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,
including:

  • 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.

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.

Financial Services Royal Commission: How the Interim Report deals with Agricultural Lending

The Interim Report of the Financial Services Royal Commission (available here) was tabled in Parliament yesterday.

Section 6 deals with Agricultural Lending, and concludes by identifying a list of ‘key questions’ for further consideration.  The full list is reproduced at the bottom of this post, but for me the most important are:

Farm Debt Mediation

  • Should there be a national system for farm debt mediation?
  • If so, what model should be adopted?
  • Should lenders be required to offer farm debt mediation as soon as an agricultural loan is impaired (in the sense of being more than 90 days past due)?

There is mandatory FDM in South Australia, Victoria, Queensland and New South Wales, and a voluntary scheme in Western Australia.  There is no legislative scheme in Tasmania, the Northern Territory or the ACT.

To replace the current patchwork coverage with a national scheme would be one of the most widely supported and least-opposed recommendations that the Royal Commission could make.  It will be easier for lenders to comply if they do not need to manage up to seven different regimes, but there is more to it than that.  Some borrowers will have farms either side of a state boundary, or will cross a State border to sign loan documents, and it will be easier for them too if only one regime applies.

The NSW system is the most well established, and best developed – it is the model that should be adopted.  There is one feature of the Victorian scheme which should be applied nationwide however: assistance with the cost of mediation so that farmers can always afford to engage.

A current problem is that FDM regimes are only available where there is a default.  It would be helpful if mediation schemes could be accessed prior to that point, but the proposed linkage to the loan being ’90 days past due’ does not go far enough.  A better option would be to also allow access to the scheme where a lender has determined that it is not prepared to extend a current loan.

Conduct of valuations

  • How, and by whom should property offered as security by agricultural businesses be valued?
  • If prudential standard APS 220 is amended to require internal appraisals to be independent of loan origination, loan processing and loan decision processes, when should that amendment take effect?

To those of us in capital cities the answer seems clear and obvious: a banker originating a loan should never be involved in valuing the security.

A farmer west of Longreach however, might be frustrated to be told that their loan approval will be held up until someone can get out from head office, and that they will need to meet the travel and accommodation costs.

There does need to be some allowance for a local banker with appropriate training in remote locations to conduct valuations for relatively small loans or small increases to existing loans.

Should LVR ratios be capped?

  • Is the possibility, or probability of external shock sufficiently met by fixing the loan-to-value ratio?

A maximum LVR sounds like a practical way of ensuring that borrowers retain some level of buffer to allow them to cope with external shocks – but it will be a double-edged sword.  A hard-coded LVR limit would also stop lenders from providing carry on funding – potentially forcing the sale of farms.

Enforcement only as a last resort

  • In what circumstances may a lender appoint an external administrator (such as a receiver, receiver and manager or agent of the mortgagee in possession)?
  • Is appointment of an external administrator to be the enforcement measure of last resort?

Each of the banks that gave evidence would agree that the appointment of an external administrator should be the last resort.  The difficulty arises in practice: what does ‘last resort’ actually mean, and when has that point been reached?

It is significant that all but one of the case studies were either from states without mandatory FDM, or pre-dated the current FDM.  There is good reason to think that FDM has played an important role in avoiding the need to enforce at all.

Not only does FDM provide an unmistakable signal to all parties that the point of ‘last resort’ may be approaching, at the same time it provides them with an alternative to enforcement.

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.

5.0 Issues that have emerged

All agricultural enterprises are subject to the effects of events beyond the control of the individual farmer. Occurrence of any of these events, let alone a combination of them, will affect cash flow and profitability and, hence, the ability to service debts. Their occurrence will often have profound personal effects on those who conduct the business.

Four issues emerged: about revaluation of securities; difficulties in obtaining access to banking services and appropriate support; changes to conditions of lending; and, enforcement by appointment of external administrators.

