Finance & Markets Update - July 2009

In this edition

• Civil Penalties under Consumer Credit Code
• Electronic Contracts
• Proposed Bankruptcy Law Changes

Civil Penalties under Consumer Credit Code

The Director of Consumer Affairs Victoria (Director) brought proceedings against Australian Finance Direct Limited (AFD) in the Victorian Civil Administrative Tribunal (VCAT).

The Director alleged breaches of four key disclosure requirements of the Consumer Credit Code (Code), namely ss.15(B), (C), (D) and (E), for which the Director sought a civil penalty.

VCAT found that AFD has breached each of the four key disclosure requirements.

Ultimately, the High Court of Australia confirmed the views of several appellant Courts that AFD had breached only s.15(B).

The proceedings were the first successful prosecution of a credit provider for a breach of a key requirement of the Code and clarifies the issues that a court must consider when determining the quantum of any civil penalty imposed under the Code.

The law

Section 15 of the Code sets out a number of items which must be disclosed in a credit contract.

Section 15(B) specifically requires disclosure of the amount of credit provided under a credit contract.

Section 100(1) provides that s 15(B) is a “key requirement” of the Code.

The breach

AFD had an arrangement with the National Investment Institute Pty Ltd and two related companies (collectively NII) to provide finance to NII’s customers for educational courses with NII.

Each credit contract between AFD and a NII customer specified that the amount of credit under the credit contract to be disbursed to NII was an amount equal to the course fees.

However, on settlement of each loan, AFD would disburse to NII the amount of the course fee less an amount known as a “holdback” which was in effect an interest subsidy paid by NII to AFD.

The holdback operated as an interest subsidy for AFD entering into a credit contract with a customer of NII at a discounted interest rate.

The holdback was not disclosed in the credit contract.

Civil penalty

Following confirmation of the breach by the High Court of Australia in December 2007, the matter was referred back to VCAT for imposition of the civil penalty.

Section 102(2) provides that VCAT may impose a civil penalty on a credit provider for a contravention of a key requirement of the Code.

The maximum civil penalty which may be imposed for a contravention of a key requirement is $500,000 – s 105(1).

AFD and the Director reached an agreement that AFD pay:

1. the Director’s costs of the proceedings; and
2. a civil penalty of $100,000.

The Court must approve any agreement between the parties as to civil penalty and make appropriate orders.

Assessing quantum of civil penalty

Section 102 of the Code outlines the issues which the Court must have regard to in considering the imposition of a civil penalty.

Section 102(3) of the Code provides:

Prudential standing. The Court, in considering the imposition of a civil penalty, must have regard primarily to the prudential standing of any credit provider concerned … However, the Court is to have regard to that prudential standing only if the credit provider requests the Court to do so.

Section 102(4) of the Code provides that:

Other matters to be considered. The Court, in considering the imposition of a civil penalty, must have regard to the following –

• the conduct of the credit provider and debtor before and after the credit contract was entered into;
• whether the contravention was deliberate or otherwise;
• the loss or other detriment (if any) suffered by the debtor as a result of the contravention;
• when the credit provider first became aware, or ought reasonably to have become aware, of the contravention;
• any systems or procedures of the credit provider to prevent or identify contraventions;
• whether the contravention could have been prevented by the credit provider;
• any action taken by the credit provider to remedy the contravention or compensate the debtor or to prevent further contraventions; (h) the time taken to make the application and the nature of the application; (i) any other matter the Court considers relevant.

In considering the appropriate civil penalty, Deputy President McKenzie considered the following:

Prudential standing (s 102(3))

Section 102(3) requires that prudential standing only be required when requested by the credit provider.

AFD did not request that their prudential standing be considered.

Conduct of the credit provider and debtor (s 102(4)(a))

• AFD did not wish to disclose the holdback.
• AFD did not wish to flout or recklessly ignore the Code and had a culture of attempting to comply with the Code. AFD provided regular training and refresher training to its staff and management and regularly obtained legal advice to ensure that it was compliant with the Code.
• AFD obtained legal advice prior to introducing the holdback between NII and itself. The Court found there was at least one respect in which AFD should have made, but did not make, further enquiries arising out of the legal advice given to it.
• After VCAT’s July 2004 judgment AFD altered its business practices with its introducers to ensure compliance with the Code notwithstanding making the alterations put AFD at a disadvantage to its competitors in the industry who continued to follow old practices and retain holdbacks.
• In September 2006, AFD ceased lending and does not intend to resume such lending.
• In a related class action, AFD entered into a settlement scheme with its debtors where AFD released the affected debtors from any liabilities to it. For those who did not have continuing liabilities (i.e. those whose debts had been paid out), each was entitled to a share in a settlement pool funded by AFD.
• AFD has incurred very substantial costs in connection with the VCAT proceedings and related class action.

