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 and Mastercard themselves. Instead, they’re what’s known as "acquiring banks", with names like First Data and First Tennessee, 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 that it was increasing its holdback to 50%, Frontier was in a very tough situation. The action would decimate Frontier’s cashflow, since substantially all of its income came through the credit card channel. With cashflow 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.)

Update: A former cash manager at a major airline clears up my last question: the money is (usually) the property of the airline, not of the credit card company.

I managed the credit card holdbacks which were in several hundred million dollars. The cash was not co-mingled with the Bank’s (Chase Paymentech in our case) and we kept all interest earned. I was able to even decide what types of securities to invest in (subject to certain limitations). These details vary from agreement to agreement and it is subject to negotiation at the onset of the processing agreement. The account had a control provision and Chase could take control in the event that our financial condition deteriorated.