The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Financial Services Royal Commission) commenced its third round of public hearings on 21 May. This round of hearings, which will run until 1 June, will focus on bank lending practices, and more particularly, on the provision of credit to small and medium enterprises (SMEs). A high level overview of the issues to be explored during the hearings as highlighted by Counsel Assisting Michael Hodge QC in his opening statement to the Commission, and of the case studies considered in the first week of hearings is below.
Focus of the hearings overall: three overarching questions to be considered
Mr Hodge identified 'three overarching questions' for consideration over the course of the hearings:
What obligations in relation to responsible lending ought to apply to small businesses?
In what circumstances might the exercise by a bank of default based contractual rights become unfair, unconscionable, or below community standards, when the relevant loan is a small business loan or a business loan?
How have the banks and the regulators responded to calls for higher standards for dealings with small business and the introduction of legislative prohibitions on unfair terms in small business contracts?
Mr Hodge stipulated that this round of hearings would not include consideration of lending to farmers as this would be the subject of the next round of hearings.
Case studies: Questions to be explored.
As previously, specific topics were explored/will be explored by reference to case studies. Mr Hodge said that the case studies in this round of hearings would collectively present an opportunity for the Commission to consider the following questions.
How 'small business' is defined in this context.
The rationale for distinguishing between small business loans and other business loans.
What meaningful difference in outcome would be expected if the requirements for lending to small businesses, as distinct from the bank’s compliance and application of existing requirements, was changed?
Whether the obligations with respect to SME loans should be adjusted to more closely reflect the obligations in relation to consumer loans, particularly where residential or other family assets are used to secure the loan.
Whether this change would result in any meaningful difference of outcome for small business customers or the guarantors.
What is the right balance between protecting SME borrowers through regulation and not creating barriers to business financing, and what does the community expect in this regard?
Whether the current policy setting for SME lending, whereby there is minimal regulatory oversight of banks in relation to SME lending and banks are effectively left to regulate in this space through the Code of Banking Practice, is correct.
The question of how significant power imbalances between the banks and SMEs in relation to lending affect the conditions for entry into and exit from these types of loans.
How sophisticated and well-resourced can SME customers be expected to be in their dealings with banks?
What is the right balance between banks being able to exercise their contractual rights to protect their interests and those of their shareholders and creditors and their promise to act fairly and reasonably towards an SME in a consistent and ethical manner?
Have banks responded effectively to relevant legislative changes, including the unfair contract terms provisions in the ASIC Act?
What has been the regulator’s role in implementing these changes?
Are SMEs able to obtain efficient and cost-effective redress in their dispute with lenders?
[Source: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry Transcript 21 May 2018 – Draft Transcript for Day 20]
Focus of the first week of hearings: 21 May – 25 May
Mr Hodge said that the first week of hearings would focus predominantly on the conduct of financial services entities in connection with applications for business loans and the approach of the entities to hardship (broadly speaking, Topics 1 and 2 as identified in the schedule of Topics and Case studies to be considered in this round of hearings). In particular, he said there would be a focus on how banks assessed such loans, whether such practices met community standards and expectations, and the circumstances where financial abuse was apparent, including where spouses or family members find themselves as co-debtors or guarantors.
Parental guarantee and mortgage case study
This case study concerned Ms Carolyn Flanagan who provided a personal guarantee and mortgage to Westpac in relation to a business loan taken out by her daughter and daughter’s partner. The Commission heard that Ms Flanagan, who suffers from glaucoma and is legally blind as well suffering from a number of other health conditions, was approved (by Westpac) to guarantee the loan. After the borrowers defaulted on the loan, Westpac sought to repossess Ms Flanagan's home (though later agreed to allow her to remain in it until her death), and an FOS complaint was lodged.
Ms Flanagan and her Legal Aid solicitor each gave evidence about the taking of the guarantee and security from Ms Flanagan. The Commission heard that Ms Flanagan's recollection of the loan approval process was unclear and that she appears not to have sought independent legal advice before providing the guarantee. The Commission also heard that Ms Flanagan's understanding of the loan amount may have been incorrect (she may have understood it was for a lesser amount that was actually the case) and questioned were asked around whether Ms Flanagan fully understood the import of providing the guarantee. Dana Beiglari (Legal Aid NSW) also gave evidence of the experience of legal aid clients more generally. She said many elderly clients felt obligated to provide similar guarantees to their children/family members and in these circumstances, were less likely to seek independent legal advice.
