Impairment of Customer Loans — a synopsis into the findings of the recent inquiry and recommendations - Charges, Mortgages, Indemnities

The Parliamentary Joint Committee on Corporations and Financial Services (the Committee) was established by Pt 14 of the Australian Securities and Investments Commission Act 2001 (Cth).

The Committee recently published its report¹ following an inquiry into the impairment of customer loans (the Report). The Report comes at a time where widespread reforms of the banking and finance industry have been recently introduced or subject to extensive public discussion.

In the last 18 months alone:

we have seen the final report of the Financial System Inquiry;
the Productivity Commission has published its report² into business set-up, transfer and closure;
the Federal Government has released the Australian Securities and Investments Commission (ASIC) Capability Review3 and its response to the review; and
sweeping changes to the insolvency profession have been proposed.

This inquiry was conducted over 11 months, received 195 submissions and more than 11,000 pages of evidence was considered from hearings conducted across Australia.

Eleven recommendations have been made and it is clear that the financial industry is in the sights of the federal government amidst apparent widespread public dissatisfaction with the current legislative and regulatory regime in place.

Terms of reference

The terms of reference required the Committee to consider the practices of banks towards borrowers who they judge may be in financial difficulty and may have breached the terms of their loan contracts.

The focus of the Committee was on small business and commercial loans given the bulk of the evidence it received and the significant personal exposure of such entities if challenges arise. In particular, the Committee was asked to examine the incidence of non-monetary defaults through the deliberate reduction, by valuation, of the value of the securities held by a financial institution, thereby raising the loan-to-value ratio resulting in the loan being impaired.

Allegations of such practices are not new, and have previously been considered by parliamentary inquiries. However, despite earlier scrutiny, such allegations have persisted and this conduct remained at the heart of the public's concern.

Lenders were not the only entities referenced in the Report as the scope of the terms of reference extended to the role of valuers and receivers.

A common thread running through the public submissions was the power imbalance between small- to medium-sized business owners and lenders and how this inequity can be exploited.

This issue and more are explored in greater detail below.

Practices of banks

While the Committee acknowledged that the majority of business loans proceed without dispute, the main allegations raised in submissions related to:

the use of a lender's power advantage to the detriment of borrowers;
the use of non-monetary defaults including loanto-value ratios; and
charging excessive fees, default interest and penalty interest.

Financial institutions disputed many of the allegations made and the views of industry bodies and banks were summarised in the Report. These views were contested by a significant number of witnesses and submitters.

It should be noted that the Committee was not able to discover evidence that demonstrated that there was widespread illegal behaviour by the banks. The evidence of the banks was that non-monetary defaults were exceedingly rare.

Indeed, the ASIC informed the Committee that in the 5 years from 1 July 2010, it had considered 66 reports of misconduct in relation to loans and determined not to pursue further regulatory action because there was insufficient evidence of misconduct on which to base an enforcement action.

However, the Committee considered that there were four factors which had created an environment in which small business borrowers were vulnerable:

the level of discretion and commercial judgment available to the banks for both initial lending and the management of loans in financial difficulty;
complex loan contracts, coupled with gaps in existing legislation and regulations;
borrowers who were unable to pursue their rights through the courts because the process is unaffordable; and
the significant gaps in the coverage of mediation and external dispute resolution schemes.

These factors weighed heavily in the recommendations of the Committee which included appropriate legislation and regulations to be put in place to:

control additional costs imposed on default;
improve protection measures for borrowers at the end of the loan period;
extend responsible lending standards to small business loans; and
require officers from lending and credit management departments to provide borrowers with copies of instructions given to valuers and investigative
accountants and their reports.

The Committee also supported suggestions from the banks regarding the development of nationally consistent standard loan contracts to ensure rights were fair and appropriately balanced.

The role of valuers

Valuers play a critical role in the provision of loans, and their services are often utilised throughout the term of the facility. Prudential Standard APS 220 on Credit Quality⁴ (APS 220) sets out the requirements for how property to be held as security against loans should be valued.

