Technical Guidance Credit Card Contracts A recent decision gives credit card debtors some relief from unconscionable clauses F rom a cup of coffee to a luxury cruise and beyond, credit card purchases are made in startling numbers, all over the world, ever y day. The terms of the contracts are often glossed over by the party responsible for payment. A recent decision, Hang Seng Credit Card Ltd & Ors v Tsang Nga Lee [2000] 3 HKC 269, applied the Unconscionable Contracts Ordinance to the terms of the contract between the card company and the customer to read down the provision relating to payment of legal costs on default. General Principles The usual credit card transaction involves three parties: 1. the creditor, as the company which issued the card and set up the scheme 2. the debtor or customer to whom the card is issued, and 3. the supplier of the goods or services who takes the credit represented by the cards as payment or the promise of payment for those goods or services. The creditor is usually a bank and the supplier is the merchant or institution that contracted with the creditor to accept the credit card. Generally there are three contracts: 1. the contract between the creditor and the debtor 2. the contract between the creditor and the supplier, and 3. the contract between the supplier and the debtor. Under his contract with the creditor, the debtor has an obligation to pay the creditor for debts incurred, at face value, for goods purchased or services supplied. In accordance with the terms of their contract, this payment must be the full amount due either within a certain time or over a period of time. In each case interest is payable on the amounts outstanding. Under the contract between the creditor and the supplier, the creditor undertakes to pay the supplier for the amount of goods sold or services rendered, but at less than face value. The difference between the price and the payment November / December 2000 represents profit for the creditor on the transaction. The third contract is between the debtor and the supplier. The nature of this contract is more difficult to assess. Generally you would expect this to be a simple contract for the sale and purchase of goods, or for the delivery of agreed services. Where the subject matter is goods, you would expect the Sale of Goods Ordinance to apply thereby giving the debtor as purchaser the protection which that Ordinance gives, including warranties of title, merchantable quality and so on. This contract does not really fit within the definition of s 3(1), which requires payment of a ‘price’, ie a money consideration. The debtor does not pay the merchant for the goods, the creditor pays the merchant an amount less than the price of the goods at a later date. As a result, some authorities argue that the contract does not come under the Ordinance, and more seriously that the purchaser is not protected by the warranties made by the supplier. Although the relationship between the creditor and the debtor is one of credit and the loan of money to the debtor, the better view is that the transaction represents a sale of contract between debtor and supplier in that the creditor pays the price on behalf of the debtor thereby satisfying s 3(1). What is the position if the debtor purchases goods, uses the card for payment, and prior to the creditor paying the supplier, the creditor becomes insolvent? Re Credit Charge Services Ltd [1989] Ch 497 held that payment by use of credit card was an unconditional payment and that the supplier could not sue the debtor as the liability of the debtor to the supplier was frozen when the card was accepted. The supplier then had to seek payment from the creditor because the contract represented authority to the card holder that he could contract with the supplier and that the creditor would honour the supplier’s voucher on presentation: R v Lambie [1981] 2 All ER 776. These are the general principles governing relationships under credit card transactions. The contract between the supplier and the creditor is considered to be one between equal bargaining parties because it is a commercial rather than a consumer contract. So any unequal terms will probably bind the supplier without the court intervening to relieve the supplier from harsh terms because the contract has been effected in the course of business. Debtor and Supplier But what of the principles in the contract between the debtor and the supplier? The contract between these parties is not generally considered to be commercial because the debtor is usually a consumer, and so not of equal bargaining power with the creditor. In cases of corporate credit cards, this interpretation may be set aside because the card was issued in the course of the debtor’s business and therefore the debtor and creditor are equal parties. A number of ordinances are relevant to contracts between debtors and suppliers. The Money Lenders Ordinance is relevant, particularly in regard to the legality of any interest chargeable. In most cases the creditor will be exempt from the operation of the Ordinance (see s 33A and Schedule 1). The Unconscionable Contracts Ordinance enables a court to refuse to enforce, limit, revise or alter the whole or part of certain types of contract where one party is a consumer and the affected part or whole is unconscionable. There are five listed guidelines that may be considered with other factors to establish unconscionability. Finally, the Control of Exemption Clauses Ordinance prevents the enforcement of unreasonable exemption clauses in certain contracts with