In the recent case of Commonwealth Bank of Australia v Doggett the Supreme Court of Victoria held that certain provisions of the Code of Banking Practice(Code) applied to the guarantors. The Code applies to individuals and to small businesses as defined in the Code.
In Doggett, a commercial loan was made to a company that was a small business. The loan was guaranteed by the directors of the borrower.
The guarantors argued that the Code applied to the loan and guarantees and that the bank had failed to exercise the necessary care and skill of a diligent and prudent banker in assessing and approving the loan.
The clauses in the documents and the Code
A clause in the bank’s terms and conditions for commercial lending facilities said that if the borrower was an individual or small business, relevant provisions of the Code would apply to the facilities.
Clause 25.1 of the Code provides:
Before we offer or give you a credit facility (or increase an existing credit facility), we will exercise the care and skill of a diligent and prudent banker in selecting and applying our credit assessment methods and in forming our opinion about your ability to repay it.
Clause 28.3 of the Code provides that a guarantee must include a statement to the effect that the relevant provisions of the Code apply to the guarantee but need not set out those provisions. The guarantee in Doggett included the required statement.
The bank argued that the Code did not apply to the guarantees.
Decision of the Court
The Court said that a promise by the bank to the customer (who was the principal debtor) to exercise care, or that it has exercised care, in the terms set out in clause 25.1 is relevant to a guarantor, or a proposed guarantor.
Any guarantor has a material interest in whether the bank, exercising the care and skill of a diligent and prudent banker, has formed an opinion that the borrower will be able to repay the loan.
The Court held that clause 25.1 was incorporated into both the loan facility and the guarantees.
The Court said that clause 25.1 is a contractual obligation extending beyond the previously recognised duties or obligations of the bank.
Did the bank comply with clause 25.1 of the Code?
In Doggett, the bank had regard to the guarantors’ assets and income in the credit risk analysis. The Court commented that such an approach makes commercial sense and, subject to cases of unconscionable ‘asset lending’, is a standard and acceptable banking practice – especially where the guarantors are in substance the proprietors of the borrower.
The Court said however that the contractual standard under clause 25.1 of the Code required the bank to exercise the care and skill of a diligent and prudent banker in forming an opinion about the borrower’s ability to repay the loan.
The Court said that the fact that the bank had regard to the guarantors’ assets and income in reaching its decision to approve the loan does not necessarily mean that the bank failed to meet the standard required by clause 25.1.
In Doggett, the evidence showed that the bank did give separate consideration to, and formed an opinion about, the borrower’s ability to repay the loan.
The Court closely examined the actual credit risk analysis carried out by the bank and held that mistakes had been made in the analysis. As a consequence of the mistakes made, the bank had not exercised the care and skill of a diligent and prudent banker because an appropriate analysis would have revealed that the borrower would not be able to service or repay the loan.
If the bank had not breached clause 25.1 of the Code, the borrower’s loan application would likely have been refused and no guarantee would have been given.
In the absence of other factors peculiar to the case, the bank’s claim against the guarantors would have been unsuccessful, because it had breached clause 25.1 of the Code.
In Doggett, the guarantors had entered into a compromise agreement with the bank that contained a release clause. The Court held the release clause included the breach of clause 25.1 of the Code.
In a commercial loan context, a bank generally owes no obligation to exercise care, in contract or in tort, to a borrower in performing its own credit risk analysis and deciding whether or not to provide finance. That position may change if a bank assumes the role of a financial adviser to the customer.
If the Code applies to the loan and guarantee, the bank will be under an extended contractual obligation under clause 25.1 of the Code to exercise the care and skill of a diligent and prudent banker in assessing and approving the loan.
This potentially increases the ability of a guarantor to attack the loan transaction and to avoid liability under the guarantee.
In Doggett, the guarantors were unable to rely upon the bank’s breach of clause 25.1 of the Code because of the release clause in the compromise agreement.
The warning for any borrower, mortgagor or guarantor is to obtain legal advice before signing any forbearance or compromise agreement with a lender. It is common for these agreements to include acknowledgements that the lending transactions are valid and enforceable and that the lender is released from all claims in relation to earlier events.