Responsible Lending guidance in turmoil following decision by the Federal Court in the Westpac case

1. The Case

The decision of the Federal Court of Australia in Australian Securities and Investments Commission v Westpac Banking Corporation (Liability Trial) [2019] FCA 1244 handed down on Tuesday, 13 August 2019 has set the “cat amongst the pigeons” and embarrassingly comes only days before the next round of ASIC public consultations on how Regulatory Guide 209 (Responsible Lending) should be updated.

While it is really too early to assess the full impact of the decision on the responsible lending practices of lenders, one thing is clear and that is that the responsible lending guidebook will need to be substantially rewritten.

2. The First case on Responsible Lending

The first and the most important issue to be mentioned is that as far as the Federal Court is concerned, this is the first case on “responsible lending”

At paragraph 92 of the Judgement we note the following comments:

92: For completeness, I should note that ASIC submitted that its construction was supported by a number of decisions of this Court…

…I do not accept that any of these cases is of assistance. ASIC v Cash Store was an undefended case. There was no debate about the issue which is presently before the Court.

…Accepting in ASIC’s favour that there are various brief remarks in these judgments which are consistent with its proposed construction, the short fact is that none of these statements results from a contested hearing or any process of analysis by the Court: cf. CSR Limited v Eddy [2005] HCA 64; 226 CLR 1 at 11-12 [13]-[15] per Gleeson CJ, Gummow and Heydon JJ.

In my opinion, these decisions have no value in the present contest.

3. Westpac Saves $35 million

In November 2018, the Federal Court refused to accept a proposal made jointly by ASIC and Westpac to resolve proceedings brought by ASIC proposing that the Court impose a civil penalty of $35 million on Westpac for contravening the National Consumer Credit Protection Act 2009 (NCCP Act) in assessing the suitability of home loans for customers in the period between 12 December 2011 and March 2015.

In his reasons for refusing to make the orders the parties had proposed, The Honourable Justice Perram said that the conduct expressed in a declaration proposed by the parties was not conduct that “could possibly be a contravention of section 128”

By this judgement, Westpac has saved itself $35 million plus legal costs.

4. Issues on which the case was decided

The case was decided on narrow issues.

4.1. Taking Declared Living Expenses into account in the credit assessment process

The first issue in contention was whether Westpac, in using an automated decision system (ADS) to conditionally approve home loan applications, had taken into account the “declared living expenses” of applicants. It was not about “all” expenses or income – only “declared living expenses”. The case did not touch on “verification” of expenses nor whether a loan met the customer’s “requirements or objectives”.

4.2 Determining affordability of loans with an Interest Only Period

The second issue decided by the Court was whether an assessment of unsuitability in relation to interest only loans requires the credit assessment to be made by reference to the level of repayments due after interest only period had ended (i.e. on principal and interest repayments) rather than on repayments averaged over the whole term of the loan. The Court rejected ASIC’s submissions in this regard and found in Westpac’s favour that averaging was acceptable.

4.3 Royal Commission acknowledged limitation of scope of case

The Royal Commission acknowledged that “verification was not considered in the case”.

I observe that the Statement of Agreed Facts filed by the parties for the purposes of the application determined by Perram J said nothing at all about ‘verification in accordance with section 130’ (as mentioned in section 128(d)) and nothing about the operation of section 130(1)(c) requiring a licensee, for the purposes of section 128(d), to take ‘reasonable steps to verify the consumer’s financial situation’.

5. The Court’s decision

5.1 The 1st Issue – taking Declared Living Expenses into account in the credit assessment process

The Court ruled that Westpac had sufficiently taken into account the declared living expenses of loan applicants in conducting the credit assessment. ASIC’s claim that Westpac had not taken into account the declared living expenses of loan applicants failed on the facts.

The Court further decided that ASIC’s assertions as to the way in which NCCP Act operated were not correct.

In the Westpac loan application process, customers’ “declared living expenses” were taken into account along with a range of other matters which did not invalidate the credit assessment made.

Specifically, one of the assessment rules under the ADS was the “70% Ratio Rule”. Under that rule, the customer’s situation was analysed in terms of “risk of default”.

ASIC submitted that:

Credit risk to the bank, on the one hand, and the inability of the consumer to meet the financial obligations under the credit contract, on the other, were not identical matters…….. the fact that a credit provider reached the conclusion that there was no credit risk in the case of a consumer did not ‘necessarily mean that it met the standard in the legislation’. (Paragraph 25)

In response the Court stated that:

I do not accept that a rule whose purpose is to gauge the risk of default is not also a rule with respect to the ability of the consumer to meet their financial obligations under the credit contract …… (Paragraph 25)

It seems that the emphasis has shifted back to lender considerations as a consequence of this Judgement.

