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Saturday, January 15, 2005

Death by Regulation

Regulation is an important topic that's all too frequently ignored in public debate since it tends not to be as visible as taxes, budgets, and the Federal Funds Rate. Classic economics doesn't do a great job with it, either; most production functions describing economic growth will include inputs such as gov't spending and savings rates but essentially ignore the friction that regulation creates. This is an increasingly dangerous perspective to have inasmuch as regulation has grown into one of the Left's favored tools for controlling the economy, and this imposes a real cost on the private sector.

Given this, I was quite pleased when a media outfit that covers developments in the rapidly growing online auction industry recently interviewed me on the topic. Specifically, I was asked to discuss the regulatory future of PayPal, the online payment service that's the subject of my book, The PayPal Wars. (I've pasted the article below.) I used the opportunity to express concern over the likelihood that regulators will continue to view innovative firms like PayPal as a target, stifling their innovation and inadvertantly imposing a huge cost of compliance on their employees, shareholders, and customers.

P.S. It came as no surprise that agents working for Eliot Spitzer -- NY's Godfather General -- defended their aggressive regulatory thrusts with "protect the consumer" language. But I'll discuss Spitzer's tactics and twisted view of the economy at length some other day...

PayPal Confident in Meeting Regulatory Challenges
By Julie Hauserman
January 12, 2005

With more than 56-million accounts, PayPal remains the leader in online payment systems. And, despite a five-day outage last fall and some loud customer complaints about PayPal arbitrarily freezing accounts and providing below-par customer service, competitors have not made significant gains on the eBay giant. What could slow PayPal's progress, however, are government regulations and lawsuits.

The company's phenomenal success has made it highly visible, and regulatory challenges could become a thorn in PayPal's side for years to come, especially with new laws, like the Patriot Act, which is designed to root out terrorists' transactions on the web, according to a PayPal expert.

"I do think ongoing legal and regulatory challenges are always going to hinder the company.
They are not going to sink the company, but they may prevent PayPal from doing new, innovative things that would benefit customers," said Eric Jackson, a former PayPal executive who wrote the book, The PayPal Wars. "It's very high profile, and it's got a big target on its back."

"There are two threats: new laws, and capricious regulators," said Jackson, who worked as a PayPal marketing executive for three and a half years. "Those are not going to go away."
But PayPal spokeswoman Sara Bettencourt says the company doesn't foresee problems.

"We don't actually see compliance with regulations as a challenge," Bettencourt said. "We have a large, dedicated team within the company that focuses on this."

Already, PayPal has scaled back some services that have drawn regulatory interest. The company no longer processes transactions having to do with online gambling, adult web sites, and buying prescriptions drugs from unauthorized sellers. PayPal went one step further, announcing it would enforce the ban by fining people up to $500 if they get caught trying to use PayPal for those purposes.

The company is regulated on a state-by-state basis. And some regulators have been more zealous than others. The state of Louisiana banned PayPal from operating there in 2002, but the issue was later resolved. New York Attorney General Elliot Spitzer fined the company $150,000, saying the PayPal misrepresented terms and conditions to account holders in its user agreement.

Part of the regulatory interest stems from the fact that PayPal and other online transaction services are a new sort of animal: not banks and not credit card companies. In the early days after its inception in 1999, PayPal was moving toward becoming a bank, but the Internet startup decided that banking regulations were too cumbersome, Jackson said.

"We just wanted to be able to facilitate a quick payment," he said. "The question of how to classify PayPal lingered for some time."

The Federal Deposit and Insurance Corporation in 2002 ruled on whether PayPal should be regulated as a bank, and concluded that it should not because it doesn't offer loans or take deposits.

"It's a sort of modern-era Western Union," Jackson said. "Really, all PayPal is doing is shifting money around on your behalf."

Customer complaints on the Web have been numerous, with several anti-PayPal websites cropping up to document problems with the company. Jackson says the customer complaints won't sink Paypal, because it is still the most convenient online payment system around. He said banks and credit-card companies deal with ongoing complaints, too. Complaints about problems with PayPal will come and go, he said, but regulatory hurdles remain the biggest challenge.

Bettencourt says the company is licensed in 32 states - the only states that require it so far. PayPal offers "pass-through" FDIC protection for user accounts, she said, because transferred money is parked in third-party banks that have FDIC protection.

"Even though we're not regulated as a bank," Bettencourt said, "we still adhere to most of the rules and regulations that govern banks."

PayPal adheres to a long list of regulations, she said, including the Bank Secrecy Act, Regulation E disclosures and consumer protections against unauthorized or incorrect fund transfers, federal and state laws against unfair or misleading practices and disclosures, SEC registration, disclosure and investment requirements for the PayPal Money Market Funds, credit card association rules and international money transfer laws.

A spokesperson for New York Attorney General Elliot Spitzer would not comment except to repeat what Spitzer said in a press release in March. "Protecting consumers' rights in online transactions is the best way to establish and maintain confidence in electronic commerce. As with any new industry, it is essential that consumers making e-payments receive full disclosure of their rights and liabilities."

Eric M. Jackson is the president of World Ahead Publishing and the former head of PayPal’s marketing department. His book,
The PayPal Wars: Battles with eBay, the Media, the Mafia, and the Rest of Planet Earth, is on sale now.