The particular questions can be identified as including:

  • How are borrowers and lenders in the agricultural sector to deal with the consequences of uncontrollable and unforeseen external events?
  • Does the 2019 Banking Code of Practice provide adequate protection for agricultural businesses? If not, what changes should be made?
  • How, and by whom should property offered as security by agricultural businesses be valued?
    • Is market value the appropriate basis?
    • Should the possibility, or probability of external shocks be taken to account in fixing lending value? How?
    • Should the time for realisation of security be taken to account in fixing value? How?
    • Is the possibility, or probability of external shock sufficiently met by fixing the loan-to-value ratio?
    • If prudential standard APS 220 is amended to require internal appraisals to be independent of loan origination, loan processing and loan decision processes, when should that amendment take effect?
  • Should distressed agricultural loans be managed only by experienced agricultural bankers?
  • Do asset management managers need more information (such as the cost to the lender of holding the loan) to make informed commercial decisions about management of distressed agricultural loans?
  • Are there circumstances in which default interest should not be charged?
    • In particular, should default interest be charged to borrowers in drought declared areas?
    • If it should not, how, and where, is that policy to be expressed?
    • Should the policy apply to other natural disasters?
  • In what circumstances may a lender appoint an external administrator (such as a receiver, receiver and manager or agent of the mortgagee in possession)? Is appointment of an external administrator to be the enforcement measure of last resort?
  • Having regard to the answers given to the preceding questions:
    • Is any regulatory change necessary or desirable?
    • Is any change to the 2019 Code necessary or desirable?
  • Should there be a national system for farm debt mediation?
    • If so, what model should be adopted?
  • Should lenders be required to offer farm debt mediation as soon as an agricultural loan is impaired (in the sense of being more than 90 days past due)?

How do we measure up? Australian treatment of SME borrowers

The first hearings of Australia’s Banking Royal Commission began in March 2018 – only one month after the final conclusion of a long running UK review into the post-GFC handling of problem loans by UK’s Royal Bank of Scotland.

A so-called ‘Skilled Person’ report was commissioned by the UK Financial Conduct Authority in January 2014, and delivered in September 2016.  But it was only released to the public in February 2018 when an apparently impatient Parliamentary Committee acted unilaterally by publishing the full report online here.

Whereas the Royal Commission hearings in June 2018 presented a small and carefully curated selection of customer complaints, the RBS review conducted an extremely detailed analysis of more than 200 cases – an unprecedented insight into the working of a workout team.

The background to the report is discussed in detail here.

The report concluded that there was ‘widespread inappropriate treatment of customers’ by GRG – RBS’ workout team.  It included recommendations for RBS specifically, and also made recommendations ‘for the wider market.’  Both are reproduced in full below.

How does Australia measure up against the RBS report recommendations?

At a time when there appears to be fierce scrutiny of the treatment of small business borrowers by Australian banks,  it is appropriate to measure the current Australian position against the four general recommendations contained in the RBS report:

1.  Extension of Unfair Contract Terms protections to SMEs

The UK’s Unfair Contract Terms regime does not apply to SME businesses at all.

The Australian UCT regime does not completely align to the UK regime (for a careful comparison see here) but what is in place does apply to loans of less than $1 million to small business (defined as those with fewer than 20 FTE) made or varied after 12 November 2016.

The ASBFEO and others argue that the $1m limit is too low, but Australia at least has some coverage.

2.  Greater access to the Financial Ombudsman Service

In the UK, ‘micro-enterprises’ (an EU definition: businesses with an annual turnover of up to two million euros and fewer than ten employees) can access their FOS scheme, with compensation awards limited to £150,000.

In Australia, the current FOS scheme compensation is limited to $323,500.  At present then, the UK and Australian schemes provide broadly similar coverage, however from 1 November 2018 the new Australian Financial Complaints Authority will commence operations.  AFCA will have power to award compensation of up to $1m in relation to business credit facilities up to $5m provided to businesses with less than 100 staff.

As of 1 November the Australian scheme will therefore be available to micro, small, and medium businesses, and it will provide significantly larger compensation.  Australian businesses will clearly have better protection from 1 November than their UK counterparts.

3.  Introduction of a Code for bank support of customers

There is a ‘Lending Code’ in the UK, but it provides limited guidance in the area of bank support, and in any event it only applies to micro-enterprises.

The Australian Code of Banking Practice – approved by ASIC last week, but to apply no later than 1 July 2019 – is available here.

The CoBP is stated to apply to ‘small businesses’ (yet another definition!): those with fewer than 100 staff and annual turnover of less than $10 million in the previous financial year, and less than $3 million total debt.

Part 6 of the CoBP sets out protections for small businesses.  Perhaps the most significant development is a limitation on the recovery of loans based on the grounds of non-monetary default.  That said, careful explanation is required because some non-monetary defaults will still apply if material: formal insolvency, lapsing of insurance, failure to provide correct and complete information, a loss of license or breach of law, or use of the loan funds for an unauthorised purpose.  There also specific types of loans where ‘financial indicator’ non-monetary defaults are ‘ruled in’ : margin lending, SMSF loans, bailments, invoice finance, construction finance, foreign currency loans and tailored cash flow lending.

