Code of Banking Practice: Outcome of Doggett appeal
On 17 December 2015, the Supreme Court of Victoria's Court of Appeal ruled in Doggett v Commonwealth Bank of Australia  VSCA 351 that banks hold an obligation toward guarantors under the Code of Banking Practice (Code) to exercise care and diligence in forming a view on a borrower's ability to repay a loan.
What does this mean for banks?
- The liability of guarantors in respect of loan facilities can be extinguished under clause 25.1 of the Code on the basis of a bank not exercising care and diligence in relation to assessing a borrower's capacity to repay.
- Guarantors and their legal advisors will use the principle from this decision and National Australia Bank v Rice  VSC 10 (which also related to guarantees under the Code) to challenge their liability.
- In challenging their liability, guarantors and their advisors will particularly scrutinise a bank’s credit approval process, including whether that bank relied on a guarantor's financial resources to service the loan and if there were any inconsistencies or errors in the supporting material that the bank ought to have identified.
- In this particular case, the bank succeeded on the basis that it obtained releases from liability under the Code from the guarantors. In this respect, the bank may have won the battle, but lost the war.
- The Court of Appeal was divided on the question of whether the bank's breach caused the guarantors to suffer loss. Should the guarantors appeal the matter to the High Court, the bank may seek special leave to cross-appeal on the issue of causation and loss.
Dogvan 007 Pty Ltd (Borrower) entered into a commercial loan facility (Loan) with the bank in order to finance a small business that purchased and managed investment properties. The Loan was guaranteed by the Borrower's two directors (Guarantors). When the Borrower defaulted on the Loan, the bank sought to enforce the guarantees to recover a $3.1m shortfall.
Before proceedings were issued, the parties entered into a compromise agreement under which the Guarantors agreed to ‘take no further action in relation to the claims/accusations that have been alleged’ against the bank.
The guarantee contained a general statement acknowledging that it was subject to the Code. The Guarantors argued that the bank breached clause 25.1 of the Code (Assessment Obligation), which states:
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.
In the first decision to interpret clause 25.1, the trial judge noted that the Code's provisions (including clause 25.1) were contractual in nature. Consequently, if it was found that the Assessment Obligation applied to the guarantees and the bank had breached it, the Guarantors were entitled to a remedy to place them in the position they would have been in had the bank complied with the Assessment Obligation. The trial judge went on to rule that:
- clause 25.1 applied to the guarantees;
- the bank breached the clause; and
- the breach had caused the Guarantors to suffer loss because, but for the breach, the bank would not have advanced the Loan.
However, the Guarantors were not entitled to a remedy because they had released the bank under the compromise agreement.
Court of Appeal's decision
The Court of Appeal, largely upholding the trial judge's findings, unanimously dismissed the Guarantors' appeal. We summarise the judgment's key points below:
- Clause 25.1 formed part of the guarantees because they contained a general term to the effect that they incorporated the 'relevant' provisions of the Code.1 The Assessment Obligation was 'of the upmost significance' to the guarantees because it involved the bank taking steps to assess the likelihood of the Guarantors potentially being liable.
- While it was natural and appropriate to take into account the Guarantors' financial positon and the Borrower's ability to call upon these or any other resources, the Assessment Obligation principally related to the Borrower's capacity to repay the Loan. The bank could not assume that the Guarantors' resources in their entirety were available for the Borrower.
- The bank breached the Assessment Obligation toward the Guarantors because the circumstances indicated that the Borrower was unable to repay the loan. In particular, the bank possessed an accounting firm's report demonstrating that the Borrower had failed to account for the need to employ personnel to manage the investment properties and provide them with rent-free accommodation.
- The Court was divided as to whether the bank's breach caused any loss to the Guarantors:
- The Court agreed that the Assessment Obligation concerned the manner in which the bank formed its opinion as to the Borrower's capacity to repay. It did not prescribe that a particular opinion must be formed before the bank could advance the Loan.
- McLeish JA departed from the trial judge's ruling by concluding that the bank's breach should not be directly traced to its decision to advance the Loan. Evidence from the bank's risk assessment executive demonstrated that the bank would need to 'rework the whole application'. However, it would not inevitably reject it - for example, funding from other sources could be obtained. Accordingly, it did not naturally flow that the bank's breach caused the Guarantors' loss.
- Whelan JA (with Garde AJA concurring) considered that McLeish JA's points in relation to other sources of funding were correct, however greater emphasis should be placed on the Borrower's inherent capacity to repay the Loan:
… the capacity of a borrower to service a loan must remain a fundamental consideration. A conclusion that a loan would not have been made to a borrower who had a demonstrated incapacity to meet the required repayments by a significant margin is not one which would be ordinarily in doubt, notwithstanding potential recourse to guarantors, other parties or security.
Notwithstanding any potential that the application could be 'reworked', Whelan JA considered that the bank caused the Guarantors' loss because the particular application that was made, 'as a matter of probability', would have been rejected.
- Despite the Court's conclusion as to causation and loss, the Guarantors were not entitled to a remedy because they had agreed to release the bank from any liability under the Code prior to proceedings being issued.
The Guarantors have 28 days to file an application for special leave to appeal to the High Court.
1The Bank conceded before trial that the Assessment Obligation formed part of the loan agreement with the Borrower.
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