The following article was written by David McCahon, head of our Consumer and Retail Finance practice, and first appeared in Finance and Credit Law, June 1999, published by Monitor Press Ltd. For details of this and other Monitor newsletters please telephone 01787 467232.
In the last few months the DTI has been extremely busy preparing a White Paper on Consumer Strategy which is due to be published in July. The 1998 Competitiveness White Paper stated that "knowledgeable consumers are a huge asset to business. Businesses have to innovate to meet their customers’ expectations. Consumers need good information on products, services and their rights." Although we are still awaiting the White Paper, it is clear that the Consumer Strategy will have three main planks:
- Better information for consumers on their rights so that they can make well-informed decisions;
- Effective enforcement of consumer protection laws to drive out rogue traders;
- Better assurance of redress.
In his post Budget speach to the House of Commons on 10th March 1999, the Secretary of State for Trade and Industry, Stephen Byers stated that:
To secure real competition we need knowledgeable and well-informed consumers. To that end, we will publish a consumer strategy White Paper before the Summer. However, there is one area of particular concern. A mortgage is the largest and most complex financial commitment that most people will ever enter into. I have today announced proposals to improve the information available to customers in relation to the marketing of mortgages and other credit. Our proposals will give them access to clear information about the interest rates on offer.
So much for the statement of intent. What are these proposals and when might we expect to see the proposals become law?
The Proposals
The proposals announced by the DTI in March range over the following issues:
(a) Clarification of the way in which the Annual Percentage Rate (APR) for low start and discount mortgages is calculated, requiring it to reflect the interest and total charges throughout the entire life of the loan;
(b) Introduction of a single formula for calculating the APR by implementing the amendment to the EC Directive on Consumer Credit;
(c) An extension of the power to take action under the Unfair Terms in Consumer Contracts Regulations to the Financial Services Authority and other consumer bodies;
(d) A limit on the circumstances in which interest rates other than the APR are shown in advertising and other pre-contractual information material;
(e) A requirement to include statutory warnings such as "Your home is at risk if you do not keep up repayments on a mortgage or other loan secured on it" to be shown in all pre-contractual information on mortgage offers.
The DTI also proposed to consult on the following matters:
(f) Making provisions on the early settlement of loans clearer and fairer for consumers;
(g) Reviewing the provisions dealing with extortionate credit in the Consumer Credit Act ("CCA");
(h) Simplifying the regulations dealing with credit advertisements and making them clearer on the requirement for informative and truthful advertising.
It is clear that the timetable has slipped on a number of those proposals due to the work which is being done on the White Paper. It is probably the case that the DTI will not want to detract from the impact of the White Paper by making any regulations dealing with smaller issues at the same time.
Proposals (a) (b) and (c) are to be dealt with by way of regulations which will probably be laid in July with the exception of the Unfair Terms Regulations (proposal (c)) which may be laid in June, to come into effect by July.
Proposals (d) to (h) will be actioned in the Autumn or perhaps even later. Running through the timing on these proposals:
The consultation paper on amendments to the Consumer Credit (Advertisements) Regulations 1989 and the proposals to prescribe the circumstances in which interest rates other than the APR can be included in advertisements, regulated agreements and pre-contractual information is now ear-marked for the Autumn.
The decision on the timing of any regulations to deal with the proposal concerning the wealth warnings in pre-contractual material has not been taken yet. This proposals may not be implemented until early 2000. It is appreciated that business would require a long lead-in period to be able to comply.
The proposals on extortionate credit bargains will not form part of the White Paper, even though primary legislation will be required if the DTI decides to change the existing provisions. The DTI is still formulating its thinking on the issue and has commissioned research on certain matters. It is thought that the consultation paper will be issued in the Autumn at the earliest.
On the early settlement rules, again this is likely to be consulted upon in the Autumn, although informal consultations may take place before then to sound out certain industry representatives.
Now that we have a rough idea of the timetable of these proposals and consultation papers, we can look at the issues in more depth.
Low start and discount mortgages and the calculation of the APR
The DTI issued a consultation paper "Clarification and Simplification of United Kingdom Consumer Credit Law" in February 1998. The OFT raised the issue in its Consumer Credit Deregulation Report in 1994.
