A more flexible approach to credit assessment

Two recent cases examined, at appellate level, lenders’ obligations when assessing prospective borrowers’ capacity to repay loans. While both considered aspects of those obligations in different (consumer and business lending) contexts, it is possible to divine from the outcomes an acceptance of flexibility in the loan assessment processes mandated by the National Consumer Credit Protection Act 2009 (Cth) (NCCPA) and the Code of Banking Practice (Code).

The endorsement of purposive (rather than prescriptive) approaches to credit assessment will be welcomed by lenders. Lenders should be less susceptible to criticism for perceived “technical” failures in the assessment process which are not (necessarily) productive of negative customer outcomes.

ASIC v Westpac

Australian Securities and Investments Commission (ASIC) v Westpac Banking Corp[1] (ASIC v Westpac) was focused on the scope of obligations imposed on lenders by s 131 of the NCCPA.

The proceedings, commenced in 2017, were brought by ASIC as a test case, as explained by ASIC Commissioner Sean Hughes, “because of the need for judicial clarification of a cornerstone legal obligation on lenders”.[2]

ASIC alleged contraventions of s 128 of the NCCPA between 2011 and 2015. They arose from the assessment of home loan applications by Westpac’s automated decision system (ADS), which applied a series of rules to information supplied by each borrower who subsequently obtained a home loan. The ADS comprised over 200 rules which were applied to the information obtained from each prospective borrower. ASIC alleged that Westpac contravened s 128 of the NCCPA by relying on a statistical estimate of the household expenditure required for a reasonable standard of living based on the prospective borrower’s circumstances (HEM Benchmark), rather than the consumer’s declared living expenses.

Additionally, in respect of loans with interest only periods, the ADS assessed affordability on the basis of equal monthly repayments of principal, interest and fees that would repay the loan at the end of the proposed term (Full Term Method), rather than taking into account the higher repayments that would have to be made after expiry of the interest only period if the consumer only made the minimum required repayments during the interest only period (Residual Term Method).

Section 131(1) of the NCCPA provides that a credit provider “must assess that the credit contract will be unsuitable for the consumer if the contract will be unsuitable for the consumer under subsection (2)”. Section 131(2)(a), in turn, provides that:

(2) The contract will be unsuitable for the consumer if, at the time of the assessment, it is likely that:

(a) the consumer will be unable to comply with the consumer’s financial obligations under the contract, or could only comply with substantial hardship, if the contract is entered or the credit limit is increased in the period covered by the assessment …

Accordingly, ASIC argued that the HEM Benchmark employed by Westpac failed to assess consumers’ likely ability to comply with their financial obligations as required under s 131 of the NCCPA. ASIC’s case was that s 131(2)(a) imposed an obligation upon lenders to take into account each consumer’s actual living expenses. Westpac argued that the use of the HEM Benchmark was permissible but that, in any case, even if s 131 of the NCCPA required it to take into account declared living expenses in its assessments, this was achieved by another rule in the ADS which would be triggered if a consumer’s declared living expenses exceeded 70% of the consumer’s income (70% Ratio Rule).

Additionally, ASIC argued that, in relation to loans with interest only periods, Westpac ought to have taken into account the higher repayments due at the end of the interest only period under the Residual Term Method and that, in failing to do so, Westpac failed to make an assessment of unsuitability within the meaning of s 131(2)(a) of the NCCPA.

At first instance, Perram J dismissed ASIC’s case, holding that a “credit provider may do what it wants in the assessment process[;] … what it cannot do is make unsuitable loans”.[3] His Honour held that ASIC’s argument “creates a whole new range of implied rules which appear altogether unnecessary”.[4]

On appeal, Gleeson and Lee JJ separately held that the NCCPA does not impose an obligation on lenders to take into account the actual living expenses of a prospective borrower and that, accordingly, Westpac’s reliance on the HEM Benchmark did not give rise to a breach of s 128 of the NCCPA. Gleeson J held that the NCCPA “does not support the degree of prescription contended for by ASIC” and instead “leaves it open” to a credit provider to decide what enquiries it will make and how it will use the results of its enquiries to make the unsuitability assessment.[5] Lee J noted that the NCCPA does not contain any “textual requirement specifying how the assessment is to be undertaken”.[6]

In a dissenting judgment, Middleton J, while accepting that the assessment process does not “prescribe one methodology”,[7] took the view that the assessment required under s 131 ought to be made based on the financial position of the particular consumer, with regard to “all relevant and material information presently available”,[8] which included the past expenses of a consumer.

