Understanding regulatory intricacies of Payment Aggregator business

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-Siddarth Goel (finserv@vinodkothari.com)

Abstract

The penetration of electronic retail payments has witnessed a steep surge in the overall payment volumes during the latter half of the last decade. One of the reasons accorded to this sharp rise in electronic payments is the exponential growth in online merchant acquisition space. An online merchant is involved in marketing and selling its goods and/or services through a web-based platform. The front-end transaction might seem like a simple buying-selling transaction of goods or services between a buyer (customer) and a seller (merchant). However, the essence of this buying-selling transaction lies in the payment mode or methodology of making/accepting payments adopted between the customer and the merchant. One of the most common ways of payment acceptance is that the merchant establishes its own payment integration mechanism with a bank such that customers are enabled to make payments through different payment instruments. In such cases, the banks are providing payment aggregator services, but the market is limited usually to the large merchants only. Alternatively, merchants can rely upon third-party service providers (intermediary) that facilitate payment collection from customers on behalf of the merchant and thereafter remittance services to the merchant at the subsequent stage – this is regarded as a payment aggregation business.

The first guidelines issued by the RBI governing the merchant and payment intermediary relationship was in the year 2009[1]. Over the years, the retail payment ecosystem has transformed and these intermediaries, participating in collection and remittance of payments have acquired the market-used terminology ‘Payment Aggregators’. In order to regulate the operations of such payment intermediaries, the RBI had issued detailed Guidelines on Regulation of Payment Aggregators and Payment Gateways, on March 17, 2020. (‘PA Guidelines’)

The payment aggregator business has become a forthcoming model in the online retail payments ecosystem. During an online retail payment by a customer, at the time of checkout vis-à-vis a payment aggregator, there are multiple parties involved. The contractual parties in one single payment transaction are buyer, payment aggregator, payment gateway, merchant’s bank, customer’s bank, and such other parties, depending on the payment mechanism in place. The rights and obligations amongst these parties are determined ex-ante, owing to the sensitivity of the payment transaction. Further, the participants forming part of the payment system chain are regulated owing to their systemic interconnectedness along with an element of consumer protection.

This write-up aims to discuss the intricacies of the regulatory framework under PA Guidelines adopted by the RBI to govern payment aggregators and payment gateways operating in India. The first part herein attempts to depict growth in electronic payments in India along with the turnover data by volumes of the basis of payment instruments used. The second part establishes a contrast between payment aggregator and payment gateway and gives a broad overview of a payment transaction flow vis-à-vis payment aggregator. The third part highlights the provisions of the PA Guidelines and establishes the underlying internationally accepted best principles forming the basis of the regulation. The principles are imperative to understand the scope of regulation under PA Guidelines and the contractual relationship between parties forming part of the payment chain.

Market Dynamics

The RBI in its report stated that the leverage of technology through the use of mobile/internet electronic retail payment space constituted around 61% share in terms of volume and around 75% in share in terms of value during FY 19-20.[2] The innovative payment instruments in the retail payment space, have led to this surge in electronic payments. Out of all the payment instruments, the UPI is the most innovative payment instrument and is the spine for growth in electronic payments systems in India. Chart 1 below compares some of the prominent payment instruments in terms of their volumes and overall compounded annual growth rate (CAGR) over the period of three years.

The payment system data alone does not show the complete picture. In conformity with the rise in electronic payment volumes, as per the Government estimates the overall online retail market is set to cross the $ 200 bn figure by 2026 from $ 30 bn in 2019, at an expected CAGR of 30 %.[4] India ranks No. 2 in the Global Retail Development Index (GRDI) in 2019. It would not be wrong to say, the penetration of electronic payments could be due to the presence of more innovative products, or the growth of online retail has led to this surge in electronic payments.

What are Payment Aggregators and Payment Gateways?

The terms Payment Aggregator (‘PA’) and Payment Gateways (‘PG’) are at times used interchangeably, but there are differences on the basis of the function being performed. Payment Aggregator performs merchant on-boarding process and receives/collects funds from the customers on behalf of the merchant in an escrow account. While the payment gateways are the entities that provide technology infrastructure to route and/or facilitate the processing of online payment transactions. There is no actual handling of funds by the payment gateway, unlike payment aggregators. The payment aggregator is a front-end service, while the payment gateway is the back-end technology support. These front-end and back-end services are not mutually exclusive, as some payment aggregators offer both. But in cases where the payment aggregator engages a third-party service provider, the payment gateways are the ‘outsourcing partners’ of payment aggregators. Thereby such payments are subject to RBI’s outsourcing guidelines.

PA Transaction Flow

One of the most sought-after electronic payments in the online buying-selling marketplace is the payment systems supported by PAs. The PAs are payment intermediaries that facilitate e-commerce sites and merchants in accepting various payment instruments from their customers. A payment instrument is nothing but a means through which a payment order or an instruction is sent by a payer, instructing to pay the payee (payee’s bank). The familiar payment instruments through which a payment aggregator accepts payment orders could be credit cards, debit cards/PPIs, UPI, wallets, etc.

Payment aggregators are intermediaries that act as a bridge between the payer (customer) and the payee (merchant). The PAs enable a customer to pay directly to the merchant’s bank through various payment instruments. The process flow of each payment transaction between a customer and the merchant is dependent on the instrument used for making such payment order. Figure 1 below depicts the payment transaction flow of an end-to-end non-bank PA model, by way of Unified Payment Interface (UPI) as a payment instrument.

In an end-to-end model, the PA uses the clearing and settlement network of its partner bank. The clearing and settlement of the transaction are dependent on the payment instrument being used. The UPI is the product of the National Payments Corporation of India (NPCI), therefore the payment system established by NPCI is also quintessential in the transaction. The NPCI provides a clearing and settlement facility to the partner bank and payer’s bank through the deferred settlement process. Clearing of a payment order is transaction authorisation i.e., fund verification in the customer’s bank account with the payer’s bank. The customer/payer bank debits the customer’s account instantaneously, and PA’s bank transfers the funds to the PA’s account after receiving authorisation from NPCI. The PA intimates the merchant on receipt of payment and the merchant ships the goods to the customer. The inter-bank settlement (payer’s bank and PA’s partner bank) happens at a later stage via deferred net-settlement basis facility provided by the NPCI.

The first leg of the payment transaction is settled between the customer and PA once the PA receives the confirmation as to the availability of funds in the customer’s bank account. The partner bank of PA transfers the funds by debiting the account of PA maintained with it. The PA holds the exposure from its partner bank, and the merchant holds the exposure from the PA. This explains the logic of PA Guidelines, stressing on PAs to put in place an escrow mechanism and maintenance of ‘Core Portion’ with escrow bank. It is to safeguard the interest of the merchants onboarded by the PA. Nevertheless, in the second leg of the transaction, the merchant has its right to receive funds against the PA as per the pre-defined settlement cycle.

