Lending Service Providers for digital lenders: Distinguishing agency contracts and principal-to-principal contracts

– Neha Sinha, Assistant Legal Advisor | finserv@vinodkothari.com

Introduction

Lending Service Providers (LSPs) are engaged by the Regulated Entities (REs) (banks or NBFCs) to carry out some functions of RE in connection with lenders’ functions  on digital platforms. These LSPs may be engaged in customer acquisition, underwriting support, recovery of loan, etc. As the LSPs are acting in association with REs and on behalf of REs, the question arises if LSPs are engaged as “agents” of REs or the arrangement between RE and LSP is that of on a principal to principal basis.

Aspects surrounding agency contracts are dealt with in Indian Contract Act, 1872. Principal-principal relation is not defined specifically in any statute, but the obligations and liability of both the parties is as in case of any usual commercial contract, where each party is acting independently. If it is the latter, the LSP cannot be termed as “agent”. If the LSP is not an agent, then, looking at the definition of LSP in the RBI’s Digital Lending Guidelines (discussed below), it is possible to contend that the activities of the so-called LSP do not bind the RE, as the so-called LSP, acting as a principal, is not to be treated as LSP within the meaning of the RBI Digital Lending Guidelines.

In this article, the defining features of agency contracts, in light of whether the role of LSPs is either a principal or an agent has been discussed, on the basis of the provisions of the contract law and jurisprudence thereunder.

Principal-to-Principal Relationship

In a principal-to-principal basis agreement, while the obligations and rights of both the parties are defined, one principal cannot be made vicariously liable for the acts of the other principal. Both parties act independently in such agreements. A principal-to-principal agreement indicates that a party (depending upon the role) does not act as an agent of the other and the arrangement between them is not in the nature of agency.

In Indian Oil Corporation v. Consumer Protection Council,^[1] the Supreme Court discussed the liability of principals against each other. In this matter, a gas agency was the authorised agent of Indian Oil Corporation (IOC). Allegations of deficiency of service to consumers were levelled against the agency and IOC was made liable for the same. It was also argued that IOC had ratified the unauthorised acts of the agency.  Opposing these allegations, it was contended that there is no privity of contract between IOC and the consumer and hence, IOC cannot be made liable for the acts of the agency. The Supreme Court observed that the memorandum of understanding between IOC and the gas agency defined the relationship to be on a principal to principal basis. Hence, this was not a case of principal-agent relationship. Further, in such principal to principal contracts, one principal cannot be made liable for the acts of another towards the consumers when there is no privity of contract between such principal and the consumer.

The principal-to-principal liability was further discussed in the case of Tata Motors Ltd v. Antonio Paulo Vaz.^[2]In this case, a manufacturer of cars contended that its relationship with a dealer of its cars was not of principal-agent but rather, on a principal to principal basis and hence, it could not be held liable for the acts of another principal, i.e., the dealer. The National Consumer Disputes Redressal Commission rejected the contention of the subsistence of principal to principal relationship on the grounds that the car manufacturer sold its cars through its dealers, exercised superintendence over its dealers including the right to terminate their dealership. Besides, there were no materials to adduce the principal-principal relationship between the parties. However, the Supreme Court set aside this decision and held that when the contract is on a principal to principal basis and one principal has no knowledge of the act in question of another principal, no liability could be fastened upon the former for the act of the latter.  In the present case, the manufacturer could not be attributed with the knowledge of the defective state of cars when with the dealer when the cars were delivered to the dealers years ago.

The principle culled out from this judgement is that in a principal-principal relationship, one principal cannot be held liable for the acts of the another principal unless  the former has knowledge of the acts of the latter.

Agent-Principal Relationship

General Principles

General principles relating to principal and agent are laid down in Chapter X of the Indian Contract Act, 1872 (“Act”). Section 182 of the Act defines agent and principal as:

“An “agent” is a person employed to do any act for another, or to represent another in dealings with third persons. The person for whom such act is done, or who is so represented, is called the “principal”.”

