The New Path to PCI Liability: 3rd Party Beneficiary Theory

An easy-to-read PDF version of this article can be found here: LINK.

Merchants face a potentially huge liability if they suffer a security breach exposing payment card data. Issuing banks (those banks that issue credit cards to consumers) have filed lawsuits to recover reissuiance costs allegedly ranging from $20-$50 per card (multiplied by thousands or millions of cards depending on the magnitude of the breach). A recent decision from the U.S. Court of Appeals for the Third Circuit (“3^rd Circuit” or “Appellate Court”) appears to have expanded the potential liability merchants face for payment card security breaches. In Sovereign Bank v. B.J. Wholesale Club & Fifth Third Bank, No. 06-3392/3405 (3^rd Circuit, July 13, 2008)(hereinafter the “BJW Decision”), while the Appellate Court affirmed the lower court’s dismissal of most of the claims against B.J. Wholesale Club, it reversed the lower court’s dismissal of Sovereign Bank’s breach of contract action that was based on a third party beneficiary theory. This article explores how the Appellate Court reached its decision, how the decision could increase the legal risk faced by merchants that suffer security breaches and potential actions merchants can take to better understand and mitigate their legal risk.

Background

The BJW Decision arose out of a payment card security breach suffered by B.J. Wholesale Club (“BJW”) that was first reported in March 2004. Criminals were able to steal (and commit crimes using) the magnetic stripe information from payment cards stored by BJW. In reaction to this security breach, Sovereign Bank and the Pennsylvania State Employee’s Credit Union (hereinafter “Issuing Banks”) incurred costs to reissue the payment cards that were the subject of the BJW breach. Litigation ensued in 2005 when the Issuing Banks separately sued BJW and BJW’s merchant bank (Fifth Third Bank) to recover their reissuance costs. The federal lawsuits were eventually consolidated in the U.S. District court for the Middle District of Pennsylvania (the “Lower Court”) and alleged the following causes of action: (i) negligence; (ii) breach of contract (Third Party Beneficiary Theory) and (iii) equitable indemnification; (iv) breach of fiduciary duty and (v) promissory estoppel. The Lower Court fully granted the defendants’ motion to dismiss and motion for summary judgment, which lead to the plaintiff’s to appeal (see Sovereign Bank v. B.J. Wholesale Club, 385 F.Supp.2^nd 183 [M.D. Pa. 2005] and Sovereign Bank v. B.J. Wholesale Club, 427 F.Supp.2d 256 [M.D. Pa. 2006]).

Relationship Between the Players in the Payment Card System

In order to understand the Appellate Court’s ruling one must first be aware of the relationships (contractual or otherwise) between the players in the payment card system.

In this case, BJW was the merchant that accepted payment cards from consumers (some of whom were issued their cards by the Issuing Banks). In order to accept credit cards and become part of payment card networks such as Visa or Mastercard, merchants must work through and contract with an acquiring bank (a.k.a. “acquirer” or “merchant bank”). In this case Fifth Third acted as BJW’s merchant bank and had a “Merchant Agreement” in place with BJW. In turn, moving upstream, Fifth Third had a “Member Agreement” in place with VISA. Pursuant to the Member Agreement, Fifth Third became a “member” of the VISA network and agreed that it would comply with VISA’s Cardholder Information Security Program (“CISP”) and VISA’s Operating Regulations (note that at the time of the breach the PCI Standard was not in effect and each card brand had its own security standard).

Sovereign Bank, was one of the Issuing Banks that had issued payment cards to various consumers that were impacted by the BJW security breach. Sovereign Bank is also a member of the VISA network by virtue of its own Membership Agreement with VISA. However, the Issuing Banks had no direct contractual relationship with Fifth Third or BJW. A graphic representation of the contract chains can be found at this link: BJW Contract Relationship Chart.

Sovereign Bank’s Breach of Contract Allegations

Despite not having a direct contractual relationship with Fifth Third, Sovereign Bank alleged a breach of contract claim based on Fifth Third’s breach of the Membership Agreement between Fifth Third and VISA. Although it was not a party to the Membership Agreement, Sovereign alleged that it was an intended third party beneficiary of the agreement (see BJW Contract Relationship Chart).

Pursuant to the Membership Agreement, Fifth Third agreed comply with VISA’s Operating Regulations (which included VISA’s Cardholder Information Security Program). The version of the Operating Regulations applicable to this case provided the following:

• Fifth Third agreed to ensure that its merchants (BJW in this case) complied with the Operating Regulations

• Fifth Third agreed to enter into a Merchant Agreement with each of its merchants requiring each merchant to comply with VISA’s Operating Regulations

• A prohibition against retaining or storing the data encoded on the magnetic stripe on the back of payment cards after a transaction is authorized (this is essentially the same prohibition set forth now in section 3.2 of the PCI Standard), and a duty for Fifth Third to impose this obligation on merchants like BJW

• Provisions concerning dispute resolution between members, including chargeback and representment procedures, and arbitration provisions.

Significantly the Operating Regulations in place at that time did not eliminate any other rights an issuing bank may have to pursue any legal remedy that may otherwise be available. As discussed further below, unless Visa’s Operating Regulations have changed, this suggests that there is no real “safe harbor” for PCI compliance.

Sovereign Bank alleged that both BJW’s failure to delete the magnetic stripe data, and Fifth Third’s failure to ensure BJW’s compliance with the deletion requirement constituted a breach of the Operating Regulations by Fifth Third. Sovereign Bank further contended that these contract breaches allowed the unauthorized access to, and use of, payment card data at BJW, and that Sovereign Bank was legally obligated to reimburse cardholders for fraudulent charges that resulted. Moreover, the resulting unauthorized access to payment card data also required Sovereign Bank to incur the expense to reissue the compromised payment cards. Finally, the Issuing Banks alleged that their customer goodwill was adversely impacted by the BJW breach. The Appellate Court was called upon to rule on these issues in a motion to dismiss/summary judgment context.

The Issue to Resolve: 3^rd Party Beneficiary Theory.

The Appellate Court considered the following issue:

Was Sovereign Bank an intended third party beneficiary of the Member Agreement between Fifth Third and VISA?

Although Sovereign Bank conceded that it is not an express third party beneficiary of the Member Agreement between Visa and Fifth Third, it based its argument on § 302 of the Restatement (Second) of Contracts (which had been adopted under Pennsylvania law, which governed this case):

Intended and Incidental Beneficiaries

(1) Unless otherwise agreed between promisor and promisee, a beneficiary of a promise is an intended beneficiary if recognition of a right to performance in the beneficiary is appropriate to effectuate the intentions of the parties and either:

(a) the performance of the promise will satisfy an obligation of the promisee to pay money to the beneficiary; or

(b) the circumstances indicate that the promise intends to give the beneficiary the benefit of the promised performance.

(2) An incidental beneficiary is a beneficiary who is not an intended beneficiary.

In the context of § 302, the court framed the issue as follows:

Under § 302, Sovereign’s contract claim depends on whether “the recognition of a right to performance” in Sovereign is “appropriate to effectuate the rights of” both Visa and Fifth Third in entering into their Member Agreement and whether “the circumstances indicate that” Visa (the promisee) “intended to give Sovereign the benefit of the promised performance.”