Regulatory approach towards PAs and PGs

The international standards and best practices on regulating Financial Market Infrastructure (FMI) are set out in CPSS-IOSCO principles of FMI (PFMI).[5] A Financial Market Infrastructure (FMI) is a multilateral system among participating institutions, including the operator of the system. The consumer protection aspects emerging from the payment aggregation business model, are regulated by these principles. Based on CPSS-IOSCO principles of (PFMI), the RBI has described designated FMIs, and released a policy document on regulation and supervision of FMIs in India under its regulation on FMIs in 2013.[6] The PFMI stipulates public policy objectives, scope, and key risks in financial market infrastructures such as systemic risk, legal risk, credit risk, general business risks, and operational risk. The Important Retail Payment Systems (IRPS) are identified on the basis of the respective share of the participants in the payment landscape.  The RBI has further sub-categorised retail payments FMIs into Other Retail Payment Systems (ORPS). The IRPS are subjected to 12 PFMI while the ORPS have to comply with 7 PFMIs. The PAs and PGs fall into the category of ORPS, regulatory principles governing them are classified as follows:

These principles of regulation are neither exclusive nor can said to be having a clear distinction amongst them, rather they are integrated and interconnected with one another. The next part discusses the broad intention of the principles above and the supporting regulatory clauses in PA Guidelines covering the same.

Legal Basis and Governance framework

The legal basis principle lays the foundation for relevant parties, to define the rights and obligations of the financial market institutions, their participants, and other relevant parties such as customers, custodians, settlement banks, and service providers. Clause 3 of PA Guidelines provides that authorisation criteria are based primarily on the role of the intermediary in the handling of funds. PA shall be a company incorporated in India under the Companies Act, 1956 / 2013, and the Memorandum of Association (MoA) of the applicant entity must cover the proposed activity of operating as a PA forms the legal basis. Henceforth, it is quintessential that agreements between PA, merchants, acquiring banks (PA’s Partners Bank), and all other stakeholders to the payment chain, clearly delineate the roles and responsibilities of the parties involved. The agreement should define the rights and obligations of the parties involved, (especially the nodal/escrow agreement between partner bank and payment aggregator). Additionally, the agreements between the merchant and payment aggregator as discussed later herein are fundamental to payment aggregator business. The PA’s business rests on clear articulation of the legal basis of the activities being performed by the payment aggregator with respect to other participants in the payment system, such as a merchant, escrow banks, in a clear and understandable way.

Comprehensive Management of Risk

The framework for the comprehensive management of risks provides for integrated and comprehensive view of risks. Therefore, this principle broadly entails comprehensive risk policies, procedures/controls, and participants to have robust information and control systems. Another connecting aspect of this principle is operational risk, arising from internal processes, information systems and disruption caused due to IT systems failure. Thus there is a need for payment aggregator to have robust systems, policies to identify, monitor and manage operational risks. Further to ensure efficiency and effectiveness, the principle entails to maintain appropriate standards of safety and security while meeting the requirements of participants involved in the payment chain. Efficiency is resources required by such payment system participants (PAs/PGs herein) to perform its functions. The efficiency includes designs to meet needs of participants with respect to choice of clearing and settlement transactions and establishing mechanisms to review efficiency and effectiveness. The operational risk are comprehensively covered under Annex 2 (Baseline Technology-related Recommendation) of the PA Guidelines. The Annex 2, inter alia includes, security standards, cyber security audit reports security controls during merchant on-boarding. These recommendations and compliances under the PA Guidelines stipulates standard norms and compliances for managing operational risk, that an entity is exposed to while performing functions linked to financial markets.

KYC and Merchant On-boarding Process

An important aspect of payment aggregator business covers merchant on-boarding policies and anti-money laundering (AML) and counter-terrorist financing (CFT) compliance. The BIS-CPSS principles do not govern within its ambits certain aspects like AML/CFT, customer data privacy. However, this has a direct impact on the businesses of the merchants, and customer protection. Additionally, other areas of regulation being data privacy, promotion of competition policy, and specific types of investor and consumer protections, can also play important roles while designing the payment aggregator business model. Nevertheless, the PA Guidelines provide for PAs to undertake KYC / AML / CFT compliance issued by RBI, as per the “Master Direction – Know Your Customer (KYC) Directions” and compliance with provisions of PML Act and Rules. The archetypal procedure of document verification while customer on-boarding process could include:

  • PA’s to have Board approved policy for merchant on-boarding process that shall, inter-alia, provide for collection of incorporation certificates, constitutional document (MoA/AoA), PAN and financial statements, tax returns and other KYC documents from the merchant.
  • PA’s should take background and antecedent checks of the merchants, to ensure that such merchants do not have any malafide intention of duping customers, do not sell fake/counterfeit/prohibited products, etc.

PAs shall ensure that the merchant’s site shall not save customer’s sensitive personal data, like card data and such related data. Agreement with merchant shall have provision for security/privacy of customer data.

Settlement and Escrow

The other critical facet of PA business is the settlement cycle of the PA with the merchants and the escrow mechanism of the PA with its partner bank. Para 8 of PA Guidelines provide for non-bank PAs to have an escrow mechanism with a scheduled bank and also to have settlement finality. Before understanding the settlement finality, it is important to understand the relevance of such escrow mechanisms in the payment aggregator business.

Escrow Account

Surely there is a bankruptcy risk faced by the merchants owing to the default by the PA service provider. This default risk arises post completion of the first leg of the payment transaction. That is, after the receipt of funds by the PA from the customer into its bank account. There is an ultimate risk of default by PA till the time there is final settlement of amount with the merchant. Hence, there is a requirement to maintain the amount collected by PA in an escrow account with any scheduled commercial bank. All the amounts received from customers in partner bank’s account, are to be remitted to escrow account on the same day or within one day, from the date amount is debited from the customer’s account (Tp+0/Tp+1). Here Tp is the date on which funds are debited from the customer’s bank account.  At end of the day, the amount in escrow of the PA shall not be less than the amount already collected from customer as per date of debit/charge to the customer’s account and/ or the amount due to the merchant. The same rules shall apply to the non-bank entities where wallets are used as a payment instrument.[7] This essentially means that PA entities should remit the funds from the PPIs and wallets service provider within same day or within one day in their respective escrow accounts. The escrow banks have obligation to ensure that payments are made only to eligible merchants / purposes and not to allow loans on such escrow amounts. This ensures ring fencing of funds collected by the PAs, and act as a deterrent for PAs from syphoning/diverting the funds collected on behalf of merchants. The escrow agreement function is essentially to provide bankruptcy remoteness to the funds collected by PA’s on behalf of merchants.

