Banking & Finance Update, October 2006

In this issue

• Unregulated loans riskier than UCCC loans?

Many lenders go to significant trouble to ensure the loans they make are not regulated by the UCCC. But does this make the loan safer?

I've generally come to the conclusion that unregulated loans secured over the borrower's principal place of residence are often riskier than regulated loans.

The starting point in reaching this conclusion is that all loan contracts are subject to review on the basis that they are unconscionable. That's true for both regulated and unregulated loans. Once a court or tribunal varies or annuls a loan contract because it's unconscionable, the mortgage securing that credit contract and any guarantee are similarly affected.

Many credit officers focus on s 70(1)(l) of the UCCC – the so-called "Exocet missile". The section got this nick name because it was initially considered a very dangerous concept for lenders. It stated that one (and importantly only one) of the matters a court can take into consideration in determining whether a contract is unconscionable, is whether the lender knew or could have found out by reasonable enquiry of the borrower, that the borrower could not make the repayments or could not make them without substantial hardship.

However, there is ample court authority that the ability to repay is also taken into account in determining whether an unregulated loan is unjust. There are several decisions making it clear that lenders who make loans to unsophisticated individual borrowers relying solely on the security are likely to encounter problems.

Against that background, it's easy to see that the greatest hardship is likely to be inflicted on borrowers who stand to lose their principal place of residence if the mortgage is enforced. If the money has been lent to assist purchasing the property or for living expenses, so long as the lender did not act recklessly, it is more likely than not that the court will not interfere with the commercial bargain. However, if the money has been lent for business purposes, particularly business purposes that were risky, or where the borrower was likely to have been influenced by advisors or relations, then it is quite likely the court will act to protect the borrower's home.

At the end of the day, courts and tribunals are trying to ensure that there are fair business dealings and that borrowers are not "ripped off". The chance of being ripped off is much higher where the principal place of residence is put at risk for speculative purposes and the lender did not make proper enquiries as to the ability of the borrower to repay and failed to enquire whether the borrower was acting sensibly. Accordingly, lenders who go to some trouble to classify loans secured by the principal place of residence is unregulated, are probably putting themselves in harm's way rather than improving their position.

On 24 October 2006 the Supreme Court of New South Wales (the Court) delivered another judgement where a mortgage loan has been found unjust (Permanent Mortgages Pty Ltd v Cook [2006] NSWSC 1104).

Mr and Mrs Cook had a long history of default and had refinanced their original loan of $110,000 a number of times, mainly through one-year loans. In October 2002 Mr and Mrs Cook took out a loan of $22,000 with Cash King Pty Ltd to assist them make the repayments on another loan they had with Liberty Financial which was for approximately $192,000.

When Mr and Mrs Cook defaulted on both loans, Cash King assisted them to refinance through Bleier Mortgage Corporation. Bleier arranged two loans for the Cooks, one from Permanent Mortgages Pty Ltd for $195,000 and one via a private lender for $45,000. Only the loan from Permanent is the subject of the case.

When the Cooks submitted their loan application they signed a business purpose declaration and stated that the loan was for business and investment purposes. However, the application also stated in another section that the purpose of the loan was to refinance their existing debt and perform home improvements. Mr Cook claimed that he followed the instructions of his solicitor and that he did not read or understand the effect of what he was completing or signing.

Mr and Mrs Cook did not make any repayments on the loans and possession action was commenced.

The Cooks argued that repossession could not take place as the loan was regulated by the UCCC and that notice of default, complying with section 80, had not been provided by the lender.

The Court found that the loan was regulated by the UCCC. The Court's reasoning was as follows:

As a result, the Court held that the lender had reason to believe that the credit was being used predominately for personal, domestic or household purposes and was therefore covered by the UCCC. Further, the Court stated that the lender was indifferent to the actual purpose of the loan and wanted to ensure that the loan was outside the UCCC.

In considering whether the contract was unjust, the Court held that the actual terms of the credit contract and mortgage were not unjust in themselves. However, the Court held that even if the actual terms of a credit contract are not unjust, a credit contract and mortgage can still be categorised as unjust within s70 because of the circumstances surrounding its formation.

It was found that the lender was aware, or should have been aware, that the borrowers could not service the loan and would need to sell the property to repay it. Further, the lender would have been aware that as the Cooks were likely to default and that they were likely to have had to pay the higher interest rate of 13.8% per annum.

The lender argued that as the Cooks had falsely declared that the loan was for business purposes and that they should not be entitled to relief. However, the Court held that while Mr Cook knew that he was making a false statement of some significance, he was unaware of the nature of that significance. Moreover, the court held that "provided the formalities were observed… the lender was....indifferent to the underlying factual situation". So while the Court took the matter of Cook's false statement into consideration, it was not found to be decisive.

Whether a credit contract is unjust was said to be a "balancing exercise" with the facts and actions of both the borrower and lender taken into account. The recent decision of Perpetual Trustee Co Ltd v Khoshaba was cited as authority for the assertion that lending to "foolish, gullible or greedy" borrowers is not of itself grounds for a contract to be found to be unjust. In order for such loans to be unjust, "something more is required".

It was ultimately held that the facts of the case constituted "something more". Accordingly, the court reasoned that

Despite this, the lender was entitled to judgement in possession. The fees paid by the Cooks were reduced (the total reduced was $13,627.50) and the Cooks were not to be charged an interest rate higher than the ordinary rate. The Cooks were also relieved of any obligation to pay the lender's default costs. While the credit contract was found to be unjust, the court did not set aside the mortgage.

Lenders must be clear about which of their loans are regulated and which are not regulated. Even if a business purpose declaration is signed by the borrower, this may not be guarantee that the loan is truly unregulated, particularly if the lender (or any intermediary, such as a broker) is on notice that the loan is not being used for business purposes.

This is only one of many recent cases which have highlighted the need for lenders to consider the borrower's capacity to repay. Further, both regulated and unregulated loans are equally at risk of being overturned if the lender does not consider the borrower's capacity to repay, particularly if the security is the borrower's residence.

Lenders should consider using UCCC compliant documents and procedures for all their retail loans. Just because UCCC documentation is used, it does not mean that the loan is automatically regulated. If a loan is clearly outside the UCCC, it will remain so despite the nature of the documentation. Skewing transactions as unregulated is likely to work against lenders when assessing whether transactions are unjust.

Do not provide for high default interest rates or high default fees. Penalising borrowers in difficulty is likely to assist a finding that the lender has acted unjustly.

This is the second case where a failure by the lender, or its intermediaries, to comply with the lending procedures has been taken into account in deciding the transaction in unjust. Lenders should strictly enforce adherence to their lending procedures and criteria and ensure that those procedures and criteria are satisfactory.

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