This proposal arises out of the cases of National Westminster Bank -v- Devon County Council ([1993] CCLR 69), Devon County Council -v- Abbey National plc ([1993] CCLR 69), and Scarborough Building Society -v- Humberside Trading Standards Department ([1997] CCLR 47). Where the interest rate on the mortgage was fixed or discounted for an initial period before moving to the variable rate, lenders used to advertise an APR calculated on the assumption that at the end of that period the rate would change to the lender’s standard variable rate. Devon County Council (the relevant Trading Standards Department) challenged the case where the lender had advertised an APR on the assumption that the interest rate would not change at the end of the fixed period.
The whole point centres on the issue of whether the interest rate change at the end of the initial period is certain to occur or not. On the facts of the National Westminster Bank case it could not be said for certain that the rate to be applied at the end of the initial period would be different from the fixed rate that had applied to that date. The Divisional Court in the Scarborough Building Society case distinguished the earlier NatWest case on the basis that in the NatWest case, there was a "real or realistic possibility, a real chance" that the variation would not occur, whereas in the Scarborough Building Society case "for all practical purposes" a variation was certain to occur.
The proposal is also important in the context of the Council of Mortgage Lenders’ Code which requires lenders and intermediaries to provide an explanation and illustration of future potential repayments at the end of any fixed, discounted or capped interest rate period based on the relevant current variable mortgage interest rate (see paragraph 3.2 of the Code).
In order to remove the uncertainty for lenders and trading standards departments, the DTI proposes to require that for "low start" loans for property improvement and house purchases, the APR shown should be derived from adding the total charge for credit which has to be paid during the low start period, to the total charge which is likely to have to be paid for the remaining period of the loan. The proposal "is based on an assumption that the change from the low start to a variable rate was certain to occur; would occur at an ascertainable time; and that the variable rate would be that offered by the lender at the date the agreement is made. If all lenders adopted this approach consumers would be given a fair description of the APR for the duration of the loan, and no lender should be at a competitive disadvantage" (to quote from the Consultation Paper).
The draft regulations are due to be laid before Parliament in July. The DTI is aiming to ensure that all such mortgages are dealt with on the same basis. The existing state of the law has come under considerable criticism from consumer groups. The existing position cannot easily be sustained since there is room for an inaccurate reflection of the cost of the loan to be given to consumers. For example, one lender may decide, having read the Regulations and the case law, to calculate the APR on the basis that the initial fixed rate will apply for the whole length of the agreement while another lender, on similar facts, may decide that the APR should be calculated as if the variable rate at the time the loan was entered into was to apply from the end of the fixed interest rate period. This is wholly unsatisfactory, particularly when there are criminal sanctions for getting it wrong. Businesses should welcome the certainty this change will bring.
Proposal on the single formula for calculation of the APR
The DTI issued a consultation paper entitled "The Annual Percentage Rate and Total Charge for Credit Regulations" in August 1998. The current Consumer Credit (Total Charge for Credit) Regulations 1980 set out three formulae for calculating the APR. The formulae enable the APR to be determined by taking into account both the total charges the borrower has to pay and the time at which the loan and charges are paid. However, the Consumer Credit Directive (87/102/EEC as amended by Directives 90/88 and 98/7) introduced a single mathematical formula for determining the APR and requires each Member State to ensure that only one formula is used - the one in the Directive. The APR formula is to be shown to an accuracy of at least one decimal point.
As far as we are aware, the DTI is proposing to delete the current formulae in the Total Charge for Credit Regulations and to replace them with the single formula in the Directive. The proposal is to require the APR figure to be shown to an accuracy of one decimal place.
The aim of the amendment is to enable consumers to compare credit offers in different Member States. This is important as consumers become more confident with the concept of buying financial services over the internet.
Various other proposals are made in Consultation Paper which would have the effect of bringing the charges which have to be included in the APR calculation more closely in line with the provisions of the Consumer Credit Directive. Replacing the three existing formulae with one formula would appear to be a good step forward but we will have to wait and see the exact terms of the draft regulations when they are published.
