New Zealand Credit Law Bulletin - Vol 8, No 3, June 2008
A free, plain English review of recent law and items of interest for creditors, produced by Hattaway & Associates Ltd, Credit Consultants. To subscribe send a blank email to: nz-bulletin-join@mailman.hattaways.com
Plain language disclaimer:
This bulletin is not legal advice. Do not make decisions on legal matters based on a brief commentary. Instead, get professional legal advice.
In this issue:
- Test case - full prepayment prosecution under CCCFA
Victory for finance company exposes fatal flaws in the “safe harbour” formula - Personal commentary by Alan Liddell on the decision in Commerce Commission –v– Avanti Finance Ltd
Alan Liddell comments on the test case which has proven to be something of a triumph for his views - How bad will the economy get and what does it mean for credit management?
This article, by Peter Hattaway, first appeared in MG Business 26 May 2008
1. Test case - full prepayment prosecution under CCCFA
Commerce Commission –v– Avanti Finance Ltd DC AK CRI-2007-004-010204 (Unreported)
Avanti Finance Ltd is a finance company. Any of its consumer loans made since 1 April 2005 are subject to the Credit Contracts & Consumer Finance Act (CCCFA). The CCCFA is enforced by the Commerce Commission. The Commission investigated Avanti and prosecuted the company in the District Court in relation to 50 credit contracts, each of which was paid off early by the borrower (a process known as “full prepayment”) at some point between June 2005 and December 2006. In each of these cases, Avanti charged the borrower a fee to cover its loss, using a formula set out in its contracts. The Commission claimed that this formula did not comply with the CCCFA.
This was the first ever prosecution under ss51 and 54 of the CCCFA.
The CCCFA aims to protect consumer borrowers. Among other things, it says that borrowers have a right to make full prepayment – that is, pay off the debt early – under a consumer credit contract at any time. If a borrower does so, the lender is likely to suffer a loss. The lender can make a reasonable estimate of this loss either by using a formula set out in the Regulations under the CCCFA (the so-called “safe harbour” formula), or by using its own formula, if it has set out that formula in its credit contract (s54). If it uses its own formula, that formula must not exceed a “reasonable estimate of the creditor’s loss arising from the full prepayment…”
Many finance company readers will remember Nicholas McBride, the solicitor for the Ministry of Consumer Affairs who spoke at the first workshops Hattaways put on about the (at that time) upcoming CCCFA. He gave evidence to the court that he instructed Price Waterhouse Coopers to draft the safe harbour formula for the Regulations. The formula assumes that any loss will be as a result of a drop in interest rates since the loan was made. The approach used in the formula assumes that a lender can immediately relend the money but that if the interest rates have gone down, the lender will relend at a lower interest rate and the loss will result from the difference between the two rates. Under the safe harbour formula there would be no loss at all if interest rates had risen. Price Waterhouse Coopers’ director Andrea Gluyas, who developed safe harbour formula, gave evidence that if it had been applied to the 50 Avanti contracts being considered, no compensation payments would have been made by the borrowers.
The CCCFA also allows the lender to recover the administration costs arising from the full prepayment (s51(b)) if provided for in the contract. Avanti did not attempt to recover these costs.
Avanti’s expert witness, Professor Robert Bowman of the Business and Economics Faculty of the University of Auckland, explained that the safe harbour formula was not a fair way of estimating Avanti’s loss (nor presumably the loss of most finance companies). The safe harbour formula assumes that relending the money wipes out most of the loss. However, this is only true if the lender doesn’t have other money to lend. If the lender hasn’t run out of money to lend, then any new loan is simply a new loan, not a relending of the money which has been repaid.
Professor Bowman had criticisms of Avanti’s formula and came up with a formula which more precisely calculated its loss. However, the effect of Avanti’s formula was to recover a loss equivalent to only 90 days of lost margin. This cap was in many cases much less than the company’s actual loss, according to Professor Bowman. He said:
The analysis I undertook shows that the average prepayment fee charged by Avanti on a loan prepaid a year in advance will be less than half its loss. Since the average prepayment is more than two years in advance, Avanti’s average prepayment fee will have been significantly below what I calculated to be a reasonable estimate of its loss.
