Causation and the Code

While appellate courts had previously sketched out the scope and operation of the Code of Banking Practice (Code) a more complete picture of the Code’s landscape has emerged as a result of brushstrokes recently added by the Victorian Court of Appeal in Doggett v Commonwealth Bank of Australia[1] (Doggett) This is particularly so in relation to cl 27, one of the Code’s most pervasive provisions.

Although the decision confirmed a number of important matters, there was disagreement on whether it was established that the relevant breach of the Code caused loss. While McLeish JA agreed with the trial judge that it was not established that the loan would not have proceeded but for the breach of the Code, Whelan JA and Garde AJA came to the opposite view. Causation has therefore emerged as a key issue in litigation where damages are claimed as a result of a breach of the Code.

The Code

The Code is a voluntary code of conduct that is incorporated by reference into many banking contracts. The content of the Code’s provisions range from the aspirational to the prescriptive. It contains provisions (such as, for example, the obligation that the bank be cooperative in a 5 yearly review of the Code) that carry little risk of being enforced by individual customers. On the other hand, cl 27 of the Code has increasingly been the subject of litigation.

Courts have to date been prepared to give contractual force to even the less prescriptive provisions of the Code, such as the obligation in cl 3.2 of the Code to “act fairly and reasonably towards [the customer] in a consistent and ethical manner”.[2] The confirmation in Doggett that cl 25.1 of the Code (cl 27 in the 2013 version of the Code) was incorporated into the bank’s guarantees has removed any doubt that at least some provisions of the Code ought to be given contractual force. It was the third occasion that an appellate court had accepted the incorporation of provisions of the Code into banking contracts.[3]

The facts

The facts in Doggett, briefly, were that Dogvan 007 Pty Ltd (Dogvan), a company controlled by the appellants, Mr Doggett and Mr Sullivan, applied for a loan to acquire a management rights business. The contract by which the business was acquired was subject to finance and verification of the financial records of the business.

The bank officer made mistakes in assessing the application. One such mistake was a wrong assumption that Mr Doggett and Mr Sullivan would be working in the management rights business when in fact they were to employ an on-site manager. While the bank officer knew this, no allowance for the on-site manager’s wages or expenses were included in the serviceability assessment.

The bank granted Dogvan a loan facility guaranteed by Mr Doggett and Mr Sullivan and the security for which included properties owned by them personally.

At first instance and on appeal, Mr Doggett and Mr Sullivan argued that the mistakes made amounted to a breach of cl 25.1 and, had the mistakes not been made, it would have emerged that Dogvan was unable to service the loan by a considerable margin and the bank would not have approved it. While there was general agreement that the Bank had breached cl 25.1, their Honours’ views differed as to whether it was demonstrated that the breach was causative of loss.

Breach of the Code

While the case ultimately turned on the construction of a deed of compromise, the treatment in Doggett of cl 25.1 of the Code (which is of identical effect to the current cl 27) is important. Clause 25.1 stated:

Before we offer or give you a credit facility (or increase an existing credit facility), we will exercise the care and skill of a diligent and prudent banker in selecting and applying our credit assessment methods and in forming our opinion about your ability to repay it.

The clause therefore defines the contractual standard of care to be applied (a “diligent and prudent banker”) in the performance of two tasks, namely the selection and application of credit assessment methods and the formation of an opinion about an ability to repay.

Hargrave J had found at first instance that the relevant opinion to be formed by the Bank for the purposes of cl 25.1 related to the borrower’s ability to repay the credit facility and not (as submitted by the Bank) the ability of the borrowers and the defendants as guarantors to do so from their combined resources.[4]

On that matter, Whelan JA observed that “other potential sources of funding and the level of security are valid considerations but … the capacity of a borrower to service a loan must remain a fundamental consideration”.[5]

Similarly, McLeish JA stated:[6]

It could not be assumed that, even though [the borrower] may to some extent be assisted by the appellants to meet repayments, it had available to it for that purpose their entire financial resources. The question of breach is therefore to be answered … by considering the way in which the Bank evaluated the financial position of Dogvan.

It therefore remains the position that the opinion to which cl 25.1 is directed is an opinion as to the borrower’s capacity to repay.

Causation

While the Court found that the Bank had breached cl 25.1 of the Code, different conclusions were reached on the question of causation.

The starting point of the analysis is McLeish JA’s observations (with which Whelan JA and Garde AJA agreed) that cl 25.1 does not oblige the bank to form the view that the borrower can repay the loan prior to making an advance. It is helpful to reproduce McLeish JA’s remarks on this point in full:[7]

The bank may take due care in forming an opinion as to whether a borrower can repay a loan and decide that, although it is possible that the borrower may not be able to repay the loan, it will offer the loan in any event. That may be, for example, because additional resources can be obtained by the borrower before the loan proceeds or during its term. Or it may be because other financial resources, not immediately available to the borrower, would in the event of default be available to the bank (in particular by way of security or guarantee arrangements). There is nothing inconsistent with cl 25.1 in a bank discharging its obligation in that way.

Whelan JA[8] and Garde AJA agreed with those observations. They are significant for two reasons. First, by making a clear distinction between the assessment of ability to repay and the decision to advance funds, they confirm that it is acceptable for a bank to take a guarantor’s financial resources into account when making a decision whether to advance funds.

Second, they emphasise that establishing a breach of cl 25.1 does not of itself prove that had the breach not occurred, the loan would not have been made or, in other words, the breach has caused loss.

Ultimately, McLeish JA formed the view that the appellants had not demonstrated that the Bank’s breach was causative of loss. His Honour did so on the basis that, at its highest, the evidence established that it would have been necessary to “rework the whole application” had the cost of on-site managers been taken into account. Moreover, it was demonstrated that the Bank was prepared to lend on the basis that the whole of Dogvan’s operating profit was applied to the loan, which was consistent with the Bank legitimately taking into account Dogvan’s recourse to the guarantors’ income and assets.

The opposite view was formed by Whelan JA and Garde AJA. Their Honours both found that the Bank would not have advanced funds to Dogvan had the mistakes in the assessment not been made, and any hypothetical “reworked” application would also have been refused.

Lessons

The decision in Doggett has clarified the manner and extent to which a guarantor’s financial resources may be taken into account in the assessment of a loan application; it may not be taken into account at all in determining serviceability but may be relevant in making a decision to advance funds. However, it should be expected that, in the absence of corroborating documentation, the absence of demonstrated serviceability on the borrower’s part will give rise to an arguable inference that the loan would not have proceeded had the requisite care and skill been applied to the formation of an opinion as to the borrower’s ability to repay.

Unfortunately, the court in Doggett had the opportunity but (with respect, quite properly) declined to consider whether cl 25.1 was an essential term, an intermediate term or a warranty. That question is important because the character of cl 25.1 (and other clauses of the Code) impacts upon the remedies which flow from its breach. It is particularly relevant to whether a breach permits a party to terminate the contract, or merely gives rise to a claim for damages. The issue has received some attention at appellate level[9] and at first instance,[10] but in the absence of further consideration by appellate courts the question of whether a breach of cl 27 of the Code will permit a guarantee to be set aside will remain open to debate.[11]