Some of the issues raised during the inquiry relating to valuers included:

reductions in valuations between loan establishment and the appointment of receivers; and
the instructions given by lenders to valuers.

It is standard industry practice for lenders to use preferred lists or expert panels of independent external valuers to undertake mortgage values under strict industry standards. However, given the circumstances in which such valuations are undertaken, it is unsurprising that there is often dispute about valuation evidence.

The misuse of valuations makes little commercial or economic sense for financial institutions. ASIC con- firmed it had not pursued regulatory action against a lender in relation to alleged misconduct for changes in valuation of assets held as security.

The Committee expressed the view that valuation reports and instructions to valuers should be provided to borrowers. While no suggestion of deliberate behaviour was made, this suggestion was based on evidence presented to it that valuations at the time of loan establishment were optimistic when compared with valuations at the time of review.

Receivers and investigative accountants

The Committee also looked at the role of investigative accountants and receivers on default, the effect of a forced sale of property in depressed market conditions and incidence of disparities between valuations and sale price.

The key issues raised in submissions included:

receivers selling properties and assets under value;
use of single organisations for investigative accountant and receivership processes; and
lack of information provided to borrowers by receivers.

The law imposes high standards in relation to the sale of property by receivers under s 420A of the Corporations Act 2001 (Cth). The history of court decisions support the compliance by receivers with the section and other duties under ss 180–184 of the Act.

However, the Committee was sympathetic to the submissions made and recognised that many of those who gave evidence had experienced dire financial consequences. It was noted that the stressors associated with these circumstances exist even if a receiver does their job in a highly professional and empathetic way.

On the basis of the evidence received, the Committee recommended that receivers selling assets under s 420A be required to take every reasonable step to ensure those assets are sold at or as close to listed market value as possible under the following conditions:

proof of marketing through but not limited to mainstream media, catalogues and online;
in cases with no monetary default, marketing periods consistent with APS 220;
in cases where monetary defaults have occurred, the marketing period can be reduced below the APS 220 standard where a shorter marketing period can be demonstrated to be in the borrower's best interest; and
that a strong penalty regime for breach of s 420A be administered by ASIC.

Two further recommendations or relevance for those who regularly engage receivers and investigative accountants include:

if the same firm engaged as the investigative accountant is appointed receiver (which reflects common practice in Australia), the borrower should be given an opportunity to request an alternate company if the borrower is concerned about a conflict of interest; and
lenders should be required to provide copies to borrowers of both the instructions to and reports by investigative accountants.

Comment

The recommendations provide stakeholders with insight into both the public's perception of the industry, some of the challenges that are faced during times of financial stress and what the federal government considers "best practice" in such circumstances.

What happens next is difficult to know given the existing codes of conduct in place, the breadth of reforms currently underway and the nature of the changes proposed.

What the Report has clearly demonstrated is that public perception of lenders, valuers and receivers continue to be mixed with those who experience a loan default, finding the power imbalance in some ways challenging.

To address this vulnerability, in addition to the measures proposed above, the Committee has recommended that the federal government being forward legislation to give the Australian Small Business and Family Enterprise Ombudsman (ASBFE Ombudsman) the relevant powers to:⁵

coordinate the implementation of the outcomes of the inquiry;
bring together a team with relevant expertise to establish standards for the conduct of bank management and their employees;
work with the banking industry to develop nationally consistent standardised loan contracts; and
act as a small business loans dispute resolution tribunal.

Footnotes

¹ Parliamentary Joint Committee on Corporations and Financial Services Impairment of Customer Loans (2016).
² Productivity Commission Business Set-up, Transfer and Closure Report No 75 (2015).
³ Australian Securities and Investments Commission Fit for the Future: A Capability Review of the Australian Securities and Investments Commission (2016) www.treasury.gov.au/ PublicationsAndMedia/Publications/2016/ASIC-capabilityreview.
⁴ Australian Prudential Regulation Authority Prudential Standard APS 20 Credit Quality (2015).
⁵ Above n 1, p x para 1.10.

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