A high level overview of issues considered by the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Financial Services Royal Commission) hearings into the provision of credit to SMEs in relation to the topics of regulation and self-regulation, the questions highlighted for consideration in relation to each topic considered over the course of the two weeks of hearings and the open findings in relation to each case study is below.
The Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry (Financial Services Royal Commission) third round of public hearings into the provision of credit to small and medium enterprises (SMEs) commenced on 21 May and ran until 1 June. The hearings considered six topics (and accompanying case studies): responsible lending; guarantees by third parties; consumer redress systems; the Bankwest business lending book; power and communication; and the issue of regulation and self-regulation. A high level overview of issues considered by the Commission in relation to regulation and self-regulation, the open findings in relation to each case study and general submissions stated by Counsel Assisting Michael Hodge QC in his closing statement in relation to each of the topics is below.
Regulation and Self-Regulation of the SME lending sector
The Commission heard evidence from both the Australian Banking Association (ABA) and from the Australian Securities and Investments Commission (ASIC) on this topic regarding their respective roles in relation to SME lending. The proposed new Code of Banking Practice (Banking Code) (presently under consideration by ASIC) and ASIC's implementation of the extension of unfair contract terms legislation to small business contracts were also considered in some detail.
Self-Regulation: The Code of Banking Practice
The Commission heard evidence from a number of witnesses about the review of the Code of Banking Practice (Code), which Counsel Assisting Mr Hodge QC observed is one of the only sources of conduct obligations on banks in relation to small business. Mr Hodge drew the Commission's attention to the following points.
No agreement (as yet) on the definition of small business: The Commission heard that the ABAs position is that the definition of 'small business' should only extend to businesses with a total debt of $3 million or less and that this differs from both ASIC's position and that of Philip Khoury (who undertook the review of the Code see: Governance News 28/05/2018). Mr Khoury recommended, and ASIC is also of the view, that the definition should extend to business with a total debt of $5m or less.
The Commission heard from ABA CEO Ms Anna Bligh that there are a number of reasons why the ABA did not adopt the higher $5m limit in the revised Code (which is yet to be approved by ASIC). These include: borrowers with facilities above $3 million tend to be more sophisticated and have access to commercial and legal advice; that a higher threshold could create a competitive disadvantage to smaller banks and that placing limits on enforcement or default based actions could potentially increase the risk for a bank to make a loan and that this in turn could potentially result in increased cost for borrowers/negatively impact the willingness of the bank to extend credit. Ms Bligh also said that the ABA is intending to market test the effect of the changes and is willing to undergo a two year review supervised by ASIC.
The Commission also heard evidence from that the contrary position put forward by some stakeholders is that a $5 million threshold is more appropriate.
The Commission heard that ASIC and the ABA had deferred further discussion on the revised Code pending the conclusion of round three of the hearings (in case any issues were raised that should be considered by the parties before the finalisation of the Code).
In his closing statement to the Commission Mr Hodge invited comment on the following questions in relation to the Code.
Whether the proposed Code of Banking Conduct (whether or not it is approved by ASIC) is 'adequate to address any 'residual concerns about the coverage of obligations imposed on the banks.'
Whether the 'absence of ASIC approval would undermine the effectiveness of the Code'.
Implementation of the unfair contract provisions
The Commission also heard evidence about the implementation of the unfair contract provisions in the ASIC Act 2001 (ASIC Act), which were extended to small businesses on 12 November 2016 including evidence from lenders as to how they had approached implementing the changes; and evidence of the regulators' (ie ASIC and the Australian Competition and Consumer Commission (ACCC)) differing approaches to the issue.
The Commission heard from Suncorp about the work they had done to amend their standard form business contracts to implement the unfair contracts changes. The Commission heard that Suncorp had engaged with ASIC on the implementation of the changes at an early stage, but was yet to fully implement the changes. At this stage, a limited number of standard form business contracts have been amended but due to the high volume of credit contracts requiring review, the process was taking considerable time. It was alleged that the time taken was excessive. The evidence of Westpac and other banks on their compliance with the changes was also tendered into evidence.
Differing ASIC and ACCC approaches
The Commission heard evidence from both the Australian Securities and Investments Commission (ASIC) and the Australian Competition and Consumer Commission (ACCC) regarding the way in which each regulator approached overseeing implementation of, and compliance with, the changes. The Commission heard that once the amending legislation took effect, the ACCC moved into what Mr Hodge characterised as 'an enforcement mode', consistent with the 'ACCCs approach to compliance, which uses enforcement as one of its effective tools to ensure broader compliance in the industry'.
