There has been significant scrutiny of financier conduct in recent times, including following the conclusion of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Financial Services Royal Commission). As a consequence, various measures have been implemented or enforced to better protect the financier’s customer, including:
- the introduction of a new Banking Code of Practice on 1 July 2019 (which has subsequently been amended on 1 March 2020) by the Australian Bankers Association; and
- active enforcement by the Australian Securities and Investments Commission of the unfair contract legislation introduced into the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act), refer specifically to the Federal Court case of Australian Securities and Investments Commission v Bendigo and Adelaide Bank.
However, these measures, do not apply to all financiers or all types of financing arrangements.
While various financial institutions in the financial services industry were required to participate in the Financial Services Royal Commission, it is our observation that there was a general increase in financing activity undertaken by other non-bank financiers who had no such involvement. This financing activity included asset-based lending.
What is asset-based lending?
Asset-based lending primarily involves lending on the value of the assets securing the loan, without any consideration of the borrower’s ability to repay the loan from their own income or other assets. Little or no credit-risk analysis other than the calculation of the loan amount to security value ratio is undertaken by the financier.
The answer to the question as to whether asset-based lending is unconscionable requires a financier to at least consider:
- whether they are engaging in lending which is regulated under the National Consumer Credit Code;
- if the circumstances of the transaction might give rise to unconscionable conduct.
If a loan is subject to the National Consumer Credit Protection Act 2009 (which incorporates the National Consumer Credit Code), credit providers who are required to hold an Australian Credit licence are obliged to comply with the responsible lending obligations set out in Chapter 3 of that Act. Specifically, they are required, among other things:
- to assess whether a credit contract is unsuitable for a consumer; and
- before making the assessment in paragraph A, they must:
- make reasonable inquiries about the consumer’s requirements and objectives in relation to the credit contract; and
- make reasonable inquiries about the consumer’s financial situation; and
- take reasonable steps to verify the consumer’s financial situation.
Effectively this legislation restricts asset-based lending. It does not, however, apply to business loans or loans to companies.
The Victorian Court of Appeal has recently considered whether asset-based lending is unconscionable in the case of Jams 2 Pty Ltd (ACN 600 173 117) & others v Jeffrey William Stubbings (the Stubbings Case).
The prevailing view prior to the Victorian Court of Appeal determining the Stubbings Case is that the existence of asset-based lending is a factor which may help determine whether a particular loan resulted from unconscionable conduct. However, the existence of asset-based lending does not determine by itself whether there has been unconscionable conduct because ‘all the circumstances’ of each case must be considered.
The Stubbings Case has not altered the prevailing view which may be good news for financiers who engage in this practice in an appropriate way.
The facts of the case
The key facts of the Stubbings case are as follows:
- Three clients of a firm of solicitors engaged in asset-based lending to a company owned and controlled by the respondent guarantor, Jeffrey Stubbings.
- The true purpose of the loan was to enable Stubbings to purchase, in his own name, a property as a home. The loan was secured by a first mortgage over the property, with the three clients being co-tenants of the mortgage in the proportions in which they provided the loan moneys.
- At the time of obtaining the loan, Stubbings was unemployed and had no regular income. He was substantially in arrears with his obligations to pay rates in respect of two of the proposed security properties and had entered into an arrangement to pay the outstanding rates over time.
- Stubbings engaged an intermediary, Zourkas, to assist him to obtain financing which would enable him to purchase a third property which he intended to live in.
- Stubbings claimed that Zourkas told him that he could borrow enough to pay out the two existing loans, purchase the third property, and have about $53,000 in surplus loan funds which would enable him to pay three months’ interest on the loan while he sold the other two properties which would enable him to reduce the loan and then refinance the loans with a bank at lower interest rates.
- Zourkas approached Myer Jeruzalski, a solicitor who specialises in arranging for his clients to lend money on the security of land. Jeruzalski is a partner in the law firm Ajzensztat, Jeruzalski & Co (AJ Lawyers).
- AJ Lawyers offered, on behalf of their clients, to provide first and second mortgage finance to a company owned by Stubbings, with the loans being guaranteed by Stubbings, who was to provide a first and second mortgage over all three properties as security for his guarantee.
- The loan approvals were conditional on certificates of independent accounting advice and legal advice being duly signed and returned. The certificates were duly signed and returned with the signed documents prior to the loan being advanced.
- Stubbings managed to pay two months interest before defaulting. The first two properties were sold after the mortgagees obtained an order for possession. Stubbings appealed the possession order in respect of the third property.
- Stubbings contended that the loan constituted ‘asset-based lending’ in circumstances where AJ Lawyers knew that the first mortgagees would have to rely on the secured properties for repayment, because Jeruzalski knew Stubbings and the company could only contribute $100 towards the purchase of the third property, no evidence had been sought or obtained as to the ability of Stubbings or the company to repay the loan and, notwithstanding that the purported purpose of the loan was to enable the company to ‘set up and expand the business’, Jeruzalski well knew that the loan funds would not be used for that purpose, rather to acquire the third property.
The decision of the trial judge
The trial judge noted the following propositions from the authorities:
- Making an asset-based loan does not of itself constitute unconscionable conduct. Something more is required in the circumstances of the particular case
- In order to find statutory unconscionable conduct, it was necessary to establish ‘moral obloquy’ or ‘some moral tainting’ in the transaction.
- The assessment of whether or not there has been unconscionable conduct is an ‘evaluative judgment’ in the context of all the circumstances of the case.
