What do Sephora, buzzy skincare company Augustinus Bader, APC, Abercrombie, ACNE, adidas, Anine Bing, Khloe Kardashian’s Good American, H&M, menswear website Highsnobiety, Lyst, Marchesa, MCM, fast fashion brands Boohoo and PrettyLittleThing, Reebok, Swarovski, and North Face all have in common? They enable consumers to buy their products now and pay for them later by way of a payment processing setup with Klarna.
After getting its start in Stockholm in 2005, Klarna has expanded to 17 “core markets,” including the U.S., and was responsible for processing some $35 billion in online sales last year, up 32 percent from 2018. For the 2019 fiscal year, its revenues topped $750 million, up 31 percent on a year-over-year basis. With such enduring growth in mind and a post-money valuation of $5.5 billion as of March 2020, Klarna is not only “the fastest growing shopping destination and payments provider” in the world and the largest private fintech in Europe, it is one of the primary faces of the buy now, pay later (“BNPL”) movement.
In offering consumers the opportunity to buy items online, take possession of them, and pay for them later, often in a number of installments, Klarna joins a swiftly growing pool of financial service providers in the BNPL space. Together, these companies are catering to a growing number of consumers, primarily millennials, who are switching from credit cards to installment payments. This shift has enabled companies like Klarna – as well as AfterPay, Clearpay, and Laybuy, among others – to garner tens of millions of consumer users (Klarna boasted 7.85 million users in the U.S., alone, as of June 2020), and billion dollar-plus valuations.
Most of them work a little something like this: instead of consumers entering their credit or debit card information and either paying by way of their line of credit or the transfer of money from their debit account in order to purchase products online, Klarna and co. requires them to enter in some information (i.e., name, date of birth, billing and email address, and phone number) instead, and take ownership of the goods. “Klarna uses machine learning and analytics to risk score the consumer in real time” based on the information provided, per CNN.
Consumers then have time to pay off the purchase – 30 days when using Klarna – with whatever payment method they want, and they can do so in installments, all without having to pay interest assuming that they pay off those installments on time.
As BNPL continues to become a popular tool for consumers, particularly as “changes to job certainty and timing for salary payments” abounds, thereby, “increasing the potential utility of these types of deferred payment solutions,” according to Freshfields’ John Risness, it also presents interesting legal questions, especially since many BNPL services “act like a credit card,” per Reuters “but with even easier access.” In fact, in some cases, “All an 18-year-old needs is a few details – as simple as a phone number and their name – to start deliveries without paying for the item upfront.”
But while they may act like credit card companies, most of these companies are not classified – or regulated – as credit providers, according to accounting academic Saurav Dutta and Lien Duong, because they do not technically charge interest.
The Rise of Regulation
The largely unregulated nature of the BNPL explosion is causing increasing concern among regulators across the globe, with Australia leading the way. In late 2018, the Australian Securities and Investment Commission (“ASIC”) issued a comprehensive report, in which it outlined “a number of issues with the BNPL industry in Australia, including instances where the price of goods had been inflated to cover the cost of providing the service and BNPL providers including unfair terms in their contracts,” according to Buddle Findlay’s Jan Etwell and Tim Hayward.
In addition, ASIC found that the BNPL schemes “increased the risk of consumers financially overcommitting themselves, resulting in missing repayments (and, therefore, being exposed to default/late payment fees), not being able to afford essential goods and services, and creating financial stress.”
Following from the ASIC report, the Australian Senate Economics References Committee released a report of its own in February 2019, recommending that a regulatory framework, as well as an industry code of practice, be established to protect consumers since BMPL giants operate beyond the bounds of traditional credit laws.
Since then, the Australian Finance Industry Association (“AFIA”), whose members include BNPL bigwigs Afterpay, Brighte, FlexiGroup, Klarna, Openpay, Payright and Zip Co, revealed that it would launch of a code of conduct for BNPL players, with the initiative coming “in response to a Senate inquiry and Australian Securities and Investments Commission calls for stronger protections for the growing number of consumers using the products,” AFR’s James Eyers reported this spring. In light of delay by the AFIA, the voluntary new code – which will set limits on late fees, a minimum age for users (18), and implement hardship provisions – is expected to be released in January 2021.
In the United States
Meanwhile, in the U.S., regulators are also paying attention. As of early this year, the California Department for Business Oversight (“DBO”), a division of the state government that regulates financial services, had taken on a number of cases centering on BNPL services. In one such case, which involved an unidentified BNPL company, the DBO spoke specifically to the California Civil Code’s definition of a loan, stating that it refers to “a contract by which one delivers a sum of money to another, and the latter agrees to return at a future time a sum equivalent to that which they borrowed.”
The definition is significant, as if a BNPL company’s services fit within this definition, they are regulated in the same way as a loan, and thus, the company at play must have a California Financing Law license in order to legally carry out its operations. In a similar but unrelated matter early this year, the DBO refused to grant Minneapolis-based, Australia-listed BNPL provider Sezzle, Inc. such a license on the basis that the company was already engaged in lending activity “without having a license to do so” as a result of its model of partnering with merchants to offer an interest free, short-term installment-payment contract to consumers.
Still yet, the DBO reached a settlement with 5-year old Afterpay in March, accusing the BNPL leader of collecting fees from more than 640,000 Californians in so-called BNPL transactions that were actually “illegal loans.” As a result of the settlement, Afterpay – which had 5.6 million active U.S. users as of June 30 – was required to refund $900,000 to consumers and pay $90,000 in administrative fees. “Afterpay does not believe such an arrangement required a license from the DBO or was illegal, [but] has agreed to conduct its operations under the DBO license as a part of this settlement,” a company spokeswoman stated in connection with the settlement.
Technically speaking, Afterpay (and other similar companies) “skirt the definition of a loan under some U.S. laws,” meaning that it is not subject to the same regulation, as reported by the Wall Street Journal this spring. However, regardless of how it defines its operations, “the more successful Afterpay becomes, the more likely it will attract regulatory scrutiny,” Tom Beadle, a Sydney-based analyst at UBS, told the WSJ. The same certainly goes for others in the BNPL space, as well.
The DBO’s decisions “suggest that the DBO will closely scrutinize ‘unregulated’ transactions,” such as those in the BNPL space, according to Paul Hastings attorneys Thomas Brown, Molly Swartz, Lawrence Kaplan, and Lara Kaplan, and “will, in certain circumstances, take steps to prevent a provider from offering such [financing] products.”
They further state that the DBO actions “provide useful guidance for helping to assess whether a consumer-facing point-of-sale financing transaction is likely to be considered a loan versus a sale,” noting that “to help bolster a claim that such transaction involves the purchase of a bona fide credit sale, providers should ensure that their contractual relationships and terminology reflect a credit sale, and do not otherwise, suggest a lending relationship; notify consumers of any financing relationship in conjunction with their purchase; and consider whether deferred payment products are subject to consumer-oriented regulatory schemes.”
While the terms of the Afterpay settlement and outcomes in the two California cases are limited to the respective parties, “the decisions have implications for providers of other ‘unregulated’ financial products.” Moreover, they are also significant, as in more cases than one, regulatory actions and other legal mandates established in California – from its low-and zero-emission vehicle rules to its state law banning racial discrimination on the basis of hair – have been enacted in other states.