By contrast, the Commission heard that ASIC tends to take, a more consultative approach working closely with industry and in the case of overseeing the implementation of this change, with individual lenders to encourage changes to be made, to raise any issues and to work with lenders (without recourse to court action or an enforceable undertaking where possible). ASIC witnesses were questioned as to why, upon finding evidence of non-compliance in relation to the implementation of the unfair contracts changes, the regulator did not take stronger measures to address the issues or to prevent what the Commissioner suggested might be 'continued breach'. ASIC indicated that taking stronger action (eg court action) may not have achieved a different/better outcome in this instance (and/or more generally).
Commenting generally on ASIC's regulatory approach, ASIC witnesses explained that the action it pursues in each case will be dependent on the particular facts in each matter and that 'One of the considerations that we give to both commencing an investigation but also to the type of outcome that we will seek is whether that outcome will have an impact on the market; whether it will change behaviour, both specifically and more generally'.
In his closing statement, Counsel Assisting Mr Hodge invited submissions on the following questions.
Is ASICs approach to the unfair contract provisions and the consumer protection provisions under the ASIC Act more generally, 'appropriate and molded to the risks of the contraventions and practical resources constraints on ASIC?'
'Has ASICs approach been effective in ensuring compliance with the UCT provisions that came into effect in November 2016 and the consumer protection provisions of the ASIC Act generally?'
Commissioner, Kenneth Hayne added that submissions should also consider whether 'ASICs approach to various things' has been appropriate and whether 'ASICs approach to various things been effective?'
Closing statement to the Commission: Open Findings and General Submissions
In his closing statement to the Commission, Counsel Assisting Michael Hodge QC outlined the findings that may be open to the Commissioner to make (or not to make) with respect to each of the case studies considered over the course of the two weeks of the hearings.
Mr Hodge also identified a number of 'general questions' arising from the case studies considered over the course of the hearings. Immediate parties to the hearings were invited to respond to the specific findings in relation to each case study by the 8 June. Responses to general submissions (open to all parties to the proceedings) are due 12 June.
An overview of the specific findings identified by Mr Hodge in relation to each of the case studies and of the general submissions/questions arising in relation to: responsible lending; guarantees by third parties; consumer redress systems; the Bankwest business lending book and power and communication topics is below.
Mr Hodge said that it was not open to the Commissioner to conclude that existing responsible lending obligations should be increased (in line with those under the National Credit Act).
Mr Hodge's reasoning was as follows: 'In all of the case studies…the causes of the failure or deterioration in the performance of the business were multifaceted but, fundamentally, the problems had their roots in the performance of the business rather than anything else… Any increase in regulatory requirements on banks to scrutinise the optimism of the small base borrower must necessarily be premised on the premise that banks are too willing to make loans to small business. Neither the case studies nor the work that we have done outside of the hearings suggests that this is the case.'
Mr Hodge stated that he recognised that the view outlined above not a universal one and invited written submissions addressing three questions.
'How much responsibility do the borrower and lender bear in assessing the cash flow forecasts and other factors when deciding whether to enter into the loan contract?
What are the outer limits of a bank's duty to act as a prudent and diligent banker in assessing a business loan application? Should the outer limit of this duty (ie the nature of the obligation of the lender to the borrower, and also the nature of the content of the duty under the Code of Banking Practice) be codified?
Should any of the provisions of the National Credit Act which apply to consumer credit contracts also apply to credit contracts with small and medium sized business commerce. If so, why and to which small and medium business customers? If not, why not?'
Possible open findings
Three franchisee case studies:
Gelato franchisee case study (ANZ): The facts in this case were outlined in Governance News 28/05/2018. Mr Hodge suggested that it was open to the Commissioner to find that, in assessing and approving the loan the subject of the case study, 'ANZ may have failed to exercise the care and skill of a diligent and prudent banker as required by clause 27 of the Code of Banking Practice'.