To establish whether Visa intended to give issuing banks like Sovereign the ability to rely on Fifth Third’s promises in the Member Agreement, Sovereign relied on the deposition testimony of Visa’s representative, Alex Miller. Miller testified that he was not aware of any intent on Visa’s behalf to create a direct right to benefit third parties, and that no documents existed that allowed issuing banks to “step into [Visa’s] shoes” to enforce the Membership Agreement with Fifth Third.

However, Miller also stated:

It’s fair to say that the core purposes of the operating regulations is to set up the conditions for participation in the system, to set up rules and standards that apply to that ultimately for the benefit of the Visa payment system, the members that participate in it and other stakeholders such as cardholders, merchants and others who may participate in the system as well.

Miller further testified that the purpose of Visa Operating Rules (including CISP in this case) was to maximize the value of the Visa system as a whole, including “to protect issuers.” Fifth Third argued that Miller’s statements evidenced that Visa’s Operating Regulations were intended not to benefit any individual member or class of members, but the Visa system as a whole.

Sovereign argued that Visa’s Operating Rules were specifically intended to benefit issuers. In addition to Miller’s testimony, it pointed to an August 1993 memo sent by Visa to its members that specifically alerted members of the (then) new requirements to delete magnetic stripe data (hereinafter referred to as “August 1993 Memo”).

That memo started off with the following:

To protect the Visa system and Issuers from potential fraud exposure created by databases of magnetic-stripe information, Section 6.21 has been revised. Effective September 1, 1993, the retention or storage of magnetic stripe data subsequent to the authorization of a transaction is prohibited. Acquirers are obligated to ensure that their merchants do not store the magnetic-stripe information from Visa Cards for any subsequent use.

Sovereign also relied on a May 2003 article printed online by Visa entitled “Issuers and Acquirers Are At Risk When Magnetic-Stripe Data Is Stored,” which indicated that magnetic stripe data compromises “impact[] Issuers” (hereinafter referred to as “May 1993 Memo).

The Appellate Court’s Decision and Reasoning

The Appellate Court considered the arguments by both sides and ultimately held that genuine issues of material fact did exist as to whether Sovereign was an intended beneficiary of the Member Agreement between Fifth Third and Visa, and therefore the case should be remanded for further proceedings (e.g. trial) rather than decided on a summary judgment motion.

The Appellate Court rejected Sovereign’s reliance on the May 2003 Memo, indicating that it simply stated the reason for the prohibition against retention of magnetic stripe data. However, the Appellate Court agreed that the August 1993 Memo and Miller’s “core purpose” testimony (referenced above), raised genuine issues of fact.

The court noted that Sovereign is a Visa member and that the core purpose the Operating Regulations according to Miller was to benefit members that participate in the Visa system. Just because Miller also indicated the Operating Rules were to benefit other stakeholders (such as cardholders, merchants and others who may participate in the system), the possibility that Visa intended to benefit individual users such as Sovereign was not negated.

Moreover, the Appellate Court held that the August 1993 Memo clearly stated that acquirers (such as Fifth Third) must act to protect Issuing Banks (like Sovereign) by ensuring that merchants (like BJW) do not retain magnetic stripe data. The Appellate Court held that this piece of evidence alone was sufficient to get Sovereign past summary judgment. Based on the foregoing, the Appellate Court remanded Sovereign’s breach of contract claim for further proceedings (e.g. trial in front of a judge or jury).

Analysis -- Increased Merchant PCI Liability

Similar to Minnesota’s Plastic Card Protection Act (discussed at this LINK), this decision has the potential to significantly increase the liability risk faced by merchants that are not compliant with PCI and that suffer a security breach.

First, although the Appellate Court’s breach of contract decision only involved the acquirer and the issuing bank, merchants such as BJW may ultimately be liable for the issuing bank’s costs. The source of this liability will also be contractual. However the contract at issue in this case is the direct contract between the merchant bank and the merchant (hereinafter “Merchant Agreement” -- see BJW Contract Relationship Chart). As the court ruled, this case will now be remanded to the lower court. A judge or jury could find Fifth Third liable to Sovereign for reissuance costs, or Fifth Third and Sovereign may settle the case based on the strength of Sovereign’s breach of contract claim. If Fifth Third wanted to recover the damages it paid to Sovereign, it may be able to rely on language in the Merchant Agreement between it and BJW to recover directly from BJW.

It is not atypical for a merchant to enter into a very one-sided Merchant Agreement with an acquiring bank (or the acquiring bank’s processor). Such Merchant Agreements often require the merchant to comply with the card association’s operating rules, security program and/or PCI. A sample of how such language may read is as follows:

Merchant agrees to comply with all security standards and guidelines that may be published from time to time by Visa or MasterCard and any other applicable industry security standards, including, without limitation, the Visa U.S.A. Cardholder Information Security Program (“CISP”), the MasterCard Site Data Protection (“SDP”), and the Payment Card Industry Data Security Standard (the “Security Requirements”).

If BJW agreed to comply with Visa’s Operating Rules and/or CISP, Fifth Third may have a right to recover any damages paid to Sovereign under a breach of contract theory (BJW having breached the Merchant Agreement).

In fact, merchant banks may have an explicitly contractual right to recover reissuance costs they are forced to pay issuing banks. It is likely that the Merchant Agreement requires the merchant to indemnify the merchant bank for liability it incurs because the merchant allowed a security breach. A sample of how such language might read is as follows:

Merchant agrees to indemnify Acquiring Bank, Member, the Associations, affiliates, officers, directors, employees, agents and issuing banks from any losses, expenses, costs, liabilities, and damages of any and every kind (including, without limitation, our costs, expenses, and reasonable legal fees) arising out of any claim, complaint, or chargeback caused by the merchant’s noncompliance with this Agreement, any Security Requirements or the Association Rules.

If similar language exists in the Merchant Agreement between BJW and Fifth Third, Fifth Third may demand that BJW indemnify it for any issuing costs that Fifth Third is required to pay to Sovereign. Of course, if BJW refuses, Fifth Third will again need to file a claim against BJW for breach of the Merchant Agreement. In short, by allowing an issuing bank to use the Visa Member Agreement to go after the merchant bank, the Appellate Court opened a path to merchant liability for the costs incurred by the issuing bank to reissue credit cards. The path starts with the Member Agreement, goes through the Merchant Agreement and ends up at the merchant.

PCI Compliance as a Defense – Existence of “Safe Harbor?”

Despite the existence of this contractual path to liability, the question arises whether a merchant’s compliance with the PCI and card association operating regulations will insulate the merchant from liability if it suffers a payment card security breach. Unfortunately, from the issuing bank’s point of view the merchant’s PCI compliance status is irrelevant – the issuing bank still must pay to reissue payment cards after a security breach of a PCI-compliant merchant. There are several points which may illuminate whether PCI compliance provides an automatic “safe harbor” from liability.

First, at least under the version in effect during the BJW case, according to the Appellate Court, issuing banks were not precluded by Visa Operating Rules from pursuing any available remedies at law. Thus, even if a merchant had fully complied with PCI and the applicable operating rules, an issuing bank’s status as a member of Visa or Mastercard does not block it from going after merchants. In fact, even if an issuing bank had agreed with Visa to refrain from pursuing merchants that were PCI compliant, the only party that could enforce that agreement would be Visa (unless, ironically, the merchant could be argued to be a third party beneficiary of the Member Agreement between Visa and the Issuing bank). Significantly, while compliance with the industry standard for protecting cardholder information will offer merchants a strong defense, it is still possible that a merchant could be liable under other theories of liability (e.g. negligence) if a court finds that the PCI standard itself is inadequate (see e.g. T.J. Hooper case).