Draft regulations will probably be laid in July. The indications are that the changeover to the new formula should not be onerous as the formula is mathematically the same as the formulae that are already present in the Regulations. However, there would be a significant compliance cost in moving from truncation to rounding up with regard to the APR. The existing regulation 6 of the Total Charge for Credit Regulations provides that the APR shall be stated to an accuracy of one decimal place, further decimal places being disregarded. The current rules have the effect that if the APR calculation on one loan works out at 14.41% and calculation on another loan works out at 14.49%, both calculations under the existing Regulations would be stated to be 14.4%. The further decimal places after the first are disregarded. The DTI is proposing to keep the requirement in the Regulations at one decimal point but to introduce the concept of rounding up to that single decimal place in line with the Directive. It is this rounding up which will cause a compliance cost to be incurred by lenders.
The consultation document does not refer to the tolerances in the amount of the APR which is stated in advertisements and the agreements themselves. The Consumer Credit Directive (87/102/EEC as amended) does not allow any tolerances in the statement of the APR in the agreement or advertisements. Consequently, Schedule 7 to the Agreements Regulations, which states that the requirement to show the APR will be complied with if the figure given is not more than 1% above or 0.1% below the true figure, may need to be amended. The Advertisements Regulations also set out these tolerances in Schedule 3 to those Regulations. Thus if the APR is 21%, a statement that it is 22% or 20.9% will comply with the RegulationsThe DTI will have to consider an amendment to these provisions if the purpose of the Directive is to be effectively transposed.
The Unfair Terms in Consumer Contracts Regulations 1995
In January 1998 the DTI issued a consultation paper entitled "Widening the scope for action under the Unfair Terms in Consumer Contracts Regulations". It is proposing to allow other public bodies, including regulators, trading standards departments and consumer bodies to take action under the Regulations.
The Regulations have been in force for nearly three years now and are enforced by the Office of Fair Trading. On the whole, businesses have been impressed with the way the OFT has gone about its enforcement job. However, the DTI is currently preparing to lay draft regulations allowing other bodies to enforce the Regulations. It seems a pretty safe bet that the powers will be extended to the Consumers’ Association, to local Trading Standards Departments (TSDs) and to other regulators such as Ofwat, Oftel, Ofgas and the Financial Services Authority (FSA). Is this a cause for concern?
The standard terms and conditions of a contract for goods or services have to comply with the Regulations if the terms are to be relied upon against a consumer. A consumer is not bound by any standard terms in a contract which are unfair.
Two questions have to be answered in deciding whether a standard term in a contract is unfair. First, does the term create a significant imbalance in the party’s rights and obligations under the contract, to the detriment of the consumer? Secondly, does that imbalance amount to a breach of the requirement of good faith?
In looking at good faith, one has to consider the relative bargaining strengths of the consumer and the business, and whether the business’ behaviour was fair and equitable.
The OFT can apply to the courts for an injunction to stop unfair terms being used. There have been a number of occasions when the OFT felt it necessary to threaten to take a case to court and, in several cases, an agreement was reached only when the issue of an application for a High Court injunction had become imminent. Recently, the OFT has taken its first case to court concerning an alleged unfair contract term. On 17th March 1999 the OFT applied for an injunction against First National Bank under Regulation 8.
The OFT only acts when it receives a complaint. It will then consider the merits of the complaint under the Regulations. If the complaint is thought to raise issues of unfairness, the relevant case officer will approach the supplier asking them to modify or drop the particular term from its contract. They may ask for more information before making a decision about unfairness. When the supplier belongs to a trade association, the OFT may decide to approach that body as well so that information on best practice can be disseminated to a wider audience.
The overwhelming number of cases are resolved by negotiation. Since the inception of the Regulations in July 1995 more than 1,200 contract terms have been successfully challenged.
The OFT has identified the need to widen the number of bodies who have responsibility for enforcement and this has now been taken up by the DTI. The OFT is concerned that breaches of the Regulations by small local traders may not be brought to its attention. It also believes that such breaches would be dealt with more effectively at a local level where trading standards officers are on hand to give advice and guidance. The statutory regulators with expertise in their particular sector are also well placed to deal with standard term contracts in their sectors. For example, if the complaint relates to a term in a contract for an investment product, the FSA would be best placed to review the fairness of the term. It understands that particular sector, which terms are standard and which terms are included in order to comply with the financial services rules and regulations.
