Decision upheld in consumer credit test case appeal

The High Court has confirmed the ability of lenders to set prepayment fees based on their business model and lending practices, rather than the "safe harbour" formula advocated by the Commerce Commission.

The High Court¹ has upheld a decision of the District Court in which it dismissed charges against a creditor under the Credit Contracts and Consumer Finance Act 2003 (CCCFA). Click here to view our earlier commentary on the District Court's decision.

The District Court case

The Commission had alleged that the prepayment fees charged by the creditor were unreasonable under the CCCFA because the formula it used did not involve a reasonable estimate of the creditor's loss on prepayment. Drawing on the "safe harbour" formula provided for in the CCCFA, the Commission alleged that the creditor's alternative formula did not relate to the time taken to re-lend funds, had no regard to changes in interest rates, and did not take into account mitigation of loss by re-lending. However, the Court found that the safe harbour formula did not reflect the creditor's loss, was not suited to the creditor's business structure, and that the creditor's formula was reasonable.

The High Court appeal

The Commission appealed to the High Court. The focus of the appeal was whether the creditor was required to calculate its loss on the assumption that it would immediately re-lend the prepaid funds, despite the fact that it had excess funds available, and prepayment did not affect its ability to issue new loans.

The Commission contended that the reasonableness of any alternative formula used to calculate a prepayment fee must be considered against the principles inherent in the safe harbour formula. This would require allowances for changes in prevailing interest rates, mitigation of loss through re-lending, the reduction of the outstanding balance due over time, and the time value of money. In the Commission's view, although the CCCFA allows creditors to use their own formula, it was wrong for this creditor to depart from the safe harbour formula for reasons linked to its business structure, rather than reasons to do with the characteristics of loans themselves.

In the High Court, Justice Asher held that a prepayment fee calculation is not unreasonable if it involves an objective estimate, at the time of entering into the contract, of compensation to the creditor. It was further held that it is reasonable for a creditor to take into account the fact that a new loan will not replace the old one, and that profit on the loan is lost through prepayment.

The judge held that the CCCFA explicitly provides two alternatives - the safe harbour formula, or an appropriate alternative formula - and that the reasonableness of an alternative formula does not depend on its similarity to the safe harbour formula. "It makes no logical sense for the legislature to have provided for alternative formulae if they were to be driven by the terms of the safe harbour formula, and that the only benchmark is reasonableness".

Finally, the judge refused to accept the Commission's contention that it is inappropriate to consider the creditor's business structure in setting prepayment fees, saying that an assessment of reasonableness requires consideration of the loss of the actual creditor, and more than "a barren focus on a contractual term against a market backdrop".

The High Court's decision affirms the District Court's decision in this important test case, and gives lenders welcome guidance on the factors they need to take into account in setting prepayment fees.

¹ in Commerce Commission v Avanti Finance HC Auckland CRI-2008-404-000210, 28 April 2009

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