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Navigating Unfair Contracts: Understanding Borrower Rights and Lender Obligations under the Consumer Protection Act 

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– Archisman Bhattacharjee & Aditya Iyer  | finserv@vinodkothari.com

Introduction

The trust and fairness in a lender-borrower relationship is one of the most fundamental drivers of financial regulation, and ensuring this trust and fairness in lender-borrower relationships is crucial for the growth and stability of the financial sector.  NBFCs doing lending business are likely very conversant with the obligations captured in the RBI regulation on fair lending practices that details the general principles on adequate disclosure of the terms and conditions of a loan, and the adoption of non-coercive recovery methods. However, they may be unaware of the rights and obligations under the Consumer Protection Act, 2019 (‘CP Act’) which inter alia deals with “Unfair Contracts”. Interestingly, the CP Act defines a contract to be unfair if such contract significantly undermines consumer rights including clauses that restrict prepayment or contains clauses towards unilateral termination of agreements etc. These terms, which are also covered under the RBI’s Fair Practice Code, highlight a convergence in regulatory and statutory protections for borrowers.

In this article, we explore the rights of a borrower and the obligations of a lender under the CP Act and highlights the extant obligations under the Fair Practices Code, and other RBI regulations, and in doing so also explore the emerging convergence in these regulations concerning consumer protection norms.

Meaning of Unfair Contract and its impact 

Section 2(46) of the CP Act, defines an “unfair contract” as follows-

(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;

Based on the aforesaid definition, from the perspective of lenders, unfair contracts would include any agreement that significantly undermines consumer rights. Examples of unfair terms include:

  1. Preventing early prepayment of debt, even with payment of applicable penalties;
  2. Allowing the lender to unilaterally terminate the agreement without reasonable cause;
  3. Assigning the contract to another party in a manner detrimental to the consumer, without their consent;
  4. Imposing unreasonable charges, obligations, or conditions that disadvantage the consumer.

It is important to note that the aforesaid list is not exhaustive. Beyond these provisions, the RBI Fair Practice Code also identifies practices that can render contracts unfair, including:

  1. Charging excessive interest rates.
  2. Imposing interest during undisbursed loan periods.
  3. Enforcing unreasonable lock-in periods in loan agreements or sanction letters, etc.

The CP Act permits the classification of any contract that results in an unreasonable bargain as unfair, and subject to review by consumer courts such as the State Commission (Section 47(iii)) and the National Commission (Section 58(ii)). Additionally, Sections 49(2) and 59(2) state that if a contract term is deemed unfair by these commissions, it can be declared null and void.

Further, via the principle of the doctrine of restitution, as outlined in Section 65 of the Indian Contract Act, 1872 if any part of a contract is declared void, the benefits received by any party must be returned or compensated to the party from whom they were obtained. 

Under the CP Act, an unfair contract exists where there is a manufacturer, trader, or service provider on one side, and a consumer on the other. Therefore, to assess the “unfair contract” aspect in loan contracts, a key consideration will be whether the borrower is a “consumer” as denoted thereunder.

Determination of ‘Consumer’ under the CP Act

Section 2(7)(ii) of the CP Act in respect of loans defines consumer as any person who has availed services for a consideration which has been paid or promised or partly paid by such person and partly promised, however, does not include any person who has availed of such service for any commercial purposes. Hence, in the context of loans, borrowers who have availed of loans for “commercial purposes” would not qualify as consumers under CP Act. As the law currently stands, any person who obtains loans for his personal use would still fall under the definition of the term “consumer”. However, there might be debates on whether a person availing business loans would fall under the ambit of the CP Act. The term “commercial purposes” per se has not been defined under the CP Act and thus, has been subject to judicial interpretation. 

We now proceed to analyse the current standing of the law in relation to business loans as well as retail loans and understand what qualifies as a service being taken for “commercial purpose”.

Are retail and commercial borrowers recognized as ‘consumers’

The definition of a “consumer” under S.2(7) of the CP Act includes any person who buys a good or hires a service for consideration paid or under any system of deferred payment. 

This would also cover in its ambit borrowers because in the context of Banks, the Supreme Court has held that persons who avail of any banking services is a consumer under the Consumer Protection Act1. 

Additionally, as the National Consumer Disputes Redressal Forum, and the State Consumer Disputes Redressal Forum pass reasoned orders on the interests of borrowers obtaining facilities from NBFC, persons obtaining non-banking financial services shall also fall under the definition of “consumer”. 

Hence, borrowers of retail loans would be recognized as consumers. However, the definition of a “consumer” under S.2(7) of the CP Act does not cover persons who have obtained goods, or availed services for a commercial purpose. 

A commercial purpose includes business-to-business transactions between entities where there is a direct nexus with profit-generating activities. “Commercial” denotes activities pertaining to commerce, and connected with/engaged in commerce having profit as a main aim. Where there is ambiguity, it may be seen whether the dominant intent/purpose of the transaction was to facilitate some kind of profit generation for the purchaser / their beneficiary2. Such activities or contracts would be out of the scope of the Consumer Protection Act3.

