21 April 2015

Internet Finance: Legal Risk Analysis

This article was written by Lei Jiping (partner)

Internet finance is generally considered to include mainly six business models: third-party payment platforms, P2P lending, big data petty loans, crowd-funding, sales of internet finance products and internet finance information services. In terms of the basis and principles of civil liability to be attributed to each of these specific business models, direct legislation is a vacuum at present. Given this situation, we propose the following recommendations for practitioner reference.

I. Civil liability risks in Internet finance

i. How to identify the principal obligee or obligor in an online transaction dispute.

For transactions where the parties have had their real names certified, the parties represented by such certified real names can stand as the obligee or obligor. On the other hand, in transactions where the parties have not had their real names certified, at present, the only way to identify involved parties is to see if such parties can use the registered username and password to conduct transactions; when more than one person share one username and password, they could be identified as joint principals. In a “click-to-register” transaction, the electronic contract which the customer accepted with a “click” will govern the obligations and rights between the customer and the online vendor. The defence raised by the customer that a standard contract shall be not binding is unlikely to prevail, excluding the circumstances stipulated in Article 40 of the Contract Law .

ii. How to view third-party payment operators using a simplified method to take funds from customers’ bank accounts.

Third-party payment operators take money from a customer’s bank account on the basis of a trustee relationship with the customer. A customer opening an account on a third-party payment platform can be understood as authorizing that payment platform. In practice, when the customer makes a payment through online banking, a complicated verification process such as ID verification, password verification or SMS verification is usually required. However, when third-party payment operators appropriate funds on behalf of customers, banks normally waive such a verification process. To some extent, by granting this waiver, banks breach their Service Agreement with the customer. However, since liability for breach of contract requires actual losses and the payment operator normally indemnifies any loss resulted from erroneous payment, a customer is not likely to claim against the bank because of the simplified verification process.

iii. How to attribute the funds which the payment platform temporarily holds for the customers and the interests accrued therefrom

Under the circumstance that a payment platform with a transaction monitoring mechanism possesses the customer’s advance payment within a monitoring period, such advance payment is directly deposited in the account of the payment platform. Given that in practice there is no third-party escrow which bears customer’s breakdown, pooled funds in escrow that can be identified from the platform’s own funds shall theoretically be deemed as a trust which shall not be enforced by the platform’s creditor to satisfy its own debt. Interests accrued from the funds in the escrow shall be, in default, attributed to the customer subject to the agreement between the platform and the customer.

iv. How to understand the enforceability of guarantee made by website announcement

In various online finance businesses including third party payment business, online finance platform usually, by making announcement on its website, undertake to guarantee or indemnify for losses incurred by payment business users or other investors. According to Article 13 of the Guaranty Law , such promises to undertake guarantee obligation shall be made in writing and the nature of such promises, according to Article 3 of Interpretation of the Supreme Court on Certain Issues Concerning the Application of the PRC Contract Law (II), shall be deemed as reward advertisement launched by the internet finance platform. If a client completes the payment activity or investment activity required by the website, then it can be loosely found that the parties entered into a guarantee contract. Such an approach shall also be applied to other third party guarantee promises. For example, a guarantee institution makes guarantee promises to unspecified third parties, even if such institution does not specifically execute contract with each of the investors (creditors), a guarantee-guarantor relationship shall also be found on the basis of the principle of reward advertisement.

v. How to understand the legal effect of dispute resolution mechanism offered by the internet payment platform

Some of the internet platforms set up mechanisms to mediate the dispute incurred in relation to the payment settlement transactions. However, compensation options rendered by internet platform is different from judgment or arbitral award that involved parties may still refer it to court or arbitration if they do not find it satisfactory. If, under the effort of such internet platform, the parties reach a settlement agreement, such settlement agreement is not by definition enforceable. In practice parties may try to acquire enforceability for such settlement agreement by complying with Article 33 of the People’s Mediation Law .

vi. The legal liabilities of the collectors and filters of internet finance information

Some websites that provide internet finance information push information of internet finance practitioners to investors. Such information could be false, and may therefore cause losses to investors. The attribution of legal liabilities of such information websites could be handled in reference of general principles of the attribution of civil liability of launching false advertisement. According to Article 38 of the Advertisement Law , if the operators or launchers of information know or have reason to know that the advertisement is false but still creates or launches it, such operators or launchers shall be liable for losses incurred to investors.

vii. The legal liabilities for breach of the duty of due care

Clear overseeing regulation in relation to the online sale of wealth management products remains vacuumed. However, according to Article 9 of the Administrative Measures for the Sales of Wealth Management Products by Commercial Banks, commercial banks may only sell products whose risk level is no higher than the risk-bearing capacity evaluation result of the customer, and the sale of products of which the risk level is not compatible to the customer’ capacity is forbidden. When dealing with investors, online wealth management products distributors shall at least undertake the same level of duty of care as undertaken by commercial banks. In the event that such a distributor violates such duty of care, and the investors suffered actual losses, the internet platform may have to be liable for its tortious act. The causation between its breach and the investors’ actual losses could be presumed.

II. Criminal liability risks in internet finance

i. Criminal liability risks of P2P online lending

In 2010, the Supreme People’s Court promulgated the Interpretations of the Supreme People's Court on Certain Issues Relating to Specific Application of Law with Respect to the Trial of Illegal Fund Raising Criminal Cases, which stipulates the four factors of the crime of illegal fund raising from public or crime of raising funds from public in a disguised fashion (1) taking in funds without the legal approval of the relevant authority or by way of using lawful business operations; (2) conducting public promotional activities by way of media, promotional fairs, leaflets, mobile text messages and other means; (3) undertaking to make a repayment of the principal and the interest accrued therein or pay returns by way of cash, in-kind payment, equity and other means within a given period; and (4) taking in funds from the general public, that is, from non-specific objects of the society.