Second, a PCI-compliant merchant’s liability will be largely contingent on the language set forth in the Member Agreement between the acquiring bank and the card association, and the Merchant Agreement between the acquiring bank and the merchant itself. If the Member Agreement makes the acquiring bank responsible for merchants’ security breaches in general (regardless of PCI compliance) and the Merchant Agreement requires the merchant to indemnify the acquiring bank for any losses, then the path to liability described above could apply. In such a case, in order to “block” the path from issuing bank through the Member Agreement, the Member Agreement would have to contain specific language providing a PCI “safe harbor” (alternatively, as discussed further below, the merchant may be able to negotiate a “safe harbor” in the Merchant Agreement to block the liability path).

Significantly, gaining access to the card associations’ operating rules and Membership Agreements has been notoriously difficult. Without the ability to read to those documents it may be hard to ascertain the scope of the liability risk under this theory since the merchant will not be aware of the merchant bank’s obligations to the card association in the event of a merchant security breach.

Limited Applicability?

Variations in the terms and conditions of Member Agreements and card association operating rules may also impact the path to merchant liability. As such, the holding in the BJW may not apply if there have been changes in subsequent versions of these documents. For example, if the current versions of Visa’s Member Agreement specifically precludes enforcement of the Merchant Agreement by third parties, then the issuing banks would not be able to use employ the 3^rd party beneficiary theory used by Sovereign. However, if the Member Agreement between the card association and acquirer bank remains silent, then the same rationale in the BJW decision could apply.

With respect to Visa’s Member Agreements, where intent is unclear, issuing banks may be able to rely on Mr. Miller’s deposition testimony in the BJW decision. As such, cases brought in jurisdictions that follow section 302 of the Restatement (Second) of Contracts may be prone to agree with the Appellate Court’s decision. Again, unfortunately, merchants will not be able to ascertain the full extent of their risk unless they can get access to the acquiring bank’s Member Agreement or be informed of whether it prohibits third party beneficiaries.

Merchant Actions to Potentially Reduce the Risk of Liability

There may be some steps that merchants can take to reduce their risk of liability for a payment card security breach. The BJW path to liability is a two step process. First the issuing bank must successfully sue the acquirer for breach of the Member Agreement between the card association and the acquirer, then the acquirer must pursue the merchant under the Merchant Agreement. Thus, merchants should consider both steps to determine the extent of their potential liability and for purposes of cutting off the path.

• Attempt to Determine Existence of 3^rd Party Beneficiary Prohibition in Member Agreement

The first step on the path to liability under the 3^rd party beneficiary theory is whether the Member Agreement between the card association and acquirer bank precludes third party enforcement of the Member Agreement. Merchants should ask their acquirer banks if they can examine their Member Agreement. It is likely, however, that the acquirer bank will be unwilling to provide the agreement itself. If not, the merchant should at least attempt seek assurances that there is a prohibition against third party beneficiaries. If the Merchant Agreement does not contain such a prohibition, then it is possible that the first step on the BJW liability path is open. Therefore, the merchant should seek to cut off the second step on the path, the Merchant Agreement.

• Negotiate a “Safe Harbor” in the Merchant Agreement

Obviously, the merchant has little control over what third party beneficiary terms its acquirer may have agreed to in the Member Agreement. However, a merchant does have some control over the terms it agrees to in its Merchant Agreement with its acquirer. It may be possible for a merchant to cut-off liability even if the issuing bank has been successful as a third party beneficiary of the Member Agreement. When entering into negotiations with acquirers (or their payment processors) merchants should attempt to negotiate a “safe harbor” into their Merchant Agreement. In essence, the safe harbor language would indicate that in the event of a security breach involving payment card information, if at the time of the breach the merchant was compliant with PCI and/or the card association’s operating rules, the acquirer would have no right to indemnification or any other recourse against the merchant. Rather than relying on (mostly likely) illusory safe harbors identified by the card associations, this would provide a direct right to avoid contractual liability if the merchant has done everything it promised with respect to PCI.

The parameters of the safe harbor should be defined to protect the merchant. First, the merchant agreement should identify a truly independent third party responsible for performing a post-breach PCI/operating rules audit, and set-up a process for the audit itself (note that one issue to consider is that the auditors findings will not be protected by attorney-client privilege, so caution is warranted). This third party would be the last word on whether the merchant was PCI-compliant at the time of the breach. Currently this post-incident response is performed by auditors hand-picked by the card associations, and some believe, because of close relationships these auditors have with the card associations, they could be less than “neutral” when performing these audits. Second, the standard for compliance should not be strict compliance. Rather, the merchant should be deemed to be compliant unless it is in material non-compliance with PCI. Finding technical non-compliance with some section of PCI or card association rules, as any security expert can tell you, is not difficult. Even better would be language requiring the non-compliance with PCI to be the actual cause of the security breach at issue – if the non-compliance was not in anyway relevant to the breach the merchant would not be liable. Last, if possible, the Safe Harbor should include indemnification from the acquiring bank if the merchant is PCI-compliant at the time of the breach. This would allow the merchant to cut off direct suits from other stakeholders (consumers, issuing banks, card associations). Admittedly, however, it will likely be difficult to convince an acquiring bank to go this far.

Whether a merchant will be able to negotiation a safe harbor or any other term of the Merchant Agreement will depend a large part on negotiating leverage. Larger merchants with clout, or any merchant willing to “shop around” between multiple acquiring banks, will be in the best position to negotiate favorable terms. Some of the same negotiating leverage issues apply for this route as well.

• Limitation of Liability

In addition, merchants should consider a limitation of liability that caps the merchant’s potential liability in the event of a security breach exposing credit card data. Merchants that have expended significant resources in becoming PCI compliant may be able to justify the cap more easily.

• Insure Against Payment Card Security Breaches

The insurance market has created information security and privacy liability policies which may cover liability arising out of a payment card breach. Since the risk of a security breach can never be 100% eliminated, insurance may be a good risk management tool to transfer unwanted risk. The key for utilizing insurance is to make sure the risk the merchant desires to transfer is actually transferred in light of the terms, conditions and exclusions in the insurance policy.

Conclusion

Merchants can no longer afford to treat PCI compliance as a pure security issue. Merchants should carefully analyze their PCI liability risk and determine ways to mitigate that risk. Laws like Minnesota’s Plastic Card Protection Act and the BJW decision have likely increased the risk significantly. The potential for huge damage is great - issuing banks have alleged that the costs of reissuing payment cards range from $20-$50 per card (multiplied by thousands or even millions of cards). For smaller and medium companies highly reliant on payment cards, the failure to address this risk ahead of time can mean bankruptcy. For larger retailers, the prospect of spending tens of millions of dollars defending and settling lawsuits against issuing banks and merchants should spur on a careful examination of all merchant agreements, and the possible shopping around for merchant banks and payment processors that provide reasonable terms.