Settlement Finality

Settlement finality is the end-goal of every payment transaction. Settlement in general terms, is a discharge of an obligation with reference of the underlying obligation (whatever parties agrees to pay, in PA business it is usually INR). The first leg of the transaction involves collection of funds by the PA from the customer’s bank (originating bank) to the PA escrow account. Settlement of the payment transaction between the PA and merchant, is the second leg of the same payment transaction and commences once funds are received in escrow account set up by the PA (second leg of the transaction).

Settlement finality is the final settlement of payment instruction, i.e. from the customer via PA to the merchant. Final settlement is where a transfer is irrevocable and unconditional. It is a legally defined moment, hence there shall be clear rules and procedures defining the point of settlement between the merchant and PA.

For the second leg of the transaction, the PA Guidelines provide for different settlement cycles:

  1. Payment Aggregator is responsible for the delivery of goods/service– The settlement cycle with the merchant shall not be later than one day from the date of intimation to PA of shipment of goods by the merchant.
  2. Merchant is responsible for delivery– The settlement cycle shall not be later than 1 day from the date of confirmation by the merchant to PA about delivery of goods to the customer.
  3. Keeping the amount by the PA till the expiry of refund period– The settlement cycle shall not be later than 1 day from the date of expiry of the refund period.

These settlement cycles are mutually exclusive and the PA business models and settlement structure cycle with the merchants could be developed by PAs on the basis of market dynamics in online selling space. Since the end-transaction between merchant and PA is settled on a contractually determined date, there is a deferred settlement, between PA and the merchant.  Owing to the rules and nature of the relationship (deferred settlement) is the primary differentiator from the merchants proving the Delivery vs. Payment (DvP) settlement process for goods and services.

Market Concerns

Banks operating as PAs do not need any authorisation, as they are already part of the the payment eco-system, and are also heavily regulated by RBI. However, owing to the sensitivity of payment business and consumer protection aspect non-bank PA’s have to seek RBI’s authorisation. This explains the logic of minimum net-worth requirement, and separation of payment aggregator business from e-commerce business, i.e. ring-fencing of assets, in cases where e-commerce players are also performing PA function. Non-bank entities are the ones that are involved in retail payment services and whose main business is not related to taking deposits from the public and using these deposits to make loans (See. Fn. 7 above).

However, one could always question the prudence of the short timelines given by the regulator to existing as well as new payment intermediaries in achieving the required capital limits for PA business. There might be a trade-off between innovations that fintech could bring to the table in PA space over the stringent absolute capital requirements. While for the completely new non-bank entity the higher capital requirement (irrespective of the size of business operations of PA entity) might itself pose a challenge. Whereas, for the other non-bank entities with existing business activities such as NBFCs, e-commerce platforms, and others, achieving ring-fencing of assets in itself would be cumbersome and could be in confrontation with the regulatory intention. It is unclear whether financial institutions carrying financial activities as defined under section 45 of the RBI Act, would be permitted by the regulator to carry out payment aggregator activities. However, in doing so, certain additional measures could be applicable to such financial entities.

Conclusion

The payment aggregator business models in India are typically based on front-end services, i.e. the non-bank entitles are aggressively entering into retail payment businesses by way of providing direct services to merchants. The ability of non-bank entitles to penetrate into merchant onboarding processes, has far overreaching growth potential than merchant on-boarding processes of traditional banks. While the market is at the developmental stage, nevertheless there has to be a clear definitive ex-ante system in place that shall provide certainty to the payment transactions. The CPSS-IOSCO, governing principles for FMIs lays down a good principle-based governing framework for lawyers/regulators and system participants to understand the regulatory landscape and objective behind the regulation of payment systems. PA Guidelines establishes a clear, definitive framework of rights between the participants in the payment system, and relies strongly on board policies and contractual arrangements amongst payment aggregators and other participants. Therefore, adequate care is necessitated while drafting escrow agreements, merchant-on boarding policies, and customer grievance redressal policies to abide by the global best practices and meet the objective of underlying regulation. In hindsight, it will be discovered only in time to come whether the one-size-fits-all approach in terms of capital requirement would prove to be beneficial for the overall growth of PA business or will cause a detrimental effect to the business space itself.

 

[1] RBI, Directions for opening and operation of Accounts and settlement of payments for electronic payment transactions involving intermediaries, November 24, 2009. https://www.rbi.org.in/scripts/NotificationUser.aspx?Mode=0&Id=5379

[2] Payment Systems in India – Booklet (rbi.org.in)

[3] https://m.rbi.org.in/Scripts/AnnualReportPublications.aspx?Id=1293

[4] https://www.investindia.gov.in/sector/retail-e-commerce

[5] The Bank for International Settlements (BIS), Committee on Payment and Settlement Systems (CPSS) and International Organisation of Securities Commissions (IOSCO) published 24 principles for financial market infrastructures and  and responsibilities of central banks, market regulators and other authorities. April 2012 <https://www.bis.org/cpmi/publ/d101a.pdf>

[6]Regulation and Supervision of Financial Market Infrastructures, June 26, 2013 https://www.rbi.org.in/scripts/bs_viewcontent.aspx?Id=2705

[7] CPMI defines non-banks as “any entity involved in the provision of retail payment services whose main business is not related to taking deposits from the public and using these deposits to make loans”  See, CPMI, ‘Non-banks in retail Payments’, September 2014, available at <https://www.bis.org/cpmi/publ/d118.pdf>

 

Our other related articles:

Overview of Regulatory Framework of Payment and Settlement Systems in India by Anita Baid – Vinod Kothari Consultants

RBI to regulate operation of payment intermediaries – Vinod Kothari Consultants

Major recommendations of the Committee on Payment Systems on Payment and Settlement System Bill, 2018 – Vinod Kothari Consultants

Law relating to collective investment schemes on shared ownership of real assets

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-Vinod Kothari (finserv@vinodkothari.com)

The law relating to collective investment schemes has always been, and perhaps will remain, enigmatic, because these provisions were designed to ensure that enthusiastic operators do not source investors’ money with tall promises of profits or returns, and start running what is loosely referred to as Ponzi schemes of various shades. De facto collective investment schemes or schemes for raising money from investors may be run in elusive forms as well – as multi-level marketing schemes, schemes for shared ownership of property or resources, or in form of cancellable contracts for purchase of goods or services on a future date.

While regulations will always need to chase clever financial fraudsters, who are always a day ahead of the regulator, this article is focused on schemes of shared ownership of properties. Shared economy is the cult of the day; from houses to cars to other indivisible resources, the internet economy is making it possible for users to focus on experience and use rather than ownership and pride of possession. Our colleagues have written on the schemes for shared property ownership[1]. Our colleagues have also written about the law of collective investment schemes in relation to real estate financing[2]. Also, this author, along with a colleague, has written how the confusion among regulators continues to put investors in such schemes to prejudice and allows operators to make a fast buck[3].

