Who Killed PayPal?

"Consumer advocates" can make life miserable for consumers.

Radley Balko from the August/September 2005 issue

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Next came a rash of lawsuits. Some came from competitors who Jackson says sought to cash in on a company keen to deflect negative publicity so close to its public offering. The first lawsuit, for example, was from a company called CertCo, which claimed PayPal's payment system violated one of its patents. It was settled for what the terms called a "non-consequential" payment.

But class action suits followed--four during one four-month stretch of 2001 alone. Some illustrated the damned-if-you-do, damned-if-you-don't dynamics of running a small business. MasterCard, for example, fined PayPal $313,600 for excessive credit card "charge backs" (that is, credit refunds), a good indicator that the service was being used for fraud. As mentioned, Levchin and the company's tech team had addressed those problems and cut fraud by a third. But those anti-fraud measures triggered more scrutiny. One class action suit accused the company of mistakenly freezing the accounts of several users for up to a week while it investigated suspicious activity.

Finally, the politicians and regulators came calling. Just hours before PayPal was set to go public, the state of Louisiana ordered it to terminate all business in that state, asserting that the company had failed to obtain a "money transfer license," which many states require from anyone in the businesses of cashing checks, transmitting money, or exchanging currency. New York threatened a similar order. The Louisiana decree was issued under the pretense of "protecting consumers," though terminating service in that state would have left all of Louisiana's PayPal-using auctioneers in the lurch.

The company managed to negotiate its way through these obstacles, and in early 2002 PayPal successfully launched its IPO. Salomon Smith Barney priced the initial 5.4 million shares available to the public at $12 to $14 each. The entire company consisted of 60 million shares, giving PayPal a market value of $720 million to $840 million. On the first morning of trading, under the ticker symbol PYPL, PayPal opened at $13 per share but jumped to $18 within minutes. Shares peaked at $22 in the mid-afternoon before settling at a little more than $20 at the close of trading. The 50 percent increase represented the first successful IPO since September 11 and a significant achievement for an e-commerce company in the post�tech bubble market.

But PayPal's regulatory troubles persisted. The banking industry had tried and failed several times to set up competitors to PayPal and Billpoint. As entrenched industries often do, it turned to government when its efforts in the marketplace failed. Oregon, California, Illinois, and Louisiana subsequently sent Billpoint notices that it had failed to get a money transfer license. A director from the American Banking Association told CNET that online payment services should be classified and regulated as commercial banks--a move that likely would have killed off all online payment services except those run by existing banks.

More class actions followed. New York Attorney General Eliot Spitzer cited PayPal for posting a user agreement that "wasn't clear enough." He also subpoenaed all documents pertaining to PayPal's use in online gaming sites, suggesting the company was in violation of New York gambling laws. Spitzer's investigation was followed by a U.S. Justice Department determination that PayPal's use by gaming sites was a violation of the USA PATRIOT Act.

The financial pressures of battling aggressive government officials and opportunistic class action lawyers, all while trying to stave off a better-funded competitor, soon became too much for the still-young company to bear. "It was clear," Jackson writes, "that PayPal now faced many challenges outside the marketplace. Entrepreneurial nimbleness may have helped us survive the company's post-merger internal turmoil and Billpoint's fierce competitive charge, but these new threats would require a different approach."

In July 2002 PayPal executives sold the start-up firm to their longtime nemesis, eBay. Jackson notes that the sale had some obvious benefits. The company's new parent already had a formidable, well-funded legal team in place to deal with PayPal's litigation and regulation troubles. Also, eBay promised to do away with Billpoint, essentially securing PayPal's position as the premier online payment provider.

But there were significant drawbacks too--most of them for consumers. Instead of allowing its customers to transact voluntarily with anyone they please, eBay, whose conciliatory approach is touted within the company as its "culture of community," settled the PATRIOT Act charge with the Justice Department for $10 million and agreed to bar its customers from using the service for online gambling. Shortly thereafter, PayPal announced the even stricter policy that ensnared Quick and Merritt (though both accounts were later reactivated). The new terms of service prohibited the use of PayPal not only for adult-oriented purchases but for "non-adult services whose Web site marketing can be reasonably misconstrued as allowing adult material or services to be purchased using PayPal."

PayPal today is a far cry from Thiel and Levchin's dream. It's a far cry even from pre-IPO PayPal. Most of the bright young minds Thiel brought in to get the company airborne left shortly after the takeover. Safely nestled within the belly of the eBay monopoly, and without Billpoint to foster a competitive itch, PayPal is far removed from the market forces that sparked the rapid innovation and entrepreneurial fire that marked its early days. Blogs bristle about PayPal's unfriendly terms of service, its difficult account management, and its tendency to freeze accounts and bar access to the assets in them. Two popular sites, paypalsucks.com and paypalwarning.com, have sprung up to document user frustrations.

PayPal's story is a sad but instructive lesson in how this country treats its entrepreneurs. PayPal is huge and growing. With eBay branding, it now boasts 73 million users, making it by far the largest online payment service. But it's nothing like what it was intended to be: a way for people to protect the money they earn from greedy governments and protect private purchases from the prying eyes of regulators. Greedy governments and prying regulators saw to that. The company sold out to eBay not because eBay beat it in the marketplace, not because eBay offered a better product, and not to reap a financial windfall for PayPal employees. PayPal sold out because, after the beating it took from those claiming to represent the interests of consumers, selling itself was the only way to keep the company alive. Exactly how consumers benefited from that isn't clear.