consumers. The Hang Seng Case So what happened in the Hang Seng case? Several debtors owed money to several creditors for credit card debts. The creditors sued and obtained judgments against the debtors. The terms of the individual contracts between each debtor and each creditor included an obligation on the part of the debtor to pay costs. Each creditor’s contract had a different clause on this issue. Hang Seng’s clause included ‘all costs payable to debt collectors’ and Pacific Finance’s clause stated that ‘the pleaded cost also includes administrative costs’. The clause in the The Prospective Accountant >> 37 Technical Guidance Standard Chartered contract was the most extensive providing for: all costs and expenses directly or indirectly incurred by the Bank in demanding, collecting and attempting to collect or otherwise in enforcing ‘the agreement’ including without limitation the charges of any agent or service provider (eg debt collectors) on a full indemnity basis. In considering whether these clauses operated to make the debtors liable for the costs of collection on a full indemnity basis, the Court said that it had a role to play in assessing the amount of any costs awarded in an action against the defendants, here the debtors. Why? Because the Court is given a discretion under s 52A of the High Court Ordinance to look at the circumstances of each case, and to review the terms of the contract, by reference to the provisions of the Unconscionable Contracts Ordinance. That Ordinance applies to contracts for the sale of goods and services. The contract between the debtor and the creditor was one for the supply of credit under which the bank was treated as lending money to the debtor to purchase goods or obtain services. The interest rates were very high. In the ordinary course of events, even without the Unconscionable Contracts Ordinance, the court would be able to look at the contract and see whether the rate of interest made it unenforceable. This reflects the right given to the Court by the Money Lenders Ordinance to reopen (or review) a money lending contract where the interest rate is too high. But in this case each creditor was a bank and so was exempt from the provisions of that Ordinance. So the only way to avoid or modify the clause was to see whether the Unconscionable Contracts Ordinance applied. If it did, and the clauses relating to payment were unconscionable on the grounds of being unreasonable, then the court would excise those clauses from the contract. The court would then simply assess costs in the usual way by reference to its discretion under the terms of s 52A. In each case the clause was considered unconscionable due to four factors: 1. The equality of the parties – the creditors were in a much stronger bargaining position and the contracts were standard form contracts without any contribution 38 The Prospective Accountant to the drafting by the debtors. 2. The ability of the debtor to understand the ‘cost’ clause – generally the clause was not only not explained to the debtor but was not drawn to his attention when he entered into the contract. 3. The availability of identical services from another source – there was no choice because in Hong Kong most of these kind of contracts contain the same terms. 4. The extent of the clause – here it was extremely wide. All factors were considered in the debtors’ favour and contra proferentem the creditors with the result that these clauses were not enforceable because they were unconscionable. The Court awarded fixed costs on the High Court scale as being the fair- ‘The court is not shackled by the traditional or classic theories in contract law’ est costs in the circumstances. These costs were not excessive and represented costs which would have been awarded by the Court in an ordinary cause of action. One other factor the Court considered was the extortionate interest rate (in one case it was in excess of 48 per cent). But as the creditors were banks and exempt by the terms of s 33A the transaction could not be reopened under the Money Lender Ordinance. Yam J in his judgment said that in applying the Unconscionable Contracts Ordinance ‘the court is not shackled by the traditional or classic theories in contract law’. His Lordship was probably referring to the fact that the guidelines used to interpret the clauses were not rules of interpretation for contracts; instead they were factors which a court of equity would consider in deciding whether or not the defendant had acted unconscionably. In some of these cases of unconscionability there is no contract between the parties, and the Court has to decide if a remedy is possible (see for example the remedy of restitution in AG v Blake [2000] UKHL 48). In other cases the plaintiff has claimed his breach of contract was caused by the unconscionable actions of the defendant (eg the estoppel against the vendor in Pacific South (Asia) Holdings Ltd v Million Unity International Ltd [1997] 3 HKC 440, which turned the tables by making the vendor not the purchaser the guilty party). The OTB Case Fortunately for the debtors the Court did not consider an earlier Hong Kong decision. This was the case of OTB International Credit Card Ltd v Michael Au [1980] HKLR 296. In that case one of the terms in the contract between the creditor and the debtor provided that: In the event of loss or theft of the card, the Holder must immediately notify the Company by registered mail or telegram and until such notification is received by the Company, the Holder will remain responsible for all purchases charged through the