As such, more than ever, merchants must work with their legal counsel and risk managers to understand and mitigate the risk. Merchant lawyers must analyze their clients’ current contractual relationships with acquiring banks and assist in negotiating favorable terms with payment processors and merchant banks. Since the risk is somewhat unpredictable and may be difficult to eliminate, information security and privacy risk insurance should also be considered. Lawyers should carefully analyze the scope of information security liability coverage to make sure their PCI risk is being transferred to the insurers. If the proper steps are taken, merchants may be able to avoid or mitigate significant losses in the event of a security breach.

The "Circle of Blame"

I prefer the "Chain of Blame" because of the better rhyme scheme... all kidding aside, Andrew Conry-Murray has done some good reporting on this story.

One money quote:

While PCI provides more concrete guidelines than, say, Sarbanes-Oxley, merchants are quick to complain that it's both too specific and too vague. For instance, the standard requires use of stateful packet inspection firewalls. "What if I choose to use another technology that I believe is equivalent?" says Michael Barrett, chief information security officer of PayPal, a Level 1 merchant. "You have a whole big fight with your auditors or you hold your nose and do it."

Level 1 merchants also clash with QSAs over issues such as "compensating controls"--technologies or processes used in place of specific requirements on the PCI checklist. "We believe our controls are adequate, but they are different from how the standard is written," Barrett says. "So you argue with auditors. Those kinds of things make you want to tear your hair out."

There's also a level of subjectivity in PCI that many find disturbing. The training for QSAs provides few guidelines for resolving this subjectivity. One PCI expert, who requested anonymity, says of the training: "When you ask if X or Y would be acceptable, or how to apply X in situation Y, they always answer 'Use your best judgment.'" He says that when others in the class pointed out how wildly their opinions could differ in a given situation, the instructor "had no answer other than to say 'do your best.'"

"It's a question of interpretation of the auditor, and the sophistication and skill set of the auditor," says Jay White, global information protection architect at Chevron, also a Level 1 merchant. "PCI was more painful than it had to be, but we've learned we have to help the auditors understand how we meet their objectives, even if they don't at first see it."

This lack of guidance can lead to significantly different approaches to compliance, even among auditors at the same Qualified Security Assessor. In one case, a company brought in a PCI expert to monitor a QSA's recommendations. The expert says the QSA had insisted the company deploy a million-dollar technical control when a simple change in operational procedure would have addressed the issue. "The assessment company then sent out someone completely different," the expert says, "and he disagreed with the recommendations of the prior QSA from his own company!"

This inconsistency can have significant repercussions for Level 1 merchants. If a merchant exposes card data, Visa dispatches a team of forensics security consultants to determine if the merchant was compliant with PCI at the time of the breach. "If a 'compliant' merchant gets compromised, I can guarantee you I can find at least one thing in the compliance report I could argue about," says the PCI expert. "This provides just enough wiggle room for the brands to point at the merchant or QSA and argue the standard was interpreted wrong."

Being judged noncompliant can result in substantial fines for the merchant and its acquiring bank, including higher per-transaction card processing fees. A judgment of noncompliance would also be useful to law firms contemplating action against the merchant.

More interesting points:

One major clothing retailer we spoke with said auditors examined four out of 1,000 stores, a sample size of just 0.4%. The retailer says all its stores share the same configuration and are centrally managed, but it's all too easy for security problems to go undiscovered with such small samples. "I could hide a multitude of sins from a QSA," says the PCI expert.

And while some retailers complain that auditors are too strict, the current system lets retailers seek out QSAs who may apply the standard less rigorously than others. "I've read several compliance reports that have been provided to us after the fact, and I wouldn't consider them appropriate," says the PCI expert. "They passed, but I don't know how." When asked if merchants are shopping for QSAs that provide an easy assessment, he says: "I can guarantee you that. Why wouldn't they?" Even the PCI Security Standards Council, which trains and certifies QSAs, admits that quality levels may not be consistent among the more than 100 active QSAs.

"It's a competitive game," says Bob Russo, general manager of the council. "One QSA might do an on-site assessment for X number of dollars, and another QSA will do the exact same assessment for less. A merchant thinks, 'If this guy is charging me $50K and this guy charges me $10K, there's a question there.'"

In response, the council is introducing a quality assurance program, due later this quarter, to ensure that all QSAs are performing assessments with the same rigor. "The goal is to make sure it's a level playing field so we don't have accusations from QSAs or merchants that some people are rubber-stamping," Russo says.

The question of rubber-stamping ties to the issue of liability. If a compliant merchant is breached, does the QSA bear any responsibility? It's a question that makes QSAs uncomfortable.

"Who's to say a retailer doesn't take what we say and toss it into the garbage?" says Barbara Mitchell, manager of security product marketing at Verizon. Along with Internet Security Systems and TrustWave, Verizon wins much of the assessment business for Level 1 merchants. "We should have some skin in the game, but if a retailer decides to not listen to our recommendations, it's a murky area," Mitchell says. "If we assume liability, we want to review all the stores, all the servers. That shoots the cost up to a prohibitive degree."

Retailers we spoke with were unclear about the liability question. "I think it would depend on whether our controls were deficient and on the audit process," says the network architect at the major clothing retailer. "I think there would be some level of liability, but we've not dug into that. There may be language in the contract I'm unaware of, but my focus has been on controls to prevent a breach rather than where we will point a finger." Unfortunately, finger-pointing is inevitable if credit card data gets stolen. "When a breach happens, if they see something out of whack, they will go back to the auditor, like Enron and Arthur Andersen," says Teri Quinn-Andry, product marketing manager for Cisco Security Solutions.

Then there's the problem of depending on what is, essentially, an honor system for Level 2, 3, and 4 merchants. There is no outside validation of a company's responses to the self-assessment questionnaire. "The reality is, you don't have to be compliant, if your business wants to take that risk," says the IT director of a Level 2 cruise ship operator.

"A lot with PCI is left to your interpretation," agrees Alan Stukalsky, CIO of Church's Chicken restaurant chain, also a Level 2 merchant.

So what does it all mean. I think it means a very volatile system with a lot of liability risk and uncertainty. I think it means that taking shortcuts could get both merchants that self-assess and QSAs into hot water (including hot water of the "going out of business" type for smaller merchants and QSAs). I think it means probably more comprehensive and expensive assessments when QSAs start getting hit with lawsuits.

So what can be done to smooth out the risk? More on that later from me... any thoughts from others?

Article Exploring PCI-related Risks in the Hannaford Breach

Interestingly, some reporters are digging deeper to explore the implications of a PCI-compliant company suffering a payment card breach: see here.

I think we don't have all the information so we everybody is engaging in various levels of speculation. However, we do know two facts: (1) compliance with PCI was represented in Hannaford's privacy policy (last visited 3-21-2008); and (2) there was a breach exposing cardholder data. In my view, here are some of the possibilities (in no particular order of likelihood, and by no means an exclusive ilst):

(1) the qualified security assessor (QSA) (or internal assessor) may have misinterpreted or loosely interpreted a section of the PCI standard (and the reality was there were security weaknesses);

(2) the PCI compliance may have been old or outdated (e.g. they may have been PCI compliant 9 months ago, but perhaps added new systems that were not secured consistently with PCI);

(3) Hannaford may not have provided all of the information to the QSA (assuming one was used) that it needed to validate its decision (e.g. this could include mistakes in defining which parts of Hannaford's networks were in-scope/out-of-scope);

(4) Hannaford may have been 100% PCI compliant and reasonably secure in general and just got unlucky (e.g. there is no such thing as 100% perfect security). Under this scenario, Hannaford would argue that it was not negligent because it did all the right things and that unfortunately these things just happen.