Other changes include:

  • A minimum 30 days’ notice of enforcement action (albeit with some exceptions where special risks are evident).
  • A minimum of 3 months’ notice where a bank decides not to extend a loan beyond its original term.
  • A blanket prohibition against the use of ‘material adverse change’ clauses.
  • Clarity around valuation processes: clear explanation around the purpose of the valuation, with copies of property valuations and valuer instructions to be provided to the borrower unless enforcement action has already commenced.
  • An undertaking to ensure that valuers and investigating accountants are members of professional organisations with appropriate codes of conduct.  Banks must apply additional internal oversight if investigating accountants are to be appointed as receivers.

ASBFEO argues that the $3m limit is too low and should be increased to $5m, but again, Australia is clearly ahead of the UK in relation to a formal code of practice.

4.  Dealings with third-party providers, especially in relation to secondees.

The RBS report identified issues which it said gave rise to concerns that third-party service providers ‘may be too ready to see the bank’s point of view.’  Most would expect that a service provider would work hard to see things from a clients’ point of view however, so it is not clear at first reading what criticism was intended by the authors of the report.

More clearly, the report identifies the need for controls around distribution of sensitive information to advisers, and the potential for conflicts of interest where secondees are involved.

Most lenders would have their own controls around such issues, but there is no industry standard in either the UK or Australia.

Recommendations do not apply to non-bank lenders

The RBS recommendations refer specifically to ‘banks’ rather than ‘lenders.’

At least in Australia, the market share of non-banks is growing strongly in some sectors.  Some part of that growth may be due to a customer preference for Fintech offerings, but it also reflects the lack of alternatives for borrowers who are excluded by the CoBP criteria (for example, those who are ‘asset rich’ but ‘income poor’), or seeking funds in areas where bank portfolio management issues translate to limited appetite (currently: property development).

Some critics of banks may argue that it is appropriate that banks are subject to a higher standard than other lenders.  Leaving the merits of that argument to one side, it raises an interesting policy question: is there a need for non-bank borrowers to have a real understanding of which regime applies, or is it acceptable for that to be left to the ‘small print’ of the loan agreement?

Overall

It may not suit the narrative of some bank critics, but protection of small business bank customers is greater than that available to small business non-bank customers, and it is clear that both have significantly better regulatory protection in Australia than their UK counterparts.


 

Part 7 of RBS Group’s treatment of SME customers referred to the Global Restructuring Group (available online here) is reproduced in full below.

Part 7 – Recommendations

7.1  Throughout this report, we have Identified Issues relating specifically to RBS, but we also believe that there are wider lessons for RBS and for the industry as a whole.  In this Part we draw together specific recommendations for RBS and draw out some wider observations in the light of our findings.

7.2  The FCA has instigated a review of its own approach to SMEs as users of financial services and we see our report and its recommendations as a contribution to that work.  There are also Important Implications for other lenders, the professionals with whom they work, policy makers, and SME customers.

Recommendations for RBS

7.3  The conclusions we have reached in this report warrant a fundamental rethink by RBS of how it handles Its SME customers in financial distress.

7.4  We recognise that some change was already being made at the end of the Relevant Period. But the terms of reference for Phase One meant that we did not review whether or not the lessons from these events have been learnt by RBS, or whether the wide-ranging changes that we consider to be necessary have been made and are embedded.  As we did not review changes made by RBS after the end of the Relevant Period we recognise that some of the recommendations set out below may already have been addressed or their relevance superseded by subsequent events but nonetheless they provide a framework within which future treatment of SME customers can be developed and provide an opportunity to address the weaknesses in governance and oversight, and indicators of poor culture in GRG that we have highlighted In this report.

7.5  We recommend that a review is carried out to ensure that our conclusions and recommendations that remain relevant to RBS have been implemented and in particular, to provide assurance to RBS, customers and the FCA that adequate governance and oversight arrangements are now in place to ensure that similar poor treatment of distressed SME customers could not happen in future.

