It’s called asset lending when a loan is made secured by real estate without regard to the borrower’s ability to pay. The lender’s recourse is to the real estate in the event of default.
The five wise judges
In Stubbings v Jams 2 Pty Ltd [2022] HCA 6 (16 March 2022), Chief Justice Kiefel, Justices Keane, Gordon, Steward and Gleeson considered an asset-based loan and unanimously ordered that:
- the loan agreement be declared invalid and unenforceable and set aside;
- the property mortgage be discharged; and
- the borrower repay $109,315 (a sum based upon a calculation to avoid his unjust enrichment following upon the loan agreement being set aside).
The five judges made the orders because they found that the lender’s conduct:
amounted to the unconscientious exploitation of the [borrower’s] special disadvantage … [and] it was unconscionable for the [lender] to insist upon their rights under the mortgages. [paragraph 52, judgment]
The loan offers
Stubbings owned two houses in Narre Warren, a suburb in Melbourne, both mortgaged to the Commonwealth Bank for $240,000. He did not live in either. They were valued at $770,000.Stubbings had a problem and a plan.
His problem was that the ANZ Bank had rejected his home loan application to refinance the loans on the two houses because he was unemployed and had no regular income, had not filed tax returns for several years and was two years in arrears of rates.
His plan was to purchase a property at Fingal on the Mornington Peninsula with five acres and two houses on it for $815,100, as a property to live in; renovate and sell the two properties at Narre Warren, pay down the loan and refinance the balance with a bank at a low interest rate.
He was introduced to a solicitor, Mr Jeruzalski a partner of AJ Lawyers, who arranged for two letters of offer to be issued to Stubbings by private lenders (Jams 2) for whom he acted:
- The first loan offer was a first mortgage loan of $1,059,000 to fund the purchase and to repay the Commonwealth Bank loans. The loan amount was two-thirds of the combined property valuations. The interest rate was 10% pa, the default rate 17% pa.
- The second loan offer was a second mortgage loan of $133,500 to fund consultancy fees, loan procuration fees, legal costs and property purchase costs. The interest rate was 18% pa, the default rate 25% pa.
- The loans were interest only: $8,825 per month for the first loan and $1,552.50 per month for the second loan.
- A minimum term of six months and a maximum term of twelve months applied. That is, a minimum of $62,265 in interest was payable for the first six months of the term.
The loan offers were made to a shell company registered by the borrower, The Victorian Boat Clinic Pty Ltd, which had no assets. Stubbings was the sole director and shareholder. The stated purpose was “for business purposes” so as to avoid the loans being governed by the National Credit Code which applies when a loan is made to “purchase, renovate or improve residential property for investment purposes”. Stubbings was required to give a personal guarantee and to mortgage the properties (which were all in his name) as security for his guarantee.
Later, the two properties at Narre Warren were sold by the lender, leaving the property at Fingal in which Stubbings lived as the sole security. The proceedings arose from the lender making application for a possession order for the property at Fingal.
The three wise monkeys approach to moneylending
The High Court found there was a “system of conduct” or “system of lending” used for the loan which amounted to unconscionable conduct. The system involved the lenders, the lenders’ solicitor and the legal and financial advisors to the borrower, who acted like the three wise monkeys.
The lenders acted like the monkey who hears no evil. They were not given and did not want any background upon the borrower and no credit assessments. They relied upon the property valuations as sufficient basis to make the loans. They were pure asset lenders.
The solicitor acted like the monkey who sees no evil. The High Court said the lender’s solicitor deployed the system to make him “wilfully blind”. He knew that the loans were “a risky and dangerous undertaking” for the borrower because of the high interest rates and the risk of the cost of forced sales. And yet, he “knowingly and deliberately failed to make” any inquiries about the borrower’s ability to service the loans, the borrower’s understanding of the loans or about his “financial nous and vulnerability”.
“The primary judge inferred that Mr Jeruzalski's ostensible indifference to the [the borrower’s] financial circumstances reflected a concern on his part that proof of his knowledge of such matters "would in some way undermine his clients' ability to recover their loans””.
He relied upon a ‘consultant’ to vet and introduce potential borrowers; had no contact with the borrower save for written correspondence and documentation; and relied upon the valuations and certificates of independent advice.