(5) Hannaford and/or its QSA may have had a security weakness or questions about an ambiguity and may have had either the PCI Council, its upstream payment processor or its merchant bank give a bad interpretation.

The interesting issue will be, assuming that some sort of negligence is shown, who was/is ultimately responsible? Hannaford? The QSA? A merchant bank that accepted Hannaford's certification?

Much more to come on this one.

Update: well that was quick. The class actions come flooding in.

Legislative Update: 2 New Plastic Card Protection Bills Pending (Alabama and Iowa)

Plastic Card Protection laws continue to be proposed in state legislatures. This time its Alabama and Iowa that are jumping into the fray with bills that incorporate the Payment Card Industry (“PCI”) Data Security Standard and/or provide financial institutions with the legal right to seek reimbursement for costs associated with payment card security breaches. However, the Iowa and Alabama bill provide some new wrinkles.

Alabama SB 382. Here are some of the wrinkles in the Alabama bill:

(1) Personal Information Deletion Requirement. Requires the deletion/destruction of personal information that is “longer necessary to be retained.”

(2) PCI Tie-In – PCI Section 3.2.. The bill prohibits the storage “in either encrypted or unencrypted form, subsequent to authorization, the card security code data, the PIN verification code data, the full contents of any track of a magnetic stripe or data chip, card-validation code, or value, or any other security information in a manner that permits access to an individual financial account.” This is essentially the same duty as section 3.2 of the PCI Standard. Note this language appears to go beyond payment card security since it relates to “any other security information that permits access to an individual financial account.” This language could possibly include passwords for online banking sites, online payment sites and other access codes tied to financial accounts (beyond credit card accounts).

(3) Financial Institutions Recovery of Reasonable Costs. Like other Plastic Card Protection laws, in the event the of a violation of the law and a security breach exposing personal information, the Alabama bill provides bank with the right to reimbursement for the reasonable costs of actions taken “to protect the personal information and account information of the customer or to continue to provide financial services to the customer,” including the costs to reissue cards, open/close accounts, contacting cardholders and refunds or credits made to customers.

(4) Private Cause of Action. In a new twist the bill specifically provides a private cause of action for financial institutions against those that “are responsible for the security breach.” The financial institution may receive not only actual damages, but also incidental and consequential damages, as well as court costs and reasonable attorney fees. Significantly, this language may help financial institutions recover damage elements that would be very difficult to recover under a traditional negligence claim.

Iowa S.S.B 3183. Here are some of the wrinkles in the Iowa bill:

(1) PCI Tie-In – Entire PCI Standard. The Iowa bill requires compliance with the entire PCI Standard by any entity that accepts a payment card in connection with transactions in the ordinary course of business. However, the bill also indicates that the Iowa attorney general must adopt rules necessary to implement the bill, including identifying the payment card industry standards to be applied.

(2) PCI Certification. Financial institutions initiating an action must request a certification of compliance from the party that suffered the security breach. The certification must be made by a payment card industry approved independent auditor. It appears that an action cannot be commenced against an entity that has not been found in violation of the PCI Standard.

(3) Financial Institutions Recovery of Reasonable Costs. The bill provides for the right to recover similar damage components as those in the Alabama bill.

(4) Attorney Fees for Prevailing Party. The bill provides that the prevailing party in an action will be entitled to recover attorney fees. However, if the prevailing party is an entity that has refused to certify PCI compliance it cannot recover attorney fees.

BOTTOMLINE: the legal liability will change radically if these bills get passed (like the Minnesota and Connecticut laws, as well as the bill in Washington State that has passed one house).

The Legal Implications, Risks and Problems of the PCI Data Security Standard

(**For an easier to read version of this article click HERE to download)

While starting off as “just” an information security standard, the Payment Card Industry Data Security Standard, v. 1.1 (“PCI” or “PCI Standard”) now presents serious legal challenges and risk for retailers. The PCI framework currently operates like a law without courts or regulators – there is no centralized body to resolve interpretative discrepancies in a consistent, precedental and binding manner. Moreover, in many cases PCI compliance is performed by security professionals with no attorney collaboration and little understanding of the legal risks involved. This article discusses the legal framework and implications PCI, the problems with the standard in the legal context, and actions that merchants should explore to reduce legal risk arising out of PCI.

PCI Background.

The PCI Standard is a grouping of six control objectives that a merchant, service provider or other entity subject to PCI must satisfy to secure cardholder data. The Standard has been universally adopted by the major payment card companies. However, each payment card company also has its own payment card security program (“Security Program”). The Security Programs are the definitional, procedural and enforcement rules and requirements of the payment card brands around payment card security. Examples include VISA’s Cardholder Information Security Program (VISA CISP) and MasterCard’s Site Data Protection. Security Programs dictate merchant level definitions, procedures, deadlines and documentation for validating PCI compliance, documentation requirements for security assessment, security incident response requirements and fines and penalties. So if a merchant deals with all the five major payment card brands, it must comply with not only the PCI Standard, but also each five separate Security Programs. All of this is enforced contractually.

The Legal Foundation of PCI – The PCI Contract Chain

Unlike security laws such as Gramm-Leach-Bliley, HIPAA and Sarbanes-Oxley, the PCI Standard and Security Program rules are not statutes or regulations enforced directly by the government. Rather, the PCI Standard and the Security Program rules are imposed and typically enforced contractually through the PCI Contract Chain.

At the top of the chain are the payment card companies. The payment card companies establish merchant relationships by working through “merchant” or “acquiring” banks. The contract between merchant banks and payment card companies is the first contractual relationship in the payment card industry chain. The merchant banks (or payment processors working with the merchant banks) process the payment card transactions for the payment card companies they partner with. If a merchant wants to be able to accept payment cards to transact business, it must be vetted by a merchant bank (or payment processor) and enter into a contractual relationship with that merchant bank (or payment processor). Finally, merchants sometimes enter into relationships with service providers for the processing, storage or transmittal of payment card data. As the final link in the chain, merchants and service providers will enter into contractual relationships.

This presents several legal issues:

(1) No Direct Contractual Relationship between Merchants and Payment Card Companies. The significance of the chain is that there is typically no direct contractual relationship between payment card companies and merchants. Therefore, generally speaking, merchants cannot be directly required to legally adhere to Security Programs or the PCI Standard by payment card companies. Rather, if any contractual obligations do exist they are passed through the contract that exists immediately upstream from the merchant (e.g. the contract between the merchant and merchant bank or payment processor). Nonetheless, in practical terms, payment card companies may be able force compliance by leveraging their relationships with merchants and access to payment card processing.

(2) No Direct Duty for Service Providers to Comply with PCI or Security Programs. There is typically no inherent duty for a merchant’s service providers to comply with the PCI Standard. Any duty for a service provider to comply with the PCI Standard will flow contractually from the merchant to the service provider (typically not from the payment card companies to the service provider). Therefore, unless merchants impose contractual obligations on their service providers, they may find themselves without leverage to force those service providers to become PCI compliant.

