Payday lender Wonga is to pay more than £2.6 million in compensation to around 45,000 customers for "unfair and misleading debt collection practices", the City regulator has announced.
The UK's biggest payday lender was found to have sent letters to customers in arrears from non-existent law firms threatening legal action, the Financial Conduct Authority (FCA) said.
In some cases, Wonga added charges to customers' accounts to cover administration fees for sending the letters.
Wonga apologised "unreservedly" for the failings, which took place between October 2008 and November 2010.
The FCA said consumers were put under "great pressure" from communications sent by fictitious law firms to make loan repayments that many could not afford.
Wonga contacted customers in arrears under the names Chainey, D'Amato & Shannon and Barker and Lowe Legal Recoveries, leading customers to believe that their outstanding debt had been passed to a law firm, or other third party. Further legal action was threatened if the debt was not repaid.
Neither of these firms existed and Wonga was using this tactic to maximise collections by piling the pressure on customers, the regulator said.
Tim Weller, interim Wonga CEO, said: "We would like to apologise unreservedly to anyone affected by the historical debt collection activity and for any distress caused as a result.
"The practice was unacceptable and we voluntarily ceased it nearly four years ago."
Martin Lewis, founder of MoneySavingExpert.com said: "This just shows that while Wonga hires expensive marketing, PR and public affairs consultants to try to position itself as 'the good guys in a bad industry', it's all a sham.
"Using lawyers as fake as its puppets, then having the stomach to charge people for it is a thuggish tactic, aimed at scaring and intimidating people who are already struggling.
"I'm glad to see the FCA taking action. I hope this is just the first move against a dirty, dangerous industry."
Mike O'Connor, chief executive of StepChange Debt Charity, said: "For too long payday lenders have subjected consumers to unfair, misleading and distressing practices and today's announcement represents a victory for a small number of those consumers.
"It's time the payday loan industry entered the 21st century in terms of treating customers fairly. If they cannot, they should leave the market, or be pushed out of it.
"I hope this will be the first of many similar actions as the FCA continues its efforts to clean up the payday lending industry and create a short term credit market that meets consumers' needs, but crucially treats those in financial difficulty fairly."
Richard Lloyd, Which? executive director said the case marks a "shocking new low" for the payday industry.
He said: "Wonga deserves to have the book thrown at it.
"The FCA must now also clamp down on excessive fees and charges, starting with default fees charged by some payday lenders, to show it is serious about getting a fairer deal for borrowers."
The ruling comes after Sir Hector Sants, a former chief executive of the Financial Services Authority, was appointed to head a task group for the Archbishop of Canterbury, the Most Rev Justin Welby, on responsible savings and credit.
Sir Hector launched the Church Credit Champions Network aimed at offering an alternative to payday lenders.
Mr Welby received widespread publicity last year when he said he had told Wonga founder Errol Damelin that he wanted to drive payday lenders out of business through the creation of credit unions.
A Church of England spokeswoman, commenting today on the FCA ruling, said: "We welcome anything that clamps down on aggressive or irresponsible debt collection practices, and not just by payday lenders.
"This highlights the need for more responsible alternatives to payday lending and other forms of high cost credit.
"That is why the archbishop's task group is developing a set of practical initiatives to meet the need for more affordable and responsible lending and saving opportunities."
The Church Credit Champions Network is being piloted in the Southwark, Liverpool and London Church of England dioceses.
Prime Minister David Cameron's official spokesman said: "As I understand it, it is regulatory enforcement activity by the FCA, which was set up by this Government, and it's absolutely right that tough regulatory action by the new regulator is taken.
"Clearly, if there has been the need for very significant regulatory intervention, then very significant failings have been uncovered. That's the whole point of having the tough new regulators that this Government has established."