This does, however, raise the question of consistency of enforcement. At present, the enforcement process works well in that a company deals with one team of OFT case officers who have dealt with a large number of such cases over the years. The case officers are advised by a close-knit team of lawyers with a consistent and balanced approach to the issues.
If the local trading standards departments and the Consumers’ Association, for example, are to have powers to enforce the Regulations, the business community will be concerned that they could be dealing with a body which takes a stronger line than the OFT. However, an enforcement approach does develop and mature with experience and provided there are clear and open communication lines between the OFT and the new enforcement bodies, and clear guidance is issued, there is every chance that the enforcement will be proportionate and seamless.
The OFT publishes regular bulletins which give general guidance and case studies of the sorts of clauses which have been dealt with and which have been amended after negotiations with the suppliers. The DTI has said that effective arrangements for co-ordination and consultation between the various bodies and for the collection and dissemination of information about actions under the Regulations and on undertakings given by traders will be important to ensure that there is consistency of approach.
It is important that businesses and their advisers, together with consumer bodies and enforcement agencies can all obtain information about cases. It is also important that businesses do not face a number of approaches by various enforcement agencies who have received complaints about a particular unfair term.
The consultation paper says that the Regulations could require a body which intends to seek an injunction to inform the OFT and to give it two weeks to act before the body can seek an injunction. It also mooted the possibility of permitting the OFT to take over a complaint or a case if it and the other consumer bodies agreed or, perhaps additionally, provision could be made to permit the Director General of Fair Trading to make representations to the court in cases in which he had an interest.
Some sort of co-ordinating role for the OFT would be useful so that the relevant trading standards department, for example, could be informed whether other consumer bodies were contemplating similar actions. The consultation paper concluded that any co-ordination could be more flexibly arranged by voluntary administrative procedures rather than statutory requirements which could be inflexible, time consuming and give opportunity for procedural challenges which would hamper the speed at which action can be taken against unfair terms.
An interesting development is that in May the OFT published its sixth Unfair Terms Bulletin. The form of the Bulletin has been changed in that to date the case reports and specimen terms have been combined in one Bulletin. Now the two are to be produced separately. New case reports are included in the Bulletin in tabular form. This is designed to make it easier to monitor the use of revised terms. More detail is now given of significant changes made to contracts following negotiations with businesses.
In view of the fact that other agencies will be given power to enforce the Regulations under the DTI's proposals, the OFT considers that a new degree of detail is essential to achieving a co-ordinated approach with the other agencies. Specimen terms will continue to be published as it is a means of giving a full account of what the OFT considers fair and unfair, but the specimen terms will in future appear in a supplement published separately from the Bulletin. This will enable case reports to be published more frequently. The OFT also states that work is in hand to compile full guidance on identifying unfair terms, and the reasons that can be given for considering them unfair, so that the new enforcement bodies can benefit from the OFT’s experience.
The amending regulations extending the enforcement powers under the Unfair Terms Regulations are probably going to be laid in June to come into force in July. Whatever is proposed by the DTI, the Unfair Terms Directive upon which our regulations must be based, makes it clear that the aim is to ensure that "in the interests of consumers and competitors, adequate and effective means exist to prevent the continued use of unfair terms in contracts". All the signs are that the OFT has positioned itself to play an important role in co-ordinating action and issuing clear guidance.
Extortionate Credit Bargains
Sections 137- 140 of the CCA contain provisions dealing with extortionate credit bargains. The provisions allow the courts to re-open extortionate credit bargains so as to do justice between the parties. An extortionate credit bargain is one which requires payments which are grossly exorbitant or otherwise grossly contravenes ordinary principles of fair dealing.
In determining whether a bargain is extortionate, a court has to have regard to evidence concerning interest rates prevailing at the time the bargain is made, a list of specified factors relating to the debtor and the creditor and any other relevant considerations. The factors to be taken into account in relation to the debtor include his age, experience, business capacity and state of health and the degree to which, at the time of making the credit bargain, he was under financial pressure, and the nature of that pressure.