7.6  Specifically we recommend that in carrying out that review RBS should, in the light of the observations and conclusions in this report:

  • Improve its governance arrangements and in particular*:
    • Review the objectives set for its turnaround division – the revised objectives should be agreed by the RBS Group Board;
    • Review the governance of its turnaround division to ensure that it is subject to effective scrutiny, and establishes effective second and third lines of defence;
    • Review the content and form of management Information to ensure that customer outcomes and experience are accurately reported:
    • Review the staff objectives set for, and culture of, those In Its turnaround unit dealing with SME customers to ensure that these more closely align with the revised objectives the RBS Board has agreed;
  • Improve the arrangements around transfer into and out of the turnaround unit:
    • Revise the criteria for the consideration of referral to the turnaround unit In respect of SME customers;
    • Review the governance of the transfer process for SME customers to ensure that It is acting both efficiently and fairly: specifically we recommend that the chair of the group considering transfers should be independent of both B&C and the turnaround division;
  • Ensure that its arrangements for returning customers to mainstream banking are clearly signposted to SME customers and that where RTS is appropriate this can be expedited promptly;
  • Provide a greater focus on turnaround options where these are viable:
  • Review and Improve Its training and guidance for staff handling turnaround issues and ensure that staff have the necessary support and training to deliver good turnaround practice;
    • Ensure in future that viability assessments are carried out on all cases following transfer and that where customers are potentially viable, a clear turnaround plan with milestones and targets should be produced and wherever possible shared and agreed with the SME customer;
    • Review the role and purpose of the Strategy and Credit Committee (or its successors) to ensure the terms of reference contain a requirement that turnaround options and the fair treatment of customers are reviewed in addition to credit considerations;
  • Rethink its approach to pricing in respect of distressed SME customers:
    • Review the policy and practice of the turnaround unit on pricing to ensure that Relationship Manager pricing decisions and reasoning are fully documented and validated and that turnaround considerations are taken Into account;
    • Review the range and form of fees and other charges for SME customers and set out for customers a clear and simple guide to when fees wiII be applied;
    • Review the rationale for an additional administrative/management fee being routinely levied on distressed customers;
  • Ensure any internal valuations are handled more carefully:
    • Ensure that internal valuations and the reasoning behind them are fully documented and that this information is shared with the customer if the valuation is to be used in the development of strategy, or in decisions around the level of facilities or pricing;
    • Where in-house resources are used to provide valuations upon which significant decisions are made In the context of a turnaround unit, RBS should ensure that there is a clear separation of functions and adequate safeguards to prevent conflicts of Interest;
  • Review its policies and practices on dealing with customers and on complaints:
    • Review its policy and procedures for Relationship Managers’ engagement with SME customers. In particular RBS should consider how Its engagement with SME customers takes appropriate account of the different circumstances of the diverse group of SMEs with which it deals;
    • Review and revise its communications with customers to ensure that it is transparent, clear and informative,
    • Revise its approach to complaint handling and provide SME customers with clearly signposted routes to escalate their complaint if necessary;
  • Review its use of third-party firms and in particular the use of secondees’

RBS should ensure that appropriate guidelines and mechanisms are in place to guard against conflicts of interest in these areas;

  • Fundamentally review its approach to the purchase of distressed assets:

Amend the governance, policies and practices and other arrangements relating to circumstances where it (West Register) acquires or considers the acquisition of assets owned by its distressed SME customers to address the shortcomings in arrangements that we have Identified and ensure effective separation of the function from any turnaround unit;

  • Review the use of Upside Instruments in the context of SME customers:
    • Review the Information provided to SME customers In relation to PPFAs to ensure that the agreements and the associated costs are transparent; and
    • Review the role of EPAs In relation to SME customers, in so far as RBS Judges their continued use is justified and helpful to some customers it should further consider customer communication, minimum timescales and notification of buy-back terms, the governance around the arrangements and more widely the Interaction between SIG, the turnaround unit and SME customers

7.7  Addressing these recommendations will help ensure that similar problems to those experienced In RBS’s GRG during the Relevant Period do not occur in future.  These recommendations do not, however, address the concerns and Issues of those SMEs that were handled by GRG.  We make two recommendations that are intended to address specific unfairness that we observed during the course of our review.  These are:

  • Revisit the cases Identified in our review where it Is clear that GRG failed to respond to a complaint or where Its response was Inadequate, and
  • Review the position of those SME customers who entered Into an EPA during the Relevant Pernod with a view to ensuring that where a West Register minority holding in their business remains in place that they have a fair means of resolving disputes about the value of that holding.