As regards loans, where a loan is obtained for a commercial purpose, the person who obtained such a loan does not come under the category of “consumer”4. 

A. Overdraft facility

In Shrikant G. Mantri vs Punjab National Bank5, the appellant took an overdraft facility to expand his business profits, and subsequently from time to time the overdraft facility was enhanced so as to further expand his business and increase his profits. The Supreme Court held that the relationship between the appellant and the respondent is purely a “business to business” relationship. As such, the transactions would clearly come within the ambit of ‘commercial purpose’ and accordingly the appellant is not a consumer under the Act.

B. Working Capital Loans

In the case of Standard Chartered Bank & Anr. v Mankumar Kundliya6, one Mankumar Kundliya was the sole proprietor of the proprietorship firm M/s Sahil Distributors, who had obtained working capital facility from the bank. The issue before the National Commission was on deciding whether the respondent was a “consumer” under the Act. The court negating the contention held that the working capital loan facility obtained by the respondent “cannot be said to be for earning livelihood of the Respondent, and the same are  inherently commercial in nature and the relationship between the parties is purely “Business to Business” in nature. Further, the Appellant also has independent commercial interests. Therefore, the transactions are essentially for ‘Commercial Purpose’ and the case does not fall under the exceptions to the term ‘Commercial Purpose’ carved out in the definition of the term ‘Consumer’ under the statute.”

C. Self Employment 

Loans obtained for the purpose of self-employment may be considered business loans from the perspective of the lender, but the CP Act views such borrowers as “consumers”7.

Would retail and commercial borrowers come under the ambit of “unfair contract” as per CP Act

As mentioned above, an unfair contract refers to a contract with a manufacturer, or trader, or service provider on one hand, and a consumer on the other having such terms as which would cause significant change in the rights of the consumer. 

Loan contracts are contracts that may be tested against this definition, and the definition of an unfair contract in the CP Act is an “inclusive definition”, i.e. it is not exhaustive. It can cover emerging industry practices not specifically captured in any legislation. The CP Act is to be construed in favour of the “Consumer” as it is a “social benefit oriented legislation”8, and lending entities would be well advised to review their restrictive covenants and terms against this definition, specifically in case of retail borrowers.

Since an unfair contract requires one of the parties of the contract to be a “consumer”, it would not include commercial loan contracts where the parties would not be “consumers” under the Act, save and except in circumstances where such loans have been obtained by the borrower for purposes of self-employment. Consequently, remedies through the State Consumer Commission or the National Consumer Commission under Sections 47 and 58 of the Act respectively are not available. Therefore, recourse to these commissions is not an option for addressing issues related to unfair contracts in this context.

However, if terms of the contract are unfair, businesses can seek remedies through the Commercial Courts Act, 2015. According to Section 2(c)(i) of the Commercial Courts Act, such unfair contracts may form subject matter of a “commercial dispute”. As a result, businesses can still address these issues through the commercial courts, subject to the dispute meeting the quantum of “specified value” as provided under 2(c)(i) of the Commercial Courts Act. Alternatively, the business which has availed business loans will also have other common law remedies, and may file a suit before a court of appropriate jurisdiction to declare the terms of the Contract as unfair and void.

Common/ prevalent terms and covenants that qualify as ‘unfair’ 

The following terms have specifically been held to be an “unfair contract” or unfair trade practice by the Consumer Disputes Redressal Commissions with regards to lenders regulated by RBI: 

  1. Excessive Penal Interest/Charge: Charging of excessive penalty/penal interest (in 2021), holding that incorporating such excessive terms into the loan agreement amounted to an unfair trade practice9.
  2. Ceiling on interest rate: Even where RBI does not prescribe an upper limit for NBFC on rate of interest to be charged, the same can still be considered an unfair contract/unfair trade practice by the consumer courts10. 
  3. Enhancement of interest without borrower consent: Enhancing of interest rate without obtaining written consent of the borrower. Additionally, where clauses of the loan agreement are not in conformity with RBI guidelines, the agreement itself becomes voidable being against the law of the land11.
  4. Repossession Clause: Forcible seizure of a vehicle particularly where no prior notice is given before seizing the vehicle, nor any opportunity given to pay dues constitutes an unfair trade practice, and a deficiency in service. The Supreme Court has in this context also held that any action for recovery in these cases may be struck down12. 

In addition, the covenants demanding instant repayment of loan facilities by the Lender without the occurrence of any default may also be construed as an unfair contract and draw the remedies/penalties as has been provided below. 

Though remedies under the CPA may not be available in case of business loans, however, clauses as has been discussed under consumer loans may also form an unfair contract even in cases of business loans in case the same are present in the terms of the loan agreement with the business entity.

Remedies/ Penalties under the CP Act 

The terms of the contract may be declared null and void (by the National Commission and State Commission (S.59 and S.49 of the Act), and the District/State/National Commissions may issue orders to the opposite party directing them to discontinue the unfair practices. 

However, penal measures are not present towards business loans considering that persons availing business loans are not included within the ambit of the CP Act.