(3)A Merchant Compliance with PCI is Directly Contingent on Contractual Obligations Imposed on its Service Providers. Section 12.8 of the PCI Standard requires merchants to do the following:

If cardholder data is shared with service providers, then contractually the following is required:

12.8.1 Service providers must adhere to the PCI DSS requirements

12.8.2 Agreement that includes an acknowledgment that the service provider is responsible for the security of cardholder data the provider possesses.

If these duties are not contractually established then the merchant may not be able to establish its own compliance with PCI.

(4) Matching Upstream and Downstream Obligations and Risk. The scope of a merchant’s PCI obligations (including compliance with the PCI Standard and Security Programs) is dictated by its upstream contracts with merchant banks or service providers. Merchants must protect themselves by imposing upstream PCI contractual obligations and risks downstream to their service providers. So if a merchant agrees to pay fines and penalties for failure to comply with PCI, it should also require its service providers to pay any fines and penalties imposed on the merchant because of the service provider’s failure to comply.

The contractual nature of PCI makes it necessary for a merchant’s legal staff to understand and become involved in the PCI compliance process. Most of the issues outlined above require legal analysis, contract drafting and negotiation. Attorneys should develop strategies for limiting liability from upstream contracts, and passing liability downstream to service providers.

One area of special difficulty is existing service provider relationships. If a merchant faces fines or the loss of processing capability because its existing service providers are not PCI compliant, it could be difficult to re-open negotiations and force service providers to invest the time and resources to become PCI compliant. As such, before fines and threats start coming in, a merchant’s legal staff should be devising a strategy for addressing PCI contractually with existing service providers (as well as new providers). While these contractual issues are challenging, the transformation of PCI into a legal standard of care can pose even greater difficulties for an organization.

PCI as a Legal Standard of Care

The PCI Standard is transforming into the legal standard of care for merchants handling payment card data. As a result, merchants may find themselves liable to financial institutions and/or consumers if they fail to adhere strictly to the PCI Standard. Unfortunately, PCI compliance is often viewed purely as a security exercise without high (or any) involvement from a merchant’s legal team. As PCI increasingly becomes a legal standard, attorney participation (including the use of attorney-client privilege) is a necessity in order to decrease liability risk. This section discusses how PCI is evolving into a legal standard, including: (1) under the common law in support of a “negligence” claim; and (2) explicitly in recently proposed and passed State legislation.

• PCI as the Standard of Care for a Negligent Security Suit

Negligence is a legal theory of recovery that exists in “common law” – negligence claims do not involve laws passed by legislators or regulators. To prevail in a negligence suit, a plaintiff must establish the following: (1) a duty to use ordinary care; (2) breach of that duty; (3) a proximate causal connection between the negligent conduct and the resulting injury and (4) resulting damage. Negligence is a theory used to support liability actions as simple as slip-and-fall lawsuits to complex environmental disaster lawsuits.

In the PCI context, plaintiffs can allege negligence by arguing that a merchant handling payment card data has a duty to protect such data, and the failure to comply with the PCI Standard represents a breach of “ordinary care” if the merchant suffers a security breach. However, even if a breached duty can be established, plaintiffs still must prove that a security breach suffered by a merchant caused them damages. As discussed further below, while it has been difficult for consumer and financial institution plaintiffs to establish damages, recently passed and future legislation may make it easier for financial institutions to recover from merchants.

The use of the PCI Standard to support a negligence claim was recently demonstrated in the TJX matter. In that case several banks sued TJX for the costs to reissue credit cards (amongst others) in the wake of a massive security breach suffered by TJX involving millions of card numbers. To support their allegations of negligent security, the banks retained an expert to critique TJX’s security posture. That expert relied on TJX’s own PCI audit reports (performed by security firms hired by TJX) to argue that PCI breached its duty of ordinary care to protect payment card data. A copy of that expert opinion can be found by clicking here. The bank’s expert noted that TXJ’s auditors concluded that TJX satisfied only 3 of the 12 sections of PCI. In addition, the expert opinion noted specific security failures tied to the TJX breach that can also be traced back to PCI requirements. For example, TJX allegedly stored “Track 2” data which can be used to recreate the magnetic strip of a payment card, which would be a violation of section 3.2. of the PCI Standard. The end result was a $41 million settlement and tens of millions in legal fees and other costs.

It is uncertain to what extent TJX’s legal team was involved in the post-breach response, whether TJX took steps to try to shield its auditor’s actions with attorney-client privilege, and if so, whether it asserted that privilege in court. Nonetheless, it is clear that conducting a PCI audit and taking steps to comply with PCI has significant legal repercussions -- any adverse finding of non-compliance that is not shielded by attorney-client or attorney work product privilege can be used by plaintiffs against a merchant. These admissions of non-compliance can result in merchant liability, especially when used in conjunction with a new species of laws that requires adherence to PCI.

• Plastic Card Protection Laws – PCI Incorporated Into New State Laws

Even more troubling for merchants of all sizes, are new proposed bills, and at least two passed laws, that provide banks with a right to obtain reimbursement from merchants that suffer a security breach exposing payment card data. In essence, these bills allow banks to get around proving the “damages” element of a negligence claim, and arguably provide for “strict liability” in the event a merchant suffers a payment card security breach. Prior to such laws, financial institutions lost some high profile lawsuits, in part, because of an inability to prove damages (see for example the B.J. Wholesalers’ lawsuit: B.J. Wholesaler Summary Judgment Ruling and PSECU Motion to Dismiss).

Some of these Plastic Card Protection bills/laws directly incorporate PCI as the requisite security standard for payment card data.

Several States have proposed bills allowing banks to seek reimbursement for security breaches, including Massachusetts, Illinois, Connecticut, Texas, Minnesota, California, Michigan, Alabama, Iowa and Washington. While many of these bills are in limbo or may not pass, they demonstrate a willingness on the part of lawmakers to seriously consider relief for banks and incorporate PCI into law (TX, CA, MI, MN, IA and AL all tie PCI compliance to their bills).

In fact, Minnesota has actually passed laws providing banks with a right to seek reimbursement after a merchant suffers a breach. This law represents a paradigm shift in terms of merchant liability and compliance. The multiplier effect of damages for a payment card security breach (e.g. $20-50 allegedly per card multiplied by thousands or tens of thousands of exposed payment card numbers) has the potential to literally wipe out small and medium organizations, and severely damage even large companies. These costs were previously unrecoverable (or at least very difficult to recover) because of the pre-emptive nature of reissuing cards to avoid potential future fraud.

Minnesota’s Plastic Card Protection Act (“Act”) incorporates, in part, the requirements of Section 3.2 of the PCI Standard. To comply with the Act, companies accepting payment cards must destroy or delete sensitive authentication data (including the same “Track 2” data that TJX allegedly stored) within 48 hours of authorizing a transaction with such data (the “48-hour rule”). If a merchant violates the 48-hour rule and suffers a breach exposing payment card data, banks can recover reasonable costs associated with addressing that breach (including the costs of reissuing new payment cards, opening and closing accounts, etc.). This Act also applies to entities using service providers that store, process or transmit payment card data – a merchant that provides sensitive authentication data to a service provider will be in violation of the Act if its service provider does not comply with the 48-hour rule. The reach of the Act is potentially nationwide – merchants only need to be “doing business” in Minnesota for it to apply – the Act is not limited to the exposure of payment card data of Minnesota residents. “Doing business” in the legal context could be as simple as having a commercial website accessible in Minnesota.

