How Holdbacks Brought Down Frontier Airlines

On Friday I got a bit confused about something called credit card holdbacks, and how they could be used to drive an airline into bankruptcy.

It turns out that it all goes back to something known as the Fair Credit Billing Act of 1978. The insurance you receive when you buy something on a credit card is not a perk the card companies offer out of the goodness of their own hearts; it's the law. If you charge something on a credit card and it isn't delivered as agreed, then the credit card has a legal obligation under the act to refund your money.

Now most of the time this isn't a big deal for credit card companies: if I buy a pair of jeans with my credit card, I walk out of the shop with them, and there's not much chance of a dispute. With airline tickets, however, I'm paying now for a service in the future, and if the airline ceases operations, the credit card company is on the hook for a large sum of money which it's quite unlikely to be able to recover from the airline.

As a result of this, everybody with an ounce of sense books their airline tickets on a credit card: It's free insurance. But that also means that the credit card companies have a huge liability to consumers if an airline stops flying. And in fact they did end up having to pay out a lot of money in the mid-80s, when a few post-deregulation startup airlines did just that.

So there was an impasse. Consumers would only pay for airline tickets with credit cards, but the credit card companies didn't want to let anybody charge airline tickets. The way to break the impasse was the holdback. Credit card companies signed agreements with the airlines that they could hold collateral and retain a certain percentage of all ticket sales, in order to indemnify themselves in the event that those charges would have to be refunded.

The credit card companies in question aren't the same companies who send you your bill; they're not even Visa (V) and Mastercard (MA) themselves. Instead, they're what's known as "acquiring banks", with names like First Data (FDC) and First Tennessee [part of First Horizon (FHN)], who process all the transactions for a single vendor.

The relationship between an airline and its acquiring bank is one of the three most important relationships that an airline has: The other two are with a global distribution system, for ticketing, and with a jet fuel supplier. When First Data suddenly announced to Frontier (FRNT) that it was increasing its holdback to 50%, Frontier was in a very tough situation. The action would decimate Frontier's cash flow, since substantially all of its income came through the credit card channel. With cash flow already tight, Frontier couldn't afford that. But no other acquiring bank was interested in taking on Frontier's business. So Frontier took the only other option available to it: declaring bankruptcy, in the hope that a bankruptcy judge would stop First Data from implementing the higher holdbacks.

Are there holdbacks elsewhere in the credit-card world? Yes, in the travel industry, of course: cruise lines, package-holiday vendors, that sort of thing. And also on the internet: I pay for my goods from Amazon.com before I receive them, and if I never receive them then I can ask for a refund.

And what happens if the credit-card company does have to pay out? In that event, the money from the holdbacks is used to mitigate the cost of the payouts. Both the holdbacks and the payouts are shared between First Data and the banks who issued the credit cards. But until that happens, First Data is in charge of looking after the holdbacks.

The only thing I'm still a bit unclear on is the ownership of the holdback money. Is it kept in an escrow account in the name of the airline? Does the airline get all the interest on that account? Or is it money which First Data can use for its own internal purposes? If First Data went bankrupt, would Frontier be just another unsecured creditor, or would it be able to take full ownership of the escrow account? Given the risks to the consumer-credit market which seem to be looming at the moment, at some point it might be the acquiring banks going bust, and not just the airlines.

(Many thanks to Joe Brancatelli for his help with all this.)

Comments

[1STSEEKER]

Felix,
FDC, First Data Corp. in the US, is owned by none other than Lehman Bros.(LEH), a company in DIRE NEED OF CASH. There is an FDC.BA (Buenos Aires Exchange), FDC.F on the Frankfurt exchange, etc., etc., ..., but not on any US exchange (Source, Yahoo! Finance).
There was a HUGE volume of Frontier (FRNT) stock traded at the end of 4/10/2008. Over a MILLION SHARES of FRNT were traded at 1539 (3:59 PM) on that date (Source: Scottrade). Even Airtran(AAI) was caught up in the frenzy! (AAI uses First Data, too! The afternoon chart of AAI looks like the stock fell off a cliff (Source: Scottrade). Astonishing to me is that 35+ MILLION shares (of 36.6 million shares autstanding) of FRNT were traded on 4/11/2008 I (cough, cough) wonder how many PUTS were on FRNT, and shares short there were by (allegedly) interested parties? Insiders owned 27%!! of the stock, and really took a bath. Among the top ten institutional and mutual fund holders, try to find, ah, the principals. Ain't there. No malice intended here, but this whole mess STINKS to High Heaven! United and "TED" are the biggest competitors in the Denver hub of both airlines.
This was good for them, for sure!

I have no interest in FRNT, other than I flew them last month. A very nice experience for a change. Nice people, nice planes (A=318s and 319s) and a very helpful bunch of folks (my wife is handicapped).

BTW, just try to buy an airline ticket with cash or check, and the TSA (Dept. of Homeland Security),the FBI, and the the airline itself, will take a GREAT interest in you and your background. You may even end up on a "No Fly List"!

[Antonov24]

Are any other LLC airlines with 'holdback' issues? How can the CCD Processor simply RAISE the amount of the holdback? How did they pick Frontier out of the lineup of air carriers. From what I understand, Frontier did nothing wrong, had money in the bank and was taking every step available to it to reduce operating costs. Are there no usery laws to catch this type of action. What about insurance against such action? Is there any government assistance available to help a carrier through such an action? Certainly, the U.S. stepped in to 'help' keep United flying these past five years. Frontier has done everything by the book, yet it will experience a difficult period financially because of this action. And, DON'T get me started on the OPEC boneheads and the daily flux in their fuel pricing! Thanks for letting me sound off.

[Sir Sid]

Felix,
I enjoyed reading your article! It was very illuminating. I also enjoyed reading 1st seekers take on the situation. Antonov, it is a pity that you didn't go on a bit more about the "OPEC boneheads". It is interesting how all of this relates to one another. It almost seems as though there is a concerted effort to wreck the economy.

It begins with oil and gas prices. They have a negative effect on transportation (for obvious reasons) and then we see a spill over into the financials. All of this translates into higher prices for everything (as far as the individual citizen is concerned). My question is: "Why is all of this happening? Is it to give the impression that the current administrations policies are substandard so that a socialist candidate will be more attractive to the mindless masses at election time? Or could it be an "economic invasion" of the U.S. by some outside force? Hmmmmmmmm, makes me wonder.

[Toobdrvr]

To clarify, I believe FDC increased their holdback from 45% TO 100%. Apparently within their contractual rights to do so, but the vice-grip treatment to be sure....

If you are truly interested in keeping a relatively small and still independant business alive. Please travel F9 whenever it is possible. We'll be thrilled to have you aboard!!!

[Elec Tech]

why wouldnt the airline try a more modest way such as offering a say 20% discount on ticket paid for by cash. department stores can do it why cant major airlines?