Interest free loans: why should they be regulated?

In recent days an increasingly popular high-cost short-term credit called 'buy now pay later' (BNPL) is frequently in the news headlines. BNPL is a type of loan that enables consumers to delay the payment; usually 14 to 30 days in full or to spread the cost over several months in installments. The attractive feature of the loan is that it is interest-free. 

This loan is essentially used when consumers buy goods online. The option to defer or slice up payment comes up at check out (for more see here). Unsurprisingly, the product is very popular with younger generations (so-called millennials and Generation Z). However, 'fashion-conscious' shoppers are not the only consumers of this product; it is increasingly being used by those in financial difficulties. On the provider side, BNPL is a world of fintech, many established and newly emerged financial technology companies such as Klarna and Paypal are offering this product, even the highly successful and popular Revolut is currently working on developing their own BNPL. Most recently Amazon teamed up with Affirm to offer BNPL to their customers.

However, as with any credit product, BNPL is not without dangers. Research shows BNPL users might not be fully aware of the potential of this product to contribute to the accumulation of large debt. The seemingly innocent, interest-free feature of the product encourages consumers to spend irresponsibly and beyond their means. BNPL tends to be heavily advertised, often resulting in unplanned and impulsive purchases. Klarna even commissioned a research study into consumers' shopping behavior, providing evidence for partner retailers on 'how to persuade shoppers to make 'emotional' purchases instead of 'logical' ones'. Although free to enter into the contract; for consumers who do not pay back the loan on time or miss a payment, the BNPL product acts as any other loan. It potentially triggers additional fees and charges such as late payment charges, and even (backdated) interest; impacts the consumer's creditworthiness and credit score; and it is subject to debt enforcement and potentially harmful debt collection practices. In the UK around the third of BNPL customers faced these consequences.

Given the nature of these credit products and the way they are sold, there is no question BNPL loans deserve regulatory attention. It is particularly positive that the EU Commission's newly presented Proposal for a Directive on Consumer Credits now proposes to regulate interest-free credit and thus these types of loans. 

Loan extension fees are within 'total cost of credit' - the CJEU in C-686/19 Soho Group

Yesterday the CJEU delivered another interesting judgment on consumer credit, C-686/19 Soho Group v Pateretaju tiesibu aizsardzibas centrs. This time the case involved the interpretation of Art. 3(g) of Directive 2008/48/EC and the question whether the term 'total cost of credit' includes loan extension fees.

The facts

Soho Group is a Latvian high cost short term credit provider, specializing in loans between 70-425 EUR for the duration of 30 days to 12 months. In performing its supervisory function the Latvian Consumer Protection Authority discovered that the firm charged high fees for extending the duration of the loan, breaching the relevant Latvian law that capped the total cost of credit. Consequently, the authority imposed a 25000 EUR fine on the firm that triggered the relevant national court process for the preliminary reference.

The legal question

The legal question in front of the court was whether the contract extension fee was within 'total cost of credit' provided by  Art. 3(g) of the Directive and implemented into the relevant national law. 

The ruling

The CJEU ruled in favor of the Consumer Protection Authority finding that the term 'total cost of credit' needs to be interpreted to include fees for the extension of the duration of the loan provided: the conditions for the possibility of the extension are laid down clearly and precisely in the relevant standard terms and conditions of the contract and that the costs are known to the creditor. 

In reaching this conclusion, the CJEU was guided by four considerations. 

First, the fairly broad language of Art. 3(g) provides that the 'total cost of credit' includes all costs, including interest, commissions and taxes and any other fees which the consumer is required to pay except notarial fees. The definition even includes ancillary services such as insurance, if they are compulsory for obtaining the loan. Thus, the provision broadly includes all costs except notarial fees.

Second, referring to its previous case-law and the recitals of the Directive, the CJEU concluded that the provision applies not only to the understanding of total cost of credit necessary for the conclusion of the contract but also for its use, that is, performance.

Thirdly, the CJEU took into account that the 'total amount payable by the consumer' under Art. 3(h) means the sum of the total amount of the credit and the total cost of credit. Thus the CJEU reasoned that the two notions, the notion of a 'total cost of credit' and the 'total amount of credit' are mutually excluding concepts and consequently the 'total amount of credit' cannot contain any cost elements comprising the 'total amount payable by the consumer'. 

Finally, the CJEU also considered the aim of the Directive to provide a high level of consumer protection and to facilitate the creation of the internal market in consumer credit.

Our evaluation

This is another important decision on the clarification of the scope of the Directive. It is particularly important that it raises and answers a substantive question on the content of the contract rather than the provision of information. Most of the CJEU case -law tackles the meaning and scope of the creditors many information obligations. Understandably so given the overwhelmingly information approach of the Directive. In practice however many cost-related questions arise, and this is now a welcomed development that the CJEU had a chance to clarify the meaning of one of these provisions.

The 'consumer friendly' approach is positive and is also justified not just by the above reasoning of the CJEU but also the broader socio-economic circumstances in which these loans are consumed. High cost short term loans are usually used by the less well of or poor(er) consumers (see more here) and it is particularly unfair to charge high fees for them because they had to extend the duration of their loans. As the facts of the case state, and this is a common practical situation, consumers would normally ask for the extension of the loan to avoid default (that would trigger even higher fees and other unwanted circumstances such as  the effect of default on ones credit rating). 

