Australia: The Good, the Bad and the Ugly – Australian banking

From Red to Black 2016
Last Updated: 17 November 2016

The Ugly

Bankers and guarantees

Who would be a banker? In both Doggett1 , and Rose2 , the Victorian Supreme Court and Court of Appeal allowed guarantors without "special disadvantages" to avoid business guarantees. Both Courts reasoned that the Code of Banking Conduct requires bankers to "prominently" make the guarantor aware they may become responsible for paying a guaranteed debt. Merely placing a warning to this effect in big bold letters on the document is not always enough, even for an experienced businessman "perfectly capable of protecting his own interests".

A cultural change

The Code, for the present anyway, has been judicially construed to place a greater emphasis on a values-based approach to bank dealings with customers. Placing the customer first, even a customer in financial default, mirrors, in many ways, the present leading trading bank approaches to customer dealings in default situations. The emphasis within the trading banks, and on advisers, is to look for customer-focused solutions that provide the customer further chances to resolve its own situation. This is variously presented as forming part of the banking culture to "put the customer first" or as being defensive in nature, as protecting the brand.

Restatements rather than forbearances

In the immediate aftermath of the GFC, when the "mark to market" values of many businesses or their key assets were uncertain, financial institutions often entered into forbearance arrangements, providing time for the market to settle or for the customer to find another solution (typically involving a sale if the customer could not refinance).

Marking a new approach, banks now typically restate the terms of loans, for example, amortising repayment obligations, changing interest or asset or market value coverage ratios, waiving default interest and other charges, altering security rights or compromising (forgiving) part or all of the loan. Restated loans allow customers time to search out solutions to restore financial non-performance - or put off today a problem for tomorrow. The paradigm industry example is the rural sector where banks are generally wary of enforcement against defaulting farmers.

It remains to be seen whether a decision to extend farming loan maturities to better seasons, to introduce further funding for fertilisers or more productive equipment is in the long-term interests of defaulting rural customers. For the moment, though, the willingness to reset loans to provide another opportunity for the customer to succeed, or fail more harshly, means that instead of forbearances, banks are more willing to restate or novate loan arrangements.

Noticeably, trading banks are taking similar positions in relation to exposures in mining services and related industry credits.

Of course, new lends look for credit quality. While farmers, mining services, retail and the like within the banking system can expect, for now, to see a greater willingness to negotiate rather than enforce on defaulting positions, new customers are finding new credit hard to come by from trading banks. With, perhaps, one exception: retail property.

When APRA changed the capital rules in 2015 to encourage banks to place more capital with business than residential property, it did so to reduce bubbles forming in particular residential assets. The dual impact of IFRS 9 and Basel III may undo that good work, encouraging banks to move risk capital away from pricier corporate lending and into retail or consumer property credits. This will not amuse the two Australian trading banks who hold books with full property spreads, nor property developers not considered to be "tier one" credits. The former cannot lend more into investment or commercial property, the latter cannot attract debt capital from the trading banks, no matter how supported the project with presale or agreement for lease commitments. Something will need to give - hopefully, not integrity.

The Bad

Playing by the Rules

Then again, who would not be a credit restructuring banker?

The London Rules are equally applicable in Australia as they are in an international situation - maintain information flows to the banking team, reduce surprises, be transparent and the restructuring might stand a chance. Play by the rules and as Atlas Iron and NRW (so far) and various other savings show, bankers are supportive of restructurings run with the help of banktrusted external advisers. In this regard, Australia is following the lead of international banks in supporting credits executing on a restructuring plan agreed with all stakeholders. This is the new paradigm - early engagement with broad stakeholders when faced with liquidity issues.

Moreover, the restatement of loan positions can be compelling in terms of bank capital requirements.

IFRS 9 and Basel III

Restatements of arrangements between the bank and defaulting or near defaulting customers may also reduce capital cover requirements for impairments - under the "expected loss" model, financiers must record credit losses that have already occurred and losses that are expected in the future (IFRS 9). The rule is designed to help ensure banks maintain appropriate balance sheet capitalisation for potential impairments.

According to guidance issued in January 2015, "where renegotiations [of credit arrangements with the customer] have been undertaken, banks must be able to demonstrate whether the renegotiated asset has "improved or restored" the ability to collect interest and principal - and reflect credit losses accordingly".