Asked whether Westpac should have accepted a guarantee from Ms Flanagan and whether Ms Flanagan's case was indicative of 'a problem' with the process for taking a guarantee general manager for commercial banking at the Westpac group Mr Alastair Welsh said that though it had a 'sad result' in the particular case, there was not a problem with the practice more generally. Mr Welsh also denied that there was any failure to exercise due care and skill as a banker in the particular case. Mr Welsh said: 'In my view of the situation is we allowed a mother to back her – back her child. And that’s…a big part of backing small businesses, where parents support their children, as we heard from Ms Flanagan yesterday. And in this situation it has turned out in a very sad way'.
[Sources: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry Transcript 21 May 2018 – Draft Transcript for Day 20; 22 May 2018 – Draft Transcript for Day 21]
Entry into loans for the purposes of purchasing franchise businesses — Three case studies.
The three case studies each concerned the provision of a loan for the purpose of purchasing a franchise which, in each instance, subsequently failed. In each case, the process by which the loans were approved by the lenders, the approach of the banks to monitoring and enforcing the loan and their approaches to dealing with the Financial Ombudsman Service (FOS) complaints was explored.
Gelato franchise case study: The case study concerned business credit facilities provided by ANZ in relation to the purchase of a gelato franchise by a husband and wife which, when the franchise failed, became the subject of a Financial Ombudsman Service (FOS) complaint. The loan was approved on the basis of the bank's assessment of a business plan containing 'optimistic' revenue forecasts.
The FOS complaint alleged that ANZ should not have approved the loan because it should have determined that the company would be unable to service it. The FOS issued a recommendation, and later a formal determination, in favour of the customer (which ANZ has complied with though it disagreed with the FOS determination) which found that ANZ did not exercise the care and skill of a diligent and prudent banker in selecting and applying credit assessment methods and in forming an opinion about the customer’s ability to repay the credit facility before giving or increasing such a facility (in accordance with clause 27 of the Banking Code of Conduct).
The Commission heard evidence from general manager home lending at the ANZ Bank Kate Gibson about the process ANZ follows to assess customer's capacity to service business loans of this kind. Mr Hodge QC questioned whether ANZ bankers had met the requirements of the banking industry code, to act with the 'care and skill of a diligent and prudent banker' in the particular circumstances and more particularly whether the approach taken to assessing loan serviceability was sufficiently stringent to meet this requirement. Ms Gibson said that ANZ disagreed with the FOS determination on the basis that it would have required ANZ to adopt an uncommercial approach to assessing the ability of customers to service a loan (that it would potentially have a detrimental effect on the ability of small businesses to get credit more generally), and on the basis that it acted reasonably in the circumstances.
ANZ was also questioned about whether a focus 'on new to bank lending may have contributed to poor practices' with regard to bringing in new loans. ANZ denied that this was the case and added that there was 'no culture of sales pressure'. Asked whether ANZ viewed the risk in taking on a loan ultimately sits with the borrower (rather than the bank) Ms Gibson said: 'I think in – in a case where the bank is lending money to them, it’s a risk for the bank, as well. But I agree with you that the decision to invest in a small business is the decision of the small business owner'.
Pie Face franchise case study: The case study concerned Westpac's assessment of the suitability of a loan to Ms Marion Messih (and her sister in law and business partner), provided for the purposes of purchasing a Pie Face franchise. The Commission heard evidence from Ms Messih about the loan approval process which Ms Messih said relied largely on the fact that Pie Face was, at the time the loan was approved, 'accredited' with Westpac as a franchisor and on the security provided by Ms Messih and her business partner (rather than on projected revenue). The commission also heard about the transfer by Ms Messih of all her banking (including her mortgages) to Westpac, the eventual failure of the business and her decision (when unable to service loan repayments) to sell her investment property. Ms Messih told the commission that she intended that the proceeds of the sale of investment property go towards settlement of various debts, including a proportion against 'her' 50% share of the business loan for the Pie Face franchise. Ms Messih said that instead, Westpac required that 100% of the proceeds be used to repay the business loan in full (ie including her sister-in-law's 50% share). The Commission heard that Ms Messih lodged a complaint with the FOS claiming that the loan should never have been made on the basis that the bank should have known that she and her sister in law would be unable to make the repayments. The FOS found Westpac should have applied a larger 'buffer' (50% higher than had been applied in this case) to test Ms Messih's ability to repay the loan and directed that Westpac repay interest and fees on the loan back to Ms Messih. However, Ms Messih was still required to repay the principal.