use of such Card. When the debtor discovered that his card had been stolen, he telephoned the creditor company the same day and the next morning wrote to the creditor. However, on the day of the theft the card had been used to make purchases to the value of HK$3,216.00. The suppliers had not checked the signature on the back of the card and the creditor billed the debtor for these purchases. The debtor argued this exemption of liability clause was unconscionable. Without any legislation to assist the Court, because this was more than a decade before the enactment of the Unconscionable Contracts Ordinance, the Court of Appeal had to rely on contract principles to decide whether the clause operated. These contract principles had recently been considered in Photo Production Ltd v Securicor Transport Ltd [1980] AC 827, which allowed an exemption clause to operate if it was not unreasonable and was necessary for the protection of the creditor in light of the benefits which the debtor received under the contract. But Photo Production concerned two equal bargaining parties whereas the OTB case concerned a bank November / December 2000 and a consumer, ie unequal bargaining parties. However, the Court said: The company ought not to be responsible indefinitely for a lost card. Indeed it may well have been lost through the negligence or foolishness of the holder. And for his part the holder obtains considerable benefits from the provision by the company of immediate credit without security. (Cons JA delivering the judgment of the court at 298). That judgment seems unduly harsh as the debtor, whilst not performing immediately his obligation to write to the creditor, did at least seek to prevent use by telephoning the creditor. The creditor maintained that it could not act on a telephone call without a letter with the debtor’s signature because the phone call may have been a hoax. So the only solution was to consider the contractual solution. What did the contract say? Did the events that happened fit within the terms of the contract? If so, the terms of the contract operated and were not unreasonable. This is how Photo Productions interpreted the clause in that contract. Reviewing Interim Reports The HKSA recently released a new auditing standard. Richard George focuses on the key features of SAS 700 I n July 2000, Statement of Auditing Standards 700 ‘Engagements to Review Interim Financial Reports’ (SAS 700) was issued by the HKSA. SAS 700 provides standards and guidance to auditors in reviewing and reporting on interim financial reports. Objective of a Review Engagement The objective of a review of an interim financial report is to enable the auditors to report to the board of directors whether, on the basis of the review procedures carried out, anything has come to the auditors’ attention that causes them to believe that material modifications should be made to the interim financial report. An interim review provides moderate assurance that an interim financial report has been prepared in accordance with the requirements of Statement of Standard Accounting Practice 25, Interim Financial Reporting (SSAP 25) and with the relevant provisions of the Listing Rules. Scope of a Review An interim review differs from an audit in the extent of the procedures performed and the level of assurance provided. An audit involves extensive procedures designed to provide the auditors with sufficient evidence to provide positive assurance regarding the November / December 2000 reliability of the financial statements. While an interim review involves the application of audit skills and techniques, the scope of review procedures is not as extensive. Accordingly, an interim review provides only a moderate level of assurance that the interim financial report is free from material misstatement. An interim review is focused primarily on enquiries to management and the application of analytical procedures to the interim financial data in order to assess whether accounting policies and presentation in the interim financial report have been consistently applied unless otherwise disclosed. In particular, the auditors will design their interim review procedures to focus on the recognition, measurement and presentation issues discussed in SSAP 25. An interim review does not normally include audit procedures such as tests of controls and verification of assets, liabilities and transactions. Engagement Letters The auditors should clarify through discussion with the client the scope of the interim review engagement and the intentions of the directors regarding the inclusion of an interim review report in the company’s interim report. These issues should be clarified before agreeing the terms of the engagement. The Result These days, given the inequality of bargaining power and that it was a standard form contract, the Court could consider matters beyond the contract. This is what happened in Hang Seng. What Photo Production did was to enable the Court to interpret the clause. What the Unconscionable Contracts Ordinance does is to enable the court to remove the clause it considers unconscionable and to interpret what is left of the contract in a more reasonable and ‘conscionable’ manner. Judith Sihombing is a Lecturer at the University of Hong Kong. Planning The auditors should plan their work to ensure that an effective interim review is performed. The auditors should update their understanding of changes in the client’s business to ensure review enquiries are relevant and review procedures are appropriate, as well as to assess the appropriateness of