Pie Face franchisee (Westpac): The facts in this case were outlined in Governance News 28/05/2018. Mr Hodge suggested that it may be open to the Commissioner to find that Westpac breached clause 3.2 of the Code of Banking Practice and its obligation as a member of FOS under clause 13.1 of the FOS terms of reference by continuing to undertake collections activities against the franchisee in this case after she had made a complaint to FOS. In addition, Mr Hodge invited Westpac to provide written submissions on the question of whether it has adequate systems in place to ensure compliance with its obligations under the code of Banking Practice and the FOS terms of reference with respect to collection activities.
Wendys franchisee case study (Bank of Queensland): The facts in this case were outlined in Governance News 28/05/2018. Mr Hodge said that it is open to the Commission to find that Bank of Queensland: breached clause 27 of the Code of Banking Practice (failing to exercise the care and skill of a diligent and prudent banker in its approval and assessment of the loan to the franchisee in this case)'; breached clause 3.1B of the Code of Banking Practice (by failing to provide effective and timely disclosure of the repayment amount and the term of the loan); and breached clause 3.2 (by contesting the FOS complaint despite being aware of the maladministration in the inception of the loan). In addition, Mr Hodge said that the case study raised a more general question as to the likely consequences of owner manager branches of Bank of Queensland being recipients of trailing or other commissions particularly having regard to the findings of the Sedgwick report into retail banking remuneration. Mr Hodge invited Bank of Queensland and all parties with leave to appear to make written submissions in response to that question.
Process of identifying a 'systemic' issue, notifying ASIC and notifying and remediating customers (CBA case study)
The facts in this case were outlined in Governance News 28/05/2018. Mr Hodge said that it was open to the Commissioner to find that: the conduct of CBA may have constituted a contravention of s 12DA of the ASIC Act; CBA's delay in notifying ASIC of the issue may constitute a breach of the requirements under s 912D of the Corporations Act; and the sending of each of incorrect statement may have constituted a contravention of s 12DB(1)(g) of the ASIC Act.
Taking a guarantee from a third party for a business loan
Referencing evidence from 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 (see: Governance News 28/05/2018) Mr Hodge observed that: 'If a parent wishes to guarantee a borrowing out of love and affection, then why should that parent – so long as fully informed and consenting – not be able to do so?'
Mr Hodge invited all parties to the proceedings to submit responses to the following questions in relation to the provision of guarantees for business loans.
'Is there any inadequacy or gap in existing protections (for guarantors)? If so, what is it? If not, would the protections apply in the context of the parental guarantee case study' ie the case of Ms Carolyn Flanagan considered during the first week of hearings.
'Is it desirable to take steps to increase the likelihood that a third party guarantor of business borrowings will be properly advised and make an informed decision before entering into a guarantee? And, if so, what might those steps be? Secondly, what difficulties will be created for banks or borrowers by steps that require more information to be provided to legal or financial advisors of a guarantor before the guarantee is signed?'
Mr Hodge said that it was open to the Commissioner to find that no reasonable person could have been satisfied that Ms Flanagan had any meaningful direct or indirect interest in the business; that Westpac may have contravened section 12CB of the ASIC Act by accepting and relying upon a guarantee from Ms Flanagan, or may have engaged in unconscionable conduct in circumstances. Mr Hodge also suggested it was open for the Commissioner to find that the lender's conduct may have fallen below community standards and expectations.
Consumer redress systems
Referencing the Low case study (which concerned five business loans made by Suncorp to Mr Peter Low which eventually became the subject of FOS complaints by the Low family (see: Governance News 04/06/2018) Mr Hodge invited submissions on the following general questions.
'If a business loan is determined to have been affected by maladministration, should the financial services provider be permitted to require the loan to be repaid within a timeframe shorter than the remaining term of the loan in circumstances where the borrower is willing and able to meet the repayment schedule under the loan?
Could FOS improve its processes for dealing with loans that are determined to have been affected by maladministration and, if so, how? Should the incoming body, the Australian Financial Complaints Authority (AFCA), adopt a different process?'
Mr Hodge said that it was open for the Commissioner to find that:
Suncorp failed to comply with clause 27 of the Banking Code of Practice (failing to properly investigate the purpose of loan, 'imprudently assessing the affordability of the loan', and in failing to control the use of the loan funds); breached obligations in clause 3.2 (by conducting its negotiations with Mrs. Low about a repayment plan for the loan following the FOS determination in a manner that was unfair and unreasonable) and that Suncorp may have engaged in conduct that fell below community standards and expectations by defending the complaint about the loan in FOS in circumstances 'where Suncorp ought to have examined and been aware of the loan approval deficiencies and the irrelevance of the material that was adduced'.