This article focuses on the shared property devices and the sweep of the law relating to collective investment schemes in relation thereto.

Basis of the law relating to collective investment schemes

The legislative basis for collective investment scheme regulations is sec. 11AA (2) of the SEBI Act. The said section provides:

Any scheme or arrangement made or offered by any company under which,

  • the contributions, or payments made by the investors, by whatever name called, are pooled and utilized solely for the purposes of the scheme or arrangement;
  • the contributions or payments are made to such scheme or arrangement by the investors with a view to receive profits, income, produce or property, whether movable or immovable from such scheme or arrangement;
  • the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors;
  • the investors do not have day to day control over the management and operation of the scheme or arrangement.

The major features of a CIS may be visible from the definition. These are:

  1. A schematic for the operator to collect investors’ money: There must be a scheme or an arrangement. A scheme implies a well-structured arrangement whereby money is collected under the scheme. Usually, every such scheme provides for the entry as well as exit, and the scheme typically offers some rate of return or profit. Whether the profit is guaranteed or not, does not matter, at least looking at the definition. Since there is a scheme, there must be some operator of the scheme, and there must be some persons who put in their money into the scheme. These are called “investors”.
  2. Pooling of contributions: The next important part of a CIS is the pooling of contributions. Pooling implies the contributions losing their individuality and becoming part of a single fungible hotchpot. If each investor’s money, and the investments therefrom, are identifiable and severable, there is no pooling. The whole stance of CIS is collective investment. If the investment is severable, then the scheme is no more a collective scheme.
  3. Intent of receiving profits, produce, income or property: The intent of the investors contributing money is to receive results of the collective investment. The results may be in form of profits, produce, income or property. The usual feature of CIS is the operator tempting investors with guaranteed rate of return; however, that is not an essential feature of CISs.
  4. Separation of management and investment: The management of the money is in the hands of a person, say, investment manager. If the investors manage their own investments, there is no question of a CIS. Typically, investor is someone who becomes a passive investor and does not have first level control (see next bullet). It does not matter whether the so-called manager is an investor himself, or may be the operator of the scheme as well. However, the essential feature is there being multiple “investors”, and one or some “manager”.
  5. Investors not having regular control over the investments: As discussed above, the hiving off of the ownership and management of funds is the very genesis of the regulatory concern in a CIS, and therefore, that is a key feature.

The definition may be compared with section 235 of the UK Financial Services and Markets Act, which provides as follows:

  • In this Part “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
  • The arrangements must be such that the persons who are to participate (“participants”) do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions.
  • The arrangements must also have either or both of the following characteristics—
  • the contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
  • the property is managed as a whole by or on behalf of the operator of the scheme.
    • If arrangements provide for such pooling as is mentioned in subsection (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single collective investment scheme unless the participants are entitled to exchange rights in one part for rights in another.

It is conspicuous that all the features of the definition in the Indian law are present in the UK law as well.

Hong Kong Securities and Futures Ordinance [Schedule 1] defines a collective investment scheme as follows:

collective investment scheme means—

  • arrangements in respect of any property—
  • under which the participating persons do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management;
  • under which—
  • the property is managed as a whole by or on behalf of the person operating the arrangements;
  • the contributions of the participating persons and the profits or income from which payments are made to them are pooled; or
  • the property is managed as a whole by or on behalf of the person operating the arrangements, and the contributions of the participating persons and the profits or income from which payments are made to them are pooled; and
  • the purpose or effect, or pretended purpose or effect, of which is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive—
  • profits, income or other returns represented to arise or to be likely to arise from the acquisition, holding, management or disposal of the property or any part of the property, or sums represented to be paid or to be likely to be paid out of any such profits, income or other returns; or
  • a payment or other returns arising from the acquisition, holding or disposal of, the exercise of any right in, the redemption of, or the expiry of, any right, interest, title or benefit in the property or any part of the property; or
  • arrangements which are arrangements, or are of a class or description of arrangements, prescribed by notice under section 393 of this Ordinance as being regarded as collective investment schemes in accordance with the terms of the notice.

One may notice that this definition as well has substantially the same features as the definition in the UK law.

Judicial analysis of the definition

Part (iii) of the definition in Indian law refers to management of the contribution, property or investment on behalf of the investors, and part (iv) lays down that the investors do not have day to day control over the operation or management. The same features, in UK law, are stated in sec. 235 (2) and (3), emphasizing on the management of the contributions as a whole, on behalf of the investors, and investors not doing individual management of their own money or property. The question has been discussed in multiple UK rulings. In Financial Conduct Authority vs Capital Alternatives and others,  [2015] EWCA Civ 284, [2015] 2 BCLC 502[4], UK Court of Appeal, on the issue whether any extent of individual management by investors will take the scheme of the definition of CIS, held as follows:  “The phrase “the property is managed as a whole” uses words of ordinary language. I do not regard it as appropriate to attach to the words some form of exclusionary test based on whether the elements of individual management were “substantial” – an adjective of some elasticity. The critical question is whether a characteristic feature of the arrangements under the scheme is that the property to which those arrangements relate is managed as a whole. Whether that condition is satisfied requires an overall assessment and evaluation of the relevant facts. For that purpose it is necessary to identify (i) what is “the property”, and (ii) what is the management thereof which is directed towards achieving the contemplated income or profit. It is not necessary that there should be no individual management activity – only that the nature of the scheme is that, in essence, the property is managed as a whole, to which question the amount of individual management of the property will plainly be relevant”.

UK Supreme Court considered a common collective land-related venture, viz., land bank structure, in Asset Land Investment Plc vs Financial Conduct Authority, [2016] UKSC 17[5]. Once again, on the issue of whether the property is collective managed, or managed by respective investors, the following paras from UK Financial Conduct Authority were cited with approval:

The purpose of the ‘day-to-day control’ test is to try to draw an important distinction about the nature of the investment that each investor is making. If the substance is that each investor is investing in a property whose management will be under his control, the arrangements should not be regarded as a collective investment scheme. On the other hand, if the substance is that each investor is getting rights under a scheme that provides for someone else to manage the property, the arrangements would be regarded as a collective investment scheme.

Day-to-day control is not defined and so must be given its ordinary meaning. In our view, this means you have the power, from day-to-day, to decide how the property is managed. You can delegate actual management so long as you still have day-to-day control over it.[6]’

The distancing of control over a real asset, even though owned by the investor, may put him in the position of a financial investor. This is a classic test used by US courts, in a test called Howey Test, coming from a 1946 ruling in SEC vs. Howey[7]. If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.

