High Court weighs in on unconscionability and personal guarantees in non-bank lending

Unconscionability personal guarantees
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The High Court has handed down the long-awaited decision of Stubbings v Jams 2 Pty Ltd [2022] HCA 6, unanimously overturning the decision of the Victorian Court of Appeal. In so doing, the Court held that enforcement of rights under a personal guarantee was unconscionable. In this case, the failure of the lender to obtain a certificate from a lawyer attesting to having provided independent legal advice to the guarantor was fatal to that enforcement.

This decision will have a significant impact on lenders, personal guarantors and third parties in the unregulated (non-bank) lending market.

Practical takeaways are toward the end of this article.

Background

The case concerns a practice known as “asset-based lending” where loans are made exclusively on the basis of the value of the assets securing the loan. Such a loan is made without any regard to the borrower’s ability to repay, because the value of the underlying security should be adequate.

Mr Stubbings (the guarantor) wanted to obtain a loan in order to purchase a property but was refused a loan from a mainstream bank due to his lack of income. He was introduced to a law firm, AJ Lawyers (the agent), who advanced the money to him on behalf of Jams 2 Pty Ltd (the lender). The loans were officially made to Victoria Boat Company Pty Ltd (the borrower) – a shell company wholly owned by the guarantor – ostensibly for the purpose of doing business but the true purpose was really for the guarantor to buy his property under a highly unusual “system of conduct”. The “system of conduct” had the following key characteristics:

  • The loans were only ever made to companies in order to circumvent the National Credit Code.
  • The lending had to be secured by a guarantor.
  • There was never any direct contact between the lender and the borrower. All communication was through intermediaries.
  • The agent provided certificates to the lender stating that the borrower had received independent legal advice and independent financial advice.
  • There was deliberate avoidance on the agent’s part from enquiring about the borrower’s/guarantor’s capacity to repay the money.

Apart from the properties, the guarantor had no income or other assets to meet his obligations and the borrower had neither assets nor any history of trading activity or income. When the borrower defaulted on the payments, the lender started legal action against the borrower and the guarantor.

Decisions of the lower courts

At first instance, the primary judge (Robson J) found that the agents (and by extension the lender) had acted unconscionably in failing to advise the guarantor as to the dangerous nature of the transaction, because “anybody with a modicum of intelligence … would not have proceeded with the loan”. As such, to the extent the guarantor was not to be unjustly enriched, his Honour made orders voiding the mortgages and loans. In so doing, his Honour also appeared to cast doubt on the overall legitimacy of asset-based lending as a commercial practice.

The Court of Appeal reversed the first instance decision, holding that the transaction was enforceable based on two main reasons (i) asset-based lending is not inherently unconscionable, and that (ii) the lender and its agents were entitled to rely on the certificates of independent legal and financial advice without making any further enquiries.

Decision of the High Court

The High Court unanimously upheld the appeal. The Court found that the lender had acted unconscionably in trying to enforce its purported rights against the guarantor, contrary to equitable principles.

The majority held that the elements of equitable unconscionability as established in Commercial Bank of Australia v Amadio (1983) 151 CLR 447, being

(i) the existence of a relationship where one party is at a “special disadvantage” against the other;

(ii) knowledge of this special disadvantage by the stronger party; and

(iii) unconscientious exploitation of the disadvantage by the same,

are “[not] to be addressed separately as if they were separate elements of a cause of action in tort” (at [39]). Rather, the Court acting in its equity jurisdiction must “take a comprehensive view”, bearing in mind “the particular facts, … the exact relations established between the parties and a consideration of the mental capacities … of the vulnerable party” (at [39]).

The Court found the following:

  • The guarantor’s inability to make a judgement as to his best interests amounted to him having been placed in a “special disadvantage” as against the lender (at [40]-[42]):
    • he was incapable of understanding the risks involved in the transaction, being unable to perform basic arithmetic;
    • he had “bleak” financial circumstances and virtually no income; and
    • his vulnerability was prima facie evident through the fact that he was disposed to enter such a transaction.
  • It is not necessary for the Court to find that the agent had actual knowledge that the loans would inevitably result in the guarantor losing all of his equity in the properties in order for the guarantor to be entitled to relief. Rather, the true question is “whether [the agent’s] appreciation of the special disadvantage was such as to amount to an exploitation of disadvantage” (at [44]).
  • The mere existence of certificates to the effect that the guarantor has received independent legal and financial advice will not bar the guarantor from relief if they “could not negate the [agent’s] actual appreciation of the dangerous nature of the loans and the [guarantor’s] vulnerability to exploitation by the [lenders]” (at [48]-[49]).
  • The primary judge was best placed to make findings concerning the agent’s state of mind, having heard him in person for extended periods, and that those findings were neither “glaringly improbable” nor “contrary to compelling inferences”. As such, it was not open to the Court of Appeal to disregard these findings, not least on the basis of the certificates (at [47]).

On the totality of the circumstances, the Court found that there was “unconscientious exploitation of [the guarantor’s] special disadvantage” and therefore the lender’s insistence upon their rights under the mortgages was unconscionable.

Steward J found that the system of conduct, which was intended to shield the lender from ever obtaining relevant information about the guarantor’s capacity to pay, amounted to wilful blindness. Similar to the majority, his Honour found that the mere existence of certificates that states independent legal and financial advice has been given does not automatically excuse the failure to make enquiries about the guarantor’s circumstances. The nature and content of the certificates will be relevant to a determination of whether such an entitlement arises.

Similarly, Gordon J found that the “system of conduct” was not only unconscionable in equity but also contrary to s 12CB of the Australian Securities and Investments Commission Act 2001 (Cth), which is a statutory prohibition of unconscionable conduct in connection with financial services. Her Honour found an attempt on the part of the lender to “studiously avoiding any inquiry about why or in what circumstances the individual guarantor provided their security as property” despite their own recognition that the loan was potentially dangerous is itself “outside societal norms of acceptable commercial behaviour [so] as to warrant condemnation as conduct that is offensive to conscience” under the Act.

Practical takeaways

As with any case involving equitable principles, the outcome was significantly dependant on the facts. However, the case nonetheless provides useful certainty on the law on unconscionability in the context of lending schemes. In our opinion:

  • Asset-based lending is not in and of itself unconscionable. The facts of individual cases will determine whether enforcement of rights is contrary to equitable principles.
  • Systems of conduct designed to shield the lender from its failure to make enquiries about the borrower’s financial prospects through the use of intermediaries will likely amount to wilful blindness and therefore unconscionable.
  • Independence is paramount. Any system where there is even an appearance of loyalty or allegiance on the part of the part(ies) giving advice to any other party other than the party being advised should be avoided. Obtaining actual independent legal and financial advice is essential.
  • In situations where loans are provided to companies which are backed by a personal guarantor, any legal or financial advice must be provided to both the company and the guarantor in their respective capacities even though the two entities might in practice be identical.
  • Although not directly in issue on appeal, a finding of unconscionability would only render any claim void insofar as the borrower is not unjustly enriched – the principal amount would still need to be repaid by the borrower.
  • Legal practitioners should not view certificates of independent advice as a mere formality – failure to include the necessary information may result in adverse findings of unconscionability and negatively impact their credibility.
  • Personal guarantors should consider, if faced with an enforcement action, if there are any grounds on which to avoid liability.

Further information

For more information about personal guarantees, banking litigation and dispute resolution contact: Trevor Withane: trevor.withane@blackwattlelegal.com.au, tel +61 (0)418 717 001

Disclaimer

Blackwattle Legal’s 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 communication.

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