the responses and other information obtained. Other Auditors The auditors should establish the scope of review work required (if any) for each division, subsidiar y, associate and jointly controlled entity. The auditors should notify any other auditors of the nature and extent of work required, the form of report required and the reporting timetable. Materiality Auditors should apply the same materiality considerations applicable to an audit opinion on an interim financial report. SSAP 25 requires that materiality should be assessed directly in relation to the interim period financial data. Documentation The auditors should document their interim review work. In particular, the auditors should document matters that are important in providing evidence to support the conclusion in their review report and that their review was conducted in accordance with SAS 700. Procedures and Evidence The auditors should use their professional The Prospective Accountant >> 39 Technical Guidance judgment in determining the specific nature, timing and extent of review procedures. The extent of review procedures should reflect the risk of misstatement in the interim financial report. In designing review procedures the auditors should be guided by the following factors: • their knowledge and experience of the entity, the industry within which it operates and of prior period audits and the areas of specific identified risk • the extent to which a particular item is affected by management judgment • the entity’s accounting systems • the materiality of transactions and account balances, and • management’s own assessment of the risks underlying the interim financial report and the monitoring and other controls established to mitigate those risks. The following procedures are ordinarily included as part of a review of an interim financial report: • obtaining an updated understanding of the entity’s business and the industry in which it operates • enquiries concerning the entity’s accounting principles and practices • enquiries concerning the entity’s procedures for recording, classifying and summarising transactions, accumulating information for disclosure in the interim financial report and preparing the interim financial report • enquiries concerning all material assertions in the interim financial report • analytical procedures designed to identify relationships and individual items that appear unusual, including: – comparison of the interim financial report with those for prior periods – comparison of the interim financial report with anticipated results and financial position, and – study of the relationships of the elements of the interim financial report expected to conform to a predictable pattern based on the entity’s experience or industry norm. • enquiries concerning actions taken at meetings of shareholders, the board of directors, audit committees and other committees of the board of directors and other meetings that may affect the interim financial report 40 The Prospective Accountant • • • reading the interim financial report to consider whether the interim financial report appears to conform with the basis of accounting indicated obtaining reports from other auditors, where considered necessary, who have reviewed components of the entity, and enquiries of persons having responsibility for financial and accounting matters concerning, for example: The review provides boards and audit committees with enhanced assurance that the interim financial report is free from material misstatement Subsequent Events The auditors should enquire about events subsequent to the interim financial report date that may require adjustment to or disclosure in the interim financial report. Management Representations The auditors should obtain written representations from the directors in respect of the interim financial report. It is important that the auditors include representations on specific matters such as the substance of significant assertions, estimates or interpretations of facts by the directors that have a significant effect on the interim financial report. Discussion of Findings Prior to issuing their interim review report, the auditors should communicate their findings in general to the board of directors and the audit committee. Matters that may be communicated include: • the scope and results of the review procedures undertaken • the process by which the interim financial report was prepared, including the process used by management in formulating accounting estimates and the basis for the auditors’ conclusions regarding the reasonableness of those estimates • changes to accounting policies and presentation, and • issues which have been discussed with management. Review Conclusion – whether all transactions have been recorded – whether the interim financial report has been prepared in accordance with the basis of accounting indicated – changes in the entity’s business activities and accounting principles and practices, and – matters as to which questions have arisen in the course of applying the foregoing procedures. If based on their review procedures the auditors have reason to believe that the interim financial information may be materially misstated, they should carry out such procedures necessary to issue an unmodified review report or to confirm that a modified review report is required. An unmodified review report contains a review conclusion expressed in terms of a ‘negative assurance’ as follows: ‘On the basis of our review, which does not constitute an audit, we are not aware of any material modifications that should