Senate Inquiry Report: Credit and financial services targeted at Australians at risk of financial hardship

On 22 February the Senate Economics Reference Committee inquiry into Credit and financial services targeted at Australians at risk of financial hardship issued its report, available here.

Much of the report deals with the regulation of credit providers, but one aspect will be of interest to Restructuring & Turnaround professionals, recommendation 8:

The committee recommends that the government implement a regulatory
framework for all credit and debt management, repair and negotiation activities
that are not currently licensed by the Australian Financial Security Authority,

  • compulsory membership of the Australian Financial Complaints Authority, giving clients access to an External Dispute Resolution scheme;

  • strict licensing or authorisation by the Australian Securities and Investments Commission or the Australian Financial Security Authority;

  • prohibition of upfront fees for service;

  • prescribed scale of costs;

  • an obligation to act in the best interests of their clients; and

  • banning unsolicited sales.

There seems to be growing recognition of the problems caused by phoenixing, and growing concern about the role played by those unscrupulous “pre-insolvency advisers” who promote and facilitate phoenixing.

A regulatory framework ‘for all credit and debt management, repair and negotiation activities’ has the potential to apply to pre-insolvency advisers – although the detail suggests that it is personal credit which is the primary focus for the Committee.

Restructuring and Turnaround professionals who believe – as I do – that there is a pressing need for regulation of pre-insolvency advisers should take any opportunity via submissions or otherwise to ensure that legislators understand the link between phoenixing and pre-insolvency advisers, and the importance of any regulatory framework extending to business and corporate ‘debt management.’

The 2019 Inquiry impacting Restructuring and Turnaround professionals?

Last night the Senate asked the Legal and Constitutional Affairs Legislation Committee to conduct an Inquiry into:

The ability of consumers and small businesses to exercise their legal rights through the justice system, and whether there are fair, affordable and appropriate resolution processes to resolve disputes with financial service providers, in particular the big four banks

The terms of reference include inquiry into whether “banks generally have behaved in a way that meets community standards when dealing with consumers trying to exercise their legal rights,” which has the potential to extend into the appointment and conduct of receivers.

The Committee is due to report by 8 April 2019.  The full terms of reference are below

(a) whether the way in which banks and other financial service providers have used the legal system to resolve disputes with consumers and small businesses has reflected fairness and proportionality, including:

(i) whether banks and other financial service providers have used the legal system to pressure customers into accepting settlements that did not reflect their legal rights,

(ii) whether banks and other financial service providers have pursued legal claims against customers despite being aware of misconduct by their own officers or employees that may mitigate those claims, and

(iii) whether banks generally have behaved in a way that meets community standards when dealing with consumers trying to exercise their legal rights;

(b) the accessibility and appropriateness of the court system as a forum to resolve these disputes fairly, including:

(i) the ability of people in conflict with a large financial institution to attain affordable, quality legal advice and representation,

(ii) the cost of legal representation and court fees,

(iii) costs risks of unsuccessful litigation, and

(iv) the experience of participants in a court process who appear unrepresented;

(c) the accessibility and appropriateness of the Australian Financial Complaints Authority (AFCA) as an alternative forum for resolving disputes including:

(i) whether the eligibility criteria and compensation thresholds for AFCA warrant change,

(ii) whether AFCA has the powers and resources it needs,

(iii) whether AFCA faces proper accountability measures, and

(iv) whether enhancement to their test case procedures, or other expansions to AFCA’s role in law reform, is warranted;

(d) the accessibility of community legal centre advice relating to financial matters; and

(e) any other related matters.

The Committee is due to report by 8 April 2019.