Section 3.2 of PCI, in fact, prohibits the storage of sensitive authentication data for any period of time. So, if an organization is strictly in compliance with section 3.2 of PCI, it should also not be in violation of the 48-hour rule. Significantly, some of the other bills incorporating PCI incorporate multiple sections of PCI, and in the case of Washington State and Texas, the entire PCI Standard.

While these Plastic Card Protection laws do provide a direct path to liability, what is the problem for companies that consider themselves PCI compliant? As discussed further below, even for PCI compliant merchants, there are several problems that arise out of the PCI standard and framework, and the use of a private security standard as a public legal standard to be ruled on by judges and juries.

The next section explains the problems with PCI as a legal standard both in terms of its administration by the PCI Council and payment card companies, as well as the risk of handling PCI as solely a security matter.

PCI: A Law Without A Judge or Jury

The overarching problem with PCI is that it is a security standard that is becoming a law. Unfortunately, the PCI Standard was not necessarily drafted like law; nor is it interpreted like a law. Rather it is interpreted by non-lawyer security professionals solely as a security standard – either qualified security assessors (QSAs) or a merchant’s internal security team (in the case where a self-assessment is appropriate). There often may be no awareness as how security interpretations will be viewed by a court of law, and little to no lawyer involvement. In addition, unlike laws passed by lawmakers, there is no mechanism for resolving ambiguities or exceptions to the PCI Standard. No body similar to a court or regulator exists in the PCI context to create precedent or provide official guidance that can be relied upon by the merchant community to make compliance decisions.

• PCI Ambiguity

During the September 2007 PCI Council Meeting in Toronto it was revealed that there had been hundreds of questions submitted concerning the interpretative uncertainty arising out of the PCI Standard. Unfortunately, as PCI becomes a legal standard, the ambiguities inherent in the PCI Standard could lead to legal liability. The problem is compounded because there is no official body within the PCI framework to resolve those ambiguities and provide merchants with guidance on how to comply with PCI.

A good example is section 12.8 of the PCI Standard, which reads:

If cardholder data is shared with service providers, then contractually the following is required:

12.8.1 Service providers must adhere to the PCI DSS requirements

12.8.2 Agreement that includes an acknowledgment that the service provider is responsible for the security of cardholder data the provider possesses.

Although section 12.8 seems fairly straightforward, according to some QSAs and merchants this language is subject to various interpretations. The following represent the range of interpretations that may apply:

(1) Narrow interpretation: contract language indicates that service provider must adhere to the PCI Standard, which means that the minute the contract is effective the service provider must be PCI-compliant and the merchant should confirm such compliance;

(2) Middle-ground interpretation: contract language indicates that service provider agrees that it must adhere to the PCI Standard, which means that the minute the contract is effective the service provider must be PCI-compliant, but the merchant does not need to confirm such compliance, but rather can trust the service provider’s representation that it is compliant; and

(3) Loose interpretation: contract language indicates that the service provider agrees that it must adhere to the PCI Standard, but the merchant has discovered that the service provider has some controls that need to be implemented to achieve full PCI compliance and imposes a deadline after the effective date of the contract to achieve such compliance in the future. Under this interpretation, the QSA would be effectively interpreting a merchant to be in compliance with 12.8.1 as long as the service provider contractually promises to adhere to the PCI Standard during the contract term by a certain reasonable date, even if not compliant at the inception of the contract. Stated differently, it is the “magic words” in the contract that matter not whether the service provider is actually PCI compliant.

It appears that the middle-ground interpretation meets the literal requirements of the PCI Standard. However, if this was presented in a court of law, a plaintiff would argue for the narrow interpretation (e.g. is it reasonable or within the spirit of PCI to simply rely on a vendor’s promises without confirming actual compliance). Herein lies the problem: unless a merchant adheres to the strictest interpretation of the various sections of PCI, plaintiffs will always have arguments (and therefore leverage in a lawsuit) that the merchant was not in compliance with PCI. Remember, these lawsuits arise because the merchant has already suffered a security breach that will likely put the merchant in a negative light in front of a judge or jury. If the breach is at all related to the failure to comply with a section of PCI (and in many cases even if its not) the merchant will have a difficult time in court.

• No Centralized or Official Binding Precedent Setting Body

Unlike laws, which have courts and regulators to render opinions and issue interpretative guidance that is binding and can be relied upon for planning purposes, the current system for PCI is ad hoc, decentralized and inconsistent. It has no mechanism for rendering “binding” decisions on interpretive differences.

The following personal anecdote underscores this problem. Interpretative issues also arise under Section 12.8 with respect to new versus existing service provider relationships. For example, despite the indication that contractual language must be in place, at least one QSA has that it will pass a merchant on section 12.8 if the merchant gets a letter from its non-PCI compliant service provider indicating that the service provider intends to comply with PCI some time in the future. The QSA that asserted this position informed me that this approach had been approved by the PCI Council and/or payment card brands in some sort of writing. I attempted to get that writing from the QSA as well as a sample of a proper letter so I could advise my clients on this short-cut, but the QSA could not produce the document.

Therefore I attempted to communicate directly with the PCI Council on this issue. The PCI Council refused to answer my questions and confirm the short-cut despite the fact that this issue dealt directly with the PCI Standard (and not a payment card brand Security Program). Instead, the PCI Council told me I had to get an answer from each of the payment card companies. I followed through by sending the question to each of the five major payment card companies. Three companies simply did not reply (JCB, Discover and MasterCard). American Express replied, but indicated that it was not in a position to make that determination and that it was up to each merchant’s QSA to make the decision. A representative from VISA, however, provided a partial answer to my question:

In general, the Service Provider's legal counsel may provide the assessor documentation/letter that 12.8 requirement is being addressed in existing (or future) contracts despite not having the exact 12.8 language. The main goal is to stipulate the accountability for keeping the cardholder data secure and responsibility in any compromise event.

I asked for some further clarification on this answer, but there was no response to my follow-up e-mail.

There are several problems with this approach now that PCI has effectively become the law. First, its clear that there is no centralized decision-making body to render decisions on PCI ambiguities. The PCI Council passed the buck to the payment card brands, and AMEX passed the buck to the QSAs. There are hundreds of QSAs, so potentially hundreds of different interpretations. Moreover, each payment card company may have a different view of how to interpret 12.8. This does not take into account payment processors and merchant banks that are also known to take their own positions on PCI.

While VISA did provide an answer, it would likely not be binding upon any of the other card brands. In fact, since VISA’s comment is outside of a contractual setting it may not even be binding against VISA itself (e.g. there is no direct contractual relationship between VISA and the merchant).

Moreover, its typically consumers, payment card processors, issuing banks and merchant banks that would sue or fine a merchant because of a security breach. How would an email from VISA be binding on those organizations?