be made to the interim financial report for the six months ended …’. Modifications Under SAS 700, the auditors will modify their interim review report where they conclude that material modifications to the interim financial report either are or may be required to be made. Such modified interim review reports will arise where the auditors disagree, either about an adopted accounting treatment or about the extent of disclosure in the interim financial report, November / December 2000 or where the auditors encounter a material limitation in the scope of their review work. Modification of the interim review report will also be required where there is fundamental uncertainty, eg a significant level of concern about the company’s ability to continue as a going concern. If the prior period review report on the interim comparatives or the auditors’ report on the preceding annual financial statements was modified and the matter giving rise to the modification has not been resolved, the review report should refer to the modification and discuss the current status of the matter giving rise to the modification and the implications for the information presented in the interim financial report. Interim Comparatives Users of interim reports are likely to assume that the interim comparatives were subject to the same review procedures as the current year interim financial information. Where an interim review is to be performed for the first time and the auditors are not engaged to perform a review of the interim comparatives in accordance with SAS 700, they should modify their review report. November / December 2000 Other information Although the auditors are not responsible for other information accompanying the interim financial report (eg MD&A), the auditors do consider whether other information is materially inconsistent with the matters covered by their review report, or if it is misleading. If any apparent misstatements or material inconsistencies cannot be resolved through discussion with the directors, the auditors may decide to make reference to the misstatements or inconsistencies in their review report. Requests to Discontinue an Engagement There may be circumstances where the auditors indicate to the directors that their report may be modified and, as a result, the directors may request the auditors to discontinue the review engagement rather than accept a modified review report. For example, where the potential modification arises from a disagreement about an accounting treatment, the directors may seek to discontinue the engagement because the Listing Rules require disclosure of such a modification to be made in the interim report. If such a situation arises, the auditors should inform the audit committee as soon as possible. Enhanced Assurance A review by the company’s auditors performed in accordance with SAS 700 brings independent professional challenge and scrutiny and, importantly, given the increasing complexity of financial reporting rules, is designed to focus on the key recognition, measurement and presentation issues. Thus the review provides boards and audit committees with enhanced assurance that the interim financial report is free from material misstatement and has been properly prepared in accordance with the requirements of SSAP 25 and the relevant provisions of the Listing Rules. It is expected that reviews of the interim financial reports will prove to be an integral part of the process by which boards and audit committees satisfy themselves as to the integrity and reliability of interim financial reports issued under the Listing Rules. Richard George, Technical Department, Deloitte Touche Tohmatsu. The Prospective Accountant 41 Technical Update This information is for students’ reference only and has no relation to the examinability of such information. Students should refer to the comparison tables that appear in the January/February costs. Sundry repairs and maintenance costs should be expensed as incurred. The Society’s Financial Accounting Standards Committee will provide an illustrative example in the final version of this Interpretation. and July/August issues of the Journal before each examination diet to understand the examinability SAS 600 ‘Auditors’ reports on financial statements’ of such materials. HKSA Standards and Guidelines Draft Interpretation 11 ‘Property, plant and equipment – major inspection or overhaul costs’ This Draft Interpretation is closely modelled on the equivalent Interpretation issued by the IASC’s Standing Interpretation Committee. It addresses the issue of whether or not the cost of a major inspection or overhaul of an item of property, plant and equipment occurring at regular intervals over the useful life of an asset and done to ensure the continued use of the asset should be capitalised or expensed. This Draft Interpretation only concerns ‘major’ inspection and overhaul The Securities and Futures Commission has amended the Securities (Accounts and Audit) Rules. The revised Rules came into operation on 12 June 2000. Under the revised Rules, where a securities dealer’s accounting period straddles 12 June 2000, auditors must report matters required for both the period up to 11 June 2000 and the period from 12 June 2000. Legislation Code LN 273 of 2000 Ordinance Inland Revenue (Amendment) Bill 2000 5 October 2000 Stamp Duty (Amendment) Bill 2000 5 October 2000 Banking Ordinance (Amendment of Third Schedule) Notice 2000 (Made under section 135(3) of the Banking Ordinance (cap 155)) November / December 2000 Gazetted on 5 October 2000 The Prospective Accountant 43