31/05/2016

Recently the Court of Appeal in Victoria has adopted a new approach to the obligations of the lender when entering into a guarantee.

A guarantee is an agreement that exists between the lender and the guarantor in respect of a loan to a third party, the borrower.

Generally speaking, the people or entities bound by an agreement of this sort are those that entered into the agreement – the lender and the guarantor. That all makes sense. However, the story doesn’t end there.

The Court of Appeal in Victoria issued a decision last year in Doggett v Commonwealth Bank of Australia [2015] VSCA 351 that takes this situation one step further. A lender is required to exercise “care and skill in forming an opinion about a borrower’s ability to repay” when entering into a guarantee. It is suggested that to not do so could be a breach of the obligations the bank has to the guarantor, and perhaps render the guarantee unenforceable.

The Code of Banking Practice is published by the Australian Bankers Association and is a voluntary code that can be incorporated into loan arrangements. Such was the case here.

The obligation arose out of that code, which, at clause 25.1, provides for an obligation on the part of the lender to assess repayment capability before granting a loan. The loan agreement between the borrower and the lender incorporated this clause of the code expressly. The speed bump here was that the guarantees stated that only relevant provisions of the code were to apply. It was successfully argued that this clause was a relevant provision. Further it was also successfully argued that even though the clause specifically named a borrower, it applied to guarantors as well.

The Court considered whether the construction of the clause was drafted widely enough that it applied to this circumstance, and then, if it did, was it read in such a way that is inconsistent or non-sensical.

Their Honours, in the majority, held that if the bank had acted with the required standard of care before entering into the loan initially then the loan ought not to have been given.

The risk for lenders now is that they simply can’t sit back and rely on the guarantee where it was clear they shouldn’t have advanced the loan to the lender in the first place.  They must consider, before entering a guarantee, whether the borrower has capacity to repay the loan. The traditional protection offered by guarantees may no longer be as sturdy as it once was.

Given the number of “low doc” loans out there, and recent reports of loan brokers falsifying loan application documents, guarantors who are approached by a lender to pay the loan for the borrower may well want to challenge the request.

For further information, please contact Townsends Business & Corporate Lawyers on (02) 8296 6222.