PayPal sent an email on Feb 18 to Mark Coker, founder of e-book publisher and distributor Smashwords, saying it would "limit" the company's PayPal account unless Smashwords removed from its website e-books "containing themes of rape, incest, beastiality and underage subjects."

PayPal sent similar warnings to online publishers and booksellers including BookStrand.com and eXcessica, according to the Electronic Frontier Foundation, a non-profit that supports free speech, privacy and other individual rights in the digital world.

A PayPal spokesman confirmed that the company sent such notifications to companies but declined to identify specific recipients.

EFF and other groups including the Authors Guild, the American Booksellers Foundation for Free Expression and the Association of American Publishers are planning to send a letter to PayPal on Wednesday asking the company to reverse its policy.

PayPal "is now holding free speech hostage by clamping down on sales of certain types of erotica," the groups said, according to a draft of the letter sent to Reuters. "We strongly object to PayPal functioning as an enforcer of public morality and inhibiting the right to buy and sell constitutionally protected material."

PayPal said it was acting in part because banks and credit card companies it works with restrict such content, according to an email PayPal sent to Smashwords on February 24. Reuters obtained copies of the emails.

"Our banking partners and credit card associations have taken a very strict stance on this subject matter," PayPal said in the February 24 email. "Our relationships with the banking partners are absolutely critical in order to provide the online and mobile services we (offer) ... to our customers. Therefore, we have to remain in compliance with their rules, which prohibit content involving rape, bestiality or incest."

The move has caused an uproar in the publishing world, which is concerned that banks and credit card companies may be exerting too much control over what books can be written, published and read.

"You're dealing with American Express, MasterCard and Visa -- are they making these decisions?" said Albert Greco, a book-industry expert at the business school of Fordham University. "That seems very strange and it could well be a very big issue."

Spokespeople at American Express, MasterCard, Visa and big card-issuing banks JPMorgan Chase, Citigroup and Wells Fargo, did not respond to phone calls and emails seeking comment on Wednesday.

"We've had deep concerns about financial payment providers choosing what sorts of transactions they process," said Rainey Reitman, activism director at the Electronic Frontier Foundation.

"Speech on the Internet relies on companies that are supposed to act neutrally," she added. "When certain chains in this link suddenly decide to become arbiters of what people read, that's a problem. This is now affecting individual book readers' choices."

A PayPal spokesman said the company allows its service to be used for the sale of "erotic" books but added that the company has to draw the line "on certain adult content that is extreme or potentially illegal."

PayPal's decision is based solely on business factors, one of which is the company's agreements with card associations and banks, the spokesman added.

Fordham's Greco said PayPal has a right to choose what type of transactions its payments services will support.

Still, Smashwords founder Coker said that the rise of e-books has shifted more power in the book world to payment processors and banks.

In the past, readers walked into a physical bookstore and could purchase a book with cash, leaving such companies out of the equation.

"Electronic payments have become the oxygen of e-commerce and e-books, so PayPal, banks and credit card companies have enormous power," Coker said. "What right does a financial institution have to censor legal content? Authors are being caught in the middle."

(Editing by Steve Orlofsky)

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