Private lenders get a glimpse into the possible future of the small business loan. What is it? And what is the best way forward?
In February 2017, the Australian Small Business and Family Enterprise Ombudsman (ASBFEO) released its report “Inquiry into Small Business Loans” (the Report). The Report targets the laws and practices of authorised deposit taking institutions (Banks) and their small business loan contracts. If implemented, will it also impact private lenders?
Which recommendations should private lenders be aware of?
A number of Recommendations could well impact both Banks and private lenders. Most concerning for private lenders is Recommendation 3. It states:
Recommendation 3: For all loans below $5 million, where a small business has complied with the loan payments requirements and has acted lawfully, the bank must not default a loan for any reason. Any conditions must be removed where banks can unilaterally:
- value existing security assets during the life of a loan
- invoke financial covenants or catch-all ‘material adverse change’ clauses
In Provident Capital Ltd v Papa  NSWCA 36 Macfarlan JA states that “public interest does not necessarily require so-called asset lending to be proscribed, or even deterred” (read our full summary of the Papa decision). However, Recommendation 3 seems to limit asset lending practices.
Let’s look at an example. A borrower meets the required payments but technically defaults under the loan, by allowing another financier to caveat the security property. Under Recommendation 3 the lender may not be allowed to balance its risk portfolio by charging the standard interest rate. Nor can the lender re-value the property to find out the extent of the risk.
30 Business day notice period
Recommendation 4: A minimum 30-business day notice period to all changes to general restriction clauses and covenants (except for fraud and criminal actions) be added to give borrowers more time to respond and react to a potential breach of conditions.
There is some value in providing notice periods to borrowers following a technical breach of a covenant, for example, restructuring a corporate entity. However, applying a mandatory notice period may cause issues.
Of particular concern to private lenders is the minimum 30-business day notice period. Some private loans are only three months in length. A 30-business day notice period covers a third of the loan term and greatly increases the risk of lending.
Recommendation 6: For loans below $5 million, banks must provide a one-page summary of the clauses and covenants that may trigger default or other detrimental outcomes for borrowers.
There are benefits to including a summary of the contract and the clauses that trigger default. It helps borrowers understand the basic expectations of the loan. It also saves small business borrowers time and money on legal advice, so they spend less time away from their businesses.
However, there are risks for the lender when providing a summary. While loan documents are often complex, many of the clauses containing detrimental effects for the borrower protect the lender from additional risk. Providing a one-page summary is impractical. And it may negatively affect a lender’s rights in a dispute with a borrower.
Let’s look at another example. A lender defaults on a loan based on a non-monetary covenant, such as a company entering voluntary administration. While the full loan documentation lists this clause, the summary does not include it as an event of default. The lender could have this interpreted against it in a dispute.
Providing a summary of the terms to the borrower could lead to an increase in litigated disputes.
Provide a choice of valuer
Recommendation 8: All banks must provide borrowers with a choice of valuer, a full copy of the instructions given to the valuer and a full copy of the valuation report.
This is logical. If a borrower pays for the valuation, then they should get the instructions and the report. However, larger Banks and private lenders use different methods of valuation. Banks often have panels of experts from large valuation firms who do their valuations. By contrast private lenders rely on smaller, local valuation firms. So it may not be possible for a private lender to offer a borrower a choice of valuers.
Recommendation 7: For loans below $5 million, banks must put in place a new small business standard form contract that is short and in plain English.
The Treasury Amendment (Small Business and Unfair Contract Terms) Act 2015 aims to extend unfair contract terms protections to cover small businesses. The Report asks: have banks made changes to their small business loan documentation? Currently the loan contracts of the four major banks are under review by ASIC. This is as a reminder to private lenders to make small business contracts easier for borrowers to read and understand.
Establish Small Business Commissioner
Recommendation 15: Australian Securities and Investments Commission must establish a Small Business Commissioner.
The Report questions the ability of ASIC to meet the needs of borrowers. A Small Business Commissioner would provide expertise to ASIC on small business matters. The Report notes that it is rare for ASIC to act on a complaint against a lender. A Small Business Commissioner would allow ASIC to take a more active role, especially with the growth of the unfair protections legislation.
How does this impact on Private Lenders?
There is no immediate concern for private lenders or Banks. The recommendations are merely that – suggestions. There is no rule binding Banks or private lenders. However, with every new Inquiry into the banking sector, regulations tighten. Stricter banking practises seem to be the future of the banking sector.
How should private lenders treat the Report? Generally, an entity referred to as a “private lender” is not an “authorised deposit-taking institution”. So if greater regulation occurs it may not be binding on private lenders.
There are also differences between Banks and private lenders. Large Banks have strict procedures while private lenders are flexible and offer a more level bargaining position. Similarly, private lenders often offer asset loans rather than cash-flow based loans. So it would seem unfair if the obligations outlined in the Report were applied to them.
Private lenders should know of the recommendations raised in the Report. These may never be legislated, but courts will be aware of the issues in the banking sector. They could consider the recommendations when deciding disputes about unfair loan contracts.
Before the Report, there were seventeen previous inquiries into the banking sector with limited actions taken. This suggests that the private lending sector is unlikely to face significant changes in the near future.
However, ASIC is checking the loan agreements of the four big banks with their small business customers. So private lenders should also review their small business loan contracts. Do they comply with the recent unfair terms legislation?
This publication is provided for your general information and interest only. It is not intended to be comprehensive, and does not constitute and must not be relied on as legal advice. You must seek specific advice tailored to your circumstances.