Why ethical investors are ditching BNPL stocks

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The fast-growing buy now pay later (BNPL) sector has attracted investor and consumer interest and has led many entrants to jump into the Australian market.

Yet investors and financial counsellors are raising concerns about the structure of BNPL products, their impact on indebtedness and financial hardship and whether increasing regulation over BNPL products represents risk or opportunity for investors.

The BNPL sector is running hot at the moment, off the back of Square's announcement that it would buy Afterpay for $39 billion in a takeover deal.

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Some super funds and ethical fund managers have declined to invest in listed BNPL companies over these social concerns. For their part, companies are implementing policies to manage potential risks to financial hardship while noting that because their products don't charge interest, they are not subject to consumer credit products.

How many people are using BNPL?

In a November 2020 report, ASIC reported that BNPL transactions had increased 90% from the 2018 financial year to the 2019 financial year. The ASIC review looked at BNPL arrangements covered by Afterpay, BrightePay, Humm, Openpay, Payright and Zip Pay.

The review found that one in five consumers are missing payments. In the 2018-19 financial year, missed payment fee revenue for all BNPL providers in the review totalled over $43 million, up 38% compared with the previous financial year, according to ASIC.

There are regulatory changes coming that will impact the industry, with the design and distribution obligations coming into effect in October 2021. That, in turn also brings risks and opportunities for companies and investors.

The sector has introduced self-regulation. In February 2021, a self-regulatory code of conduct came into effect for BNPL providers via the Australian Finance Industry Association. Under the code, transactions above $2000 will require credit checks including income and expense information, with more stringent checks for purchases above $15,000.

BNPL providers will also be subject to new regulation coming into effect from October, which could impact on uptake and popularity of products as well as limit the late fees that some BNPL providers charge.

Why is it concerning?

BNPL allows consumers to make purchases pay down the cost through a set series of instalments - lay-by for the digital era. Proponents say that it can be used as a budgeting tool for people to plan their purchases.

Yet financial counsellors note that they are receiving more calls from consumers who are stretched beyond their financial capability and who have multiple accounts of BNPL that they are struggling to pay back.

"It's a concern," says Tom Abourizk, policy officer at the Consumer Action Law Centre. "Even with the introduction of the BNPL code that the Australian Finance Industry Association brought in, that only brought in the level at $15,000. There is no credit check below $2000 whatsoever.

"Because there's no credit check under $2000, you could have consumers that have either have numerous debts, or numerous debts all at the same time - credit card, payday loans, and rather than seeking assistance from a financial counsellor, they go and say we'll get another form of credit and BNPL becomes another form of that. It is absolutely a major concern for us. Australia has one of the highest levels of debt in the world and this is adding to it."

Is BNPL different?

Afterpay differentiates its product from consumer credit products because it does not charge interest.

"We don't charge interest, and consumer credit products are defined by the fact that they charge interest on their products," says Afterpay vice president, global regulatory affairs Michael Saadat.

"There are some key in-built safeguards that exist for our product. Those safeguards are important because they go above and beyond the features that credit cards have. When a customer misses a payment with us, we don't let them spend until they get up to date. We pause the facility."

Afterpay has also capped late fees at the lesser of 25% of the value of the transaction or $68, Saadat says.

Afterpay is also a voluntary member of AFCA, meaning its users can apply to the financial ombudsman regarding issues they may have with the service.

"I think this speaks to the diversity of the BNPL industry itself," Saadat says.

"You do hear about concerns with BNPL from financial counsellors and people working in the community legal sector, but Afterpay at the moment, the average order value is $150, the average amount of outstanding is around $200. It's possible that people could have multiple liabilities and might be using Afterpay as well, but the driver of financial stress is never going to be Afterpay."

Saadat noted that Afterpay is contributing from a corporate social responsibility perspective as well. Afterpay is partnering with the Australian Retailers Association and Open Learning to develop online financial literacy courses designed for retail workers.

What about credit checks?

