In a unanimous decision on 13 October 2009, the High Court of Australia (regarding Ronald John Bofinger & Anor v Kingsway Group Limited, formerly Willis & Bowring Mortgage Investments Limited & Ors) allowed guarantors, who had provided guarantees to the first, second and third mortgagees involved in a property development project, the right to claim equitable compensation from the first mortgagee. This was as a result of the first mortgagee failing to account to the guarantors for the amounts they had paid to the first mortgagee in reduction of the borrower's facility, by transferring amounts recovered in excess of the first mortgagee's debt (and securities held from the borrower) to the second mortgagee rather than the guarantors. The outcome of the case was to place the guarantors in a secured position, ahead of the second and third mortgagees.
Consequences to financiers
As a result of this case, financiers will need to review the terms of their guarantees to ensure that they are sufficiently drafted so as to include a restriction on the guarantors from exercising their rights of subrogation. In the case of transactions involving multiple layers of financiers, this restriction should apply not only in relation to the beneficiary of the guarantor but any other prior ranking financiers. Alternatively or in addition, guarantors should be made a party to priority deeds in which the guarantors accept that they are not entitled to benefit from their rights of subrogation until all financiers are paid in full.
Senior lenders will need to make sure that in transactions involving guarantors, (who have paid some or all of the amounts due to the lender), on repayment of the facility, the lender does not discharge its securities or transfer them to any subsequent ranking lender or pay any balance of realisation proceeds to such lender without first considering the position of the guarantors and the restrictions applicable to them under the documents.
In transactions where the first mortgagee has the benefit of a guarantee but subsequent mortgagees do not have the benefit of such guarantees, the consequences of this case can be quite dire as the subsequent mortgagees will not be able to rely on guarantees from the guarantors to recoup the moneys which the first mortgagee may be required to pay to the guarantors as a result of this case.
We strongly recommend that financiers consider reviewing both existing and standard guarantee and priority documents and their settlement procedures to ensure that any appropriate amendments are made to minimise the impact of this case. Case not e The matter involved a property development where finance was provided by three mortgagees. In addition to the security provided by the borrower, the guarantors provided guarantees in favour of each of the three mortgagees and the security held by each of the mortgagees was the same. No priority deed was entered into.
When the borrower went into default, the guarantors (without demand having been made on them by the first mortgagee) sold two properties over which mortgages had been granted to each of the three mortgagees and paid the proceeds of sale to the first mortgagee in reduction of the borrower's debt. Each of the mortgagees consented to the sale of those properties and discharged their mortgages without seeking the release by the guarantors of their rights of subrogation. As a result of the discharge of these mortgages, the second and third mortgagees were no longer secured creditors of the guarantors.
Subsequent to such payment, the first mortgagee realised part of the remaining security held by it from the borrower. The proceeds of such sale were more than enough to repay the first mortgagee in full.
The first mortgagee (at the request of the second mortgagee) then transferred the surplus proceeds of sale to the second mortgagee. In addition, the first mortgagee discharged the remaining security held by it from the borrower and provided the certificates of title in relation to such security to the second mortgagee together with the discharges.
The guarantors claimed that the first mortgagee held the balance of sale proceeds and the securities which it discharged as constructive trustee for the guarantors due to the rights of subrogation to which the guarantors were entitled as a result of their payment to the first mortgagee. The Court agreed with the guarantors, notwithstanding that under section 58 of the Real Property Act 1900 (NSW), the purchase money from the sale of land by a mortgagee in exercise of his power of sale is to be applied:
- firstly in payment of the expenses of the sale;
- secondly in payment of the first mortgagee;
- thirdly in payment of subsequent mortgagees in order of priority; and
- fourthly in payment of any surplus to the mortgagor.
The Court held that notwithstanding the statutory requirement, equity may place on the first mortgagee requirements relating to the disposition of the surplus purchase moneys. This requirement includes the equitable duty of the first mortgagee to account to guarantors who have paid moneys in reduction of the debt which they have guaranteed.
Indeed, the Court held that the first mortgagee owed a fiduciary obligation to the guarantors and that such obligation was to account to the guarantors for surplus money and securities it held for the debt of the borrower. In addition the first mortgagee was required not to undertake or perform any competing engagement in respect of those moneys or securities without the prior release of the guarantors.
As a result of the breach of this fiduciary obligation and the knowledge of that breach by the second mortgagee and others involved in the transaction, the second mortgagee and others were tainted with the breach under this 'second limb' of Barnes v Addy.
Following the Court's decision, the guarantors are now entitled to commence proceedings to claim equitable compensation for the loss of the use of the money and securities to which they were entitled. The first mortgagee must account to the guarantors for the proceeds and securities which were previously held by the first mortgagee (and which, upon payment in full to the first mortgagee, should have been held on constructive trust for the guarantors). To the extent that the first mortgagee cannot satisfy such claims, the guarantors will also be entitled to take action against the second mortgagee and others involved in the breach of the first mortgagee's fiduciary obligations.
The right of subrogation to which the guarantors were entitled effectively placed them in the same position as the first mortgagee. To the extent that the value of the securities to which the guarantors were entitled is less than the amount to which they are entitled as a result of the Court's decision, the second mortgagee will not be able to recover any of the realisation proceeds of the securities. In addition, due to the second mortgagee's discharge of the securities it held from the guarantors, should the second mortgagee wish to demand payment under the guarantees provided by the guarantors, any amounts so payable would only be recoverable by the second mortgagee as an unsecured creditor of the guarantors.
The Court accepted that the guarantors could, by agreement, exclude their entitlements (as mentioned above) or vary those entitlements however the terms of the guarantees executed in this matter in favour of the second mortgagee did not exclude the subrogation rights of the guarantors in respect of the first mortgagee. In addition, the second mortgagee did not obtain a release of the guarantor's rights of subrogation in consideration of the second mortgagee agreeing to release its mortgages over the guarantor's property.
We strongly recommend that financiers consider reviewing both existing and standard guarantee and priority documents and their settlement procedures to ensure that any appropriate amendments are made to minimise the impact of this case.
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