling the credit-card companies that internal auditors didn't think the chargeback rates were excessive. Carr blamed dishonest cardholders, not Xpics, for chargebacks. He admits now that that was a mistake.

Although online casinos, cyberauctions and porn sites are particular problems, any kind of Internet merchant can be scammed by cardholders because refunds are automatic, even when goods are shipped. Expedia, an online travel agency owned by Microsoft, earlier this year announced that chargebacks would cost the company between $4 million and $6 million. In that case, investigators believe scammers used stolen card numbers to purchase airline tickets. Carr says he's seen cases in which cardholders have obtained refunds for hotel rooms they said they didn't use and bedroom furniture they claimed didn't arrive. "You can only do it several times per card, because eventually your bank is going to say, "Wait a minute. There's a problem here,'" Carr says. "They'll cancel your card if you do it too much." But there is nothing to prevent dishonest cardholders from getting new credit cards and pulling the same scam over and over again. "There is no blacklist of consumers in this business," Carr says. "Nobody can stop it." Shuster, who argues that credit-card companies should allow a higher chargeback rate for the Internet-porn industry, insists that's what happened to Xpics. "It's easy to do," he fumes. "There's no questions asked. Why not? Who wouldn't do it?"

As chargebacks mounted, Visa and Mastercard threatened six-figure fines. By mid-June 1998 -- less than three months after Xpics opened its account -- the number of chargebacks had exceeded 20,000 and would eventually top 90,000. Visa agreed to hold off with the fines if Xpics brought chargebacks under control by Aug. 1, 1998, but fines weren't HPS's only worry. Xpics' monthly transactions hit $6 million in May, and the bank would have to pay refunds if Shuster and Carmona went out of business. No one knew just how many chargebacks lay in the future. The chargeback process can take more than two months, which helps disguise high chargeback rates when companies are growing fast, as was the case with Xpics and other Internet pornographers HPS took on, Carr says. "You're taking month one's chargebacks against month three and four's processing volume," he explains. "If the numbers are ratcheting up pretty good, you can go quite a ways before you know there's a problem." It amounts, he says, to a Ponzi scheme of sorts.

Founded in 1997, Heartland Payment Systems is now the largest privately held credit-card-processing company in the nation.
Founded in 1997, Heartland Payment Systems is now the largest privately held credit-card-processing company in the nation.

Under its agreement with Xpics, HPS was supposed to withhold 5 percent of transactions to build up a $3 million reserve account to cover chargebacks. Worried that there wouldn't be enough money in the reserve, HPS began withholding 25 percent of Xpics transactions. Even that wouldn't be enough, Carr feared, and so HPS started withholding 100 percent of Xpics transactions in the middle of June 1998, leaving the pornographers with no cash flow. "The main reason was, we thought if Xpics closed their accounts or went out of business, Heartland Payment Systems would have to pay out millions," Carr says.

After four days of no money from HPS, Xpics stopped sending transactions to Heartland, triggering an immediate response from Carr. He called Shuster and asked why the money had stopped. By now, Xpics' main Web site was the 19th most-visited site on the Internet, right behind RealNetworks and just ahead of Amazon.com. Despite the chargebacks, Heartland still wanted the business.

During a June 18, 1998, telephone conversation with Shuster that lasted hours, Carr agreed to release $750,000 from Xpics' reserve account so the company could make payroll and pay webmasters for advertising. But Xpics never did process cards through HPS after Carr released the $750,000. Instead, Xpics sent its transactions to First Bank of Beverly Hills (which was eventually fined by Visa for excessive chargebacks). Carr didn't expect that. "I noticed you didn't process with us over the weekend," he told Shuster in an e-mail. "What does this mean?"

All told, HPS processed more than $17.9 million in credit-card transactions for Xpics over a span of 83 days. The pornographers ended up with most of it. "The bottom line is, we paid them $12 million in cash in 10 weeks," Carr says.

Carr admits HPS made mistakes with Xpics and other Internet pornographers. "These guys inoculated themselves by giving me this sob story -- which I bought into -- that there's so much consumer fraud," he says. "We were given this antidote, so we were expecting there to be a small problem. By the time we found out what was really happening, it was a pretty bad situation. Frankly, Visa was on top of it before us. We wanted to form our own opinion. And we did."

Two months after Xpics sent its business elsewhere, HPS demanded payment for chargebacks and threatened to report the company to the U.S. Secret Service or the FBI. Eventually HPS gave the FTC a list of adult Internet merchants it suspected had scammed consumers. "We believed that these people were defrauding consumers and felt it was our obligation as good citizens to do that," Carr explains.

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