Australia: The Code of Banking Practice and guarantees: are you a diligent and prudent banker?

This week's TGIF considers whether banks owe guarantors a duty to exercise the care and skill of a diligent and prudent banker in selecting and applying their credit assessment methods and forming an opinion about a customer's ability to repay.

In the decision of Doggett & Anor v Commonwealth Bank of Australia [2015] VSCA 351, the Victorian Court of Appeal confirmed that provisions of the Banking Code of Practice (the Code) may be incorporated into guarantees and a bank, in discharging its obligations under the Code, is required to take into account the ability of a borrower to repay from the resources available to it.

BACKGROUND

The appellants, Mr Doggett and Mr Sullivan, were guarantors for their company under a commercial loan agreement with the respondent (the Bank). Following the global financial crisis, the company defaulted on its loan repayments and the Bank appointed receivers. After the sale of the secured assets, the Bank commenced proceedings against the guarantors to recoup a shortfall owing under the loan.

At trial, the guarantors alleged that the Bank owed them a contractual obligation to exercise the care and skill of a diligent and prudent banker in assessing the company's loan application and forming an opinion about its ability to repay the loan and that the Bank had breached that obligation. That obligation was said to arise by virtue of clause 25.1 of the Code, which was incorporated into the appellants' guarantee by reference.

At first instance, the Court found that clause 25.1 of the Code applied to the guarantee and that the Bank had failed to exercise the care and skill of a diligent and prudent banker when assessing the company's ability to repay the loan. This failure was attributed to mistakes made by the Bank when applying its credit risk analysis. For instance, the Bank officer had failed to take into account the cost of additional wages for an on site manager.

The Court found that, had the Bank not breached the Code, the Loan application would likely have been refused and the guarantee would not have been given. Accordingly, the appellants were entitled to be put in the position they would have been in had clause 25.1 not been breached.

However, the Court also held that a compromise letter defeated the guarantor's claims pursuant to clause 25 of the Code and ultimately found in favour of the Bank. The Court of Appeal agreed that the letter of compromise extinguished the claims.

THE DUTY TO EXERCISE THE CARE AND SKILL OF A DILIGENT AND PRUDENT BANKER

In dismissing the appeal, the Court of Appeal helpfully clarified the scope of the duty to exercise the care and skill of a diligent and prudent banker.

The Court of Appeal found that, when forming an opinion about a customer's ability to repay the loan:

• clause 25.1 of the Code does not presuppose or require that a bank must form an opinion that a borrower will be able to repay the loan; but
• rather, clause 25.1 requires care in the formation of an opinion as to whether a borrower will be able to repay the loan.

The Court of Appeal explained that "a 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)" [para 163].

Ultimately, the failure of the Bank to exercise due care and skill went to the manner in which it applied its credit assessment methods and formed its opinion in evaluating the company's financial position, but not necessarily to the decision to advance the loan. Clause 25.1 of the Code is concerned with the processes and forming the opinion.

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