Under Professor Bowman’s own formula, all 50 cases would have paid a higher fee except one which would have paid $8.27 less. His conclusion, which the judge accepted, was that the Avanti formula was a reasonable estimate of its loss.
The District Court judge said that “[Professor Bowman] stressed and I have accepted that there was no link in Avanti’s business between full prepayment being made and any subsequent lending. Further, it is not relevant that interest rates may have fallen or indeed risen.”
Avanti was also prosecuted under the Fair Trading Act 1986 (also policed by the Commerce Commission) that it made a false or misleading representation concerning the price of a service (s23(g)) or, alternatively, made a false or misleading representation concerning the existence of a condition (s13(i)). This was because the ‘full prepayment’ clause of Avanti’s contracts stated:
The creditor may have suffered a loss if the creditor’s current interest rate is lower than the interest rate applying to your original consumer credit contract.
The Avanti full prepayment formula did not take into account any change in interest rate, so this sentence (which appears in the ‘safe harbour’ version of the clause) was not relevant to Avanti’s formula. The actual formula used by Avanti was set out in the credit contracts.
The Commerce Commission claimed that the sentence implied that the safe harbour formula would be used. However, the judge concluded that there was no such implication and that in itself the sentence was true and not misleading. The sentence states that the creditor may have suffered a loss if interest rates have dropped. “Indeed if interest rates have dropped,” the judge pointed out, “of course the creditor would have suffered a loss…” The charge under s23(g) was therefore dismissed.
The judge also concluded that the wording of the sentence made no representation about the existence of a condition so the charge under s13(i) was also dismissed.
Back to top
Information on our current seminars
2. Personal commentary by Alan Liddell on the decision in Commerce Commission –v– Avanti Finance Ltd
Alan presents his views on this case. He does not speak for any of his clients in this commentary.
As many finance company readers will know, I have conducted an ongoing argument with the Commerce Commission on the issue of full prepayment fees under the Credit Contracts and Consumer Finance Act.
Essentially I have advised my clients that they could charge prepayment fees exactly in the manner which Professor Bowman recommended and the court upheld – all future interest reduced by the cost of funds, discounted to net present value. Avanti elected to use a simpler formula which in fact charged less that the Act otherwise entitled them to charge.
However, understandably, many clients have followed the Commerce Commission line for fear of the costs of conducting a criminal defence. My frustration at this has been increased by the Commission’s flat refusal to discuss its reasoning or any view contrary to its own. That refusal is all the more strange when one considers the Commission’s educative role under the Act.
It now turns out that the Commission’s refusal to enter into discussion turned out to be based on there being no legal justification for its views. It had nothing to say. At the District Court hearing, the Commission’s lawyer was not able to cite a single precedent for its point of view on full prepayment. The defence, on the other hand, was able to rely on principles supported by a number of British and Australian authorities – the same principles I relied on when first crafting my advice three years ago.
The Commerce Commission now has a period during which it has the right to appeal. The Commission has previously said it would appeal if it lost. However, it is hard to see their lawyers encouraging this path. The safe harbour formula has been shown to be a flawed and unrealistic way of calculating losses.
Assuming the Commission doesn’t appeal, I assume that many finance companies will be increasing the fees they charge for prepayment loss. They must ensure they amend the operative terms in their credit contracts and disclosure statements.
Hattaways presented various sessions on the CCCFA as it was developed, essentially providing most of the initial training for the finance industry, often in conjunction with speakers from the Commerce Commission and Ministry of Consumer Affairs, and featuring Alan Liddell.
Alan’s next presentation of our seminar, the Law of Credit for Finance Companies, is on 21 August in Auckland and the next Law of Credit Management (the trade creditor version) is 11 August, also in Auckland. See http://www.hattaways.com/seminars/index/nz
Alan can be contacted at alan@creditlawyer.co.nz or 07 578-2124.