Hence, an agent is authorised by the principal to act in its behalf and act as its authorised representative.

Following are the broad principles surrounding contracts of agency:

1. Agent enters into transactions/contracts with third parties on behalf of principal;
2. Authority granted to the agent may be express or implied;
3. Agent must act within the scope of the authority;
4. Agent can do every lawful thing necessary to carry out the authorised act.
5. Principal has the power to ratify the acts of agent done without his knowledge or authority.
6. Agent is bound to conduct the business according to the directions given by the principal. 

A person/entity earning commission does not sell goods or services on his account, but on behalf of another called “principal”.^[3] In CIT- XVII v. Idea Cellular Ltd.,^[4] Delhi High Court distinguished between principal-principal agreements and principal-agent agreements in terms of interaction with consumers, either directly or through intermediary (agent). When the manufacturer sells goods to the distributors so that the distributors can then sell the goods to the consumers, such a transaction creates a principal- principal relationship between the manufacturer and distributor and the manufacturer does not come into picture at all. This is a contract of sale wherein the title of the goods passes from the manufacturer to the distributor to be sold by the latter to the ultimate users- consumers. However, in a contract of agency, the principal sells the goods or services to the consumers through the medium of an agent. “The agents act as a linking agent in the chain of delivery of services to services to consumers.”  

The essence of agency is that a person or entity, acting as an agent, sells the goods not as its own property but as the property of the principal who continues to be the owner of the such goods and the agent is accountable for the sale proceeds.^[5]

Scope of agency

Under section 182 of the Indian Contract Act, 1872, an “agent” is defined as “a person employed to do any act for another or to represent another in dealings with third persons.” With respect to the expression used in this provision, the Court, in Ganesh Export and Import Co v. Mahadeolal Nathmal,^[6] held that when the only duty of an entity was to secure orders for the company’s products and propagate their sale, such a duty did not amount to “act for another”, and hence, it would not create principal-agent relationship. In a contract of agency, the agent sells the goods or services under the instructions and directions of the principal.^[7] 

In Bhopal Sugar Industries v. Sales Tax Officer,^[8] the Supreme Court had observed that the mere word ‘agent’ or ‘agency’ is not sufficient to lead to the inference that parties intended the conferment of principal-agent status on each other. Mere formal description of a person as an agent is not conclusive to show existence of agency unless the parties intend it so hence, “the true relationship of the parties in such a case has to be gathered from the nature of the contract, its terms and conditions, and the terminology used by the parties is not decisive of the said relationship.”

The scope of principal-agent relationship was explained by the Delhi High Court in the case of CIT v. Singapore Airlines:^[9]

“It is clear from the definition that an agency comes into existence where one person is vested with the authority or capacity to create a legal relationship between person referred to as principal and an outside third party. Therefore, the basic and essential requisites of an agency ordinarily would be that:

• The agent makes the principal answerable to third persons whereby the principal can sue third parties directly and renders himself, that is, the principal, liable to be sued directly by the third parties. (See Varsha Engineering Pvt. Ltd. v. Vijay Traders & Ors., AIR 1983 Guj 166 at pages 168-169, para 5). 
• The person who purports to enter into a transaction on behalf of the principal would have the power to create, modify or terminate contractual relationship between his principal, that is, the person whom he represents, and the third parties. (See P. Krishna Bhatta v. Mundila Ganapathi Bhatta AIR 1955 Mad. 648 at page 651, para 36).
• An agent, though bound by instructions given to him by the principal does not work under the direct control and supervision of the principal. The agent thus uses his own discretion to act on behalf of the principal subject to the limits to his authority prescribed by the principal. (See Lakshminarayan Ram Gopal & Son Ltd. v. Government of Hyderabad, AIR 1954 SC 364 at page 367, para 11 & 12. This cited with the approval in Qamar Shaffi Tyabji v. Commissioner of Excess Profits Tax  (1960) 39 ITR 611 (SC) at pages 615 & 616).
• There is no necessity of a formal contract of agency, it can be implied which could arise from the act of parties or situations in which parties are put.”