However, while the ambit of “Unfair Contract” under the CP Act is broader in its coverage, the Fair Practice Code of the RBI generally applies to retail loans as well as business loans, save and except to the circumstances where certain paras in the Fair Practice Code are explicitly made applicable on loans provided to individuals. Accordingly, the persons who have availed retail loans as well as persons who have availed business loans can raise their grievances with the RBI ombudsman in circumstances where the grievances have not been addressed by the lender to the satisfaction of the borrower.

Key Takeaways 

Lenders Borrowers 
Consumer Definition:
Retail Loans: Borrowers are recognized as consumers under the CP Act.

Business Loans: Borrowers are not considered consumers if the loans are for commercial purposes.		Consumer Protection:
Retail Loans: As a consumer, borrowers are protected under the CP Act, which includes rights against unfair contract terms and practices.

Business Loans: Loans obtained for commercial purposes do not fall under the CP Act. 
Unfair Contracts:
Retail Loans: Lenders must ensure that contract terms do not qualify as unfair under the CP Act to avoid legal challenges.

Business Loans: While the provisions relating to “unfair contract” as provided under the CP Act may not apply, lenders should be aware that such contracts could still be challenged under other legal frameworks.		Unfair Contract Terms:
Retail Loans: Borrower can challenge unfair contract terms such as restrictions on prepayment, unreasonable lock-in periods, and excessive interest rates under the CP Act.

Business Loans: Although  remedies under the CP Act might not apply, the borrower can seek redress through other legal means if unfair practices are present.
Common Unfair Terms:Lenders should avoid terms that restrict prepayment, impose unreasonable lock-in periods, charge foreclosure fees, or apply excessive interest rates. Even though the CP Act might not apply to business loans, similar terms can affect borrower satisfaction and lead to disputes.



Grievance Redressal:
Retail Loans: Utilise the mechanisms for redressal, including filing complaints with the National or State Consumer Disputes Redressal Forums.

Business Loans: Address grievances through the Commercial Courts Act, 2015, or common law remedies if contract terms are deemed unfair.
Remedies and Compliance:
Retail loans: Lenders should be prepared to modify or eliminate unfair terms to comply with the requirements of the CP Act and avoid regulatory as well as statutory action.

Business loans: Lenders should understand that while  remedies under the CP Act might not be available, there are still other legal avenues for addressing unfair practices.		Fair Practice Code:Both retail and business loan borrowers can escalate unresolved grievances to the RBI ombudsman under the Fair Practice Code.
Fair Practice Code:Ensure compliance with the RBI’s Fair Practice Code for both retail and business loans. Complaints can be escalated to the RBI ombudsman if unresolved satisfactorily.

Conclusion

In navigating the complex landscape of borrower rights and lender obligations under a financial transaction, the CP Act, and the RBI’s Fair Practices Code play pivotal roles. The CP Act safeguards borrowers by addressing “unfair contracts,” including terms that restrict prepayment or impose excessive penalties. While these robust protections are available for retail loans, they do not extend to business loans intended for commercial purposes. However, borrowers of business loans are still covered under the Fair Practices Code, which ensures fair treatment and provides a grievance redressal mechanism through the RBI ombudsman. 

We recommend that Lenders be vigilant in crafting fair contract terms to avoid legal disputes, and ensure compliance with both regulatory and statutory frameworks. For retail loan borrowers, avenues for challenging unfair practices are clear and accessible. For business loan borrowers, while direct remedies under the CP Act may not apply, alternative legal channels are available. Ultimately, understanding and adhering to these regulations is crucial for maintaining trust and fairness in lender-borrower relationships which constitutes the bedrock of the financial services sector. 

  1. Arun Bhatiya vs. HDFC Bank and Ors. (08.08.2022 – SC) : MANU/SC/1210/2022. ↩︎
  2. National Insurance Co. Ltd. vs. Harsolia Motors and Ors. (13.04.2023 – SC) : MANU/SC/0380/2023. ↩︎
  3. Shrikant G. Mantri vs. Punjab National Bank (22.02.2022 – SC) : MANU/SC/0225/, . Lilavati Kirtilal Mehta Medical Trust vs M/S Unique Shanti Developers ↩︎
  4. Gurumoorthy vs. The Canara Bank and Ors. (26.07.2023 – SCDRC Puducherry) : MANU/SZ/0001/2023 ↩︎
  5. Refer footnote 3 of this article ↩︎
  6. Standard Chartered Bank & Anr. v Mankumar Kundliya, 2023 ↩︎
  7.  Refer footnote 4 ↩︎
  8.  Ireo Grace Realtech Pvt. Ltd. vs. Abhishek Khanna and Ors. (11.01.2021 – SC) : MANU/SC/0013/2021 ↩︎
  9.  Manish Sehgal v. L&T Finance Ltd. ↩︎
  10.  Awaz And Others vs Reserve Bank Of India ↩︎
  11. India Bulls Housing Finance Ltd. & Anr. Vs. Boota Singh Sidhu ↩︎
  12. Citicorp.Maruti Finance Ltd vs S.Vijayalaxmi on 14 November, 2011 AIR 2012 Supreme Court 509 ↩︎

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