The providers of independent advice acted like the monkey who speaks no evil. The accountant and lawyer who gave the advice were not independent – they were nominated by Mr Jeruzalski. The certificates of advice (which were prepared by Mr Jeruzalski) did not draw the borrower’s attention to the difference between the cost of borrowing under the Commonwealth Bank loans and the proposed loans, review the business plan of the borrower company and the fact that the Fingal property was zoned “green wedge” with commercial use permissible only with consent. No financial or legal advice was given on these issues. The legal advisor witnessed the borrower’s signing of the loan documents but gave no advice on their terms, nature and effect.
The High Court finding of unconscionable conduct
In finding that the equitable principle of unconscionability applied, the High Court (Chief Justice Kiefel, Justices Keane and Gleeson) took into account these circumstances:
- The loans were “asset-based lending” or “pure asset lending”, which are easier for a borrower to obtain because they are made: “without regard to the ability of the borrower to repay by instalments under the contract, in the knowledge that adequate security is available in the event of default”.
- The loans were made to a company which “had no assets and had never traded”. The “commercially unnecessary interposition of the company as borrower” was “a step calculated to prevent or impede scrutiny of the transaction under the [National Credit] Code”.
- The loans were dangerous for the borrower: the fact that the borrower had no income which meant the properties would be sold in the event of default. There were no surplus funds available for renovations as had been promised. After two months, interest payments ceased, and the loans fell into default.
- The borrower suffered a special disadvantage, because of his poor financial literacy, inability to understand the nature and risk of the transactions, and his bleak financial circumstances: his “lack of commercial understanding coupled with his inability to repay the loans from his own income or other assets meant that default in repayment … was inevitable”.
- The lenders (through their agent Jeruzalski) had sufficient appreciation of the borrower’s vulnerability and the likelihood loss would be suffered (actual knowledge was not essential). Yet, they made the loans: “The dangerous nature of the loans ... was central to the question whether [Stubbings’] special disadvantage had been exploited by the [lenders]”.
- The high interest rates payable. The “profit to be made by taking ... the [borrower’s] equity by way of interest payments made the exploitation of the [borrower’s] disadvantages good business for the [lenders]”.
- The certificates of advice were “mere “window dressing”” given their “bland boilerplate language” and the fact they did not address Stubbings’ financial circumstances, contained no reference to a business plan or the property zoning at Fingal. They could not negate the lender’s actual appreciation of the dangerous nature of the loans and the borrower’s vulnerability.
Justice Gordon agreed that the equitable principle of unconscionability applied but went further. Justice Gordon considered that section 12CB of the Australian Securities and Investments Commission Act 2001 (Cth) (the ASIC Act) also applied to the lender’s system of conduct. Justice Gordon found that the lender’s conduct was unconscionable contrary to s 12CB of the ASIC Act for the same reasons that it was unconscionable in equity.
Justice Steward said the appeal turned upon whether the Victorian Court of Appeal was correct in concluding that the Legal Certificate and the Financial Certificate “not only precluded a finding of wilful blindness on the part of AJ Lawyers but also, as a result, effectively immunised its failure to make enquiries about the circumstances of [Stubbings]”.
He concluded that the Victorian Court of Appeal had erred, and said that “Neither Certificate had the effect of validating the system used by AJ Lawyers” for these reasons:
- The Legal Certificate was defective because it did not address the fact that the borrower’s lack of capacity to service the loans made the transactions “risky and dangerous”.
- The Financial Certificate was defective because it did not refer to the borrower receiving any advice in his capacity as guarantor; and nothing in the Certificate addressed the borrower’s or guarantor’s ability to service the loans and the financial risk in the transaction.
Is there a future for asset-based loans?
The High Court rejected the suggestion that asset-based loans are inherently unconscionable. Indeed, in their judgment, Chief Justice Kiefel, Justices Keane and Gleeson gave two instances of asset-based loans which would not be objectionable:
The transaction in this case cannot be regarded as if it were, for example, a loan to an asset-rich but income-poor individual sought for the purposes of meeting a temporary liquidity problem. The transaction could not even be seen as a high-risk loan to a person willing to gamble on the prospect of a rise in property values. [paragraph 51, judgment]
There is much to be said for the High Court’s view that default was inevitable. The loan structure was flawed by providing that interest was payable monthly by a borrower who had no income or funds to pay it.
Had the loan been structured (as many asset-based loans are) that interest be capitalised and be paid when the loan is repaid, it might have overcome this flaw. But in Stubbings’ situation, the loan amount was already high and exceeded the prudential ratio of two-thirds of valuation.
Take-out: The effect of the High Court decision in Stubbings is an investigation of the borrower’s financial circumstances is advisable, especially when an asset-based loan is to be secured by a residential property and regular interest payments are to be made.