As has been held in CIT- XVII v. Idea Cellular Ltd,^[10] a principal entity may require services of another entity to run an operational system.  Such entities employed by the principal entity acts as linking agents in the chain of delivery of services to consumers and resulting relationship does not tantamount to principal-to-principal agreement. Thus, as agents, LSPs act as a linking chain between REs and consumers.

Consent for Agency

In the case of Chairman, Life Insurance Corporation v. Rajiv Kumar Bhasker,^[11]the Court delved into the consensual arrangement between agent and principal.

“In the Garnac case Lord Pearson with the concurrence of the House, used these words:

‘“The relationship of principal and agent can only be established by the consent of the principal and the agent. They will be held to have consented if they have agreed to what amounts in law to such a relationship, even if they do not recognize it themselves and even if they have professed to disclaim it. But the consent must have been given by each of them, either expressly or by implication from their words and conduct.”’

The significant words, for the present purpose, are “if they have agreed to what amounts in law to such a relationship.” These I understand as pointing to the fact that, while agency must ultimately derive from consent, the consent need not necessarily be to the relationship of principal and agent itself (indeed the existence of it may be denied) but may be to a state of fact upon which the law imposes the consequences which result from agency. It is consensual, not contractual. So interpreted, this formulation allows the establishment of an agency relationship in such cases as the present.”

An express consent need not be of principal and agent so long as they have agreed to state of facts on which the law imposes consequences which result from agency, the relationship of principal and agent will govern the parties.^[12]Hence, the conduct of the parties and the circumstances surrounding the contract is paramount in determining whether an entity is acting as an agent.

Degree of control by Principal

In the case of Lakshminarayan Ram Gopal v. Government of Hyderabad,^[13] the Supreme Court had outlined the characteristics of an agent:

1. Degree of control: an agent receives the principal’s instructions but is generally free to carry out those instructions according to his own discretion.
2. Commission: an agent is paid commission upon effecting the result which he was instructed by his principal to achieve.
3. Entering into contract: an agent has authority to enter into contract on behalf of his principal.

Further, an independent contractor is entirely independent of any control or interference, and merely undertakes to produce a specified result employing his own means to produce the result. Whereas, an agent is bound to exercise his authority in accordance with lawful instructions of the principal, however, the agent is not subject to direct control or supervision of the principal.^[14]

Analysis of relation between LSPs and REs

The Digital Lending Guidelines issued by RBI  define LSPs in para 2.5 as:

“An agent of a Regulated Entity who carries out one or more of lender’s functions or part thereof in customer acquisition, underwriting support, pricing support, servicing, monitoring, recovery of specific loan or loan portfolio on behalf of REs in conformity with extant outsourcing guidelines issued by the Reserve Bank.”

From the definition of the LSP as envisaged by RBI, the function and role of LSPs can be identified as one where the LSP carries out certain functions on behalf of REs, thereby meaning that RE carries out these functions through the medium of LSP.

The language and expressions used in the DL Guidelines for the duty of REs with respect to overseeing the functions of LSP are noteworthy. For instance, in the Technology and Data Requirements section, REs have been given the responsibility to ensure that LSPs collect only need based with prior explicit consent of consumer, personal data and biometric data is not stored by LSPs, LSPs have comprehensive privacy policy and they comply with the requisite technology standards. This indicates that REs have a superintendence role or supervisory role in overseeing the activities of the LSPs engaged by them. As explained in the existing jurisprudence relating to the extent of control by principal on agent’s actions, the LSPs are required to perform the functions in consonance with the instructions of the RE. This does not imply that RE shall be guiding as to how to perform the functions. A degree of discretion and independence is inherently associated with agencies so long as it is confined within the statutory requirements and instructions of the RE.

