Greater clarity around responsible lending on the way

A new draft Banking Code of Practice[1] (the New Code) was released publicly in April 2018. While at the time of writing a final version has not been settled, it seems that the only remaining debate concerns the New Code’s definition of “small business”. That being the case, in this article, we explore:

• the proposed changes to the obligation to exercise the care and skill of a diligent and prudent banker and their likely impact
• the extent to which (if at all) the New Code changes the way lenders can take guarantors’ financial resources into account
• the responsible lending obligations owed directly to guarantors

We conclude that the New Code helps to clarify the obligations around responsible lending. The proposed formulation of the duty to act as a diligent and prudent banker is simpler, and its breadth is increased to cover all aspects of a loan transaction. Similarly, the New Code clarifies the position in relation to guarantors’ financial resources, articulating in express terms the position that has emerged from the authorities interpreting the previous codes. Finally, by casting responsible lending obligations as being expressly owed to guarantors, the New Code will make it more likely that a guarantee will be discharged where those obligations are breached.

The current position

Clause 27 of the current Code of Banking Practice[2] (the 2013 Code) (which is substantially similar to cl 25 of the 2004 Code)[3] (the Duties Clause) amplifies the statutory and other duties which apply to a bank’s dealings with its customers. Clause 27 provides:

27. Provision of credit

Before we offer, give you 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 the credit facility.

A superficial analysis of the Duties Clause might suggest that its purpose is to impose an obligation on lenders to ensure that a borrower can repay a proposed facility. Certainly, borrowers and guarantors have relied on it for this purpose. Courts have, however, interpreted it more narrowly.

In National Australia Bank Ltd v Smith,[4] Slattery J found that the Duties Clause established an objective contractual standard, the content of which is a question of construction of the 2013 Code. Conduct amounting to “accepted banking practice” is not necessarily relevant.

In Doggett v Commonwealth Bank of Australia[5] (Doggett), McLeish JA (Whelan JA and Garde AJA agreeing) found that the Duties Clause is relevant to the manner in which the bank applies its credit assessment methods and forms its opinion in evaluating the borrower’s financial position, but not necessarily the decision to advance the loan. In that case, while deficiencies in the bank’s analysis of the borrower’s financial position were identified, their Honours were divided as to the consequences of that analysis. Essentially, McLeish JA found that it was not proven that had the bank’s financial analysis been correct, it would not have made the loan. Whelan JA and Garde AJA reached the opposite conclusion. Causation therefore emerged as a key issue after Doggett.

More recently, in Haynes v St George Bank (a division of Westpac Banking Corporation); Haynes v Westpac Banking Corp[6] (Haynes), the Full Court of the Supreme Court of South Australia confirmed[7] the content of the duty imposed by the Duties Clause. However, the Full Court observed that:

The most obvious purpose of clause 25.1 is to provide a remedy for the wrongful refusal of credit. Its application to claims that credit was wrongfully given is both problematic and counterintuitive.[8]

The duty to exercise the care and skill of a diligent and prudent banker has been the subject of some debate. Courts have received expert evidence to assist them in a determination of its scope and application. Ultimately, relying upon a breach of the Duties Clause to establish that a loan should not have been made has, historically, been a complicated exercise. Further, the observations in Haynes suggest that is not the purpose of the duty in any event. It is unsurprising, therefore, that those responsible for drafting the New Code have sought to simplify and clarify the scope and application of the duty.

New formulation of the duty

The relevant provisions of the New Code (which appear in ch 17 titled “A responsible approach to lending”) are expressed in wider terms than their predecessors. They relevantly provide:

49. If we are considering providing you with a new loan, or an increase in a loan limit, we will exercise the care and skill of a diligent and prudent banker.

50. If you are an individual customer, that is not a business, we will do this by complying with the law.

51. If you are a small business, when assessing whether you can repay the loan we will do so by considering the appropriate circumstances reasonably known to us about:

1. your financial position; or
2. your account conduct.

Where reasonable to do so, we may rely on the resources of third parties available to you, provided that the third party has a connection to you. For example, where the third party is a related entity of yours (including but not limited to your directors, shareholders, trustees, beneficiaries or related body corporates), or is a partner, joint venturer, or guarantor of yours.