7.8  But those specific recommendations do not address the central findings of our review.  We have identified a number of cases where we conclude that the actions of RBS are likely to have caused material financial distress to the customers affected and there are other cases where it seems clear that the customer will have suffered from some unfairness.  It is understandable that there will be calls for RBS to compensate the customers affected.

7.9  As we have noted previously the extent and nature of financial distress vary considerably and are often hard to quantify with any precision.  The circumstances of GRG customers often meant that the Bank had considerable discretion under the law, and those Individuals who suffered may not have a straightforward legal position.  In any case, for example because the company was the Bank’s customer, and they may no longer be the owners, or the company may have ceased to exist.  The inappropriate actions we identify and their wide ranging consequences for customers were not caused by breaches of regulatory rules or principles so the scope for regulatory action is limited

7 10  Responsibility for responding to these Issues and the distress GRG caused many of its customers rests with the Board of the RBS Group.  We do not underestimate the challenges of any redress scheme it would likely require independent, lengthy and complex mediation, operating outside the strict legal framework.

7.11  Nevertheless we recommend that RBS should consider the practicalities of providing redress to GRG customers who are likely to have experienced financial distress as a result of its actions.

7.12  There are also some wider Issues for RBS to consider. First the extent to which the Issues we report here In respect of GRG were or In particular remain features of other units handling SME customers.  We recommend that RBS reviews the relevance of these findings more widely to its handling of SME customers.

7.13  Second the terms of the Requirement Notice meant that we did not review the extent to which those in RBS outside GRG were aware of the Issues.  In any event it appears to us that there are wider lessons for RBS to consider in terms of how the events in GRG could have continued for so long apparently either unnoticed or unchallenged by others in the wider RBS Group.

Lessons for the wider market

7.14  The FCA has, as noted above, Instigated a review of its own approach to SMEs as users of Manual services.  Our report and its recommendations can be viewed as a contribution to that work.  Our findings highlight the diversity of SMEs and the Inequality of bargaining power between less sophisticated SMEs and banks.  They also underline the lack of protection available more widely to SMEs.

7.15  The case for standards – established either by regulation or by agreement – In relation to lending to SMEs Is derived from the special features of the market, as described In the CMA/FCA Market Study and the  wider CMA Retail Banking – SME market Investigation: a sector with high concentration in lending, the lack of understanding of many SMEs as to the pricing of banking products Including loans, and the paradox of Simultaneous low levels of satisfaction and of switching among SME bank customers.  As our work has shown, SME customers facing hardship may have even more limited choices.  They  will often have little realistic prospect of changing their banking arrangements – whatever their level of satisfaction or dissatisfaction  with the services provided, and whatever the price of those services.  This Is particularly the case during periods of economic uncertainty

7.16  The SMEs In our sample illustrate the variety of SMEs that banks have to deal with.  They included some SMEs with a reasonable level of financial sophistication who had available to them expert advice; but they also included SMEs without access to Independent advice, and with little financial experience.  Even when a SME had some reasonable understanding of financial Issues, this was not necessarily sufficient for the increased complexity of the Issues which often arose once the SME was transferred to GRG, where the situation could be complicated both by general legal issues such as the different protections and treatments offered to limited companies and to sole traders, and by the complexity of the solutions which GRG on occasion brought forward.  There were other important differences some were In effect sole traders or owner managers where the sickness of a key individual could have catastrophic consequences for the business for some smaller customers the lending was closely intertwined with personal financial arrangements, so that when things went wrong in the business the consequences were personal as well as professional.

7.17  We have noted that GRG had few arrangements for drawing such distinctions in its customer base and for shaping its services and communications with an eye to these differing levels of capability. Indeed, it is not clear that RBS now accepts the need for this.

7.18  We believe that policies and practices for the SME sector need to be based at least In part on an appreciation of differing customer capabilities, if the SME customer is to be treated fairly. This is not readily defined by arbitrary limits such as amounts of debt or even turnover. But it will be relevant to take account of the stage in the banking relationship reached by the customer, to ensure that products, services and communications are appropriate for the needs of the SME customer.

7.19  The present regulatory protections for SME-related conduct are limited. Given the widespread inappropriate actions Identified in this report in relation to lending activities, we consider that the FCA should work with the government and other relevant parties to extend the protections available to SME customers.