The financial world and the real world

As is apparent, the definition in sec. 235 of the UK legislation has inspired the draft of the Indian law. It is intriguing to seek as to how the collective ownership or management of real properties has come within the sweep of the law. Evidently, CIS regulation is a part of regulation of financial services, whereas collective ownership or management of real assets is a part of the real world. There are myriad situations in real life where collective business pursuits,  or collective ownership or management of properties is done. A condominium is one of the commonest examples of shared residential space and services. People join together to own land, or build houses. In the good old traditional world, one would have expected people to come together based on some sort of “relationship” – families, friends, communities, joint venturers, or so on. In the interweb world, these relationships may be between people who are invisibly connected by technology. So the issue, why would a collective ownership or management of real assets be regarded as a financial instrument, to attract what is admittedly a  piece of financial law.

The origins of this lie in a 1984 Report[8] and a 1985 White Paper[9], by Prof LCB Gower, which eventually led to the enactment of the 1986 UK Financial Markets law. Gower has discussed the background as to why contracts for real assets may, in certain circumstances, be regarded as financial contracts. According to Gower, all forms of investment should be regulated “other than those in physical objects over which the investor will have exclusive control. That is to say, if there was investment in physical objects over which the investor had no exclusive control, it would be in the nature of an investment, and hence, ought to be regulated. However, the basis of regulating investment in real assets is the resemblance the same has with a financial instrument, as noted by UK Supreme Court in the Asset Land ruling: “..the draftsman resolved to deal with the regulation of collective investment schemes comprising physical assets as part of the broader system of statutory regulation governing unit trusts and open-ended investment companies, which they largely resembled.”

The wide sweep of the regulatory definition is obviously intended so as not to leave gaps open for hucksters to make the most. However, as the UK Supreme Court in Asset Land remarked: “The consequences of operating a collective investment scheme without authority are sufficiently grave to warrant a cautious approach to the construction of the extraordinarily vague concepts deployed in section 235.”

The intent of CIS regulation is to capture such real property ownership devices which are the functional equivalents of alternative investment funds or mutual funds. In essence, the scheme should be operating as a pooling of money, rather than pooling of physical assets. The following remarks in UK Asset Land ruling aptly capture the intent of CIS regulation: “The fundamental distinction which underlies the whole of section 235 is between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value; and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can be either pooled or managed in common, in return for a share of the profits generated by the collective fund.”

Conclusion

While the intent and purport of CIS regulation world over is quite clear, but the provisions  have been described as “extraordinarily vague”. In the shared economy, there are numerous examples of ownership of property being given up for the right of enjoyment. As long as the intent is to enjoy the usufructs of a real property, there is evidently a pooling of resources, but the pooling is not to generate financial returns, but real returns. If the intent is not to create a functional equivalent of an investment fund, normally lure of a financial rate of return, the transaction should not be construed as a collective investment scheme.

 

[1] Vishes Kothari: Property Share Business Models in India, http://vinodkothari.com/blog/property-share-business-models-in-india/

[2] Nidhi Jain, Collective Investment Schemes for Real Estate Investments in India, at http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/

[3] Vinod Kothari and Nidhi Jain article at: https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html

[4] http://www.bailii.org/ew/cases/EWCA/Civ/2015/284.html

[5] https://www.supremecourt.uk/cases/docs/uksc-2014-0150-judgment.pdf

[6] https://www.handbook.fca.org.uk/handbook/PERG/11/2.html

[7] 328 U.S. 293 (1946), at https://supreme.justia.com/cases/federal/us/328/293/

[8] Review of Investor Protection, Part I, Cmnd 9215 (1984)

[9] Financial Services in the United Kingdom: A New Framework for Investor Protection (Cmnd 9432) 1985

 

Our Other Related Articles

Property Share Business Models in India,< http://vinodkothari.com/blog/property-share-business-models-in-india/>

Collective Investments Schemes: How gullible investors continue to lose money < https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html>

Collective Investment Schemes for Real Estate Investments in India, < http://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/>

 

Digital Consumer Lending: Need for prudential measures and addressing consumer protection

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-Siddarth Goel (finserv@vinodkothari.com)

Introduction

“If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck”

The above phrase is the popular duck test which implies abductive reasoning to identify an unknown subject by observing its habitual characteristics. The idea of using this duck test phraseology is to determine the role and function performed by the digital lending platforms in consumer credit.

Recently the Reserve Bank of India (RBI) has constituted a working group to study how to make access to financial products and services more fair, efficient, and inclusive.[1]  With many news instances lately surrounding the series of unfortunate events on charging of usurious interest rate by certain online lenders and misery surrounding the threats and public shaming of some of the borrowers by these lenders. The RBI issued a caution statement through its press release dated December 23, 2020, against unauthorised digital lending platforms/mobile applications. The RBI reiterated that the legitimate public lending activities can be undertaken by Banks, Non-Banking Financial Companies (NBFCs) registered with RBI, and other entities who are regulated by the State Governments under statutory provisions, such as the money lending acts of the concerned states. The circular further mandates disclosure of banks/NBFCs upfront by the digital lender to customers upfront.

There is no denying the fact that these digital lending platforms have benefits over traditional banks in form of lower transaction costs and credit integration of the unbanked or people not having any recourse to traditional bank lending. Further, there are some self-regulatory initiatives from the digital lending industry itself.[2] However, there is a regulatory tradeoff in the lender’s interest and over-regulation to protect consumers when dealing with large digital lending service providers. A recent judgment by the Bombay High Court ruled that:

“The demand of outstanding loan amount from the person who was in default in payment of loan amount, during the course of employment as a duty, at any stretch of imagination cannot be said to be any intention to aid or to instigate or to abet the deceased to commit the suicide,”[3]

This pronouncement of the court is not under criticism here and is right in its all sense given the facts of the case being dealt with. The fact there needs to be a recovery process in place and fair terms to be followed by banks/NBFCs and especially by the digital lending platforms while dealing with customers. There is a need to achieve a middle ground on prudential regulation of these digital lending platforms and addressing consumer protection issues emanating from such online lending. The regulator’s job is not only to oversee the prudential regulation of the financial products and services being offered to the consumers but has to protect the interest of customers attached to such products and services. It is argued through this paper that there is a need to put in place a better governing system for digital lending platforms to address the systemic as well as consumer protection concerns. Therefore, the onus of consumer protection is on the regulator (RBI) since the current legislative framework or guidelines do not provide adequate consumer protection, especially in digital consumer credit lending.

Global Regulatory Approaches

US

The Office of the Comptroller of the Currency (OCC) has laid a Special Purpose National Bank (SPNV) charters for fintech companies.[4] The OCC charter begins reviewing applications, whereby SPNV are held to the same rigorous standards of safety and soundness, fair access, and fair treatment of customers that apply to all national banks and federal savings associations.

