Britain's biggest payday lenderWonga will pay £2.6m in compensation to 45,000 customers after sending them bogus letters from non-existent law firms that threatened legalaction.
Britain's financial watchdog said the "unfair and misleading" debt collection practices took place between October 2008 and November 2010.
It said that customers were upt under great pressure to make loan repayments that many could not afford.
Wonga is the biggest short-term lender in Britain and has come under fire, along with the industry as a whole, for the high level of interest rates it charges.
In some instances Wonga added charges to customers' accounts to cover the administration fees of sending the bogus letters, according to the findings of the investigation begun by Britain's Office of Fair Trading and taken on by the Financial Conduct Authority (FCA).
The FCA ordered Wonga to offer all 45,000 customers a flat rate of £50 for distress and inconvenience as well as to refund those who had paid legal charges, estimated at £400,000.
The payday loan industry is under increasing scrutiny from politicians and regulators. The FCA, which took over responsibility for consumer credit in April, has been cracking down on the industry to tackle the way cash-strapped consumers are treated when they struggle to repay loans.
One in three high-cost, short-term loans goes unpaid or is repaid late in Britain and the FCA wants lenders to help people regain control over their debt and treat debtors with more sympathy as part of a drive to change the culture in financial services to focus on customers, rather than profit.
Wonga's interest rates can equate to as much as 5,853% a year, though its loans are only supposed to be held for a short period of time, often to provide funds for someone until they are paid. In 2012 it made nearly 4 million loans to over one million customers.
Wonga apologised to customers for the debt collection practices and also unrelated systems errors that resulted in amiscalculation of some customers' balances.
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.
"We would like to apologise unreservedly to anyone affected by the historical debt collection activity and for any distress caused as a result," commented Tim Weller, Wonga's interim CEO.
"The practice was unacceptable and we voluntarily ceased it nearly four years ago," he added.