7.20  One option would be to extend the regulatory perimeter to bring SMEs  within the scope of FCA’s regulated activities, to ensure that regulatory action can be taken to guard against unfair treatment of customers and that the principles for  business and standards of good governance and personal respon5ibility apply to this sector as they do to other parts of retail banking However a higher priority may be to give SMEs avenues to challenge banks where they are treated unfairly For example consideration should be given to extending the unfair contract terms protections to SMEs, and giving them greater access to the F0S.

7.21  Contracts with SMEs for the provision of credit facilities and other services can be markedly more complex than their retail market equivalents. In part this reflects limited protections for SMEs – in particular the Unfair Terms in Consumer Contracts Regulations (UTCCRs).

7 22  As a result, SME contracts can give banks  wide discretionary rights to vary terms that would not be compliant with unfair contract terms provisions in a retail setting.  The lack of unfair contract terms protections, taken together with the restricted access to redress/dispute mediation for SMEs, can give rise to a risk of unfair treatment of customers.  Whilst some discretion may be inevitable given the nature of the products involved, the ability of banks to change lending criteria, or to treat many loans as well as overdrafts as ‘on demand’, means that banks have a wide discretion that SMEs cannot readily plan against or challenge.

7.23  The Law Commission’s recommendation” that Unfair Terms in Consumer Contracts provisions should be extended to at least some SME customers has not been progressed.  Coupled with the restrictions on access to dispute resolution services, this can place SMEs at a material disadvantage

7 24  A concern raised by many SME customers in our sample related to the absence of any serious consideration of their complaints while RBS had a policy to respond to complaints in line with its requirements under regulatory rules, many SME customers were not micro-enterprises and as such complaints from them were not covered by DISP.  That meant the Bank had no regulatory obligations to handle complaints promptly, to investigate them fairly or to consider the root causes of such complaints. And there was no obligation to record and report on those complaints or to publish information about them.

7.25  For customers other than micro-enterprises there is no access to the F0S.  The ability, alternatively, to litigate for most of these customers will be limited, litigation is notoriously slow and costly and detracts from the running of the business.  FCA is committed to reviewing the scope of FOS following the report of the Banking Standards Commission. But the micro-enterprise definition is not the only barrier facing SMEs in their dealings with FOS. Even for micro-enterprises, the F0S award limit (£150,000), coupled with the inability to litigate for any additional compensation Following a FOS decision, limits the relevance of FOS as a redress option

7.26  We encourage the FCA to work with the government to ensure that there are adequate protections for the less sophisticated SMEs.  This could include the extension of the unfair contract terms protections to SMEs and greater access to the F0S.

7.27  An alternative (or supplementary) approach would be to develop professional standards governing banks’ lending to SMEs.  The Lending Code applies to some SMEs, but only micro-enterprises.  It includes some provisions on helping micro-enterprises who are experiencing financial difficulties and complaints handling.  The Lending Code is monitored by the Lending Standards Board.

7.28  In relation to turnaround divisions the need for additional protection for SME customers is more acute.  At present there are no generally recognised professional standards for turnaround or restructuring units in the UK, although various guides and codes exist which are seen as relevant.  These include for restructuring the IMF Restructuring Guidelines, the ‘London approach’ and the INSOL Principles. Both the Insolvency Practitioners Association and the Institute for Turnaround publish codes of ethics, and the latter has recently published a ‘Statement of Principles for the UK ‘ Business Support Units’ of Banks’.

7.29  The principles cover Issues we identified as part of our review, including provisions on treating customers sympathetically, communication, appropriate pricing and complaints handling. They have been endorsed by several banks. However, there is little transparency about what banks have done to ensure that they meet the principles, and it seems no independent monitoring of compliance with the principles it is unlikely, therefore, to give customers confidence that this will make a difference to their treatment in future.

7.30  Both the Lending Code and the Institute for Turnaround Statement may have a useful role here.  What is Important is that any self-regulatory action has the confidence of both banks and customers and has demonstrably effective independent oversight and monitoring.

7 31  We encourage the industry and customer groups to develop a code on how banks can best support customers in need of business support.  Such a code should be subject to independent oversight and monitoring.

7.32  The situation In RBS and GRG was particular to that organisation at that time.  Nevertheless the themes raised in this report may have wider resonance as banks consider how they should further develop turnaround units.  For example, a concern that was raised with us by some stakeholders was the nature of the relationship between lenders and various professional firms that support the turnaround or Insolvency process.

