Unfair terms in small business loan contracts
Small businesses and ASIC can commence proceedings against lenders alleging that certain terms used by the lender in their small business loans are unfair contract terms.
ASIC commenced proceedings in the Federal Court this month, seeking orders against some lenders that a number of their small business contracts entered into from 16th November, 2016 where a clause is determined as an unfair term be deemed void pursuant to the Australian Securities and Investments Commission Act 2001 (“ASIC Act”).
Is this a big deal?
Lenders will now have to consider that ASIC may take up the cost to commence proceedings not only for one-off matters, but classes of loan dealings.
Traditionally, lenders who dealt with consumers and small businesses left clauses in contracts that may have been considered unfair. These lenders would consider on a case-by-case basis as to whether to rely on these if an event arose to trigger such a clause, or back away if challenged by a consumer or small business on the grounds of such clause being unfair.
In the original communications, report and conduct, ASIC conveyed “generally, we do not take action on behalf of individual consumers or businesses” and recommended such parties to enforce their rights via:
- making a complaint directly to the lender;
- if the lender is unable to resolve the issue, making a complaint to the financial services provider’s external dispute resolution scheme (Australian Financial Complaints Authority (AFCA); and
- take court action against the lender.
This hands-off position from ASIC, before the Royal Commission, may have provided commercial comfort for some lenders to leave in such clauses, for if there was a dispute claiming a clause as being unfair, the consumer or small business would have to seek relief from a Superior Court to have same heard and enforced. This is a costly exercise which also provided the lender plenty of opportunity and time to consider the clauses in question and determine whether to waive and settle the matter or push on – usually on a case-by-case basis.
What does this mean regarding the Loan Contracts in question?
If clauses are found to be unfair then the Court will deem such clauses void. This does not mean the entire loan contract is deemed void or unenforceable, unless in the rare circumstance the unfair clause being removed is so fundamental to the loan agreement that it cannot operate by merely excising such unfair provisions.
A lender faced with such ASIC action will consider the provisions in question and:
- if they form the view that a provision may be unfair then they may seek to enter into a settlement. Additionally, they may provide an enforceable undertaking not to enforce some or all of the provisions in question if they form the view that they are unfair, and further undertake that such clauses will not be used for future small business loans. For banks that participate under the new Banking Code of Practice (1 July, 2019) providing such an undertaking will not be an issue for certain provisions, that may have been considered unfair conditions, have already been deemed unenforceable or largely restricted by the banks to use due to the New Code.
- if the lender forms the view that such provisions are not unfair terms then they are entitled to and would likely challenge the ASIC action.
New Banking Code of Practice – 2019
A large number of banks have adopted the new Banking Code of Practice since 1 July, 2019. A list of such banks that have adopted the new Code can be found on the Australian Banking Association website: https://www.ausbanking.org.au/policy/banking-code/code-signatories/.
Why is this significant?
Participating banks are bound by the provisions of the Code regardless of such terms being in their small business loan contract – in particular, Part 6 which relates to Small Business loans. It places additional restraints on the banks to enforce a loan against a small business for non-monetary defaults. The definition of small business loans in the Code is greater than that covered by the ASIC Act.
This provides further grounds for a small business to challenge enforcement by a bank under a small business loan but it also highlights that regardless of an unfair term being in the loan agreement that participating banks have placed restraints on themselves from utilising such clauses and publicly conveyed their intent that they will not exercise provisions that may previously have been considered unfair terms in small business loans.
This is a significant departure of ASIC’s previous hands-off stance and they may be gearing up to target other lenders regarding unfair contract terms. Lenders should consider revisiting their terms and conditions in light of the above and possibly fine-tune their provisions which may have been too discretionary, broad or one-sided.
If ASIC approaches lenders regarding their lending book, there are numerous steps that can be undertaken to consider, challenge and/or broker a mutually acceptable outcome (e.g. enforceable undertakings, adoption of the new Code, orders, etc…)
If interested, the following is a brief overview of loan contracts and commonly used clauses that may be captured by the ASIC Act regarding unfair term provisions.
Small Business Contracts
The unfair contract term provisions of the ASIC Act have been in play since 1 July, 2010 in relation to standard form consumer contracts for financial products (including loans). However, this was extended on 12 November, 2016 to capture standard form ‘small business’ contracts.
The unfair contracts law applies to standard form small business contracts entered into, or renewed, on or after 12 November 2016 where:
- the contract is for the supply of financial goods or services (which includes a loan contract);
- at least one of the parties is a ‘small business’ (under the ASIC Act, a business employing fewer than 20 people is a ‘small business’); and
- the upfront price payable under the contract does not exceed $300,000, or $1 million if the contract is for more than 12 months.
When is a term of a small business contract unfair under the ASIC Act?
A term in a standard form small business contract is ‘unfair’ if:
- it would cause a significant imbalance in the parties’ rights and obligations arising under the contract;
- the term is not reasonably necessary to protect the legitimate interests of the party that would benefit from its inclusion; and
- the term would cause financial or other detriment (e.g. delay) to a small business if it were to be applied or relied on.
Examples of commonly used clauses
Some examples of clauses that may be considered unfair are:
- ‘Entire agreement’ clauses which state that the contract document, as agreed to by the parties, represents all of the rights and obligations between the parties
- ‘Broad indemnification’ clauses that make the borrower liable to the lender for losses, costs, liabilities and expenses suffered or incurred by the lender, including those that may arise outside the control of the small business borrower;
- ‘Non-monetary events’ default clauses (i.e. not based on a failure to pay money to the lender) which may present a change in credit risk to the lender. Non-monetary events of default can include a misrepresentation by the borrower, a failure to maintain insurance, a breach of a covenant, an unauthorised use of the borrowed funds, or a change in control of the borrower company;
- ‘Material Adverse change’ events of default clauses which allow lenders to apply default consequences to the loan for an unspecified negative change in the borrower’s circumstances, even if the borrower is meeting their financial obligations in full and on time under the contract;
- ‘Financial Indicator Covenant’ clauses where the financial position or operations of the business (typically in the form of a ratio) must satisfied by the borrower.
- ‘Unilateral variation’ clauses that give lenders (but not borrowers) a very broad discretion to unilaterally vary terms and conditions of the contract, without the consent of the small business borrower.
Such clauses are not necessarily unfair clauses and ASIC appreciates that it is common for the terms of the loan contract to give the lender some flexibility and a broad discretion about whether to call a default (because events of default are defined very broadly) with a broad discretion about what consequences to impose if a default is called.
However, these combined discretions present a significant risk of the terms being unfair because they empower the lender to respond to an event in a way which is significantly disproportionate to the credit or other risk to the lender created by the event. The terms are likely to be unfair if the combined broad discretions are not reasonably necessary to protect the legitimate interests of the lender.
In response to ASIC’s concerns, some banks have limited these two discretions under their terms to more precisely specify events of default which presented a credit risk to the lender and to ensure that the consequences imposed by the lender were not significantly disproportionate to that risk.
Lenders should consider revisiting their terms and conditions in light of the above and possibly fine-tune their provisions which may have been too discretionary, broad or one-sided.
This article is general commentary on a topical issue and does not constitute legal advice. If you are concerned about any topics covered in this article, we recommend that you seek legal advice.
For further information please contact the author Paul Agnew, Partner (Brisbane), Glenn Hughes, Partner (Sydney), Paul McCann, Partner (Sydney), Nick Amore, Partner (Melbourne), or any member of our Banking & Finance team.