The SPNV that engages in federal consumer financial law, i.e. in provides ‘financial products and services to the consumer’ is regulated by the ‘Consumer Financial Protection Bureau (CFPB)’. The other factors involved in application assessment are business plans that should articulate a clear path and timeline to profitability. While the applicant should have adequate capital and liquidity to support the projected volume. Other relevant considerations considered by OCC are organizers and management with appropriate skills and experience.

The key element of a business plan is the proposed applicant’s risk management framework i.e. the ability of the applicant to identify, measure, monitor, and control risks. The business plan should also describe the bank’s proposed internal system of controls to monitor and mitigate risk, including management information systems. There is a need to provide a risk assessment with the business plan. A realistic understanding of risk and there should be management’s assessment of all risks inherent in the proposed business model needs to be shown.

The charter guides that the ongoing capital levels of the applicant should commensurate with risk and complexity as proposed in the activity. There is minimum leverage that an SPNV can undertake and regulatory capital is required for measuring capital levels relative to the applicant’s assets and off-balance sheet exposures.

The scope and purpose of CFPB are very broad and covers:

“scope of coverage” set forth in subsection (a) includes specified activities (e.g., offering or providing: origination, brokerage, or servicing of consumer mortgage loans; payday loans; or private education loans) as well as a means for the CFPB to expand the coverage through specified actions (e.g., a rulemaking to designate “larger market participants”).[5]

CFPB is established through the enactment of Dood-Frank Wall Street Reform and Consumer Protection Act. The primary function of CFPB is to enforce consumer protection laws and supervise regulated entities that provide consumer financial products and services.

“(5)CONSUMER FINANCIAL PRODUCT OR SERVICES  The term “consumer financial product or service” means any financial product or service that is described in one or more categories under—paragraph (15) and is offered or provided for use by consumers primarily for personal, family, or household purposes; or **

“(15)Financial product or service-

(A)In general The term “financial product or service” means—(i)extending credit and servicing loans, including acquiring, purchasing, selling, brokering, or other extensions of credit (other than solely extending commercial credit to a person who originates consumer credit transactions);”

Thus CFPB is well placed as a separate institution to protect consumer interest and covers a wide range of financial products and services including extending credit, servicing, selling, brokering, and others. The regulatory environment has been put in place by the OCC to check the viability of fintech business models and there are adequate consumer protection laws.

EU

EU’s technologically neutral regulatory and supervisory systems intend to capture not only traditional financial services but also innovative business models. The current dealing with the credit agreements is EU directive 2008/48/EC of on credit agreements for consumers (Consumer Credit Directive – ‘Directive’). While the process of harmonising the legislative framework is under process as the report of the commission to the EU parliament raised some serious concerns.[6] The commission report identified that the directive has been partially effective in ensuring high standards of consumer protection. Despite the directive focussing on disclosure of annual percentage rate of charge to the customers, early payment, and credit databases. The report cited that the primary reason for the directive being impractical is because of the exclusion of the consumer credit market from the scope of the directive.

The report recognised the increase and future of consumer credit through digitisation. Further the rigid prescriptions of formats for information disclosure which is viable in pre-contractual stages, i.e. where a contract is to be subsequently entered in a paper format. There is no consumer benefit in an increasingly digital environment, especially in situations where consumers prefer a fast and smooth credit-granting process. The report highlighted the need to review certain provisions of the directive, particularly on the scope and the credit-granting process (including the pre-contractual information and creditworthiness assessment).

China

China has one of the biggest markets for online mico-lending business. The unique partnership of banks and online lending platforms using innovative technologies has been the prime reason for the surge in the market. However, recently the People’s Bank of China (PBOC) and China Banking and Insurance Regulatory Commission (CBIRC) issued draft rules to regulate online mico-lending business. Under the draft rules, there is a requirement for online underwriting consumer loans fintech platform to have a minimum fund contribution of at least 30 % in a loan originated for banks. Further mico-lenders sourcing customer data from e-commerce have to share information with the central bank.

Australia

The main legislation that governs the consumer credit industry is the National Consumer Credit Protection Act (“National Credit Act”) and the National Credit Code. Australian Securities & Investments Commission (ASIC) is Australia’s integrated authority for corporate, markets, financial services, and consumer credit regulator. ASIC is a consumer credit regulator that administers the National Credit Act and regulates businesses engaging in consumer credit activities including banks, credit unions, finance companies, along with others. The ASIC has issued guidelines to obtain licensing for credit activities such as money lenders and financial intermediaries.[7] Credit licensing is needed for three sorts of entities.

  • engage in credit activities as a credit provider or lessor
  • engage in credit activities other than as a credit provider or lessor (e.g. as a credit representative or broker)
  • engage in all credit activities

The applicants of credit licensing are obligated to have adequate financial resources and have to ensure compliance with other supervisory arrangements to engage in credit activates.

UK

Financial Conduct Authority (FCA) is the regulator for consumer credit firms in the UK. The primary objective of FCA ensues; a secure and appropriate degree of protection for consumers, protect and enhance the integrity of the UK financial system, promote effective competition in the interest of consumers.[8] The consumer credit firms have to obtain authorisation from FCA before carrying on consumer credit activities. The consumer credit activities include a plethora of credit functions including entering into a credit agreement as a lender, credit broking, debt adjusting, debt collection, debt counselling, credit information companies, debt administration, providing credit references, and others. FCA has been successful in laying down detailed rules for the price cap on high-cost short-term credit.[9] The price total cost cap on high-cost short-term credit (HCSTC loans) including payday loans, the borrowers must never have to pay more in fees and interest than 100% of what they borrowed. Further, there are rules on credit broking that provides brokers from charging fees to customers or requesting payment details unless authorised by FCA.[10] The fee charged from customers is to be reported quarterly and all brokers (including online credit broking) need to make clear that they are advertising as a credit broker and not a lender. There are no fixed capital requirements for the credit firms, however, adequate financial resources need to be maintained and there is a need to have a business plan all the time for authorisation purposes.

Digital lending models and concerns in India

Countries across the globe have taken different approaches to regulate consumer lending and digital lending platforms. They have addressed prudential regulation concerns of these credit institutions along with consumer protection being the top priority under their respective framework and legislations. However, these lending platforms need to be looked at through the current governing regulatory framework from an Indian perspective.

The typical credit intermediation could be performed by way of; peer to peer (P2P) lending model, notary model (bank-based) guaranteed return model, balance sheet model, and others. P2P lending platforms are heavily regulated and hence are not of primary concern herein. Online digital lending platforms engaged in consumer lending are of significance as they affect investor’s and borrowers’ interests and series of legal complexions arise owing to their agency lending models.[11] Therefore careful anatomy of these models is important for investors and consumer protection in India.

Should digital lending be regulated?