7.33  Inevitably banks are a major user of accounting/Insolvency, valuation and legal services.  Given their scale and scope providers of these services will understandably wish to have strong and constructive relationships with banks.   A complex pattern has emerged of links between Individual suppliers and banks which, It Is argued, includes frequent use of secondees from professional firms, complex and sometimes non-transparent fee and revenue agreements between advisers and individual banks, and questions around the control of sensitive information between the banks and their advisers

7.34  Such Issues can give rise to concerns about the availability of qualified third-party support with the relevant experience to support customers (given that most with experience will have extensive conflicts with the banks serving those customers) There is also a perception that customer perspectives will be Ignored because of the commercial significance of meeting wider bank requirements where a bank Is a major client of a specific adviser and that the professionals may be too ready to see the bank’s point of view.

7.35  In the case of GRG we identified weaknesses in the management of potential conflicts of interest, in particular around the use of secondees. It was not surprising that many customers were left with the Impression that third-party providers were too close to the Bank. But a more general comment is that, whether or not such behaviours take place, the absence of agreed standards can create a suspicion of inappropriate practice, particularly where clients are facing economic distress, even If this may not In fact exist.

7.36  We suggest that banks should review how they interact with third-party providers, especially in relation to secondees.

7.37  More generally we suggest that banks should review their own turnaround units with a view to ensuring that the lessons from this report in so far as they are relevant to other institutions are applied more widely.

Subsidiary roman numerals do not reproduce in WordPress format, so they appear here as second-order bullet points

Continuous Disclosure, Class Action Regulation, and Restructuring

The continuous disclosure regime presents additional challenges for directors trying to turn around a listed company.  The turnaround itself will probably mean that that there is more to keep the market informed about, but there is more to it than that.  A perceived failure to properly disclose may well lead to a class action, adding to the workload of an already busy management team and board, as well as adding to the list of creditors.

Perhaps the most extreme example is that of Surfstitch, where on one analysis the commencement of a class action claim resulted in a majority of directors concluding – incorrectly in the view of the administrator that they appointed – that their company was insolvent. For these reasons, turnaround and restructuring professionals should have a keen interest in the outcome of a recently commenced Australian Law Reform Commission review.

Background

In December 2017, the Attorney-General asked the ALRC to inquire into the regulation of class actions and those who fund them, with a report due by 21 December 2018.

After a series of bilateral consultations with forty-three parties: regulators, funders, lawyers and other industry participants, the ALRC issued a discussion paper (available here) on 31 May 2018.

A ‘standard approach’

The discussion paper identified what it described as a ‘standard approach’ by litigation funders:

Litigation funders and/or plaintiff law firms (or their hired experts) identify a significant drop in the value of securities.  This is analysed to determine whether it is likely that the relevant drop had been occasioned by the late revelation of material information.

Typically, the analysis determines whether or not it is likely that there is a sufficient basis for assuming the existence of contravening conduct during a period prior to the eventual announcement of the material information.  The litigation funders and/or plaintiff law firms then determine the size of the potential loss that may have been occasioned by the suspected period of contravening conduct.  The duration of that period may extend back for a considerable period, as in the recently announced class actions against AMP where a period of five years has been identified.

Once the funders and/or lawyers are satisfied that there is a sufficient basis for assuming the existence of contravening conduct, funding terms are discussed and (at least prior to the advent of the common fund order) there is an effort to sign up institutional and other group members (complex questions relating to issues of privacy and data sets are likely to arise in this context).  During this developmental stage, an announcement might be made of a potential class action, attracting media attention which may augment the number of affected shareholders who wish to participate in the proposed class action

To address the problems it identifies, the discussion paper has recommended:

The Australian Government should commission a review of the legal and economic impact of the continuous disclosure obligations of entities listed on public stock exchanges and those relating to misleading and deceptive conduct contained in the Corporations Act 2001 (Cth) and the Australian Securities and Investments Commission Act 2001 (Cth) with regards to:

  • the propensity for corporate entities to be the target of funded shareholder class actions in Australia;
  • the value of the investments of shareholders of the corporate entity at the time when that entity is the target of the class action; and
  • the availability and cost of directors and officers liability cover within the Australian market.

The impact of the continuous disclosure regime is is arguably outside the terms of reference so perhaps it is difficult for the ALRC to do more than it has, but the recommendation of a further review will not quickly take us closer to a solution.

Those with practical suggestions should make a submission, due before 30 July.