Asked whether the loan should have been made in this case, general manager for commercial banking at the Westpac group Mr Alastair Welsh maintained that it should have been made. Mr Welsh, said that the bank disagreed with (though complied with) the FOS finding in the case on the basis that it would be uncommercial to adopt the FOS approach to assessing serviceability. Had the bank adopted the approach FOS advocated he said it 'would prohibit a lot of business lending….[and] that would be very concerning for me' he said. Westpac was also questioned over possible conflict of interest arising in relation to sales incentives. Westpac outlined changes that had been made to the incentive programs since the Sedgwick revue which mean that incentives are now not solely reliant on the achievement of financial targets.
Wendys case study: The case study concerned the credit assessment undertaken by the Bank of Queensland (BOQ) in relation to a business loan to Suzanne Riches for the purpose of purchasing two Wendys outlets in a shopping centre in Adelaide. The Commission heard that Ms Riches applied for the loan with the intention of running the business with her husband (who had some experience in the industry). She provided the family home and another block of land (investment property) both of which were in her name as security. Following a meeting with the manager of BOQ, Ms Riches said she had made an offer for two Wendys franchises on the understanding that BOQ would provide her with the necessary financing, but before securing formal approval for the loan from BOQ. Ms Riches said that due to delays in the loan approval, and after missing the settlement date, she ultimately accepted a revised loan from BOQ on different terms from what had previously been discussed with her. Notably the repayments were significantly higher than what she had originally been offered. The Commission heard that Ms Riches defaulted on the loan and after one of the Wendys outlets closed, took her case to the FOS seeking reimbursement for her losses. Ms Riches then described her experience following bringing the complaint.
Asked about the process for approving the loan, banker, general manager of product performance and governance Mr Douglas Snell said that BOQ acknowledged there was 'maladministration' in the loan approval process and acknowledged various other issues at the particular branch that approved the loan (including that the manager in question acted outside his authority).
Mr Snell was also questioned about the approach the bank took to the FOS complaint. The Commission heard that internal documents showed that BOQ considered making an offer to Ms Riches to settle the complaint which for reasons that are unclear, was not put to Ms Riches. Referencing various internal BOQ documents, it was alleged that despite agreeing with the FOS's summary of the dispute, BOQ internal processes delayed the FOS process with the object of limiting the eventual payment amount to Ms Riches. Mr Snell said that the approach to resolving the complaint in the particular case 'wasn't fair and reasonable'.
Mr Snell was also questioned about the remuneration structures for BOQ franchisees and separately, about whether it is clear to SME borrowers that the bank is acting in its own (not necessarily the borrower's) commercial interests. The Commissioner asked: 'When trying to understand what is, what could be, what should be the relationship between bank and small to medium enterprise customer, is there at least a possible misunderstanding by the customer of the role of the bank arising out of comments of the kind [the Commissioner had previously given several examples including: 'putting our customer first', 'focus on the customer' and 'activing the best interests of the customer']'. Mr Snell responded that 'I think the goal and the intention is there, but if I’m – if I’m answering your question, yes, there’s definitely a deviation in terms of what the client expects and gets at times'.
Cross-collateralisation case study: Brad Wallis
This case study concerned a business loan provided by Bank of Melbourne (a Westpac subsidiary) to Brad Wallis for the purchase of a property to be used to run a bed and breakfast and restaurant business near Port Macquarie. Mr Wallis said that he and his wife also intended to live on the property and described the loan approval process in some detail. The loan eventually taken out by the couple with Bank of Melbourne was a residential loan rather than a commercial loan.
The Commission heard that the couple were required by the lender to refinance a separate investment property with the Bank of Melbourne in order to secure the loan.
When the business failed to prosper, Mr Wallis sought to sell the investment property.
As a condition of releasing the mortgage over the investment property, the couple were required by the Bank of Melbourne to set up a term deposit into which $100,000 of the surplus proceeds of sale would be held. Mr Wallis told the Commission that the couple understood that they were unable to access these funds. It was also a condition imposed by the bank that the couple agreed to restructure the residential loan (over the bed and breakfast) as a business loan.
