Consumer Watch: The Problem With Paypal

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Kris Slevens was burned by a PayPal outage last October.
Photograph: John Abbott

Ask Kris Slevens what he thinks of PayPal, and you won't hear too many friendly words. Slevens, who used PayPal to accept payments for his Web hosting firm, HostMerit, in Berkeley Heights, New Jersey, was one of thousands of merchants caught when the online payment company's site was sporadically unavailable for nearly a week last October.

PayPal officials blamed the problem on a faulty software upgrade; it locked some customers out of their accounts and scotched a number of transactions (click here for details).

As if losing potential clients and revenue weren't enough, PayPal's system failure also caused Slevens to lose out on a used car he had planned to purchase that week. For four days, he was unable to access his PayPal debit/ATM account, despite dozens of calls to customer support. By the time he did access his funds, the seller's deadline had passed.

Once Burned

The experience prompted Slevens to sign on with several alternative payment services to avoid being burned again. "I've used PayPal as my main payment processor since I started my business, and it's often had random glitches here and there," he says. "But this shows that it's not a bank. With all the money that runs through its servers, it needs a disaster recovery plan, system backups, and better communication with customers. Basically, [PayPal] needs to reassure me of why I should let my business depend on it."

It's a reasonable request, especially for users like Slevens whose livelihood depends on the system's integrity. But even casual PayPal users might understandably be feeling a little wary these days. Last fall's system outage happened on the heels of a class-action lawsuit settlement in which PayPal--while denying any wrongdoing--agreed to pay more than $9 million to customers who felt that the company had unfairly and improperly restricted their accounts. (PayPal, which attributed the account restrictions to fraud prevention measures, reports that it has changed its procedures.)

Show Me the Money

PayPal spokesperson Amanda Pires admits that the site had "intermittent issues" in October. "We know that these issues caused an inconvenience to our customers, and for that we apologize."

Problems notwithstanding, PayPal sets the standard when it comes to person-to-person online payments. The company, which was acquired by EBay in 2002, boasts over 56 million accounts and processes more than 27 million transactions a month. About 70 percent of PayPal's total payment volume comes from auctions, most of them on EBay. One of its few major competitors, Yahoo's PayDirect, shut down its servers last November due to a lack of users.

And frankly, if you're just trying to send a quick 50 bucks to some stranger in St. Louis who's selling vintage baseball cards, PayPal fits the bill perfectly: It's a fast, easy way to send cash to someone you don't know without compromising your personal information.

Basically, it works like this: The buyer goes to the PayPal site (or to a site with PayPal integration, such as EBay) and enters the seller's e-mail address and the amount to pay. The seller receives the e-mail message, goes to PayPal, and collects the payment in his or her PayPal account.

PayPal solves a simple but important problem in online commerce, by allowing people to exchange money electronically rather than having to rely on writing checks, according to Penny Gillespie, a senior analyst at Forrester Research.

While PayPal may sometimes act like a bank, it isn't. The company itself is "subject to very strict consumer policies and regulations, but it's licensed as a money transmitter, not a bank," Pires says.

Though money transmittal services such as PayPal are regulated in many states, they're considered "nonbank financial institutions" and aren't FDIC insured, which means that their customers aren't covered by federal banking protections. That's important for consumers to understand before they enter into a service agreement with a money transmitter, according to Jeffrey Taft, a partner at the Washington, D.C.-based law firm of Mayer, Brown, Rowe, and Maw, who specializes in consumer financial services. "Because banks are subject to so many rules, regulations, and disclosures, they're much more accountable for consumer complaints. Consumers should understand that their transactions on a service such as PayPal are largely governed by their agreement with PayPal, and there's no omnibus regulator overseeing the company's activities."

Many PayPal competitors have closed, but a few are left. BidPay, for example, a subsidiary of Western Union, is intended only for online auctions. It lets buyers complete transactions by direct deposit into a seller's checking account or by money order.

Another option is IKobo, a general-purpose money transfer service that operates in over 170 countries. Buyers and sellers send and receive money by using an I-Kard--a special, reloadable Visa debit card issued by the IKobo company; users can access their cash via participating ATM machines.

Chances are that your online payments will go through without a hitch. But just in case, here are a few tips:

  • Look for specific information on error and conflict resolution to learn how the service handles disputes. Review the company's policy on fraud prevention, too.
  • Avoid leaving large sums in any money transfer service account.
  • Try to limit your use of money transfer services like PayPal to smaller purchases (transactions under $500 or so). Consider an escrow service for larger purchases.
  • When possible, use a credit card for purchases to protect yourself against fraud or unauthorized charges.
  • Finally, diversify. If you run an online business, consider using more than one payment service. If you're a buyer, use PayPal or another service when that method makes sense, but don't forget that sometimes even a good old-fashioned paper check may be a better option.
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