Breach – deliberate or not (s 102(4)(b))

• Whilst AFD intended to not disclose holdbacks, Deputy President McKenzie was not satisfied that AFD intended to breach the Code.
• When it became clear from VCAT’s decision that the Code had been breached AFD changed its business practices.

Loss or detriment to debtors (s 102(4)(c))

• AFD’s failure to disclose holdbacks meant that the debtor did not understand the true nature or cost of the transaction they were entering into.
• Without the information, the debtor could not make meaningful comparisons with other financial products or decide whether it would be better to pay for their courses in cash or to approach the NII for a discount. With this information, they might have decided not to borrow from AFD at all. This constituted a detriment to the debtors.
• ·his issue of loss or detriment to an individual debtor was addressed in the settlement scheme of the related class action, where virtually all debtors had the opportunity to either have their liabilities released or share in a settlement pool.

Awareness of breach (s 102(4)(d)

• Whilst AFD’s legal advice was that it did not breach s 15(B) of the Code, it became aware of the possibility of a breach when the Director applied to VCAT in November 2003. The fact of the breach became clear when VCAT handed down its decision in July 2004.

Systems to prevent or identify breaches (s 102(4)(e))

• AFD had in place systems to prevent or identify potential Code breaches. It had a compliance manager, trained its staff and conducted regular legal advice and audits.
• AFDs systems did not contemplate that legal advice received may be incorrect or might have been based on an incorrect assumption.

Whether breach could have been prevented (s 102(4)(f))

• AFD could have prevented the breach if it had disclosed the holdbacks to debtors.Its legal advice was that non-disclosure did not breach s 15(B) of the Code.

Action to compensate debtors, to prevent further breach and remedial action (s 102(4)(g))

• Deputy President McKenzie reiterated her comments under the heading “Conduct of the credit provider and debtor” (s 102(4)(a)).
• AFD altered its business practices with its introducers following the VCAT decision in order to comply with the decision.
• AFD has ceased this kind of lending.

Time taken to make the application and nature of application (s 102(4)(h))

• The application was made by the Director and not AFD.
• Because the holdbacks were not disclosed by AFD, it is not surprising that a debtor has not made the application.

Other relevant factors (s 102(4)(i))

Seriousness of breach

• s 15(B) is a key requirement of the Code;
• a key objective of the Code is truth in lending – disclosure which allow debtors to make fully informed choices and to allow them to understand fully the transactions into which they are to enter – s 15(B) is a fundamental disclosure requirements;
• AFD concedes that the breach was serious.

Effect of the Civil Penalty to deter or punish

• Civil penalty will have little deterrent effect on AFD as AFD has ceased this type of lending;
• The civil penalty will have a deterrent effect on other suppliers of goods and lenders who offer discounted interest rates or interest free products and retain holdbacks, promoting better compliance with the Code;
• The deterrent effect has somewhat been weakened because of the passing of time. The VCAT decision occurred some 4½ years prior to the decision as to civil penalty.

Other losses to AFD in connection with the holdback arrangements

• AFD has expended very large sums in costs in these proceedings and related class action proceedings, including paying the Director’s costs in this proceedings, paying the solicitors' costs in the related class action and entered into a settlement agreement with most of the debtors whose contracts involved holdbacks.

AFD’s conduct of the proceedings

• Deputy President McKenzie did not take AFD’s conduct in the proceedings into account in relation to the civil penalty. Other then AFD reluctantly producing its legal advice, during discovery, AFD conducted the remainder of the proceeding in a fair and frank way;
• There may be other instances where a credit provider has conducted a civil penalty proceeding in such an outrageous way that its conduct of the proceeding should be taken into account in imposing a civil penalty, but it is the credit provider's conduct in breaching the Code and the factors in s 102(4) of the Code that must be the primary considerations;
• Generally, costs will compensate for any disadvantage caused by the credit providers conduct of the proceeding.

Judgment

Electronic Contracts

Whilst the Electronic Transactions Act 1999 (Cth) (ETA) and equivalent State based legislation has been in place for 10 years, the take up rate by companies in Australia, particularly banks and finance companies has been slow.

When introduced, the purpose of the ETA was to facilitate the use of electronic transactions and promote business confidence in such transactions.

The application of the ETA has also been confirmed in other legislation. For example, s 164A(1) of the Consumer Credit Code (as set out in the appendix to the Consumer Credit (Queensland) Act 1994 and adopted in all other States and Territories of Australia) (Code), declares that any contract, mortgage or guarantee referred to in the Code, may be made in accordance with ETA.

It was not until last year that a major Australian bank first applied the provisions of ETA and Code to create an electronic contract for one of its business and consumer loan products.

What the ETA permits

ETA permits the giving of and acceptance of information by electronic communication.

Information is defined in s.5 of ETA to mean information in the form of data, text, images or speech.

