BANK’S CREDIT ASSESSMENT UNDER THE JUDGE’S MICROSCOPE

CAMPBELL HUDSON, PARTNER, 3 OCTOBER 2014

Responsible Lending

Overview of Responsible Lending Obligations

National Consumer Credit Code Whether the credit provider knew, could have ascertained by reasonable enquiry at the time that debtor could not pay without substantial hardship (s.76).

Contracts Review Act Set aside unjust contract if it imposed obligations that were unjust.

Clause 25 of Banking Code of Practice - Provision of Credit 25.1 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.

New Statutory Obligations

Obligations before providing credit assistance

Not provide credit assistance unless preliminary assessment and inquiries and verification

Preliminary assessment of unsuitability of credit

Reasonable inquiries about Consumer before preliminary assessment

q  Make reasonable inquiries about the consumer’s requirements, objectives and financial situation.

q Take reasonable steps to verify the consumer’s financial situation.

q Take any steps prescribed by the regulations.

Based on these inquiries, make a preliminary assessment : proposed credit contract is ‘not unsuitable’ for the consumer.

Will be unsuitable if, it is likely that:

Ø  The consumer will be unable to comply with financial obligations or only comply with substantial hardship.

Ø  Proposed contract will not meet consumer’s requirements or objectives

Responsible Lending and the Code of Banking Practice – Doggett’s Case

Clause 25 - Provision of Credit

25.1 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.

Clause 25 of Code of Banking Practice - incorporated into a loan contract and guarantees.

CBA had entered into a compromise agreement prior to litigation.

Defendants were shut out from raising breach of Code.

If not for compromise agreement – Guarantors would escape Guarantee due to Bank’s breach of Clause 25.

Commonwealth Bank of Australia v Doggett & Ors [2014] VSC 423

Responsible Lending and the Code of Banking Practice – Doggett’s Case

Trickett Gardens

Background to the Case

§  Mr Doggett is a self-employed painter and handyman.

§  Mr Sullivan was employed as an operating theatre technician.

§  Dogvan 007 Pty Ltd acquire management rights for an apartment complex “Trickett Gardens”

§  Trickett Gardens was a family orientated property.

§  Retained an accountant (Mr Valmadre) to verify minimum net operating profit.

§  Net operating profit for the full year ending 31 March 2008 was $217,751.

§  Mr Valmadre mistakenly assumed Dogvan directors (Mr Doggett and Mr Sullivan) would work in the business.

§  Rather, the directors always intended to employ a two person resident management team.

§  The Valmadre report assumed that the guarantors would manage the business onsite, but that assumption was incorrect.

§  The management rights contract required that the independent accountants’ verification exclude wages for ‘work which would normally be performed by a two person resident management team‘.

§  The Bank having had regard to the report proceeded to approve the loan.

Incorporation of clause 25.1 of the Code into the Loan Contract and Guarantee

Loan Contact and Guarantee

Court concluded clause 25.1 of the Code was:

§  incorporated into the loan contract §  incorporated into the guarantees given by Messrs Doggett and Sullivan

As to the loan contract

§  obligation was contractual by reference to express terms of contract

As to the guarantee Obligation is incorporated in to the guarantee due to various provisions of the Code being:

§  clause 1.1, clause 28.1, clause 28.3, §  For the purpose of clause 28.3, 25.1 was a relevant provision.

Responsible Lending enquiries made by Bank The Bank proceeded as follows

§  Application reports were prepared electronically.

§  Approval processes are undertaken to approve a Better Business Loan of $1.57M on 11 July 2008.

§  On 22 July 2008, a Bills Discount Facility of $1.63M to replace previously approved Better Business Loan.

§  11 July 2008 application report prepared by one bank officer and assessed and approved by a second bank officer.

§  Application took 2 hours to approve reading documents attached to hyperlinks including contract for sale of management rights business, vendor’s financial statements for management rights business and Valmadre report – a “genuine credit risk analysis” was undertaken.

§  Detailed consideration given to ability to service the loan supported by income from the guarantors, if necessary, to service the loan from income from management rights business.

Mistakes made were §  Incorrect assumption that deposits of $150K had been paid under management rights contract and

managers apartment contract.

§  (Note – defendants failed to notify bank that no deposits had been paid).

§  Failure to note that wages of a two person resident management team to be taken into account.

§  Assumption that the guarantors would relocate to Queensland and become managers was rejected.

Court critical of responsible lending enquiries

v  Court found that a prudent banker exercising diligence would have formed the opinion that the borrower could not make payment obligation to Bank from cash flow of management rights business as verified nett profit of $217,751 omitted any allowance for wages for 2 onsite managers.

v  Application report and documents on their

face disclosed that the borrower would not be able to repay or service the loan.

v  In effect the Court found the Bank did not

make reasonable enquires and take reasonable steps to verify customer’s financial situation.

Outcomes

Clause 25.1 overrode the current common law position.

A lender now owes a duty of care to a loan applicant when assessing that loan applicant’s application for credit.

The Bank breached that obligation by failing to appreciate business income had to be adjusted downwards.

Guarantors were entitled to damages.

Court determined, without any expert evidence, that Bank was negligent in its credit assessment, by:

‒  Reference to clause 25 which makes it clear that relevant enquiry concerns borrowers ability to repay.

‒  Commercial Court Judge could himself conclude breach of clause 25.1.

‒  Case does not involve a complex technical field of expertise.

There may be circumstances where the bank could be held responsible for losses suffered by the customer if the business fails.

Had the loan been declined upon proper analysis of the financials, Dogvan and the guarantors could have pulled out of the contracts.