FOS 'did not function as an effective mechanism for redress in this case' because of the lack of clarity in FOS communications with the borrowers regarding the priority in which the loan should be repaid, and due to the error in advising the parties that 12 to 18 months was a reasonable timeframe for repayment of the loan.
Bankwest loan book case studies
The facts in this case were outlined in Governance News 04/06/2018. Mr Hodge said that it is not open to make any open findings of misconduct by CBA in relation to the case studies:
'It is not open, we submit, on the evidence and on the documents available to find that Project Magellan was intended to be, or was intended to be part of, a process of deliberately defaulting loans against Bankwest customers. It was in this context that the Commission heard four case studies relating to customer experiences of Bankwest during this period' he said.
Mr Hodge added that though there had been errors in communication and transparency that may be below community expectations it 'is apparent…that any such admissions do not amount to admissions of misconduct and we do not suggest to you, Commissioner, that there are any open findings of misconduct in relation to these case studies'.
General questions arising
Mr Hodge suggested that the issues raised by the BankWest case studies have relevance to business lending more generally. Specifically, he invited submissions on the following questions.
'How are banks to deal with circumstances in which, for reasons extraneous to the conduct of the borrower, the bank no longer wishes to fund a particular business or industry. That is, what is the bank to do if, for example, the market has changed such that its security is no longer adequate? What are the obligations, if any, on a bank in those circumstances?
Is there any reason why valuations or investigative accountant's reports ought not be provided to customers in circumstances in which the reports have been paid for by the customer and the bank wishes to take reliance, at least in part, on such reports? Is there any reason why such transparency obligations should be limited by the size of the loan or limited to providing only parts of the report?
Is it appropriate for a bank to take enforcement action when no monetary defaults have occurred and the bank can rely only on non-monetary defaults? Why or why not? Should there be some additional protection for borrowers in these circumstances and ought the bank be obliged to explain such matters?
Is there a disconnection between what the banks are saying in their advertising, their annual reports, their other public documents, and their conduct?'
Power and communication
Mr Hodge observed that the case studies considered during the hearings highlighted the need for banks to be mindful of not focusing on relentlessly acquiring new business, especially in the context of the lower level of regulation over business lending (as opposed to consumer lending). Mr Hodge suggested 'that the danger of that type of selling model was identified particularly in relation to the case studies involving ANZ, Westpac and the Bank of Queensland'. Mr Hodge invited submissions on the following questions.
'Should the sales culture for small business reflect that of consumer lending in that business bankers are discouraged from focusing primarily on financial incentives in their key performance indicators?
Specifically in relation to this case study, should lenders be required to clearly draw the cross-collateralisation clauses and its effects to the attention of borrowers? If so, how should this done? Westpac, I should also say, is also invited to specifically address the findings that we have submitted may be open, and any other findings that it considers may be open on the evidence.'
Wallis case study (Bank of Melbourne): The facts in this case study were outlined in Governance News 28/05/2018: Mr Hodge said that it was open for the Commission to find that the Bank of Melbourne may have breached clause 3.2 of the Code of Banking Practice (by requiring the loan to be restructured in 2017 and retaining $100,000 of the proceeds); and s 12DA of the ASIC Act (by representing that it had a legal entitlement to withhold $100,000 the borrowers without legal entitlement to do so). Mr Hodge also suggested that the bank's conduct (in representing to the borrowers that it was legally entitled to withhold the $100,000) may have fallen below community standards an expectations.
Dillon case study (NAB): The facts in this case study were outlined in Governance News 04/06/2018: Mr Hodge suggested it was Commissioner, to find that NAB might have engaged in misleading or deceptive conduct (failing to inform the borrower that the intentions he had expressed to the bank in respect of the proceeds of sale would not be possible and why this was the case, and representing to Mr Dillon that it was entitled to use the proceeds of sale to reduce the debts of his business without legal entitlement to do so) in the circumstances. Mr Hodge also suggested that it was open to the Commission to find that NAB breached clause 3.2 of the Code of Banking Practice (failure to communicate its expectations and intentions to the borrower). Mr Hodge suggested that NABs conduct (in not adhering to NAB policies around communication with borrowers) may also have fallen below community standards and expectations.