- The requirement of moral obloquy or moral taint could be satisfied where, absent deliberate wrongdoing, there was a reckless failure to inquire involving ‘wilful blindness’.
The trial judge found that Stubbings was under a special disadvantage in his dealings with Zourkas and the first Mortgagees as he was ‘unsophisticated, naïve and had little financial nous’, and ‘unrealistic in the management of his financial affairs and demonstrated a complete lack of business understanding’.
The trial judge considered various factors relevant as to whether the unconscionable conduct case had been made out, including:
- The deliberate steps taken by AJ Lawyers to ensure that they did not ascertain any information about Mr Stubbings’ financial circumstances and his ability to service the loan
- The knowledge of AJ Lawyers that the loan they were making on behalf of the financiers could cause severe damage to the guarantor if the guarantor was not able to service the loan
- The steps taken by AJ Lawyers to immunise themselves from the taint of any knowledge that might expose them to a claim that they had acted unconscionably in making the loan requested by Mr Stubbings – they did not meet Stubbings or obtain any information about him
- The system of conduct used by AJ Lawyers to procure and make the loan sought by Mr Stubbings
As a result, the trial judge concluded that the asset-based system of lending, combined with the failure to inquire about Stubbings’s personal and financial circumstances when Jeruzalski ought to have done so given his knowledge, was unconscionable in all the circumstances.
The decision of the Court of Appeal
The financiers appealed to the Victorian Court of Appeal.
The Court of Appeal, in reaching it decision, acknowledged the state of the prevailing law — that asset-based lending is not, by itself, unconscionable conduct especially when combined with the fact that the system of lending included a requirement for certificates of independent legal and accounting advice. The Court of Appeal found that the system of asset-based lending by AJ Lawyers was not unconscionable.
The Court of Appeal considered the real question to be whether the trial judge correctly held that Jeruzalski had knowledge of facts which ought to have put him on inquiry as to Stubbings’s personal and financial circumstances, including details of the company’s assets and business.
They noted that Jeruzalski, among other things:
- assumed that Stubbings and the company had ‘no income’, in the sense that he did not have sufficient income to service interest under the loans for between six and 12 months;
- knew that Stubbings and the company had paid only a token deposit under the two contracts to purchase the third property;
- had been informed by Zourkas that the proceeds of the two loans would be used to both settle the purchase of the third property and to pay out the existing CBA mortgage loans over the two properties already owned by Stubbings; and that Stubbings’s plan was to then sell the existing security properties and then refinance the loans with a bank;
- knew the net proceeds of the loans available to Stubbings and the company for any business purposes (being the stated loan purpose) would be very small in comparison to the amount borrowed.
However, the Court of Appeal noted that, as part of the system of lending, the loan approvals were conditional on the company and Stubbings obtaining independent legal and accounting advice. Signed certificates were in fact returned to him. The Court of Appeal held that Jeruzalski was entitled to rely on the certificates — both as evidence that Stubbings had consulted a solicitor and an accountant for advice and as to the truth of the matters stated in the certificate.
The critical factor to the finding of the Court of Appeal was that the certificates, especially the accountant’s certificate, made it reasonable for Jeruzalski to refrain from inquiry as to how the company and Stubbings intended to, or whether they could in fact, service the loans pending refinance following sale of the two existing security properties.
A transaction may be set aside where:
- an innocent party is subject to a special disadvantage in dealing with the other party when the transaction was entered into, ‘which seriously affects the ability of the innocent party to make a judgment as to his/her own best interests’; and
- the other party unconscientiously took advantage of that special disadvantage.
It is not possible to identify exhaustively what amounts to a special disadvantage. However, relevant matters may include, but are not limited to, ‘poverty or need of any kind, sickness, age, sex, infirmity of body or mind, drunkenness, illiteracy or lack of education, lack of assistance or explanation where assistance or explanation is necessary’; as well as ‘illness, ignorance, inexperience, impaired faculties, financial need or other circumstances’ that affect the innocent or weaker party’s ability to protect their own interests. It is not sufficient that the matters give rise only to an inequality of bargaining power.
Where the financier is aware of such a disadvantage, the financier should consider whether it ought to proceed with the loan at all. We note that section 12CB of the ASIC Act provides that a person must not, in trade or commerce, in connection with:
- the supply or possible supply of financial services to a person (other than a listed public company); or
- the acquisition or possible acquisition of financial services from a person (other than a listed public company);
engage in conduct that is, in all the circumstances, unconscionable.
The ASIC Act sets out factors to be considered in assessing whether a contract is unconscionable. Without being exhaustive, they include:
- the relative strengths of the bargaining positions of the supplier and the service recipient;
- whether, as a result of conduct engaged in by the supplier, the service recipient was required to comply with conditions that were not reasonably necessary for the protection of the legitimate interests of the supplier;
- whether the service recipient was able to understand any documents relating to the supply or possible supply of the financial services;
- whether any undue influence or pressure was exerted on, or any unfair tactics were used against, the service recipient or a person acting on behalf of the service recipient by the supplier or a person acting on behalf of the supplier in relation to the supply or possible supply of the financial services;
- whether the supplier has a contractual right to vary unilaterally a term or condition of a contract between the supplier and the service recipient for the supply of the financial services; and
- the extent to which the supplier and the service recipient acted in good faith.
These factors, and others, are potentially very broad in their application and should make financiers think twice before proceeding with a loan where they are aware of a special disadvantage.
It is clear, however, from Stubbings case, in any asset-based lending transaction, that it may be a very good idea to insist that the other party obtain independent legal and accounting advice before providing any loan.