While classification and principle-based rules look at credit deterioration histories, and measure both individual and market events, impairments are usually taken according to cash flow characteristics and according to the business model of the underlying credit.

A restated facility based on credible commercial-based expectations of returns on better seasonal conditions, changes in the macro landscape, sometimes involving debt deferrals, compromises or reallocations against specific assets (eg. in the case of rural arrangements, limiting security to the sale of water rights rather than to the underlying farming enterprise) can permit credit enhancement.

In the right case, a restatement of facility can accordingly improve the bank's balance sheet. At the very least, a restatement of facility allows the bank to encourage a customer into focusing on its own solutions, typically involving refinancings, asset sales, capital raisings or the engagement of restructuring advisers.

By the same token, since March 2015, when the Reserve Bank released its warning of a coming oversupply of apartments in inner Melbourne (and other centres) and APRA began a program tightening lending to investors and foreign buyers, both investors and commercial property developers with exposures to settlement risk in the settlement of apartments, have found it harder to attract finance. It remains to be seen whether banks would be forced, under IFRS 9 categorisations, to restate the credit risk of existing property developer credits on their books. This remains a possibility.

Meantime, as capital searches out new lending opportunities, owner occupier lending has increased by about 18% over 2015 figures (total residential lending increased by about 4% in the same period, itself indicative of the reducing appetite in financial institutional lending to investors and foreign buyers). While this may be a better allocation of capital within the property sector from a credit risk point of view, it suggests we are still yet to see a successful reallocation of capital from residential to business.

The Good — The Rise of Restructuring

Who would not be a company exposed to international markets? Australian banks are removing the shackles of the "reset and forget" forbearance in place of refinancings. Singaporean, Japanese and most Asia based banks are supportive of anything that does not cause added risk. Noteholders are accepting the need to restate longer term instrument maturities in exchange for better coupon, security, easier default covenants and, increasingly, cash-backed interest reserve accounts. There is plenty of money offshore.

A company under financial distress should be encouraged by the bipartisan approach of politicians at the federal level favouring amendments to the Corporations Act to introduce "safe harbour" protections to directors engaging with turnaround advisers to devise and implement restructuring plans. The earlier the engagement, the more likely the advisory team will be able to deal with short-term viability and immediate funding needs before working on both balance sheet as well as P+L stresses in the company.

Best of all, who would not be playing treasury in a smart well-run company like Fortescue Metals Group? Take unsecured near term bonds and replace these with secured longer term bonds, then use the market confusion to buy back even shorter term higher priced bonds at discount! The long play is to reduce the average cost of financing at a time when reducing the average cost of everything makes FMG one of the best iron ore producers in the world.

Stay tuned

Earlier this year we were involved in a proceeding commenced in the Supreme Court of Western Australia by Hamersley Iron against Forge Group (in liquidation and with receivers appointed), in which we acted on behalf of Forge's receivers and managers. In that proceeding, Hamersley argued that it was entitled, under the Corporations Act (section 553C, because Forge was in liquidation), to set off all moneys it owed to Forge under various construction contracts (circa $100m) against all moneys owed to it by Forge (circa $150m-$200m) for not completing those contracts, in circumstances where Hamersley terminated the contracts shortly after the appointment of the receivers and took approximately $100m in security bonds.

To complicate things further, Forge had charged its rights under those contracts in favour of the ANZ, which were now governed by the Personal Property and Securities Act. The issues for determination by Justice Tottle included the scope of set-off under section 553C of the Corporations Act, whether the ANZ security destroyed the requisite mutuality for section 553C set-off, the nature of a security interest under the PPSA and whether it is fixed or floating in nature and the application of statutory and equitable set-off in an insolvency situation where section 553C applies.

Justice Tottle is yet to hand down his decision (we anticipate it will be late 2016 to mid-2017). The ramifications of the decision will likely significantly affect the way lenders structure their security arrangements particularly in the construction sector, having regard to how the Court views the relative strengths and weaknesses of a PPSA security interest in an insolvency situation.


1 Doggett v Commonwealth Bank of Australia [2015] VSCA 351

2 National Australia Bank Ltd v Rose [2016] VSCA 169

Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states and territories.

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