Mr Wallis said that he regarded this action by the lender as 'unjust', and sent emails to Bank of Melbourne asking that they explain the basis on which they were making the changes. He subsequently lodged an FOS complaint.
Mr Wallis went on to say that before the FOS had made any recommendation or determination he entered into a contract to sell the bed and breakfast business and the property after which, the Bank of Melbourne released the term deposit. Following this, the FOS made a recommendation which found that the loan should have been a commercial loan, and that though entitled under the terms of the loan documents to retain part of the sale proceeds of the investment property, it was not fair for the bank do to so which the Bank accepted.
General manager for commercial banking at the Westpac group Mr Alastair Welsh was questioned about the loan approval process in this case. Counsel Assisting Rowena Orr QC questioned the reasoning behind offering the loan as a residential rather than a commercial loan suggesting that the decision to do so may have been motivated both by the fact that it enabled the bank to lend a larger amount, and that the banker may have been motivated by incentives linked to his financial performance.
Mr Welsh said that he agreed with the FOS that the loan should have been structured as a commercial rather than as a residential loan. Asked to comment on the decision by the bank to require the couple to create the $100,000 term deposit, Mr Welsh said that he agreed that it was an 'unfair' requirement: 'It was our mistake. We made the mistake originally, our banker got it wrong, and we shouldn't have imposed that mistake on the client.' Commissioner Hayne asked whether the decision was motivated by a desire on the part of the lender to improve its security position. Mr Welsh agreed that this could have been the case.
Commissioner Hayne went on to note that 'cross-collateralisation' is common in business lending and asked Mr Welsh to comment on how bankers think about fairness in this context: 'by what criteria is a banker to determine whether insisting on the letter of the law and insisting on the letter of an all moneys
instrument, is fair to the small business enterprise? What sorts of consideration can come to bear upon that?' Mr Welsh responded that some measure of flexibility was necessary to enable businesses to 'back themselves' and that requiring additional information could add additional complexity to the process. He said: 'I don’t want our bankers making too many of the judgment calls on – on what they [SMEs] should or shouldn’t do. You know, we need a set framework to be very clear and I want our clients to be informed, I want them to understand what they’re getting into, because that’s absolutely critical, but I also want them to be able to operate their businesses and – and go for the things they want to go for'.
[Sources: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry 24 May 2018 – Draft Transcript for Day 23; 25 May 2018 – Draft Transcript for Day 24]
Process of identifying a 'systemic' issue, notifying and remediating customers: case study
In his opening statement to the Commission, Mr Hodge QC summarised the submissions received from the various lenders including issues identified by the Commonwealth Bank of Australia (CBA). He said that one of the issues identified in the CBA submission concerned the charging of incorrect interest rates on some accounts. More specifically, the Commission heard that some customers were charged interest at a rate of 33.94% rather than 16%. Mr Hodge said that the defect was first identified in CBA in 2013 with 'manual remediation being carried out until 2015 when it was thought a systemic fix had been put in place'. After additional cases relating to the same issue were identified as a result of an FOS dispute in 2016, an enhanced system fix was introduced by CBA in 2017. The issue has since been reported to ASIC.
CBA's handling of this issue — the process undertaken to identify and correct it, to notify and remediate customers and to report it to the regulator — was the primary (though not the exclusive) focus of questions put to CBA Executive General Manager Retail Products Clive Van Horen. The Commission heard that there was initially no investigation to ascertain whether the issue was 'systemic' following the FOS complaint. The Commissioner asked Mr Van Horen whether it was 'practical, sensible, useful to impose a system that said, in effect, "Unless and until you demonstrate that this error is unique, it will be treated as systemic"'. Mr Van Horen said that this would not be a practical solution, given the number of errors (most of which were not systemic).
The Commission also heard that the average time for remediating customers was 960 days and that there had been some delay in notifying customers of the issue, to avoid it being brought up at House of Representative hearings. This was acknowledged by Mr Van Horen not to have been the correct decision. Asked why disclosure of the issue was not made to ASIC until 15 May 2018, Mr Van Horen said that no disclosure had been made initially on the basis that it was not considered at the time to be a reportable breach (though it was now acknowledged to be so) and confirmed that a report has been made to the regulator.
[Sources: Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry 24 May 2018 – Draft Transcript for Day 23]