Guarantors gave evidence even if CBA had rejected their loan application, they would have gone to another lender.

No reference in the judgment to consideration being afforded to whether Messrs Doggett and Sullivan could be regarded as “concurrent wrongdoers” for the purposes of the Victorian Civil Liability Act

Responsible Lending

credit assessment under the microscope

Questions?

Campbell Hudson Partner, Gadens Sydney T +02 9931 4957 E campbell.hudson@gadens.com

AMY CIOLEK – SENIOR ASSOCIATE, GADENS

Responsible Lending Part 2

Responsible Lending

Assessment

Four key steps:

1.  Make reasonable inquiries about the consumer’s requirements and objectives in relation to the credit contract.

2.  Make reasonable inquiries about the consumer’s financial situation.

3.  Take reasonable steps to verify the consumer’s financial situation.

4.  Make any other inquiries or take additional steps prescribed by the regulations.

What is reasonable?

Objective standard – reasonable (not necessarily all) considerations taken into account, considerations objectively assessed, lower standard than best efforts

Reasonable enquiries

Reasonable person

Reasonable efforts

Reasonable steps Reasonable

doubt

Reasonable belief

Reasonably certain

Requirements and objectives

Lenders can reduce the risk of non-compliance by ensuring records to support their assessment of unsuitability demonstrate an understanding of the enquiries at RG309.33 (Report 410 at 87).

Use inquiries in RG209.33 as a baseline, and have clearly documented procedures for escalating grey areas (Report 410).

Understand the borrower’s purpose in adequate detail, and conduct further inquiries if the loan amount is inconsistent with the purpose (ASIC v The Cash Store).

make reasonable inquiries about the consumer’s requirements and objectives in relation to the credit contract

Financial Situation

Accountant statements should not contain ‘no liability for accuracy’ statements, and should identify the accountant and their professional qualification.

Clear procedures should be documented describing which documents can be used by non-PAYG borrowers, and what constitutes sufficient supporting evidence, or when further inquiry is required.

Ask individuals specifically about expenses. It is unreasonable to rely solely on ratios, benchmarks, income matrices, or indexes. APRA expects ADIs to use borrower declared income and expenses

Inquire about, and understand fixed expenses beyond checking against a credit report to identify commitments such as balloon repayments.

make reasonable inquiries about the consumer’s financial situation

REPORT 410

Findings q  None of the 12 lenders reviewed in REP410 adequately documented further

investigation into fixed expenses.

q  7 of the 12 lenders reviewed asked about living expenses, and 1 of the 12 lenders reviewed asked about ‘other’ expenses.

An alternative to living expenses q  If living expenses are difficult to estimate, it may be reasonable to make

enquiries into regular savings.

How much enquiry is reasonable?

COSL Position Statement 5

The obligation to make reasonable enquiries… should include information that allows the person making the assessment to form a view on whether the consumer’s financial position could change during the term of the loan (and if so, how)

ASIC Report 358 – around 20% asked about medium to long term requirements and objectives and recorded this on file. (REP 358 at 74)

Verification

take reasonable steps to verify the consumer’s financial situation

Lenders often rely on information collected by a third party – the lender is still required to verify financial information. A higher standard of verification may be appropriate (RG109.50, APG 223 at 47) Inconsistencies should be verified. Does that mean if a borrowers self claimed expenses are lower than an index they should be verified? Non PAYG borrowers – additional verification may be waranted.

Unsuitability

Argentina, August 2010. FIFA Soccer World Cup. Diego Maradona coached Argentina, and the country had high expectations of winning.

The government launched a plan called ‘LCD for all’ to boost the market. Consumers could buy their televisions sets with discounts, and up to 5 years interest free finance. Rates at that time were approx 20%, and the country had around a 20% annual inflation rate.

Thousands of Argentines were out on the streets, in the stores buying LCD and LED TV sets to watch the matches on the biggest screen they could afford.

Argentina did not win the World Cup. On top of defeat, many low income consumers had to repay their TV, which they could not.

Unsuitability - Buffers

Draft Prudential Practice Guide APG 223 – Residential Mortgage Lending A prudent ADI… •  borrower should retain a buffer above expenses for unexpected

changes and ability to save; •  assessment should not be based on honeymoon rates or discounts;

•  buffers and adjustments to interest rates; and

•  regularly review interest rate buffers. (APG223 at 28-32)

Unsuitability

Automation, system decisioning engines – Is responsible lending really technology neutral? (RG209.39-41 )

Relying on the lenders serviceability requirements - COSL will not accept a defence that the credit assistant relied on the lender’s serviceability requirements. (COSL position statement 5 at 7.7)

Does ‘reasonable’ require consideration of the LVR? •  Valuation is only referred to in RG209 in relation to reverse mortgages.

Does this mean value is irrelevant when assessing whether loans other than reverse mortgages are ‘not unsuitable’?

REPORT 410 – Improving compliance

Document procedures

Clearly documented responsible lending procedures including which documents are accepted, how they are verified, how inconsistencies are addressed, and when to escalate.

Information from third

parties

Taking a risk-based approach to identifying transactions that require further verification. Follow up materially different

information directly from consumer and document.

Consumers ability to reduce variable

expenses

If a consumer is willing to reduce its variable expenses, licensees should make additional inquiries and verifications, and record all

details on file.

Ratios and expense matrices

Licensees increase their compliance risks if they rely on business expense ratios, income matrices, or similar rather than taking into

account the specific borrower’s actual expenses.

Questions?

Amy Ciolek Senior Assoicate, Gadens Sydney T +02 9931 4952 E amy.ciolek@gadens.com