A sense of purpose: when is credit caught by the Code?

The protections afforded by the Sch 1 — National Credit Code (the Code) are available only to a certain type of credit. That credit is described in s 5 of the Code as having at least one of two attributes; it must be provided for either personal, domestic or household purposes or “to purchase, renovate or improve residential property for investment purposes”.[1]

The question of the circumstances in which credit will have been provided for the purposes described in s 5(1)(b)(ii) was a focus[2] of the decision of the Victorian Court of Appeal in MAG Financial and Investment Ventures Pty Ltd v El-Saafin[3] (MAG Financial). As discussed below, the court clarified how this important question is to be approached, finding (contrary to the judge at first instance) that the ultimate use of the funds is not necessarily determinative of the purposes for which it was advanced. Rather, the court found, whether credit is regulated by the Code is determined by reference to the immediate purpose of the loan.

Circumstances of the loan

Prior to its liquidation, Saafin Constructions was a company engaged in a mixed commercial and residential development in North Melbourne. The project, comprising 25 apartments and two commercial tenancies, was never completed.

Pausing here, the large scale of the proposed development was relied on by MAG Financial as disqualifying the property from being “residential property” for the purposes of s 5(1)(b)(ii) of the Code. This argument was rejected on the (compelling) bases that first, the definition of “residential property”[4] provided no textual support for it, and secondly, because reading such a limitation into the definition would give rise to inherent uncertainty as to when residential would become too large for the Code to apply.

One of the loans obtained in connection with the development was made by Mark Franek to Wael El-Saafin (one of the directors and a shareholder of Saafin Constructions) and his wife, Bayda El-Saafin. It was a $100,000 loan with a 3-month term, with interest payable at a rate of $12,000 per month. Both Mr Franek and Mr El-Saafin gave evidence to the effect that it was both parties’ intention that the funds advanced would be used by Saafin Constructions to develop the North Melbourne property.

About 10 months after the first loan, a second loan of $311,000 was made by Mr Franek to the El-Saafin. It was not controversial that the purpose was to refinance the first loan. The effective rate of interest payable on the loan meant that, if the credit were regulated by the Code, the credit contract would have been (as the trial judge held it was) unenforceable by operation of s 39 of the Consumer Credit (Victoria) Act 1995.

Relevant purpose

The competing arguments advanced focused on the relevance, if any, of the purpose of the credit advanced to the question of whether the credit was advanced “to purchase, renovate or improve residential property”.[5]

It was submitted on Saafin Contructions’ behalf that, when construing beneficial legislation such as the Code, it is appropriate to look to the substance of the transaction. In this case, it was clear that the ultimate use to which the funds would be put would be the residential development. It did not matter that it was Saafin Constructions, not the individual borrowers, who used the funds advanced for the development. The particular structure adopted, whether it be a partnership, trust or company, was not relevant. The gravamen of Saafin Contructions arguments were, therefore, that the relevant purpose was that of the credit, not the borrower.

It was, however, conceded by Saafin Constructions that this argument was not without limitations. It could not (for example) be extended to the point that funds borrowed to purchase shares in an Australian Securities Exchange Ltd (ASX) listed company that invests in residential property could not fall within the scope of s 5(1)(b)(ii). Wherever the line was to be drawn, so it was argued, the investment by an individual borrower in their own company gave rise to a sufficient connection so as to be caught by the Code.

“To”

The court did not accept the contention that the relevant purpose of the credit was its ultimate purpose, even where that purpose was known to and accepted by all of the parties to the transaction. In reaching this conclusion, the court found the word “to” in the phrase “to purchase, renovate or improve residential property”[6] to be of particular significance.

It was held that, in the context of s 5(1)(b)(ii) of the Code, the word “to” required focus on the immediate purpose for which the credit is provided. That is, the purpose for which the debtor to whom the credit was advanced was to apply the funds.

This construction, it was found, was reinforced by the absence of any express reference to the purpose of the credit advanced in s 5(1)(b)(ii). The legislation did not, for example, provide that credit caught by s 5(1)(b)(ii) was that advanced “for the purpose” of purchasing, renovating or improving residential property.

Rather, the word “to” necessarily requires the debtor to be the person who purchased, renovated or improved the relevant property, and connotes “a direct and immediate connection between the provision of the credit and the act of purchasing, renovating or improving the property”.[7]

The words “for investment purposes” in the text of s 5(1)(b)(ii) were also found to support the court’s conclusions as to the relevant purpose of the credit advanced. It was held that these purposes are evidently that of the person to whom the credit was provided, rather than the purposes of a third party. This conclusion was said to accord with the consumer protection objects of the Code — the protection of the recipient of the credit.

Conclusions regarding the credit advanced

In light of the court’s construction of s 5(1)(b)(ii), it was held that the purpose of the funds advanced to Wael and Bayda El-Saafin was not the improvement of the land upon which the proposed development was to be constructed. Rather, the immediate purpose of the credit provided to them was to advance funds to the Saafin Constructions and for Saafin Constructions to undertake the improvements. This was so even though all of the parties intended the funds advanced would be used, and they predominantly were in fact used, for the improvement of residential property.

Form over substance?

The conclusions of the Court of Appeal in MAG Financial may be thought to give primacy to the form rather than the substance of a credit transaction. While such criticism might have some superficial attraction, it is unjustified for two reasons.

First (and importantly) a construction of s 5(1)(b)(ii) that requires consideration of the ultimate use to which the funds advanced are used places an unreasonable burden on the lender. The decision of the Lauvan Pty Ltd v Bega[8] is a good illustration of this point. In that case, funds were advanced to Mrs Bega for the express purpose of making short-term loans to family members for proposed commercial opportunities. Mrs Bega advanced funds to her son, who used them to assist his company to purchase residential units. In the result, Gleeson JA held that the funds advanced were not provided nor intended to be provided to Mrs Bega to purchase residential property.

The facts in MAG Financial differ slightly, in that all parties intended the funds be used to improve residential property, or at least knew that they would be applied for that purpose. However, the intention (or knowledge) of the parties as to the ultimate use of the funds in the hands of a third party to the transaction is an inherently uncertain basis upon which to determine whether the Code applies.

The uncertainty that attends the degree of connection between the funds advanced, and their ultimate use, is a further basis upon which to reject the notion that the ultimate use of funds advanced is determinative as to the application of the Code. Saafin Constructions’ suggestion that funds on-lent to a borrower’s own company should be treated differently to funds advanced to purchase shares in an ASX listed company engaged in residential property development, does nothing to elucidate the point between these two extremities where the line should be drawn. The “borrower’s own company” exception was problematic even in MAG Financial, because co-borrower Bayda El-Saafin held no shares in Saafin Constructions.

Conclusion

The reasons of the Victorian Court of Appeal in MAG Financial make it clear that it is the immediate purposes of the borrower, and not the ultimate purpose of the credit, that determines whether funds have been advanced “to purchase, renovate or improve residential property for investment purposes”.[9] It should be noted that there was no suggestion that the manner in which the credit was advanced to the El-Saafins was an artifice employed by the lender to avoid the operation of the Code. The result may have been different had there been a finding to that effect.

It also should be noted that the credit contract under consideration in MAG Financial did not state the purposes of the loan. It goes without saying that articulating the purpose of the loan on the loan instrument will diminish the likelihood of debate as to whether or not a credit contract is regulated by the Code.