On November 25, 2013, in the meeting on the issue of illegal fund raising called by CBRC and jointly participated by nine departments, the People’s Bank of China explicitly announced three kinds of activities that constitute “illegal fund raising activity in the name of P2P internet lending business”: (1) wealth management on a fund pool basis; (2) illegal fund raising risk caused by unqualified borrower, unqualified borrower refers to fake project or fake borrower; (3) Ponzi Scheme. The operators of some P2P online lending platform launch fake high interests subject to raise fund and then use latter loan to pay back former loan, the huge amount of funds are raised in a short period for personal business. What was worse, some operators simply slinked with the funds.

CBRC once drew four bottom lines for P2P internet fund raising, they are (1) neutral platform, (2) no guarantee allowed, (3) no fund pool allowed, and (4) no illegal fund raising from the public. Meanwhile, the CBRC Office of Illegal Fund Raising Disposition pointed out that there are three scenarios in P2P internet fund raising business that may be found suspected of illegal fund raising: first, setting up fund pool; second, failure to perform reviewing obligation which lead to acquiescing to or failing to identify the lender committing crime of illegal fund raising; third, engaging in self-financing business.

In view of the opinion of the judicial authority and the supervision authority, we understand that, in practice, the following criteria may apply to distinguish legitimate P2P business and illegal fund raising crime:

1) The nature of P2P platform

The original function of P2P platform is to provide agency service for the lender and the borrower through the internet. Normally, a pure platform providing agency service is not likely to incur criminal liabilities. Under other circumstances, whether such platform may incur criminal liabilities depends on, first of all, the nature of act people do with the platform, and second, whether the P2P platform has the knowledge that someone is utilizing it to commit crime. For instance, some officers of the P2P platform may fail to conduct a thorough review of the borrower’s identity and credit capacity, acquiesce to the borrower’s criminal act of illegal fund raising from the public and thus become the accomplice to the crime.

In the case that P2P platform go beyond agency services and conduct self-financing business, or pool funds with a faked borrowing purpose, such act may very likely be deemed as crime of illegal fund raising from the public, crime of setting up financial institution without license or crime of illegal business dealing.

2) The outlet of the funds

Another criterion to evaluate the legitimacy of the P2P platform is to exam the outlet of the investor’s funds. In particular, are the funds directly transferred to the borrower or are they deposited the account of the company that run the platform. In the latter case, the risk that the platform violates illegal fund raising laws and regulations may arise.

3) Business model: criminal liability may arise in creditor’s right transfer scenario

In terms of the source and outlet of the funds, the creditor’s rights transfer model is different from the normal pooled funds model and self-raising model. In the former case, funds are actually consideration for the equity transfer, while in the latter, funds are pooled through funds-demanding project by means of indebting. Superficially, the creditor’s right transfer model does not bear the factors required to be found as crime of illegal fund raising from the public. Of course, whether the creditor’s right transfer itself is suspected of the illegitimate sale of wealth management product or trust product that constitute crime of illegal business operation is pending further research. However, it must be pointed out that given the funds obtained by creditor’s right transfer is normally put into other projects and become a new creditor’s right rather than being distributed to equity holders, in practice such approach may also be suspected of crime where funds-demanding project advance money through the platform and then raise funds from the public to displace the advanced money, thus, criminal liability risk may still arise.

ii. Criminal liability risk in the crowd-funding business

The crowd-funding model, in formality, is very likely to go across the legitimate border, which means it meet actus reus of illegal fund raising, i.e. without license, public referral through website, promising certain reward, and raising funds from the unspecified public. Of course, the types of the reward may to some extent be of weight on whether the crowd-funding constitute crime. The types of reward in crowd-funding include donation, goods, stock and creditor’s rights. If the project provides stock or cash as reward, it is very likely to be suspected of crime. As to goods, although it is not forbidden by law as stock and cash, its validity is yet not explicitly recognized by Judicial Interpretation. As a result, crowd-funding providing goods may still be found guilty of illegal fund raising related crime, although with a relatively lower possibility. In contrast, if the reward is service or media content, then it is not likely to be found as crime.

III. Other criminal liability risks

Business models like third-party payment platform, online petty loan, crowd-funding, sales of internet wealth management products may incur two kinds of criminal liability risks:

  • Criminal risk of internet finance entity in its business operation: if the entity is a non-financial entity, and such entity is established and engages in financial business without being duly licensed by competent authority, it may be suspected of crime of setting up financial institution without authorization. Internet finance activities frequently involve business related to securities, insurance, funds and payment/settlement, if such entity engages in such business without valid approval from governmental authority, it may be suspected of crime of illegal business operation. If the entity issues stock to unspecified public or to specified investors exceeds 200 people, then such entity may be convicted of the crime of issuance of stock, corporate/enterprise bond without authorization.
  • Criminal liability due to other’s criminal act by utilizing internet financial platform: Offender may take advantage of the quick cash flow of the platform. They may conduct sales of funds, sales of insurance, securities brokerage, fund raising agency service of P2P platform, money transfer by dispatching Wechat red envelope, and the internet financial platform may facilitate such money laundering activities.

IV. Essentially, the level of criminal liability risk depends on the tolerance of supervision authority on internet finance

Currently, internet finance is at the stage of “no entry threshold, no industrial standard and no supervision.” Relevant authorities normally acquiesce to those creative business models. Thus, it is suggested that criminal law enforcement remains continent to such business models which may in formality touch the legal bottom line. If criminal law focuses too much on punishment, it may strangle financial innovation.

Editor’s note: This article was first published on Chinalawinsight.com

(This article was originally written in Chinese, and the English version is a translation.)

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