Inquiries dealing with the conduct and performance of restructuring and turnaround professionals since 2010:

2017 – Senate Select Committee on Lending to Primary Production Customers

2016 – Parliamentary Joint Committee Inquiry into The impairment of customer loans

2015 – Senate Inquiry into Insolvency in the Australian construction industry

2014 – Senate Inquiry into Performance of the Australian Securities and Investments Commission

2012 – Senate Inquiry into The post-GFC banking sector

2010 – Senate Inquiry into The regulation, registration and remuneration of insolvency practitioners in Australia

The Final Report of the Banking Royal Commission

Business and Agricultural lending accounts for only 30-odd pages of the almost 500 page volume 1 of the final Report of the Banking Royal Commission.

Most significantly, the Report recommends broadening the application of the Code of Banking Practice to small businesses with debts of up to $5m (currently $3m).

Notably, the Report recommends against extending the application of the National Consumer Credit Protection legislation to Small Business.

Lending to Agribusiness

The report recommends that internal valuations should be conducted by bank staff independent of the loan origination and loan decision processes.  That may add a little to costs, and cause some delays for remote regional customers, but is otherwise hard to argue against.

The Report also recommends that valuations of agricultural land should be conducted:

in a manner that will recognise, to the extent possible:

  • the likelihood of external events affecting its realisable value; and

  • the time that may be taken to realise the land at a reasonable price affecting its realisable value

The first adjustment would seem to be a complex calculation, and arguably unnecessary –  many would say that the market implicitly adjusts for such factors, and so there is no need to make an explicit adjustment.

The second adjustment seems to seek an allowance for holding costs that would result in a modest decrease in value – but it would have been very much easier if the Report had identified a specific period: six months perhaps?

Dealing with Distressed Agricultural Loans

The Report recommends that banks dealing with ‘distressed agricultural loans’ should:

  • ensure that those loans are managed by experienced agricultural bankers;

  • offer farm debt mediation as soon as a loan is classified as distressed;

  • manage every distressed loan on the footing that working out will be the best outcome for bank and borrower, and enforcement the worst;

  • recognise that appointment of receivers or any other form of external administrator is a remedy of last resort; and

  • cease charging default interest when there is no realistic prospect of recovering the amount charged.

The Report does not provide a definition of ‘distressed,’ and it is not a technical term defined in APS 220, and so unfortunately the practical application of these recommendations is probably not as clear as its author intended.

Currently Farm Debt Mediation is only available where enforcement action has commenced.  The call for earlier availability – which will be supported by banks – will require legislative amendment.

Lastly, least surprisingly, Commissioner Hayne adds his voice to the unanimous calls for a National Farm Debt Mediation Scheme.  The Government has said that it will ‘take action on all 76 recommendations.’  Perhaps we will finally see a National Farm Debt Mediation scheme.

Disclosure of lender-imposed conditions

The 2019 Financial Reporting season has thrown up examples of very specific disclosure of the conditions imposed on listed borrowers by their lenders.

Case 1 – The amount and timing of an equity raise.

Case 2 – A requirement to conduct a ‘strategic review’ of ‘funding options.’

Case 3 – The timing and requirement for an equity raise to meet a balance sheet ratio.

Two-edged sword

Such disclosure is a two-edged sword.

Certainly, potential purchasers of the shares will be very well informed – but at the same time, the disclosure is likely to make it harder for management to achieve a turnaround. Perceived financial fragility may lead key staff to look elsewhere, and will probably make it harder for the businesses to win new business.  In some cases, it will also create liquidity problems if suppliers decide to reduce trade credit limits.*

Why is such disclosure required?

Listed companies have multiple disclosure requirements.  The Listing Rules impose a continuous disclosure regime, with limited exemptions – for example where negotiations are underway, or are confidential to another party.  The Accounting Standards also impose further disclosure requirements.

If disclosure was made to comply with the continuous disclosure regime then arguably it should have been made earlier – when the companies received notice of their lender’s requirements.

Disclosure in the Annual Report suggests that the disclosure was prompted by the auditor’s review of the financial statements – but for an outsider it is difficult to say whether it reflects a belated ‘catch up’ of continuous disclosure, or whether it is intended to ensure compliance with Accounting Standards.

