EBay's PayPal funds freeze plan draws fire

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(FORTUNE Small Business) -- Editor's note: This story was originally published Feb. 8 and is being updated to add links to follow-up stories.

In the uproar that erupted over the planned fee hikes and other policy changes eBay announced last week, one drew particular ire and incredulity: eBay's plan to hold payments sent through its PayPal payment service for up to 21 days in certain circumstances.

The freeze will apply to transactions eBay (EBAY, Fortune 500) considers high-risk, and is intended to protect buyers from the hazards of a bad transaction. By hanging on to funds, eBay can easily refund them if a seller doesn't ship a purchased item or sends damaged goods.

What is sparking reactions ranging from annoyance to panic among some of eBay's sellers is the company's criteria for determining what transactions fall into the "high-risk" category. Factors beyond sellers' control, including the number of "feedback" comments they have from previous buyers and how many of those comments are positive, can trigger the freeze.

"It's like a bad dream, really," said Dana White, an eBay seller who lives outside Ocean City, Md., and deals in used clothing, shoes and accessories. "I'm a small seller. All I need is two negatives in a 30-day period, and they will hold funds."

Representatives from PayPal, which eBay acquired in 2002, declined to comment on how the new policy would affect individual cases, but noted that the changes are paired with increased protections for merchants who use the service.

If Paypal deems a transaction fraudulent, it currently covers merchants for up to $5,000 per year. That cap will be lifted for eBay's PowerSellers, the site's highest-volume merchants, who will now receive unlimited coverage. PayPal will also offer PowerSellers protection on items sent to any address (not just confirmed addresses, the current policy) and expand its merchant coverage for international sales.

PayPal estimates that its new hold policy will affect less than 5% of eBay transactions, and it emphasizes that only relatively untested sellers risk incurring a freeze. Merchants who have been registered with eBay for more than six months, have a feedback score of 100 or higher (meaning they've received positive comments for at least that many transactions), and have a "dissatisfied buyer" rate of less than 5% will never have their funds held.

But on a site that hosts an estimated 113 million listings worldwide at any given time, a policy affecting as many as 5% of those transactions puts millions in jeopardy. If funds are frozen after a sale, PayPal will release them after the buyer leaves positive feedback, three days after the item's confirmed delivery, or at the end of 21 days without a dispute, whichever happens first.

Paypal says the factors that will play into its formula for triggering a hold include the length of time a seller has been on eBay, the seller's feedback rating, and the final cost and shipping fees for the item.

Because PayPal has sole discretion over whether to freeze funds, sellers are upset about a perceived lack of accountability. They're also grouchy about eBay's efforts to force buyers to rely on PayPal: in some categories and for all new sellers, eBay requires vendors to offer PayPal as an option or have their own merchant credit card account. The site has blocked rival payment systems such as Google (GOOG, Fortune 500) Checkout, saying they are not yet proven safe.

"The feeling among my forum members is that this new [21-day hold] policy is beneficial for buyers but negatively affects sellers," said Bob Lee, who runs PowerSellersUnite, a popular outlet for entrepreneurs who run businesses on eBay. "A seller is at risk of being taken advantage of by the buyer. Not having access to revenue and having to wait for a buyer to leave positive feedback leaves sellers in the lurch. PayPal and eBay are not allowing sellers to play on a level field."

The new policy has some questioning its legitimacy: Can PayPal legally freeze funds at will for up to three weeks?

The answer is yes. While PayPal offers interest-bearing accounts, debit cards, and other trappings traditionally associated with banks, it legally isn't one.

PayPal is classified as a "deposit broker," according to David Barr, a spokesman for the Federal Deposit Insurance Corporation (FDIC). A deposit broker can perform some of the same functions that bank might, but it ultimately depends on banks to hold its money. Other examples of deposit brokers include companies like Charles Schwab (SCHW, Fortune 500), the discount brokerage house.

Buyer and seller money passes through PayPal - "a conduit, so to speak," Barr said - and is then deposited in a traditional bank. That means money parked with PayPal can be eligible for so-called "pass-through" insurance by the FDIC. However, that protection doesn't apply to funds held in a PayPal money market account, which are not FDIC-insured. (Coincidentally, PayPal money-market holders were recently issued incorrectly low January dividends, but that mistake stemmed from a third-party glitch and is now being corrected, according to a PayPal representative.)