As PCI is becoming the law a system without a centralized decision-making body to resolve interpretative differences poses significant liability risks. Under a legal system, courts resolve interpretative differences in lawsuits or regulators provide interpretative guidance (see e.g. the HHS and HIPAA and the FTC and GLB). While that system is imperfect for several reasons, at least at the end of the day legally binding precedent is created. Organizations can rely on the court’s opinion or regulators’ guidance to make their own decisions on various interpretations with some certainty that those decisions will be legally binding. Those decisions and guidance are available for the entire world to read and they end up creating consistency across the business community in general.

Unfortunately, the PCI system is extremely decentralized and uncertainty abounds. The PCI Council reportedly may begin addressing this issue by issuing a series of “FAQs” to address interpretive issues. However, even with FAQs, the legally binding effect is uncertain. Are FAQs rendered by the PCI Council binding on merchant banks and payment processors that have contracts with merchants?

The PCI Council should consider establishing an official centralized body that renders interpretative decrees that become part of the PCI Standard itself and that are binding on all of the participants in the PCI contract chain. In addition, merchants should take steps to have their attorneys deeply involved in PCI compliance efforts to reduce the risk of liability – the Standard needs to be viewed as a law, not merely a security standard.

• Security Analysis versus Legal Analysis

The reality right now is that non-lawyer QSAs are making the essential decisions on PCI compliance for merchants. However, their interpretations of PCI are made through a security prism, not a legal prism. Moreover, some QSAs may accept looser interpretations of the PCI Standard because of economic incentives (e.g. preservation of client relationships) or pressure from their merchant clients to “pass” them.. While looser interpretations may be fine in the security world in some areas, some of those interpretations may be ripped apart when scrutinized by a plaintiff’s attorney and/or judge or regulator.

From a legal standpoint, merchants should assume that the narrowest interpretation of the PCI standard will be used against them in a court of law. Plaintiff’s attorneys will present expert witnesses who will testify in favor of the narrow and literal interpretations of PCI, and those experts will have the actual wording of the PCI Standard to back them up. In addition, those experts will use any and all adverse security assessment findings, including those made by the merchant’s own auditors, against them. If PCI is not approached through a legal prism (in addition to a security prism) the liability risk increases. Attorneys should be used to attempt to shield adverse assessment opinions as well as to scrutinize the security team or QSA’s interpretation of the PCI Standard. Attorneys should also be used to assist in the development of written policies and procedures, as well as documenting compliance with the PCI standard where appropriate. As the legal risks continue to grow, relying solely on security professionals for PCI compliance will not be an option.

Action Items for Merchants

As the PCI Standard increasingly becomes the law, merchants need to adjust their practices and develop a more legally-oriented approach to PCI compliance. On the security side merchants should consider the following:

(1) Choose QSA’s wisely. Right now QSAs are the interpretative bodies of PCI. If a merchant uses a “fly-by-night” QSA it may be opening itself to risk. Merchants should use QSAs that are not afraid to give the merchant “bad news” and that understand how their interpretations may be viewed in a court of law.

(2) Insurance. Make sure that your QSAs are fully insured for their errors and omissions, and try to get named as an additional insured on their policies if possible. In addition, the merchant should check its own policies to determine whether it is covered if one of its service providers suffers a breach or if the merchant is required to pay a fine or penalty for non-compliance with PCI.

(3) Not a Rubber Stamp. Despite potential pressures to become PCI compliant quickly and at the least cost, merchants should not view their QSAs as “rubber stamps” of PCI compliance. QSAs, like all professional service providers, enjoy happy clients and will work hard to please their clients. However, if this causes them to take short cuts or apply loose interpretations, it could come back to haunt the merchant in the long run.

(4) Develop Relationships with General Counsel. The merchant’s security team needs to engage the general counsel (or other members of the merchant’s legal team). Many attorneys are intimidated by technology and security issues and may not be aware of the legal issues surrounding PCI compliance. Internal security professionals need to act as the expert advisors to the merchant’s legal team and work together to translate security practices into legally compliant practices.

(5) Narrow Interpretations. To reduce risk of liability, security professionals should err on the side of interpreting the PCI Standard literally and narrowly. Of course this may conflict with other goals such as keeping expenses down and avoiding business disruptions. The security team should work with the merchant’s business decision-makers and risk managers to achieve a balance that reflects the organization’s risk tolerance.

The merchant’s legal team also needs to get involved in the PCI compliance process, including:

(1) Reaching Out to the Merchant’s Security Team. Security professionals are often intimidated or uncertain about the law. Security professionals are not lawyers, and they need information to understand how the legal system scrutinizes and judges their activities and decision-making process. The merchant’s legal team needs to translate legal and compliance concerns into terms that allow the merchant’s security team to implement legally compliant security controls.

(2) Use Attorney-Client Privilege. Any adverse PCI compliance finding or assessment can and will be used against a merchant in court. Moreover, drafts of security and privacy policies, and documents (e.g. emails) surrounding the creation of such policies and practices, can be used against an organization in court. Some of the activities and documents of a merchant’s internal and external security team may be shielded using attorney-client privilege or attorney work product privilege. While such privileges are not foolproof by any means, taking steps to preserve the privilege may at least pose an obstacle in litigation. Attorneys need to get involved early on in the compliance process to make this work.

(3) Analyze Upstream and Downstream PCI-Related Contracts. Much of the legal risk associated with PCI is contractual. Merchants cannot know their risk unless they know their contractual obligations and rights. Attorneys need to understand upstream contractual risk, and use their contracts to pass it on to service providers downstream.

(4) Draft Strong Service Provider Contracts. Attorneys should draft strong service provider contracts that require compliance not only with the PCI Standard itself, but also the specific Security Programs of each payment card company program that is applicable. These contracts should address section 12.8 of PCI, as well as providing assessment and audit rights, breach notice and remediation obligations, indemnification clauses and insurance clauses

(5) Develop a Service Provider Strategy. Service providers are likely to resist the imposition of additional PCI duties. A merchant’s legal team should have contract language and a negotiation strategy developed ahead of time. The strategy should address both new service provider relationships and existing service provider relationships. For existing relationships, the merchant may be highly dependent on its service provider and may lack leverage to re-open contract negotiations. Nonetheless, an approach should be developed to persuade existing service providers to become PCI-complaint before the merchant is fined or receives threats to have its payment card processing privileges revoked because of the service provider’s non-compliance.

(6) Strict Compliance – Upstream Waiver. If strict compliance with PCI is not possible, try to get a written waiver from the merchant’s upstream contractor (e.g. payment processor merchant bank). The best case scenario is to get a formal amendment to the upstream contract reflecting the waiver. While this may not fully protect the merchant from third party suits, it may be helpful in contract disputes with the upstream contractor.

Conclusion

As the legal ramifications of PCI continue to develop and increase, PCI compliance will become an increasingly risky endeavor for merchants. Unfortunately, because the system is run privately by the payment card companies and does not have a centralized body to provide binding guidance and rulings, the system may pose more risk than a traditional governmental regulatory scheme. Regardless, now is the time for merchants to begin engaging their legal teams to address PCI compliance, and opening the lines of communication between the lawyers and security pros. It is also the time to start pressuring the PCI Council and payment card brands to develop a centralized body to provide publicly available and binding guidance and decisions resolving ambiguities within PCI. If these actions are not taken, the PCI Standard could present significant liability challenges for the retail community.