Theoretical arguments about the reasons for the disclosure and whether it is strictly required may not be much help up for companies up against a deadline.  Two of the case studies had audit reports signed on the latest possible date – perhaps they simply ran out of time?

How should directors mitigate harmful disclosure?

Of course it is important that directors ensure that investors are adequately informed – but they should try to avoid do so in a way that makes it harder for the business to achieve a turnaround.

Harmful disclosure can be mitigated – but it becomes so much harder after balance date.

Businesses in turnaround mode should be projecting their compliance with covenants as part of their normal board reporting.  If non-compliance seems likely, then it is important to negotiate with lenders well ahead of any deadline.  Of course, those negotiations are far easier if supported by a well thought-out and comprehensive turnaround plan that will provide comfort that any underlying issues have been identified, and will be addressed.

First published here

My “Hot-Tubbing experience” – giving expert evidence concurrently

One of the more interesting things I have done in the last six months was to ‘hot tub’ – give evidence concurrently with another expert – in the Supreme Court of Victoria.

The standard approach to expert evidence has each side engaging their own expert, who is asked to answer specific questions seen as most central to their own case.  Each expert is cross-examined separately.

The Supreme Court Rules allow the Court to direct experts to confer, and if so, specifically requires them to try to agree.  The experts must then prepare a joint report identifying areas of agreement and areas of disagreement, setting out the reasons for any disagreement.

In the matter I was involved with (which was concerned with compliance with the Banking Code of Conduct) the Court also made orders that that the two experts give evidence concurrently, sitting side by side in the witness box.

Australian Courts are apparently seen as leading the world in the use of concurrent evidence, which has been described as enabling:

“each expert to concentrate on the real issues between them. The judge or listener can hear all the experts discussing the same issue at the same time to explain his or her point in a discussion with a professional colleague. The technique reduces the chances of the experts, lawyers and judge, jury or tribunal misunderstanding what the experts are saying”  Rares J

As well as answering questions from the two barristers and the judge, at times each expert was given the opportunity to comment on the evidence given by the other expert.

The joint nature of the evidence lengthened the time that we were in the witness box to a full day’s hearing.  Even when not being directly questioned it was still necessary to pay close attention because of the possibility of being asked to comment on the evidence given by the other expert.

In my case the other expert was a person I know well, and respect very highly, which in one sense made things easier because we each thought even more carefully before disagreeing with the other!

All in all it was an enjoyable experience, and well worth considering if you have the opportunity.

First published here

Restricting Related Creditor Voting Rights

One of the worst problems caused by the Insolvency Law Reform Act 2016 – the ability to remove an insolvency appointee without Court scrutiny – appears to have been partly addressed by changes to the Insolvency Practice Rules effective from 7 December 2018.

It will no longer be possible for related parties to buy debt cheaply and then vote the full face value to replace an external administrator.  Instead, the related parties’ voting rights will be limited to the amount paid to acquire the debt.

This will be similar to the long standing position in personal insolvency – however in personal insolvency the restriction to the amount paid to acquire the debts applies to all debt sales, not just debt acquired by related parties.

Replacement by non- related creditors

There is still no Court scrutiny on liquidator replacement, so those unrelated creditors who work together to replace liquidators seen as too aggressive in pursuing preferences will not be affected by the changes.

Is ‘assignment’ broad enough?

The rules only apply to assignment of debt.  In modern financial practice there are a range of ‘sub-participation’ and risk sharing arrangements which may achieve a similar outcome but perhaps be outside the scope of the rules as drafted.

Impact on debt traders

Some active debt traders will take equity positions as well as acquiring debt.  In some cases that could mean that they have become a ‘related party,’ with the consequence that their voting rights will be very different under a scheme of arrangement (i.e. intact) compared to a deed of company arrangement (reduced).

Some market participants will recognise the differential treatments, and adjust their strategies to take advantage.  The form of restructuring vehicle may become the next battlefield!

What’s next?