The term “information” is broad allowing for a wide range of documents, including loan applications, loan contracts, sales contracts, terms and conditions, notices and other transaction documents.

Electronic communication is defined in s.5 of ETA to mean:

This paper focuses generally on electronic contracts.

Formation of electronic contract

It is a requirement of a number of different laws that information be given in writing or a contract be in the form of a written contract document. For example, s.12 of the Code requires credit contracts to be in the form of a written contract document.

Section 9 of ETA permits the requirement for writing to be met by electronic communication.

Where there is a requirement to give information in writing, s.9 of ETA provides that requirement is taken to have been met by means of electronic communication as long as:

1. the information is readily accessible so as to be usable for subsequent reference; and
2. the recipient of the information consents to the information being sent by way of electronic communication.

Form of electronic contracts

Under the provisions of ETA it is not mandatory for electronic communication to be the means of communication both to and from a customer.

Electronic communication can be limited to the distribution of information electronically by a company to a customer with paper versions including execution copies required in return from a customer.

Under the provisions of ETA it is also not mandatory for electronic contracts to be fully electronic. Electronic contracts may be partly electronic and partly on paper or oral.

ETA gives companies the flexibility to tailor electronic contracts to their particular requirements.

Requirements for signature

One of the main reasons the take-up rate of electronic contracts has been slow in Australia is the lack of development in the field of electronic signatures.

In America, a number of companies offer to provide encrypted digital signatures which may be applied to electronic contracts.

Section 10 of ETA does not prescribe the form a signature must take, rather it deals with signatures generally. The key requirements for a signature under the ETA are:

1. the method of signature used identifies a person’s approval to the information communicated;
2. having regard to all the relevant circumstances the method used was as reliable as was appropriate for the purposes for which the information was communicated; and
3. the person who requires the signature consents to the form of signature provided electronically.

Based on the requirements of ETA, it is important that a company determine the most appropriate signature for its circumstance, whether it be electronic or physical.

If adopting an electronic signature, the types available include:

1. providing credit card details;
2. entering passwords;
3. PKIs (digital signatures);
4. dual factor authentication (the signing process requires a physical security token in addition to passwords).

Benefits of electronic contracts

There are many benefits to using electronic contracts. The following, whilst not an exhaustive list, provides an overview of some of the key benefits:

1. contracts may be formed online;
2. bulky documents such as terms and conditions booklets may be emailed to customers to save printing costs, postage, handling and storage space;
3. contracts may be stored electronically allowing their contents to be searchable, making them easier to locate when required, particularly if required for litigation; and
4. electronic contracts, stored electronically may be relied on in court, avoiding the need to keep paper copies.

Conclusion

ETA was drafted in such a way as to provide companies with the ability to adapt new technologies to their business processes as well as the particular requirements of different legislation.

Proposed Bankruptcy Law Changes

In late May 2009 the Federal Government released a discussion paper regarding proposed changes to the Bankruptcy Act of 1966. The proposed changes come amid the economic downturn and are an attempt by the Government to deal with the increasing number of Australians drowning in debts accumulated from heavy credit usage.

The number of Australians filing for bankruptcy and entering into other forms of debt agreements has increased in the past three months, compared with this time last year.

Figures published on 3 July 2009 by the government agency, Insolvency and Trustee Services Australia, show the number of bankruptcies, debt agreements and Part X insolvency agreements between April and June rose by 3 per cent to 9437.

This represents not only a rise year on year but also quarter on quarter when compared with the number reported between January and March. The figures reflect rising unemployment, large loan repayments on mortgages, credit cards and other personal debts, and business failures.

The proposed changes include:

In the discussion paper, the Government gives a variety of reasons for the proposed changes including:

• Most bankruptcies are the result of misfortune rather than misdeed, which the current bankruptcy system does not recognise;
• The current system imposes the same restrictions on all bankrupts and consequently does not assist in the rehabilitation of debtors or result in any greater returns for creditors;
• The aim of the system should be to deal quickly with a person’s insolvency and make sure they are able to quickly return and start contributing to the economy again; and
• The system should also do more to encourage informed decision making and access to alternative solutions including debt agreements or personal insolvency agreements under the legislation.

Key stakeholders have had mixed reactions to the proposed changes with only the increase of thresholds for Part IX debt agreements being widely accepted as an appropriate amendment in light of recent economic developments.

The other changes have been criticised for their apparent failure to maintain a balance between the interests of creditors, debtors and those involved in the administration of insolvent estates and agreements under the legislation.

The Government has also been criticised for the limited time given to stakeholders to consider and respond to the proposed changes. Submissions in response to the proposed changes closed in mid June, 2009.

In light of the lukewarm response it is not clear if the proposed changes will be pursued through parliament, but if the increase in bankruptcies continues then it is unlikely that this will be the last that we hear of possible amendments.