This Brief Counsel is the fourth in our six-part series on the interim report of the Australian Royal Commission into the Banking, Superannuation and Financial Services Industry. This time our focus is on the implications for small and medium sized enterprises (SMEs).
SMEs account for 97% of all businesses in New Zealand and contribute around 26% of GDP but here, and in Australia, are almost entirely reliant on the voluntary Codes of Banking Practice (the Code) for protection against irresponsible lending practices.
Status quo to prevail
The Commission found that there was not much support for substantial change to the current legal framework and did not reach a conclusion that greater protection was needed. This may reflect:
- an inherent tension between ensuring SMEs have access to affordable credit and ensuring they are adequately protected, and
- the Commission’s view, conveyed in the report, that alleged misconduct in this area often related to the banks’ commercial judgement and the exercise of its legal rights, rather than a breach of moral norms.
Chapman Tripp comment
There is a strong argument for SMEs having the same legal protections as consumers because they have similar attributes including a lack of bargaining power, resources and financial expertise, and often limited access to financial and legal advice.
Legal advice is particularly necessary where a SME owner has an unsophisticated understanding of finance, and their personal finances are closely integrated with their business.
Key issues for SMEs
Commissioner Hayne focused on:
- the role of third party guarantors
- whether the lender’s conduct met the standard of care and skill expected from a diligent and prudent banker, and
- how the lender exercised their power and communicated to their customer.
Third party guarantors
The Commissioner considered whether there were any circumstances in which a guarantee should not be enforced, even if the current legal framework of unconscionability doesn’t relieve the guarantor from liability.
An example would be if a guarantor didn’t fully understand or wasn’t fully informed about the commercial viability of the business – a circumstance which is more likely to arise where the guarantees are given by a family member not directly involved in the enterprise.
No firm conclusions were reached.
The Commissioner suggested lenders could:
- be more proactive in ensuring guarantors are appropriately informed about the business they are guaranteeing, and
- take a more subjective approach in assessing whether the guarantee could be satisfied without the guarantor suffering substantial hardship (although he rightly questioned how this solution could be implemented to ensure it was neither “over-inclusive nor under-inclusive”).
Due care and skill
The Commissioner asked what inquiries should be made by a “diligent and prudent banker” when deciding to lend to a SME. There was wide divergence in the submissions on this point, reflecting the subjective nature of the question and differences in risk appetite among banks.
The main issue here is whether the Code provides a sufficient standard for a banker to form an opinion about the customer’s ability to repay the loan facility and – again – the Commission was inconclusive, asking but not providing a view on:
- whether banks should closely analyse the business plans and cash flows presented by the SME, or
- whether it was enough to be satisfied that the loan can be repaid and that the business plan is not significantly flawed.
In some cases poor record keeping prevented the Commissioner from fully investigating whether the banker exhibited the standard of care and skill expected.
Power and communication
The case studies under this theme considered whether the lender had acted “fairly and reasonably and in a consistent and ethical manner” as required under the Code when a loan is distressed. Some lenders had used the power imbalance to their advantage, for example, by asserting a legal right they did not have to achieve their desired outcome. SME owners were not well placed to challenge the lender’s demands.
The Commissioner provided a recommendation to resolve this issue, emphasising the importance and value of transparency:
“Much more often than not, telling the customer what power is being exercised, and why, will expose to both the bank and customer whether it would be fair, reasonable, consistent and ethical to use the power.”
This recommendation does not require any new legislation.
The Commissioner believed that if “proper communication” had been used in the cases he examined, the lender would have been less inclined to act unfairly and the SME owner would have been able to make more informed decisions and feel more in control of the process.
Chapman Tripp comment
Lenders should use the interim report as an opportunity to consider their own practices when lending to SMEs to see whether they meet an appropriate standard of care and expertise.
While any legislative change in this area is unlikely to be a top priority for the Government, it is possible responsible lending requirements will be extended to include SMEs generally. Even if this doesn’t occur, there is an increasing expectation from media, the public and regulators that lending policies should be formal and comprehensive.
How a lender decides to meet these expectations will involve balancing the competing interests of ensuring SMEs can readily access credit on the one hand and enjoy the benefit of adequate protections on the other.
Our thanks to Tom van Schaik for writing this Brief Counsel.