The court unanimously dismissed ASIC’s appeal in respect of Westpac’s use of the Full Term Method. Middleton J held that Westpac’s use of the Full Term Method “reflected a legitimate choice in the exercise of Westpac’s judgement as to how to conduct a suitability assessment for an interest only loan”.[9]

ASIC has confirmed that it will not seek special leave to appeal to the High Court.[10]

Gooley

In Gooley v NSW Rural Assistance Authority[11] (Gooley), the appellants, a husband and wife, operated a farming business on two properties, “Clovass” and “Dyraaba”. Bankwest first provided lending facilities to the appellants in December 2007. The principal facility was a $1.2 million fixed interest commercial loan for a term of 15 years, referred to as a FICL. The FICL was subject to an “interest only” period for the first 5 years.

In January 2008, Clovass was flooded and the appellants sought assistance from the NSW Rural Assistance Authority in the amount of $130,000. This advance was secured by a second mortgage and required the consent of Bankwest. This consent was given on the basis that the term of the FICL was reduced to 5 years interest only with the principal to be repaid on 12 December 2012.

In February 2011, Bankwest agreed to advance a further $550,000 to the appellants. The $400,000 of this further advance was used by the appellants to purchase Dyraaba and a small adjoining property, with the balance of the funds being used to fund repairs of Dyraaba. In support of their application for this further advance, the appellants furnished Bankwest with forecasts based on the following assumptions:

• The FICL loan (at that time reduced to $1,050,000) would continue with interest only payments beyond December 2012.
• No repayment of principal would be required in relation to the Dyraaba loan which would continue beyond March 2013 as an interest only loan.

The appellants submitted in the proceedings that the approval of the Dyraaba loan involved a breach of cl 25.1 of the Code, which provides that a bank will:

… exercise the care and skill of a diligent and prudent banker in selecting and applying [its] credit assessment methods and in forming [its] opinion about [the borrower’s] ability to repay it.

At first instance, Parker J held that cl 25.1 had been breached by the bank as there was “no evidence that the Bank asked itself whether the [appellants] would be able to repay the principal … on maturity”,[12] but that the appellants had failed to establish their claim to damages, as the breach was not causative of loss.[13]

Meagher JA (Macfarlan and White JJA agreeing) held that the primary judge erred in concluding that the bank had breached its obligation under cl 25.1 by failing to consider whether the appellants could repay the Dyraaba loan. Meagher JA noted that a borrower’s ability to repay the principal at maturity describes the capacity to do so either by refinancing or from the borrower’s own resources, which may require the disposal of assets. Notwithstanding this, Meagher JA noted that Parker J’s judgment, on its face, did not “take account of the possibility of repayment of the existing and proposed facilities by refinancing, either with the bank or with some other financier”.[14]

The credit assessment undertaken by the bank established that, by reference to the budget forecast period ending 30 June 2013, the appellants had the capacity to make principal and interest repayments assuming that the whole of their bank debt was, in that period, refinanced over 15 years. The Court of Appeal held that, taking account of the evidence, the primary judge could not have been satisfied that the bank had not applied its assessment method and formed the view that, premised on the appellants’ forecasts and its own workings, the appellants could afford to refinance the existing facilities.

Comment

Deteriorating economic conditions will undoubtedly result in an increase in lenders’ enforcement activity. Experience tells us that this will, in turn, generate a greater volume of disputes as to the adequacy of banks’ credit assessment methods. The decisions in ASIC v Westpac and Gooley suggest that resorts to allegations of technical defects in the credit assessment process (perceived or otherwise) are unlikely to be given substantial weight when unaccompanied by demonstrated detriment on the part of the borrower.

Whether the result in ASIC v Westpac prompts further review of ASIC’s regulatory guide for responsible lending (RG 209)[15] remains to be seen.