It’s pleasing to see an effort made to fix some of the damage done by the ILRA.  Hopefully work is now underway to fix the other problems such as the  impractical cash handling rules and the odd requirement for registered liquidators to have bankruptcy experience, to name a few.

Banking Royal Commission: SME Lending & Personal Guarantees

The use of personal guarantees to secure SME lending has been the subject of special focus by the Financial Services Royal Commission, especially where the guarantee is provided by an person not directly involved in the business (an ‘Outsider’) – typically a family member who does not receive any real benefit for providing the guarantee.

The Interim Report (available here) raises a number of specific questions around possible changes to the use of guarantees, which are reproduced at the bottom of this post.  The main options are:

Better Information for guarantors

If there is concern that some guarantors are blindly taking a greater legal risk than they realise, then better information might be part of the solution.  In theory, a document like a Product Disclosure Statement could help, but how likely is it to be read and genuinely understood? A more concrete step might be to make it mandatory for a guarantor to take independent legal advice.

If the concern is that guarantors underestimate a financial risk, then the Royal Commission might recommend that guarantors be given the same financial information that is used by the lender to make its decisions. But not all guarantors will have the skills and training to understand financial information – perhaps there will be a requirement for guarantors to also take independent financial advice?

The argument against such measures is that certificates of independent advice will add to costs, and may not change much in reality: as Commissioner Hayne has already highlighted, a parental desire to help family members can outweigh all other considerations.

Prohibiting enforcement of Outsider guarantees

A far more radical option would be to flatly prohibit the enforcement of guarantees given by Outsiders.

The key issue is whether or not lenders would reduce the availability of credit if Outsider guarantees were no longer enforceable, or whether they would continue to lend as they do now.

The  argument that regulatory changes will not impact lenders’ willingness to provide credit was used to support the Code of Banking Practice prohibition against the use of financial covenants in SME lending.  Lived experience shows that it was a wildly optimistic argument then, and it should be subject to more scrutiny now.

It is important to recognise that a blanket prohibition would not just be an issue for new lending.  Unless there are grandfathering arrangements, it would apply to current loans as they expire, and so the potential impact could be massive if lenders decide that they cannot carefully and prudently extend credit to renew those loans.

Case by case?

The commission asks whether their might be circumstances that might justify the release of an Outsider’s guarantee – even if the lender had met the Code of Banking Practice standard of a ‘diligent and prudent banker.’

It might be simple to quickly answer that question with a ‘yes,’ but it is harder to identify examples of such situations and it will be more difficult to develop a new standard that will not impact the availability of SME finance.

Applicability to non-bank lenders

One of the questions that the Royal Commission will need to deal with is whether any new or higher standards should also be applied to non-bank lenders.  If not, many borrowers denied finance by the application of a higher bank standard will turn to non-bank lenders, and take the same loan – but at a higher interest rate.

The Next Phase

The executive summary explains that the next round of public hearings will address the questions raised in the interim report.

The Interim Report of the Financial Services Royal Commission is available here.

7.2    Guarantees

  • If established principles of judge-made law and statutory provisions about unconscionability would not relieve a guarantor of responsibility under a guarantee, and if, further, a bank’s voluntary undertaking to a potential guarantor to exercise the care and skill of a diligent and prudent banker has not been breached, are there circumstances in which the law should nevertheless hold that the guarantee may not be enforced?
  • What would those circumstances be?
  • Would they be defined by reference to what the lender did or did not do, by reference to what the guarantor was or was not told or by reference to some combination of factors of those kinds?
  • Is there a reason to shift the boundaries of established principles, existing law and the industry code of conduct?
  • If the guarantor is a volunteer, and if further, the guarantor is aware of the nature and extent of the obligations undertaken by executing the guarantee, is there some additional requirement that must be shown to have been met before the guarantee was given if it is to be an enforceable undertaking?
  • Should lenders give potential guarantors more information about the borrower or the proposed loan? What information could be given with respect to a new business?

Discussion of how the Interim Report deals with Agricultural Lending is available here.