The buy-now-pay-later (BNPL) sector has hit its latest regulatory hurdle. ASX-listed Sezzle Inc (ASX: SZL) shares slumped 33% last week when the company was denied a lender's licence in California.
California's Department of Business Oversight (DBO) rejected Sezzle's application for a lender's licence, finding Sezzle had contravened California Financing Law by engaging in the business of a finance lender without a licence. Sezzle shares are currently trading at $1.20, down from $2.10 at the end of 2019.
Sezzle's business
Although listed on the ASX, Sezzle is focused on the North American market and operates from Minneapolis. In its licence application, Sezzle said it provides "interest free online financing to consumers". Sezzle finances consumers' purchases with Sezzle affiliated merchants. Consumers pay Sezzle 25% at the time of purchase and the rest in 3 equal instalments. Merchants pay Sezzle a proportion of each transaction, and consumers pay Sezzle if they miss or want to reschedule a payment.
Sezzle had more than 7,500 active merchants at the end of the September quarter and reported strong YoY sales growth during the Black Friday/Cyber Monday event. Underlying merchant sales increased 400% compared to the previous year and 36,000 new customers were added. In December, Sezzle announced it had secured US$100 million in debt funding to fuel future growth. The new debt facility, provided by a syndicate of lenders, tripled the size of the company's existing debt facility.
DBO's ruling
Following a review of Sezzle's product and information, the DBO concluded the credit sales made by Sezzle's merchant partners were not bona fide. Instead, the DBO found they were structured to evade otherwise applicable consumer protections, concluding Sezzle was making loans under Californian law. According to the DBO, Sezzle had engaged in unlicenced lending in California so was denied a licence to make loans.
Sezzle's reaction
Sezzle maintains that it operates a sales finance company and does not make loans. Despite the ruling, Sezzle continues to operate from the state of California in partnership with its affiliated retailers. According to Sezzle, retailers originate retail sales instalment contracts and then subsequently assign those contracts to Sezzle so that Sezzle can service the payment processing. The purpose of obtaining the loan licence is to remove the merchants from the process. Given the DBO approved a loan licence for a competitor operating under a similar model previously, Sezzle believes a path to resolution can be found.
Second BNPL provider
In its press release, the DBO announced it had issued a legal opinion to a second, unnamed lender. This opinion advised that the lender's point of sale products meet the definition of loans and require a licence to be offered in California. Speculation as to the identity of this second lender has been rife.
Afterpay Ltd (ASX: APT) issued a statement in response to queries, advising that Afterpay had applied for and been granted a lender's licence in California in late 2019. Afterpay shares increased 4.6% as following the announcement. According to the Australian Financial Review (AFR), market speculation as to the identity of the unnamed second lender is centred on Klarna, in which the Commonwealth Bank of Australia (ASX: CBA) invested $150 million in exchange for a 2.7% stake.
BNPL market
There are now a number of BNPL providers listed on the ASX. Sezzle listed last July at $1.20 and has since traded as high as $2.73. Afterpay is perhaps the best known of the BNPL shares and is up 150% since last January. Afterpay operates in Australia, New Zealand, the United States (US), and the United Kingdom (UK). The company reported 6.6 million customers at the end of November, an increase of approximately 0.5 million in the month. Underlying sales of $1 billion were reported in November with 42,500 active merchants onboard.
Zip Co Ltd (ASX: Z1P) is trading at $3.53, up 226% from last January. As at November, Zip Co reported 1.6 million customers, 20,000 retail partners, and more than 45,000 points of acceptance. Zip Co finalised the acquisition of New Zealand-headquartered PartPay in November. The acquisition provides exposure to 4 key geographies – New Zealand, South Africa, the US, and the UK. Zip Co also inked a deal with Amazon Australia to provide a BNPL option at checkout in November. Zip Biz, an interest free digital wallet that provides a revolving line of credit is expected to be launched in 3Q20.
The latest BNPL provider to list on the ASX is Openpay Group Ltd (ASX: OPY), which debuted in December. Shares in Openpay listed at $1.60 and closed their first day down 17% at 1.325. They are now trading at $1.24. The lacklustre performance of Openpay shares may indicate waning interest by investors in what is becoming a crowded sector. Openpay differentiates itself from other BNPL providers with higher payment limits and longer payment terms. At the end of November, Openpay reported 1,834 active merchants, up from 1,510 at the end of June.
Regulatory pressures
The BNPL sector has come under increased regulatory scrutiny as users have multiplied rapidly. According to the AFR article, there were almost 2 million Australian users of BNPL products in 2019. BNPL providers don't charge consumers interest, so have avoided being regulated as credit providers. They do charge merchants fees to offer the service and may charge customers late, administration, and rescheduling fees.
In October, in the annual report of the Payment Systems Board, the Reserve Bank of Australia (RBA) announced next year's review would examine "no-surcharge" rules imposed by BNPL operators. These rules forbid merchants from passing on the costs of the BNPL service to customers. By contrast, debit and credit card providers cannot legally prevent merchants from adding a surcharge to cover payment costs. According to the RBA, "an issue for the Bank to consider is whether policy action in relation to these no-surcharge rules should be considered."
Foolish takeaway
The numbers of BNPL customers in Australia and overseas has gone from zero to several million in just a few years. Regulators are playing catch up as this new form of financing takes hold and friction may be inevitable as new business models interact with existing regulations.