Coming to RBI’s Guidelines on Outsourcing (Annex XXV), para 5.5 of Annex XXV discusses the broad nature of the outsourcing agreement. The provision states that “The agreement shall be sufficiently flexible to allow the NBFC to retain an appropriate level of control over the outsourcing and the right to intervene with appropriate measures to meet legal and regulatory obligations. The agreement shall also bring out the nature of legal relationship between the parties – i.e. whether agent, principal or otherwise.”

On a bare perusal of the provision, it can be observed that the agreement between NBFC and service providers for outsourcing can be either in the nature of principal to principal basis or principal-agent basis. Further, para 5.7 stipulates that NBFC shall ensure that recovery agents, direct sales agents, direct marketing agents are well trained. Besides, NBFCs shall require its service providers to develop a robust framework for documenting, maintaining and testing business continuity and recovery procedures.

Inter se relation between LSP and RE & the status of LSP while dealing with third parties

The Outsourcing Guidelines have given the flexibility to NBFCs to define its relation with service providers as either on a principal to principal basis or as agent and principal. It can be inferred that LSP can either be agent or principal as agreed between the parties. So REs and LSPs can transact between themselves on a principal-to-principal basis or on principal-agent basis. However, under the Digital Lending Guidelines, such flexibility is not provided as LSPs are defined as “agents”. This brings forth a conflict between Outsourcing Guidelines and Digital Lending Guidelines in respect of the status of LSPs. On a harmonious interpretation of both these guidelines, it can be concluded that the flexibility provided under Outsourcing Guidelines is limited to the inter se relation between parties, while the LSP shall act in the capacity of agents of RE while dealing with third parties. In other words, the RE and LSP may choose to define their liabilities and obligations as either principal-agent or principal-principal. However, merely because the agreement between the parties define the relationship as principal-principal will not imply that LSPs are not acting as agents, allowing RE to evade its vicarious liability arising from the acts of LSP. The inter se relation between RE and LSP can be either in the form of principal-principal or principal-agent, but the LSP shall be acting as agents of the RE while dealing with consumers and the RE shall be vicariously liable for the acts of LSP towards third parties.

As has been held in Life Insurance Corporation v. Rajiv Kumar Bhasker, when the circumstances surrounding a transaction indicate that an entity is acting as an agent, then even if there is no express consent for creating a principal-agent relationship, principles relating to agency shall govern the transaction. In line with this ratio, even when the inter se relation between LSP and RE is that of principal-to-principal, LSP shall remain as agents of RE in its interaction with consumers as it essentially exhibits the features of an agent. So in an outsourcing agreement, if the nature of the agreement is defined as principal-agent, the rights and obligations of RE and LSP towards each other shall be governed by laws of agency. But where the nature of agreement is defined as principal to-principal, the rights and obligations of RE and LSP shall be that of an independent principal towards another independent principal. Irrespective of the nature of agreement, the LSP shall always be acting as agents of RE with the consumers and the principle of vicarious liability shall be applicable on RE. 

It is pertinent to point out that LSPs are not being held as “agents” solely relying upon the terminology of the definition of LSP in Digital Lending Guidelines wherein the word ‘agent’ has been used to define LSP. The mere word ‘agent’ is not sufficient to establish agency as was held in Bhopal Sugar Industries. The LSPs extend the various services in relation to the loan, not as their own service, but as the service of the RE. LSPs act as an intermediary between RE and consumer and the acts of RE has supervisory role in ensuring that LSP adheres to the regulatory requirements. LSPs do not act independent of instructions of RE; while they can exercise their discretion in performing their functions, the same shall be guided by the instructions of RE. In light of these factors, it is established that in essence, LSPs are agents of REs.

