When a loan guarantee goes wrong

Accountants are often asked to provide certificates of independent advice in financial transactions and usually do so as a matter of formality, without much appreciation of the consequences.

Moreover, they are at the coalface of advising directors and others who have given personal guarantees. This is an important decision for accountants to know about, especially if advising a client about a personal guarantee.

A recent decision of the High Court found that a lender had acted unconscionably in trying to enforce its purported rights against the personal guarantor, even though there were certificates of independent legal and financial advice.  

Practical takeaways from the case

• Asset-based lending is not in and of itself unconscionable. The facts of individual cases will determine whether enforcement of rights is unconscionable.
• Systems of conduct designed to shield the lender from its failure to make enquiries about the borrower’s financial prospects through the use of intermediaries will likely amount to wilful blindness and therefore be unconscionable.
• Independence is paramount. Any system where there is even an appearance of loyalty or allegiance on the part of the part(ies) giving advice to any other party other than the party being advised should be avoided. Obtaining actual independent legal and financial advice is essential.
• In situations where loans are provided to companies which are backed by a personal guarantor, any legal or financial advice must be provided to both the company and the guarantor in their respective capacities even though the two entities might in practice be identical.
• Accountants should not view certificates of independent advice as a mere formality – failure to include the necessary information may result in adverse findings of unconscionability and negatively impact their credibility.

Facts of the case

Mr Stubbings (the guarantor) wanted to obtain a loan in order to purchase a property but was refused a loan from a mainstream bank due to his lack of income.

He was introduced to a law firm, AJ Lawyers (the agent), who advanced the money to him on behalf of Jams 2 Pty Ltd (the lender). The loans were officially made to Victoria Boat Company Pty Ltd (the borrower) – a shell company wholly owned by the guarantor – ostensibly for the purpose of doing business but the true purpose was really for the guarantor to buy his property under a highly unusual “system of conduct”.

The “system of conduct” had the following key characteristics:

• The loans were only ever made to companies in order to circumvent the National Credit Code.
• The lending had to be secured by a guarantor.
• There was never any direct contact between the lender and the borrower. All communication was through intermediaries.
• The agent provided certificates to the lender stating that the borrower had received independent legal advice and independent financial advice.
• There was deliberate avoidance on the agent’s part from enquiring about the borrower’s/guarantor’s capacity to repay the money.

Apart from the properties, the guarantor had no income or other assets to meet his obligations and the borrower had neither assets nor any history of trading activity or income. When the borrower defaulted on the payments, the lender started legal action against the borrower and the guarantor.

The decision

In a highly critical judgment, the Court held that the lender’s insistence upon their rights under the mortgages was unconscionable.

The Court held that the elements of unconscionability, being (i) the existence of a relationship where one party is at a “special disadvantage” against the other; (ii) knowledge of this special disadvantage by the stronger party; and (iii) unconscientious exploitation of the disadvantage by the same, must be assessed holistically.

On the facts, the Court found that the guarantor suffered from a “special disadvantage” due to his financial illiteracy and there was “unconscientious exploitation of [the guarantor’s] special disadvantage” by the lender and their agents.

The Court also found that the system of conduct used by the lenders in this case, which was intended to shield the lender from ever obtaining relevant information about the guarantor’s capacity to pay, amounted to wilful blindness and was therefore also unconscionable.

Ramifications

The decision underscores the importance of advice given by professionals (in other words, accountants and lawyers) to their clients, particularly (1) the independent nature of the advice and (2) the quality of the advice itself.

This ruling shows the importance of obtaining actual independent legal and financial advice when entering personal guarantee arrangements. Any system where there is even an appearance of allegiance on the part of the part(ies) giving advice to any other party other than the party being advised should be avoided.

It is importance not to view independent advice as merely a “box-ticking exercise”.

Failure to include the necessary information may result in adverse findings of unconscionability, having a negative impact on the practitioner’s credibility. In areas where the element of trust is as important as accounting, this might have huge repercussions on professionals’ ability to get work and/or referrals in the future.

Trevor Withane is a partner at Blackwattle Legal, a Sydney-based firm which specialises in commercial litigation, insolvency and bankruptcy.