The factors applicable in relation to the creditor include the degree of risk accepted by him, having regard to the value of any security provided, his relationship to the debtor, and whether or not a colourable cash price was quoted for any goods or services included in the credit bargain.
If the court decides a credit bargain is extortionate it may direct accounts to be taken; set aside the whole or part of any obligation imposed on the debtor or persons giving security; require the creditor to repay the whole or any part of the sum paid under the credit bargain or any related agreement by the debtor or person giving security; direct the return of any property given as security; or alter the terms of the credit agreement or any security instrument.
The OFT first reviewed these provisions in its 1991 Unjust Credit Transactions Report. The OFT was aware of only 23 court cases in which the provisions had been used or mentioned since 1977. In only 15 of those cases was the issue of whether or not a credit bargain was extortionate actually decided. Only one of the cases involved proceedings initiated by the debtor, and in only four cases was the debtor successful in having the credit transaction ruled extortionate by the court.
The Unjust Credit Transactions Report maintains its relevance even though it was written eight years ago. It has been re-submitted to the DTI by the OFT earlier this year at a time when there has been a renewed emphasis on social exclusion (for example, see the Social Exclusion Unit launched by the Prime Minister and recent publicity about access to bank accounts). The OFT has recently published a study on vulnerable consumers. The OFT believes, that the proposals it made in 1991 still have merit in today’s financial market.
The 1991 Report was concerned that the statutory test should be less restrictive. It was hoped that such a relaxing of the test would make it easier for debtors and their advisers to bring cases to court and that the courts would be able to give clearer guidance identifying those aspects of credit transactions which justify their reopening. The existing provisions did not appear to the OFT to be providing the required protection for consumers. The provisions have failed to provide redress for debtors where so-called "bargains" are so oppressive as to be socially harmful.
The OFT makes it clear that any proposals should be targeted on the margins of the credit markets. Responsible lenders should not face a challenge to legitimate practices. The new provisions should be effective but not draconian. Draconian powers would only serve to drive lending underground. The provisions have to be sufficiently flexible to deal with the limitless variety of circumstances surrounding each loan but provide enough certainty for lenders and borrowers to know where they stand. The cost of credit and lending practices must both be dealt with by the reforms
One loose end which is not set out in the 1991 Report and which should be dealt with by any reforms is the uncertainty as to whether the Limitation Act 1980 prevents any action to re-open an agreement six years from the date of the agreement. Decisions have gone both ways on this point in the county courts and it would seem sensible to deal with this uncertainty.
In the report, the OFT proposed (and we presume that it is still proposing) that:
- The Government should introduce legislation to reform and develop sections 137-140 of the Consumer Credit Act, re-casting them with a view to making them work as originally intended. The concept of an "unjust credit transaction" should replace that of an "extortionate credit bargain". In such cases the court, would, as now, have the power to re-open an agreement, on application by the debtor (or surety), so as to do justice between the parties.
- A finding that a transaction involved excessive - not grossly exorbitant - payments should be a factor in determining whether the transaction was unjust.
- A new test of whether the transaction involved business activity which was deceitful or oppressive or otherwise unfair or improper (whether unlawful or not) - using the same statutory wording as is used to assess the fitness of a trader to hold a credit licence - should be a further factor in determining whether a transaction was unjust.
- The other factors to be taken into account should remain as they are, but with one addition - "the lender’s care and responsibility in making the loan, including steps taken to find out and check the borrower’s credit-worthiness and ability to meet the full terms of the agreement".
- The court should be empowered to re-open a credit transaction of its own motion. It should also be stated explicitly that this would apply to defended and undefended cases.
- The court should be required to notify the Director General of each case where a credit transaction has been found to be unjust.
- The Director General and local authority trading standards departments should be empowered to initiate proceedings for a declaration that a particular credit transaction or any particular aspect of it shall be deemed unjust. Such power should be exercisable only in the public interest.
- Tougher penalties should be introduced for the unlicensed (i.e. illegal) provision of credit. The DTI is currently reviewing its policy thinking on sections 137-140. It is important that the provisions are amended so that they are effective in dealing with unfair lending practices and excessive credit charges. The number of cases in which the courts have found in favour of the borrower under the existing provisions is a clear indication of the need for reform provided there is a mischief which needs to be dealt with.