Looking broader than the high cost short term loans in question, regulating ancillary fees is always a positive approach. Financial firms would use these to covertly achieve high profits, with very little market control over the amount of these fees and with uncertain application of legal control mechanisms such as the unfair terms legislation. Therefore, bringing loan extension fees under the control of the Directive via the notion of  the 'total cost of credit' may be necessary to provide the envisaged high level of protection for consumers.

* This comment is based on the Hungarian language version.

How much redress is too much? The case of the UK payday loans market

Yesterday the collapse of another payday lender in the UK hit the headlines of BBC News. WageDay Advance, a middle-sized payday lender went into administration earlier this year due to a surge of claims for compensation for mis-sold loans. This follows the collapse of Wonga, the largest payday lender in the UK that went into administration last year for the same reason. So what exactly is going on?

Background

Payday loans are unsecured loans for a small amount of cash (usually between £100-1000)  for a short period of time. Traditionally they were repaid before the next payday (hence their name) although nowadays they may last up to 1 year. This type of financing is very popular in the UK, and has caused a lot of detriment to consumers in the past.

Advertisements targeted children and vulnerable adults, the loans were given to everyone without proper creditworthiness assessments, the application process was simple and easy, the basic price was extremely high (the annual percentage rate of charge of a Wonga loan could be as much as 5853%), and multiple extensions involving additional fees and charges were routine. Consumers who easily found themselves trapped in debt, were subject to unfair treatment and aggressive debt collection often being left without essential funds to live on. 

Needless to say payday loans gained considerable public attention, and hence when the Financial Conduct Authority (FCA) took over the regulation and supervision of consumer credit from the former Office of Fair Trading, the regulation of the payday loans market came top of its list of priorities. The Financial Services and Markets Act 2000 as amended in 2012 equipped the FCA with very significant powers, including to regulate the features of a financial products or to ban them completely (product regulation power) and a power to order consumer redress (so called regulatory redress power). Using these powers the FCA decided to keep payday loans on the market subjecting them to detailed rules and to robust enforcement. 

The initial forecast was that the new regime that made payday loans a much less attractive business than would drive out most of the firms. This has not happened (for more on the new regime for payday loans in the UK see my paper here), with a fair number of firms remaining in the market and operating under the new regime.

Reasons for failure 

While the new rules stopping firms from earning excessive profits did not drive these firms out from the market, their life was ended by the new approach to enforcement.  

Accepting the new regime meant complying with the stringent regulatory regime. It also meant  in the eyes of at least some lenders, that they needed to improve their public image and to establish a cooperative relationship with the FCA. In this effort, Wonga voluntarily agreed to compensate consumers for wrongdoings in lending irresponsibly before before the new regime. Within the redress scheme Wonga agreed to contact affected consumers and explain whether they were entitled to compensation under the redress programme, and also to write off the outstanding debt for 330,000 customers and to enable 45,000 consumers to repay their debt free of interest and charges. Wonga also agreed to compensate customers for unfair and misleading debt-collection practices, for sending debt collection letters from non-existent law firms threatening legal action. This action affected some 45,000 consumers and cost Wonga around £2.6m. In 2015 Dollar Financial UK (known as The Money Shop) followed Wonga's steps and agreed with the FCA to compensate 147,000 consumers for irresponsible lending practices costing  the company £15.4 million. In 2016 CFO Lending become subject to a redress scheme, agreeing to compensate 97,000 consumers for various unfair commercial practices costing the firm £34m. And so the list continues....

CFO Lending could not bear the costs, and collapsed into administration in 2017. Wonga followed suit in 2018. These companies collapsed because they could not bear the costs of the redress scheme.

In addition to the redress schemes, another trend affected the well-being of these companies. Following the FCA's approach to enforcement as 'credible deterrence' providing for exemplary and spectacular punishments with maximum publicity, the media and money advise charities took up the problem (see an example here) advising consumers how to claim compensation for unfair, primarily, irresponsible lending practices. In addition, consumers protecting their own interests, claims management companies took interest in reclaiming mis-sold payday loans, to an extent, that claiming this type of compensation became one of the most common complaints directed to the Financial Ombudsman Service.

While it is unclear what exactly happened with Curo Transatlantic Limited trading as WageDay Advance it seems that payday firms that stayed on the UK market are now paying the price for their past behavior, either within a redress scheme agreed with the FCA and/or by a surge of claims from claims management companies and consumers.

The consequence of failure on consumers 

How does the failure of a company affects its customers? First of all, consumers who have loans need to continue with the repayments. However, consumers who were due compensation might have suffered harm. For instance, CFO Lending's capital was not enough to pay compensation to all consumers, and WageDay Advance's consumers are still unsure how much compensation they are going to get as it depends on the amount of revenues earned from loans being repaid. The prospect of these consumers is not very good. They will become unsecured creditors at the bottom of the scale, and are likely not to be repaid.


Concluding thoughts

The case-study of the UK payday loans firms show the importance and the power of effective enforcement tools, but at the same time, it also shows the  danger of having too robust enforcement that may ultimately harm consumers. It raises two important questions. First, should we care about the well-being of companies, and should the redress schemed be tailored to what is sustainable for the firm in question? 'Sustainable redress' would ultimately also serve the interests of consumers by boosting competition on the market, and arguably providing better services and products. Secondly, should the FCA and other regulators having similar schemes rethink their approach to enforcement and design the redress schemes to protect the collective interests of all affected consumers? Bearing in mind the collective interest of consumers would lead to a reduction of individual sums of compensation, but every affected customer would get their fair share. And finally, one might also think about combining the two approaches. Reducing the amounts of compensation to individual consumers to an extent to compensate every consumer and to provide for sustainable redress. What do you think?