Consumer credit test case provides guidance on fees

The dismissal of charges against a finance company in a test case over loan fees should bring greater clarity for an industry that is increasingly under the watch of New Zealand regulators.

The Commerce Commission prosecuted a large New Zealand lender to low-income borrowers in the first case of its type under the Credit Contracts and Consumer Finance Act 2003 (the CCCFA). Not surprisingly, many industry participants were interested in the outcome.

The Auckland District Court¹ has dismissed charges that the lender breached the CCCFA by charging excessive fees to borrowers who repaid loans early.

The decision provides helpful guidance that lenders are not obliged to use the regulatory formula to calculate their early repayment fees, and may use an alternative approach if that is more appropriate to the structure of their business. However, the decision also reinforces the need for lenders to be able to show that their fees are calculated on actual estimated costs and losses, and are not simply arbitrary.

The Commission has announced its intention to appeal the District Court decision.

The prosecution

The Commerce Commission's prosecution related to the lender's prepayment fees. The lender was charged with offences over the fees it charged on 50 fixed-rate fixed-term loans that were fully repaid before their contractual date for repayment.

CCCFA's provisions

The CCCFA specifies that a fee charged by creditors on early repayment of a consumer loan must not exceed a reasonable estimate of a creditor's loss from early payment. The loss may be calculated using either the "safe harbour" formula set out in the regulations, or "an appropriate procedure set out in the consumer credit contract for calculating that loss". Prepayment fees calculated using the safe harbour formula are deemed to be reasonable.

The safe harbour formula calculates the loss as the present value of the difference between the interest payments the creditor was expecting under the original contract and those that it can obtain by re-lending the repaid funds at prevailing interest rates. The formula assumes that the creditor can mitigate its loss by re-lending the repaid funds. If interest rates have not fallen since the original loan was made, then the creditor is considered to have suffered no loss.

Many lenders have chosen not to use the safe harbour formula because it does not capture their actual losses on prepayment, such as marketing and broker commission costs. Nor does it reflect the fact that, in many cases, re-lending is unrelated to prepayment. Until now, the Commission has taken the narrow view that any formula that results in a higher calculation of loss than the safe harbour formula is likely to be "unreasonable" and to breach the CCCFA.

The Commission's case

The lender's prepayment fee was calculated on the basis of the difference between the rate charged on the loan and the 90 day bill rate, plus a margin of 1.9%, for a 90 day period. The Commission alleged that this resulted in an unreasonable estimate of the lender's loss because the formula:

• imposed an arbitrary 90 day interest period that did not relate to the time taken to re-lend funds;
• had no regard to changes in prevailing interest rates and therefore no regard to a variation in the rate at which funds would be re-lent; and
• did not take into account mitigation of loss by re-lending prepaid funds.

The Commission argued that the formula captured three months of future profit in a situation where the creditor had use of the prepaid funds, no risk associated with those funds, and offered no service to the prepaying debtor. The safe harbour formula would not have allowed the lender to claim a prepayment fee because interest rates had increased over the relevant period.

The lender's defence

The lender argued that its loss was the unearned interest on the loan over the remainder of the loan term, less the amount saved by repaying the prepaid funds into its bank, plus the administrative costs incurred on early termination (which the lender did not charge a separate fee for). The lender's formula was intended to estimate that loss of margin. In fact, according to the lender's expert witness, the company's actual loss was greater than the amount of its prepayment fee on all but one of the 50 loans.

The lender contended that the safe harbour formula was inappropriate for its business because subsequent lending would occur regardless of any prepayment. The lender had maintained a significant unused bank facility during the relevant period, meaning that it had excess lending capacity. This capacity meant prepayment created no further opportunity to re-lend the prepaid funds.

The judgment

The judge found that a creditor's loss is the gain the creditor would have made if the contract had run its course and was not prepaid, subject to the creditor's obligation to mitigate its loss. In this case, the judge said that prepayment did not create new lending opportunities for the company, but merely reduced its borrowings. The court agreed with the lender that the safe harbour formula did not reflect its actual loss because there was no link in the lender's business between prepayment and subsequent re-lending. The judge commented that the legislation does not stipulate how the lender should run its company or source its funds and the court was satisfied that the lender's formula was a reasonable estimate of its loss, and so dismissed the charges.

¹ Commerce Commission v Avanti Finance Limited Auckland District Court 10 June 2008

Enquiries and information

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