Back to top
Information on our current seminars
3. How bad will the economy get and what does it mean for credit management?
The original article from MG Business
“You need to keep as many people as possible in their houses so that they don't come onto the market. You need to arrest the decline in house prices, but you also need to prevent human suffering and social disruption because it's going to be very, very severe.”
Billionaire investor George Soros on the US subprime housing crisis. New York Review of Books, 15 May 2008
“For the first time in our company’s history, our board is paying attention to credit management,” one credit manager told me last week. Two months of the worst debt figures his company has ever seen mean that he has the go-ahead to employ more staff.
It’s obvious that New Zealand faces hard times. Petrol and food prices are rising. Unemployment is up. But really, it’s what happens overseas that determines how bad this gets.
How bad is it going to be? Most of those who know, don’t want to say for fear of depressing the economy further. Are we heading for a 1930s-style depression? What are the implications for New Zealand businesses and particularly for those trying to collect debts? I don’t want to spread doom and gloom – I was much more optimistic by the time I’d finished writing this article than I was when I started the research – but I think we need a realistic understanding of what’s happening.
The story starts in the 1980s, when banks in the US started selling their home mortgages. They packaged up bundles of mortgages into ‘mortgage bonds’ and Wall Street traders sold them to investors. The home owners kept paying the banks, and the banks passed the money on to the bond holders.
Of course, if any homeowners didn’t pay, their houses would be sold in mortgagee sales. If the mortgagee sales didn’t cover the value of the debt, the investors lost out. Rating agencies such as Standard & Poors and Moodys gave the bonds a creditworthiness rating so investors could understand the risk and decide what the bonds were worth. Today, the mortgage bond market is worth US$6 trillion, the biggest single part of the US$27 trillion US bond market.
House prices in the US rose steadily from about the
start of the 1990s. Roughly 5 years ago,
‘subprime’ home loan lending took off in the US.
This is lending to higher risk borrowers who wouldn’t normally get
mortgages. These loans, too, were
on-sold as bonds. 
By 2005, one in five mortgages was subprime. About six million people who had little or no money borrowed around 100% of the value of a house, at about the top of the housing market. From 2006, house prices dropped sharply and it turned out that millions of credit decisions, and the ratings of the agencies, had been poor. Many subprime borrowers have lost or will lose their homes. Of course, that hits investors who own subprime mortgage bonds and banks which lent to those investors. Of the banks, those in the US were hit hardest. To pick just one example, in November 2007, Chuck Prince, the CEO of US bank, Citigroup, the world’s biggest bank, resigned as the bank estimated that it had lost up to US$11 billion on investments related to sub-prime mortgages. European and Japanese banks have also suffered.
Many bond investors reduced the risk of non-payment of their bonds with contracts known as ‘credit default swaps’ (often known as CDS). CDS work like this – the owner of bonds pays the equivalent of a premium to another party, which has to pay out on any default on the bonds, like an insurance company would. But insurance companies are regulated to make sure they have the cash to pay claims. CDS are traded on a ‘grey’ market on a huge scale. They are widely used to speculate on market changes and they are not regulated. In June 2007, the Bank for International Settlements reported the notional amount on outstanding over-the-counter CDS to be US$42.6 trillion.
This looms as another disaster for financial markets. The party which is supposed to pay out on a default may turn out not to have the money or may not be around to pay.
Bear Stearns – the fifth largest US investment bank and the ninth-biggest player in the CDS market – is still around, but only just. In March 2008, the company had a US$10 billion run on its funds as investors lost confidence and pulled their money out. On 16 March, to avoid bankruptcy, the firm was sold to another Wall Street trader, JPMorgan, for 1.3% of its market value of a year earlier. The sale was backed by an unprecedented US$29 billion of special financing from the US government. The government did this to prevent havoc in financial markets.