52. We also owe an obligation to any guarantor of the loan to comply with the above paragraph in assessing the borrower‘s ability to repay the loan.

Obligation to exercise the care and skill of a diligent and prudent banker

As outlined above, the authorities dealing with previous versions of the Code established that the obligation to exercise the care and skill of a diligent and prudent banker was not an overarching duty but rather applied to discrete tasks. The terms of cl 49 suggest an intention that the duty applies to all aspects of a proposed loan transaction, including the bank’s decision to make the loan.

Taking into account third-party resources

Following the decision in Doggett at first instance, there was debate as to the extent to which, if at all, lenders could take into account the resources of third parties in assessing a borrower’s ability to repay a loan. The Court of Appeal in Doggett confirmed that an assessment of a borrower’s ability to repay a loan could take into account third-party resources, but suggested that a lender was not permitted to effectively “pool” the resources of a borrower and guarantor in undertaking a serviceability analysis.[9]

In our opinion, the new cl 51 restates the position expressed in Doggett regarding the extent to which third-party resources may be taken into account. Limiting consideration of third-party resources to circumstances in which it is “reasonable” to do so means that the bank is still unlikely to be permitted to pool borrowers’ and third parties’ resources in assessing serviceability, or (for example) rely solely on a guarantor’s resources. A borrower’s capacity to repay from its own resources is, therefore, likely to remain a fundamental consideration.

Obligations owed to guarantors

The court confirmed in Doggett that the obligation to exercise the care and skill of a diligent and prudent banker was incorporated into the terms of a guarantee and, as a result, guarantors have the right to rely on a bank’s promise to act with diligence and prudence.

Clause 52 creates an obligation owed to a guarantor to “comply with the above paragraph in assessing the borrower‘s ability to repay the loan.” The paragraph immediately above cl 52 obliges the bank to consider particular circumstances regarding the borrower’s financial position. It refers also to the circumstances in which the bank may have recourse to third-party resources.

It is also possible, and is in our view likely, that the “above paragraph” is a reference to cl 49, with the effect that the bank owes an obligation to a guarantor to exercise the care and skill of a diligent and prudent banker in all aspects of a loan.

Are they essential terms?

A number of cases[10] have considered whether the provisions of the Code relevant to guarantors are essential terms, intermediate terms or warranties. The category into which a particular term falls is relevant to the remedy or remedies that flow from a breach of that term and, particularly, whether breach justifies the guarantee being set aside.

Whether that remedy is available is determined by reference to the decision in Ankar Pty Ltd & Arnick Holdings Ltd v National Westminister Finance (Australia) Ltd[11] in which it was held that:

If the surety is to be discharged for breach of a promissory term in the suretyship contract, the justification for the discharge must be that the creditor has failed to comply with a provision that, as a matter of interpretation, requires strict performance as a condition precedent to the surety’s obligation or at least requires substantial performance of the promise such that the surety would not have entered into the contract if it had not been assured that there would not be a breach such as the breach which in fact occurred. If on its true interpretation the term is not intended so to operate, it is not easy to understand why the surety should be discharged by its breach.

It remains to be seen whether courts will consider a breach of cl 52 of the New Code as justification for setting aside a guarantee. Obligations owed to guarantors in previous versions of the Code have not been determined as sufficient.

However, the position courts take may be of limited relevance following the commencement of the Australian Financial Complaints Authority (AFCA). The greater jurisdiction exercised by AFCA (compared with its predecessor, the Financial Ombudsman Service Australia (FOS)) means that AFCA is likely to determine the vast majority of disputes involving loans to small business.

FOS’s position is that (contrary to the decided cases) guarantees that breach the Code are unenforceable.[12] If AFCA adopts that position, it is likely that guarantees will be set aside where it has determined that there has been a failure to exercise the care and skill of a diligent and prudent banker in relation to some aspect of the loan transaction.

Conclusion

While previous versions of the Code have been substantially shaped by the courts’ construction of its terms, there are likely to be fewer disagreements (and litigation) in relation to the responsible lending provisions of the New Code.

We expect AFCA to take a more “broad-brush” approach and, where it is found that a loan ought not to have been made, AFCA’s starting point will be that guarantees which support it ought to be discharged.