Early Redemption Rules
The DTI's proposals to consult on the early settlement rules centre on the Rule of 78. What is this Rule of 78?
The CCA gives borrowers the right to settle regulated agreements early. To do so, they must give notice to the lender and pay the outstanding amount of the loan and the total charge for credit (less a rebate, where appropriate). The rebate is designed to relieve the borrower of liability for interest and other charges in the total charge for credit which would otherwise have been payable had the agreement run its full course.
The Consumer Credit (Rebate on Early Settlement) Regulations 1983 (as amended) set out five formulae for calculating the rebate and make some allowance for costs incurred by lenders in accepting early settlement. Four of the five formulae in the Rebate Regulations apportion the charges across the whole term of the loan using a method known as the Rule of 78.
The Rule of 78 derives its name from the way interest and other charges are apportioned over a hypothetical loan lasting for 12 months. It assumes that the costs of setting up the loan are recovered in the early part of the loan term. The amount of charges are assumed to reduce by equal proportions during the term of the loan. If this were to be expressed in units, 12 units are said to be charged in the first month, 11 in the second, and so on. The total number of units over the 12 months is 78.
The rebate is calculated as being the total of the charges to be allocated to the repayments which were due to be paid after the settlement date.
The Rebate Regulations also permit the lender to defer the effective settlement date. This is designed to allow lenders to recoup their administrative costs and to provide some compensation for the fact that they will not be able to lend that money at interest for the time being. The effect of this deferment is that the proportion of the total charge for credit which is capable of being rebated is reduced.
The OFT, in its 1998 Non-Status Lending Guidelines, stated that the Rule of 78 was inappropriate in that market as it tends to produce a settlement figure which is excessive relative to the amount borrowed and the repayments made and relative to the cost incurred by the lender. In certain cases where the loan is settled early in its term, the settlement figure produced using the Rule of 78 can be considerably higher than the amount borrowed. The OFT called for its use to be discontinued. Of course, these comments related to the unregulated loans since the Rebate Regulations permitted the use of the Rule of 78. This built upon the OFT’s comments in its 1994 Deregulation Report which recommended that the Rule of 78 formula in the Consumer Credit (Rebate on Early Settlement) Regulations 1983 should be replaced by a more accurate method of calculation reflecting the principles of compound interest, such as the actual reducing balance method.
The OFT also said (in its 1998 Guidelines) that the use of the Rule of 78 in unregulated loans was liable to challenge under the Unfair Terms in Consumer Contracts Regulations (from 1 July 1995). Schedule 3 to those Regulations includes, as an example of terms which may be regarded as unfair, terms which have the object or effect of requiring any consumer who fails to fulfil his obligation to pay a disproportionately high sum in compensation. The application of the Rule of 78 in long term loans can result in a rebate to the borrower which is disproportionately low and so the borrower may end up paying an exceedingly high sum to redeem the mortgage.
Article 8 of the Consumer Credit Directive (87/102/EEC, as amended) states that:
The consumer shall be entitled to discharge his obligations under a credit agreement before the time fixed by the agreement. In this event, in accordance with the rules laid down by the Member State, a consumer shall be entitled to an equitable reduction in the total cost of the credit.
It is doubted whether the Rule of 78 accords with an "equitable reduction in the total cost of the credit" under the Directive, especially when it is combined with the right to defer the settlement date. A further concern is that the raising of the financial limit for regulated agreements under the CCA from £15,000 to £25,000 from 1 May 1998 means that the Rule of 78 is now capable of being applied to lending between the two limits - which is more likely to relate to longer term loans. The position appears to be untenable.
Conclusion
The Consumer Strategy White Paper will be a major event in this area. However, that should not detract from the importance of the matters which we have discussed above. These proposals are central to two main planks of the White Paper - transparency enabling consumers to make well informed decisions and dealing with unfair trading practices. The White Paper and the smaller initiatives go hand in hand.
David McCahon is a senior lawyer and head of Cameron McKenna’s Consumer Finance Group specialising in consumer credit, unfair terms and regulatory advice. He was a lawyer at the OFT from 1992 to 1997.