At the homeowner level in the US, the news is equally bad. In a speech on 4 May 2008, Ben Bernanke, Chairman of the US Federal Reserve, said that, “About one quarter of subprime adjustable-rate mortgages are currently 90 days or more delinquent or in foreclosure… [F]oreclosure proceedings were initiated on some 1.5 million U.S. homes during 2007, up 53 percent from 2006, and the rate of foreclosure starts looks likely to be yet higher in 2008.”
Mortgagee sales reduce house prices even further. Then banks like Citigroup find they need to make further write-offs. In January, two months after estimating losses of up to US$11 billion, Citigroup wrote off US$18 billion in bad investments. At time of writing, its losses totalled US$40 billion.
These sorts of banking problems have meant that banks have been generally unwilling to lend to other banks, a major problem for the banking system. No-one knows how bad anyone else’s problems are going to be, and who they can trust. Everyone is therefore struggling to find the money they need.
The US economy is in deep, deep trouble. Is this the start of a 1930s-style Great Depression? In April, the International Monetary Fund warned that America's mortgage crisis has spiralled into "the largest financial shock since the Great Depression" and said there is now a one-in-four chance of a full-blown global recession (which the IMF defines as less than 3% world growth) over the next 12 months. So they’re not yet talking about a depression (a severe economic downturn that lasts several years) but it could be a global recession if we’re unlucky.
Here are some of the positives. First, the major credit markets are starting to recover following the rescue of Bear Stearns. The Wall Street Journal on 15 May said, “A significant improvement in the credit markets since late March is emboldening more companies to undertake acquisitions and share buybacks that will be financed largely with debt.” There is still caution, but investors are becoming more willing to borrow, and banks more willing to lend. The US Federal Reserve is stepping up as lender of last resort for a wider range of financial institutions and is prepared to accept a wider range of securities as collateral. This has been positive and economists hope that it proves to be the circuit breaker.
This is evidence of a second positive factor: Governments and central banks know a lot about dealing with financial crises. After the Wall Street crash of 1929, the US central bank did more to exacerbate the problem than to fix it. By contrast, in the last six months, central bankers have bailed out banks, lowered interest rates, and increased the money available.
For example, in March 2008, a group of central banks in North America and Europe said that they would inject US$200 billion into money markets. And in April 2008, consumers in the US received more than US$100 billion in tax rebates – up to US$600 for individuals and US$1,200 for couples – as part of a plan to stimulate the economy.
The third piece of good news is that the world economy doesn’t depend on the US as much as it used to. In 1929, the US economy was much more important, so when it failed, the whole world went into a depression. Today, the annual gross domestic product of the US is actually exceeded by that of the European Union (though the EU has its own, somewhat less serious problems housing finance problems), and there is substantial wealth elsewhere.
It’s significant that when Citigroup sought to raise $12.5 billion at the end of 2007, it got the money from such sources as the Singapore government's investment arm, the Kuwait Investment Authority and prince Alwaleed bin Talal of Saudi Arabia. A report by HSBC in February 2008 says that "… huge quantities of money from the emerging world – some $60bn at the last count – are injecting a measure of stability into the developed world's arteries [meaning Citibank and others].”
Merrill Lynch chief Asia economist Timothy Bond was quoted in The Australian on May 15 2008 saying, "Europe has been the main driver of Asian exports over the past few years, not the US." Asian economies expanded 9.5 per cent and China grew by 11.5 per cent in the second half of last year, he said.
And closer to home, Westpac is bidding to buy Australia’s fifth-largest bank, St George, a clear sign that Australian banks (which own our major banks) are not that worried by the problems in the US. Our banks have not been directly affected by the US subprime mortgage problems, though the fallout has caused them some problems.
Clear-sighted billionaire George Soros, one of the world’s most successful investors and now one of its most influential philanthropists, wrote an article in the Financial Times on 22 January called “The worst market crisis in 60 years”. Clearly Soros thinks the problems are serious, but he saw hope:
Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.
So he thinks the West faces a recession but it won’t be worldwide, and when we come out of it the US probably won’t be the world’s leading economic superpower. These are changing times we live in.