While PayPal's operations lie outside of U.S. federal banking regulations, states can individually decide to regulate the company - and in the past some have made overtures in that direction. In 2002, Louisiana banking officials asked the company to cease offering its services to the state's residents until it received a money transmitter's license. PayPal did, and hasn't faced any significant state-level action since. A spokeswoman for the Louisiana Office of Financial Institutions confirmed this week that PayPal is a registered money transmitter with the state.

Some sellers have talked of challenging PayPal money freezes in courts, something that's been done before. In 2002, PayPal users in California sued, arguing that PayPal violated the state's consumer-protection laws by locking accounts containing money involved in a fraud investigation. (PayPal froze all cash in affected accounts, not just the money involved in the investigation.) However, the case did not result in any determination of liability: PayPal paid a $9.5 million settlement to end the case in 2004.

PayPal spokeswoman Amanda Pires said the issues at stake in the California case were "totally unrelated" to those being raised in relation to the new 21-day hold provision.

"Obviously, it's legal. We wouldn't do it if it wasn't," Pires said of the provision, noting that the right to temporarily hold funds is reserved in PayPal's user agreement.

PowerSellersUnite's Lee conceded that point: "Everyone who joins PayPal agrees to their terms. Unless a court finds PayPal subject to the same regulations as a bank, it would be a hard case to make."

PayPal's Pires says the changes will increase buyer confidence and generate more sales for eBay's merchants. Some eBay entrepreneurs agree with that assessment.

Jon and Stacie Sefton are the owners of B & H Factory Outlet, a Cedar Rapids, Iowa, designer-clothing retailer that sells exclusively on eBay. What began as a home business five years ago now has 70 employees and is eBay's largest clothing merchant. The Seftons are in favor of PayPal's new policies, and believe the changes will achieve PayPal's aim of boosting protections for both buyers and sellers.

B&H does 20% of its business internationally, so PayPal's expanded global protections will directly benefit the company's bottom line, as will its move to expand PowerSeller protections for shipments to any address, not just confirmed ones. Overall, Paypal's effort to weed out unreliable sellers helps everyone who does business through its marketplace, Jon Sefton said.

Also backing the changes is Jonathan Garriss, CEO of eBay shoe store Gotham City Online and executive director of the eBay Professional Sellers Alliance, an influential outside lobbying group.

"That is a big deal because now eBay and PayPal are getting involved in the transaction to make sure buyers get what they are expecting," Garriss said.

His group has long been frustrated by the hands-off, "buyer beware" stance eBay's management has traditionally had about its marketplace: "Imagine if that was the case at the local mall," Garriss said. "That's no way to shop."

But eBay's PayPal changes have already cost the company Suzy Lancaster, a 52-year-old seller from Wichita Falls, Tex., who has been selling on eBay for more than a decade - or, as she puts it, since "back when [eBay founder] Pierre Omidyar started it as Auction Web and ads looked more like e-mail." Lancaster remembers the days when bidders sent cash to sellers through the mail to pay for their purchases.

After last week's announcement of eBay's upcoming policy changes, she closed her Pigeon Alley Books store on eBay and began working on a standalone e-commerce website. EBay's PayPal changes will make small sellers even more vulnerable to unscrupulous buyers, because they will have every incentive to avoid getting dinged with bad feedback that might trigger a freeze on their PayPal account, she said.

"We've spent years trying to build up a good business reputation," she said. "It's going get shredded by someone who doesn't realize [the impact of their feedback]."

Lancaster echoed a common sentiment expressed by eBay business owners in this week's uproar: concern that the site is transitioning to a marketplace only for professional sellers, with no room for smaller vendors or hobbyists. John Donahoe, elevated to CEO-elect two weeks ago when Meg Whitman announced her impending retirement, fed those fears with an oft-repeated dismissive comment to the Financial Times in December, complaining that "our home page still looks like a flea market."

Lancaster said she is sad to see eBay becoming a marketplace only for businesses that "buy inventory by the boatload."

"They already have a place for that," she said. "It's called Wal-Mart (WMT, Fortune 500)."