Under the current system, only banks, NBFCs, and money lenders can undertake lending activities. The regulated banks and NBFCs also undertake online consumer lending either through their website/platforms or through third-party lending platforms. These unregulated third-party digital lending platforms count on their sophisticated credit underwriting analytics software and engage in consumer lending services. Under the simplest version of the bank-based lending model, the fintech lending platform offers loan matching services but the loan is originated in books of a partnering bank or NBFC. Thus the platform serves as an agent that brings lenders (Financial institutions) and borrowers (customers) together. Therefore RBI has mandated fintech platforms has to abide by certain roles and responsibilities of Direct Selling Agent (DSA) as under Fair Practice Code ‘FPC’ and partner banks/NBFCs have to ensure Guidelines on Managing Risks and Code of Conduct in Outsourcing of Financial Service (‘outsourcing code’).[12] In the simplest of bank-based models, the banks bear the credit risk of the borrowers and the platform earns their revenues by way of fees and service charges on the transaction. Since banks and NBFCs are prudentially regulated and have to comply with Basel capital norms, there are not real systemic concerns.

However, the situation alters materially when such a third-party lending platform adopts balance sheet lending or guaranteed return models. In the former, the servicer platform retains part of the credit risk on its book and could also give some sort of loss support in form of a guarantee to its originating partner NBFC or bank.[13] While in the latter case it a pure guarantee where the third-party lending platform contractually promises returns on funds lent through their platforms. There is a devil in detailed scrutiny of these business models. We have earlier highlighted the regulatory issues in detail around fintech practices and app-based lending in our write up titled ‘Lender’s piggybacking: NBFCs lending on Fintech platforms’ gurantees’.

From the prudential regulation perspective in hindsight, banks, and NBFCs originating through these third-party lending platforms are not aware of the overall exposure of the platforms to the banking system. Hence there is a presence of counterparty default risk of the platform itself from the perspective of originating banks and NBFCs. In a real sense, there is a kind of tri-party arrangement where funds flow from ‘originator’ (regulated bank/NBFC) to the ‘platform’ (digital service provider) and ultimately to the ‘borrower'(Customer). The unregulated platform assumes the credit risk of the borrower, and the originating bank (or NBFC) assumes the risk of the unregulated lending platform.

Curbing unregulated lending

In the balance sheet and guaranteed return models, an undercapitalized entity takes credit risk. In the balance sheet model, the lending platform is directly taking the credit risk and may or may not have to get itself registered as NBFC with RBI. The registration requirement as an NBFC emanates if the financial assets and financial income of the platform is more than 50 % of its total asset and income of such business (‘principal business criteria’ see footnote 12). While in the guaranteed return model there is a form of synthetic lending and there is absolutely no legal requirement for the lending platform to get themselves registered as NBFC. The online lending platform in the guaranteed return model serves as a loan facilitator from origination to credit absorption. There is a regulatory arbitrage in this activity. Since technically this activity is not covered under the “financial activity” and the spread earned in not “financial income” therefore there is no requirement for these entities to get registered as NBFCs.[14]

Any sort of guarantee or loss support provided by the third-party lending platform to its partner bank/NBFC is a synthetic exposure. In synthetic lending, the digital lending platform is taking a risk on the underlying borrower without actually taking direct credit risk. Additionally, there are financial reporting issues and conflict of interest or misalignment of incentives, i.e. the entities do not have to abide by IND AS and can show these guarantees as contingent liabilities. On the contrary, they charge heavy interest rates from customers to earn a higher spread. Hence synthetic lending provides all the incentives for these third-party lending platforms to enter into risky lending which leads to the generation of sub-prime assets. The originating banks and NBFCs have to abide by minimum capital requirements and other regulatory norms. Hence the sub-prime generation of consumer credit loans is supplemented by heavy returns offered to the banks. It is argued that the guaranteed returns function as a Credit Default Swap ‘CDS’ which is not regulated as CDS. Thus the online lending platform escapes the regulatory purview and it is shown in the latter part this leads to poor credit discipline in consumer lending and consumer protection is often put on the back burner.

From the prudential regulation perspective restricting banks/NBFCs from undertaking any sort of guaranteed return or loss support protection, can curb the underlying emergence of systemic risk from counterparty default. While a legal stipulation to the effect that NBFCs/Banks lending through the third-party unregulated platform, to strictly lend independently i.e. on a non-risk sharing basis of the credit risk. Counterintuitively, the unregulated online lending platforms have to seek registration as an NBFC if they want to have direct exposure to the underlying borrower, subject to fulfillment of ‘principal business criteria’.[15] Such a governing framework will reduce the incentives for banks and NBFCs to exploit excessive risk-taking through this regulatory arbitrage opportunity.

Ensuring Fairness and Consumer Protection

There are serious concerns of fair dealing and consumer protection aspects that have arisen lately from digital online lending platforms. The loans outsourced by Banks and NBFCs over digital lending platforms have to adhere to the FPC and Outsourcing code.

The fairness in a loan transaction calls for transparent disclosure to the borrower all information about fees/charges payable for processing the loan application, disbursed, pre-payment options and charges, the penalty for delayed repayments, and such other information at the time of disbursal of the loan. Such information should also be displayed on the website of the banks for all categories of loan products. It may be mentioned that levying such charges subsequently without disclosing the same to the borrower is an unfair practice.[16]

Such a legal requirement gives rise to the age-old question of consumer law, yet the most debatable aspect. That mere disclosure to the borrower of the loan terms in an agreement even though the customer did not understand the underlying obligations is a fair contract (?) It is argued that let alone the disclosures of obligations in digital lending transactions, customers are not even aware of their remedies. Under the current RBI regulatory framework, they have the remedy to approach grievance redressal authorities of the originating bank/NBFC or may approach the banking ombudsman. However, things become even more peculiar in cases where loans are being sourced or processed through third-party digital platforms. The customers in the majority of the cases are unaware of the fact that the ultimate originator of the loan is a bank/NBFC. The only remedy for such a customer is to seek refuge under the Consumer Protection Act 2019 by way of proving the loan agreement is the one as ‘unfair contract’.

“2(46) “unfair contract” means a contract between a manufacturer or trader or service provider on one hand, and a consumer on the other, having such terms which cause significant change in the rights of such consumer, including the following, namely:— (i) requiring manifestly excessive security deposits to be given by a consumer for the performance of contractual obligations; or (ii) imposing any penalty on the consumer, for the breach of contract thereof which is wholly disproportionate to the loss occurred due to such breach to the other party to the contract; or (iii) refusing to accept early repayment of debts on payment of applicable penalty; or (iv) entitling a party to the contract to terminate such contract unilaterally, without reasonable cause; or (v) permitting or has the effect of permitting one party to assign the contract to the detriment of the other party who is a consumer, without his consent; or (vi) imposing on the consumer any unreasonable charge, obligation or condition which puts such consumer to disadvantage;”

It is pertinent to note that neither the scope of consumer financial agreements is regulated in India, nor are the third-party digital lending platforms required to obtain authorisation from RBI. There are instances of high-interest rates and exorbitant fees charged by the online consumer lending platforms which are unfair and detrimental to customers’ interests. The current legislative framework provides that the NBFCs shall furnish a copy of the loan agreement as understood by the borrower along with a copy of each of all enclosures quoted in the loan agreement to all the borrowers at the time of sanction/disbursement of loans.[17] However, like the persisting problem in the EU 2008/48/EC directive, even FPC is not well placed to govern digital lending agreements and disclosures. Taking a queue from the problems recognised by the EU parliamentary committee report. There is no consumer benefit in an increasingly digital environment, especially in situations where there are fast and smooth credit-granting processes. The pre-contractual information on the disclosure of annualised interest rate and capping of the total cost to a customer in consumer credit loans is central to consumer protection.