So what does this mean for those involved in credit management? Well, imagine you are collecting subprime mortgages in the US. You have lots of customers who can’t pay. If you seize their homes, homeless people will trash the empty houses. When they’re sold – if they’re sold – it will be for bargain prices which will help drive the housing market lower. And then there’s the social cost… It’s not just the borrowers who are between a rock and a hard place – the creditors are too, and so are their collection staff.
The majority of New Zealand credit staff will be too young to remember the crash of 87 and the hard times of the early 90s. Collecting debts in a recession is not the same as collecting in good times. If there is a recession, there will be more good customers who go bad, more stressed and angry customers, and more threats of violence or self-harm. If your usual assumption is that people bring their problems on themselves, you should put that aside. In these circumstances it’s even more important to treat debtors with respect. Bad things can happen to good people.
In a recession there will be more debts sent to debt collectors, more legal action, and more debtors entering into some form of insolvency. “Over the next 12 months we expect to be inundated with debt to collect,” says industry veteran Bob Garters of debt collection company, RML. There will also be more people who decide to set up as debt collectors, on the incorrect assumption that it’s an easy way to make money in tough times. As Garters points out, it’s already much harder to collect debts, both consumer and commercial, than it was six months ago. It is likely to become harder still.
There will be more pressure to negotiate practicable payment arrangements and more need to vary contracts to avoid having to repossess and sell worthless goods. Businesses which can afford help customers through tough times should find that they build strong loyalty.
Not only will there be more debts but negotiations will take longer. Because there is more work, more staff will be required. In some businesses, sales staff with time on their hands will end up doing collection work. “Sales in my area are drying up so I’m helping out by making collection calls for the credit controller,” a salesman explained to me at a collection seminar this month.
Speed in following up on unpaid accounts is crucial. Credit staff who take a hard line early on will sometimes get paid where others miss out. Of course, in other cases they will upset customers who survive. So the ability of credit staff to assess the person and the situation they are dealing with is also crucial.
The problem for reasonable creditors who negotiate fair payment arrangements with their debtors is that they may find that other creditors are unreasonable. The reasonable creditor’s arrangement falls over and the money goes to the creditor who sued, or in some other way took a hard line. Creditors should be aware of the legal options for compromise arrangements and the orderly distribution of payments to creditors. Voluntary Administration (VA) for companies, is a new process, introduced in November 2007 and barely used since then. It can be triggered by the directors of the debtor company or any secured creditor. Most creditors who supply goods will be secured creditors.
For individuals, a Summary Instalment Order (SIO) allows debtors with unsecured debt of less than $40,000 to pay it off all or part over up to 3 years. The process was revamped in December 2007. Robyn Cox of the Insolvency & Trustee Service says that to the end of April only 30 orders have been made! Demand for SIOs must be driven by budget advisers, but they don’t seem to have taken to it.
The new SIO rules were introduced at the same time as the
much more popular No Asset Procedure (“NAP”).
This is a 12-month bankruptcy alternative for debtors with debts below
$40,000 and with no assets and no worthwhile income. The NAP is not administered by the Official
Assignee because, with no assets or income, there is nothing to do. The fear of creditors is that debtors will
abuse this. One creditor quotes an Otaki
voluntary budget adviser who told one of her staff, “I just love the No
Asset Procedure because I am really sticking it to all those finance companies
at the moment...” Others report debtors
starting to use it as a threat to creditors:
“If you don’t give me more time I’ll just take a NAP.”
Robyn Cox says that numbers of debtors using the process to date has been relatively low, though rising. She stresses that the Insolvency & Trustee Service is very keen to make sure that creditors have faith in the system. “If a creditor tells us that a debtor has run up debts recklessly or lied about their assets or income we will look at terminating the NAP,” she says.
This article is reproduced by kind permission of MG Business (the Mercantile Gazette). To subscribe, go to http://www.mgpublications.co.nz/subscription-form.htm