There are inherent differences in duties and rights of parties towards/against each other arising out of such arrangement. For instance, the principal has to indemnify the agent against losses when the agent was exercising its authority given by the principal^[15] or when the agent was acting in good faith.^[16] On the other hand, indemnification depends on the terms and conditions of the contract as agreed by the parties.

As regards commission, commission to paid agents for performance of their functions is liable to tax deduction at source under section 194H of Income Tax Act, 1961.^[17] “Commission” has been defined as to include “any payment received or receivable, directly or indirectly, by a person acting on behalf of another person for services rendered (not being professional services) or for any services in the course of buying or selling of goods or in relation to any transaction relating to any asset, valuable article or thing, not being securities.” Hence, commission is typical to agency and in case of principal-to-principal agreement, section 194H cannot be applicable.

In principal-to-principal agreements, the duties and obligations may be defined by the parties since the principles of agency will not govern the duties and responsibilities of parties towards each other.

Conclusion

RBI has provided an option under Outsourcing Guidelines regarding the inter se relation between RE and LSP to either principal-to-principal basis or principal-agent. In a principal-to-principal agreement, the doctrine of privity of contract comes into play, which would absolve RE of the liabilities arising out of its LSP engaging with a consumer. Hence, an escape route for RE is created since it is not interacting with consumers directly, limiting the liability to the LSP only.  To address this loophole, RBI has adopted a stricter approach towards LSPs role of agents. Notwithstanding the nature of the agreement between RE and LSP, LSPs shall be governed by the laws relating to contract of agency in its interaction with consumers. While there is a scope of flexibility in inter se relation, RBI has maintained its rigidity in respect of the role of LSPs as agents to ensure that the RE does not escape its ultimate and paramount  liability to consumers under the garb of principal-to-principal arrangement with LSPs. Such stringency reinforces accountability of RE towards consumers and promotes consumer welfare, thereby creating a well regulated and robust digital lending ecosystem. 

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[1] 1993 SCC (1) 397.

[2] Civil Appeal No. 574/2021, Supreme Court (decision dated 18.02.2021).

[3] CIT v. Jai Drinks Pvt. Ltd., ITA No. 399/2010, Delhi High Court (decision dated 06.01.2022).

[4] ITA No. 145 of 2009 with ITA No. 784 of 2009, Delhi High Court, (decision dated 19.02.2010).

[5] Bhopal Sugar Industries Ltd. v. Sales Tax Officer, 1977 AIR 1275.

[6] AIR 1956 Cal 188.

[7] Ahmedabad Stamp Vendors v. Union of India, (2002) 3 GLR 613. 

[8] 1977 AIR 1275.

[9] 2009-ITOL-183-HC-DEL-IT.

[10]  ITA No. 145 of 2009 with ITA No. 784 of 2009, Delhi High Court, (decision dated 19.02.2010).

[11] Appeal (Civil) 6028 of 2002, Supreme Court (decision dated 28.07.2005).

[12] Shree Digvijay Cement Co. Ltd. v. The State Trading Corporation of India, 128 (2006) DLT 319.

[13] 1954 AIR 364.

[14] Lakshminarayan Ram Gopal v. Government of Hyderabad, 1954 AIR 364.

[15] Indian Contract Act, 1872, section 222.

[16] Indian Contract Act, 1872, section 223.

[17] CIT- XVII v. Idea Cellular Ltd,  ITA No. 145 of 2009 with ITA No. 784 of 2009, Delhi High Court, (decision dated 19.02.2010).

Our write-ups on Digital Lending:

1. FAQs on Digital Lending Regulations – https://vinodkothari.com/2022/08/faqs-on-digital-lending-regulations/
2. Digital lending: Footnote prescriptions heavier than the headlines – https://vinodkothari.com/2022/09/digital-lending-footnote-prescriptions-heavier-than-the-headlines/
3. RBI Regulations on Digital Lending: FLDGs come under regulatory ambit – https://vinodkothari.com/2022/08/rbi-regulations-on-digital-lending/