A Zip Pay spokesman told FS Sustainability that the company performs credit and identification checks, resulting "in an industry-leading low bad debt rate of 1.78%, which is actually slightly lower than a year ago".

"In fact, only one in 100 customers are late each month, compared with up to one in six credit card users that are struggling with their debt," Zip Pay says. "Our business model is not based on customers falling behind and only 1% of our revenue comes from late fees."

Zip Pay contributed to the development of the BNPL Code of Conduct as well.

Other providers are opting to view BNPL as credit products. Commonwealth Bank of Australia is launching its own BNPL offering from mid-2021, and CBA CEO Matt Comyn told the House of Representatives Standing Committee on Economics in mid-April that the bank will perform credit background checks before extending the BNPL service to customers.

"In some instances it's not what we would be required to do but what we've elected to do, in the context of undertaking reasonable inquiries about a person's financial situation, in terms of their income liabilities and any outstanding debts," Comyn says.

"Often this is used interchangeably with reporting to credit bureaus and understanding what existing facilities or debts may be outstanding. We don't do that in a way that marks someone's credit file or gives them a negative impact on their overall credit standing, but we think it's important, obviously, to act responsibly, even if currently the legislation wouldn't require us to do so."

Concerns over the impact of greater indebtedness and financial hardship fall under ESG and ethical considerations for some investors, who have divested from listed BNPL providers or screened them out proactively.

Why are some companies divesting of BNPL stocks?

Ethical investor U Ethical owned shares in Afterpay, but divested around 18 months ago due to concerns about growing debt among a younger customer base and governance.

"I think the main concern is [for the sector] the lack of consumer protections and the fact that there's a fairly low level of regulation in the space," notes Jon Fernie, head of equities at U Ethical.

"From our perspective, Afterpay is a well-run company and the other buy now pay later companies are well run, but they aren't covered by the national credit code, so they're self-regulating and there's a risk of that leading to higher indebtedness. If people are taking on additional buy now pay later commitments on top of existing credit cards and loans, that isn't necessarily a great thing."

Fernie explains that U Ethical's divestment decision at the time was based on engagement with stakeholders on the ground, and notes that the company has taken steps to improve its governance since U Ethical divested.

"We owned Afterpay early on, but after consultation with some investors and also consumer advocacy groups, we thought they were sailing too close to the wind," he says. "We recognise that there are things that they have done to improve their performance. They've capped late fees, they have signed up to a code of conduct, I think that they have avenues to deal with complaints with the Australian Financial Complaints Authority. It's not all bad, but on balance, there's a lack of consumer protection there which could be a risk."

What changes are coming?

There is new regulation coming - from October 2021, ASIC's design and distribution obligations will apply to buy now pay later arrangements. These obligations will require the industry to design fit-for-purpose products that meet consumer needs. They will also need to take steps to ensure their products are reaching the right consumers, ASIC noted.

Future Super does not invest in the BNPL sector either, says founder and executive director Adam Verwey.

"Credit and debt aren't bad," Verwey says.

"Debt can help pay for essential items, buy a house, pay for education, and even within our impact investing portfolio, we provide debt through microfinance, helping people get out of poverty, or to access renewable energy. Where we think that debt is predatory or a predatory nature to it, when we feel it seeks to exploit people who are poor, young and find it difficult to repay loans, that's where we screen out."

Verwey noted that the fund does not engage with companies that they screen out, but that the fund does engage with banks and credit card providers on BNPL products and concerns around financial hardship.

Australian Ethical Investments does not hold any stock in Afterpay, but holds stock in other listed BNPL providers, noted head of ethics research Stuart Palmer. Palmer pointed to restrictions by certain BNPL providers that prevent merchants that use the services from passing on the cost of those services to their customers.

"We've met with Afterpay, we've met with FlexiGroup which have the humm product, and we've discussed a range of issues including the merchant restrictions," Palmer says. "We've advanced the proposition that we don't see an ethical justification for it.