Royal Commission: Round 3 - experiences with SME lending

Interim Report – small and medium enterprises

Written by Senior Associate James Campbell and Associate Lucy Moclair-Adams

The third round of the Royal Commission's hearings concerned lending practices to small and medium enterprises (SMEs). The hearings considered a range of case studies, including:

• lending by ANZ, Bank of Queensland and Westpac to SME customers for the purchasing of franchises;
• CBA's lending practices and overcharging of interest on business overdrafts;
• Westpac obtaining a guarantee for a business loan and mortgage over the home of a business owner's mother;
• The CBA/Bankwest business lending book;
• Bank of Melbourne withholding of funds in deposit; and
• NAB's communication with a business borrower about the sale proceeds of a residential property used to secure a small business loan.

The case studies demonstrated that dealings between SME borrowers and lenders are always complicated, and highlighted the difficulty of striking an appropriate balance between ensuring that SMEs have access to credit and imposing standards on the provision of that credit to protect SME borrowers and third-party guarantors. Accordingly, the Interim Report outlines that the overarching issue arising from the hearings is whether there should be any change to the legal framework governing SME lending, and in particular, whether lending to SMEs should come within the reach of the National Consumer Credit Protection Act 2009 (Cth) (NCCP).

Key points

The third round of hearings considered a range of issues regarding lending practices to SMEs, including irresponsible lending, protections afforded to third-party guarantors of business loans, the approach of banks to defaulting loans, the function and effectiveness of consumer redress systems, and the effectiveness of self-regulation through the Code of Banking Practice (COBP).

After the third round of hearings concluded, on 31 June 2018, ASIC conditionally approved the new COBP, which is due to commence on 1 July 2019. The Interim Report outlines that the COBP is the 'chief protection' for SME borrowers, yet the industry and regulators do not agree on the bounds and contents of key obligations. In particular:

• what inquiries and analyses a diligent and prudent banker should undertake when deciding to lend to an SME (including to what extent the banker should test the information given by the customer and go beyond what the bank's policies require); and
• whether the requirement to assess whether an SME customer can repay a loan based on their financial position and account conduct is sufficient.

Two other key issues were raised in the hearings and canvassed in the Interim Report. They concern the approach taken by banks and protections afforded to third-party guarantors of business loans and the approach taken by external dispute resolution bodies to dealing with loans that are affected by maladministration. In summary, the issues are:

• whether greater protections should be afforded to third-party guarantors, including to prevent enforcement of a guarantee where there have not been any breaches of statutory or equitable principles or the COBP. The Interim Report observes that there is a disconnect between how the law and lenders may treat third-party guarantors (as interested, or at least, rationally motivated actors) and the reality of many, if not most, guarantors (family members assisting their loved ones in their business plans); and
• whether the Australian Financial Complaints Authority should adopt a different approach to the Financial Ombudsman Service when dealing with business loans that have been affected by maladministration, as the case studies demonstrated that customers who have been successful in such claims nonetheless sometimes struggle to achieve a satisfactory outcome.

The hearings also considered general issues regarding how banks communicate with customers, their sales culture and remuneration and incentive structures, which overlapped with similar issues considered in other rounds of hearings. The Interim Report particularly focuses on issues concerning communication and transparency in dealings with SME borrowers, and sets out that:

• while no additional regulation is required, if a bank is to give effect to its key commitment under the COBP to act fairly and reasonably in a consistent and ethical manner, it should: communicate when it seeks to exercise a power; identify clearly what power it is sought to exercise; how the power is engaged; and why the bank seeks to exercise it; and 
• language used in banks advertising to SMEs based on notions of help or partnership exacerbates the gap between a customer's hopes and expectations of the bank and the reality that banks are commercial entities. More generally, language such as 'meeting the customers' needs' should not be used to obscure the truth of banks' motivations to increase profit, which is not in of itself misconduct or conduct falling below community standards or expectations.

The Interim Report also addresses the extension of unfair contracts legislation to certain small business contracts, and is critical of what it portrays to be a tardy and overly consultative approach by ASIC to overseeing the implementation of the legislation.

What's next?

The Interim Report outlines that there was no substantial support for changing the legal framework regulating SME lending, in particular by extending the NCCP to cover SME lending. It also expresses the more general view that the existing regulatory framework for the financial services industry is broad and complex, and adding a new layer of law or regulation will only increase the complexity and cost of compliance. It is, therefore, unlikely that the Commissioner will recommend the addition of broad legislation or other changes to the current regulatory framework for SME lending.

The Interim Report does suggest that that an appropriate response may be to give the COBP legislative recognition, making it enforceable by ASIC – similar to other industry codes under the Competition and Consumer Act 2010 (Cth). The Interim Report observes that the banks have agreed to comply with the COBP and that compliance with the Code is frequently incorporated as a term of lending contracts for institutions that have adopted the Code. It also argues that making contraventions a breach of the law would not necessarily impose any additional costs or burdens on banks, which, in turn, would restrict the availability or cost of credit to SMEs. However, the COBP was developed as a voluntary code, and there must be questions about the suitability of retrospectively turning it into a mandatory standard with the potential for civil penalties for breaching.

The Commission's general criticism of ASIC and its particular criticism of ASIC's approach to the extension of unfair contracts legislation to SME lending may see a hardening of attitudes towards terms that favour the lender in small business finance documents falling within the unfair contracts regime.