The UK legislation has been pro-active in addressing the underlying unfair contractual concerns, by fixation of maximum daily interest rates and maximum default fees with an overall cost cap of 100% that could be charged in short-term high-interest rates loan agreements. It is argued that in this Laissez-faire world the financial services business models which are based on imposing an unreasonable charge, obligations that could put consumers to disadvantage should anyways be curbed. Therefore a legal certainty in this regard would save vulnerable customers to seek the consumer court’s remedy in case of usurious and unfair lending.

The master circular on loan and advances provide for disclosure of the details of recovery agency firms/companies to the borrower by the originating bank/NBFC.[18] Further, there is a requirement for such recovery agent to disclose to the borrower about the antecedents of the bank/NBFC they are recovering for.  However, this condition is barely even followed or adhered to and the vulnerable consumers are exposed to all sorts of threats and forceful tactics. As one could appreciate in jurisdictions of the US, UK, Australia discussed above, consumer lending and ancillary services are under the purview of concerned regulators. From the customer protection perspective, at least some sort of authorization or registration requirement with the RBI to keep the check and balances system in place is important for consumer protection. The loan recovery business is sensitive hence there is a need for a proper guiding framework and/or registration requirement of the agents acting as recovery agents on behalf of banks/NBFCs. The mere registration requirement and revocation of same in case of unprofessional activities will serve as a stick to check their consumer dealing practices.

The financial services intermediaries (other than Banks/NBFCs) providing services like credit broking, debt adjusting, debt collection, debt counselling, credit information, debt administration, credit referencing to be licensed by the regulator. The banks/NBFCs dealing with the licensed market intermediaries would go much farther in the successful implementation of FPC and addressing consumer protection concerns from the current system.

Conclusion

From the perspective of sound financial markets and fair consumer practices, it is always prudent to allow only those entities in credit lending businesses that are best placed to bear the credit risk and losses emanating from them. Thus, there is a dearth of a comprehensive legislative framework in consumer lending from origination to debt collection and its administration including the business of providing credit references through digital lending platforms. There may not be a material foreseeable requirement for regulating digital lending platforms completely. However, there is a need to curb synthetic lending by third-party digital lending platforms. Since a risk-taking entity without adequate capitalization will tend to get into generating risky assets with high returns. The off-balance sheet guarantee commitments of these entities force them to be aggressive towards their customers to sustain their businesses. This write-up has explored various regulatory approaches, where jurisdictions like the US and UK, and Australia being the good comparable in addressing consumer protection concerns emanating from online digital lending platforms. Henceforth, a well-framed consumer protection system especially in financial products and services would go much farther in the development and integration of credit through digital lending platforms in the economy.

 

[1] Reserve Bank of India – Press Releases (rbi.org.in), dated January 13, 2020

[2] Digital lending Association of India, Code of Conduct available at https://www.dlai.in/dlai-code-of-conduct/

[3] Rohit Nalawade Vs. State of Maharashtra High Court of Bombay Criminal Application (APL) NO. 1052 OF 2018 < https://images.assettype.com/barandbench/2021-01/cf03e52e-fedd-4a34-baf6-25dbb55dbf29/Rohit_Nalawade_v__State_of_Maharashtra___Anr.pdf>

[4] https://www.occ.gov/topics/supervision-and-examination/responsible-innovation/comments/pub-special-purpose-nat-bank-charters-fintech.pdf

[5]  12 USC 5514(a); Pay day loans are the short term, high interest bearing loans that are generally due on the consumer’s next payday after the loan is taken.

[6] EU, ‘Report from the Commission to the European Parliament and the Council: on the implementation of Directive 2008/48/EC on credit agreement for consumers’, dated November, 05, 2020, available at < https://ec.europa.eu/transparency/regdoc/rep/1/2020/EN/COM-2020-963-F1-EN-MAIN-PART-1.PDF>

[7] https://asic.gov.au/for-finance-professionals/credit-licensees/applying-for-and-managing-your-credit-licence/faqs-getting-a-credit-licence/

[8] FCA guide to consumer credit firms, available at < https://www.fca.org.uk/publication/finalised-guidance/consumer-credit-being-regulated-guide.pdf>

[9] FCA, ‘Detailed rules for price cap on high-cost short-term credit’, available at < https://www.fca.org.uk/publication/policy/ps14-16.pdf>

[10] FCA, Credit Broking and fees, available at < https://www.fca.org.uk/publication/policy/ps14-18.pdf>

[11] Bank of International Settlements ‘FinTech Credit : Market structure, business models and financial stability implications’, 22 May 2017, FSB Report

[12] See our write up on ‘ Extension of FPC on lending through digital platforms’ , available at < http://vinodkothari.com/2020/06/extension-of-fpc-on-lending-through-digital-platforms/>

[13] Where the unregulated platform assumes the complete credit risk of the borrower there is no interlinkage with the partner bank and NBFC. The only issue that arises is from the registration requirement as NBFC which we have discussed in the next section. Also see our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[14] The qualifying criteria to register as an NBFC has been discussed in our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[15] see our write up titled ‘Question of Definition: What Exactly is an NBFC’ available at http://vinodkothari.com/nbfcs/definition-of-nbfcs-concept-of-principality-of-business/

[16] Para 2.5.2, RBI Guidelines on Fair Practices Code for Lender

[17] Para 29 of the guidelines on Fair Practices Code, Master Direction on systemically/non-systemically important NBFCs.

[18] Para 2.6, Master Circular on ‘Loans and Advances – Statutory and Other Restrictions’ dated July 01, 2015;

 

Our Other Related Write-Ups

Lenders’ piggybacking: NBFCs lending on Fintech platforms’ guarantees – Vinod Kothari Consultants

Extension of FPC on lending through digital platforms – Vinod Kothari Consultants

Fintech Framework: Regulatory responses to financial innovation – Vinod Kothari Consultants

One-stop guide for all Regulatory Sandbox Frameworks – Vinod Kothari Consultants