5.2 Determining affordability of loans with an Interest Only Period

The Court rejected ASIC’s submissions and found in Westpac’s favour that averaging was acceptable

6. The Analysis of the Court – the 1st Issue

The Court could have stopped there – findings that the alleged breaches of responsible lending obligations were not proved on the “facts”, but the Court went much further.

What makes this case so interesting and important is how the Court interpreted the requirements of the responsible lending obligations contained in the NCCP and the implications that flow from that interpretation.

6.1 Credit Assessment

The crux of the issue as far as the Court was concerned was whether Westpac has complied with its responsible lending obligations in conducting its credit assessments.

The Court said that there were basically 2 questions that Westpac had to answer when conducting a credit assessment pursuant to section 129 of the NCCP relating to the Assessment of unsuitability of the credit contract. These questions were determined by the provisions of section 131(2).

The 2 questions to be answered are:

whether the consumer will be unable to comply with their financial obligations under the contract (i.e. make the repayments) (Question 1)
whether the consumer, whilst able to afford the repayments, will not be able to do so without being placed in circumstances of substantial hardship (Question 2)

6.2 ASIC argued that credit provider in performing a credit assessment must base that on the consumer’s financial information

ASIC argued differently. ASIC tried unsuccessfully to roll the obligation to make reasonable inquiries about a consumer’s financial situation (under section 130) into the credit assessment process.

ASIC argued that it was mandatory that the credit assessment be based on the results of the inquiries about the consumer’s financial circumstance (certainly in relation to “declared living expenses”)

That proposition was considered problematic by the Court (paragraph 60) and was ultimately rejected by the Court.

6.3 The Process by which the Court arrived at its conclusion on the 1^st Issue

This is the way the analysis progressed:

ASIC accepted that a credit provider did not need to take into account all of the information gathered under its enquiry process about the consumer’s financial position (paragraph 65).

However, ASIC argued that the credit provider at a minimum needed to assess the individual consumer’s financial situation as a whole (paragraphs 65 and 67).

The Court noted that ASIC’s argument (with regard to gathering information about the financial situation of a consumer) does not identify what a credit provider is to do with the financial information it has gathered. (paragraph 69).

ASIC conceded that what the credit provider did with the information about the financial situation of the borrower was ‘legitimately up to the lender’ (paragraph 69).

The Court agreed that it was mandatory that the credit provider ‘must at least conduct an assessment of the consumer’s financial situation with a sufficient understanding of the consumer’s income and expenses’ (paragraphs 70 and 71).

But, the Court then goes on to ask what is it that the credit provider is actually meant to be doing with the information obtained?

The Court concluded that the only statutory purpose for which the financial information is collected is to answer the 2 questions that need to be answered in the credit assessment process (paragraph 70).

The Court concludes that it is unable to discern why information about a consumer’s declared living expenses is a mandatory matter that must be considered as part of the credit assessment process in answering Question 1 (paragraph 73).

The Court acknowledged that “stated living expenses” of a borrower were not immutable. A borrower could adjust their expenses in order to be able to afford the loan repayments – give up gym memberships, not take an overseas holiday etc. (paragraphs 74 and 78)

The Court provides a worked example in relation to answering Question 1 (whether the consumer will be unable to comply with their financial obligations under the contract (i.e. make the repayments))

74:

A worked example illustrates the problem. Let it be assumed artificially that a consumer with a monthly after-tax income of $4000 has three declared living expenses of food ($1200 per month), utilities and internet ($200 per month) and gym memberships ($200 per month). The declared living expenses are therefore $1600 per month and the consumer will have a surplus of $2400 per month. If the consumer proposes to take out a home loan which will require monthly repayments of $2500 the outgoings will then be $4100 per month as opposed to the after-tax income of $4000 per month. The consumer will therefore have a shortfall of $100 per month.

75:

But this does not tell one that the consumer cannot afford to meet the repayments. One reason this is so is because the consumer may choose to discontinue their gym memberships and meet the repayments in that way. The problem for ASIC’s argument is that the mere fact that there are living expenses is not necessarily relevant to whether a consumer will be unable to comply with their loan obligations because it is always possible that some of the living expenses might be foregone by the consumer in order to meet the repayments.

77:

Without additional information, I do not consider that it is possible to accept that the consumer’s declared living expenses tell one anything about their capacity to meet the repayments under the loan…

The Court reaches a similar conclusion in relation to the relevance of “declared living expenses” in relation to Question 2 (whether the consumer, whilst able to afford the repayments, will not be able to do so without being placed in circumstances of substantial hardship):

78:

Here the issue is not whether some or all of the declared living expenses can be done without but the even more complex question of whether, if done without, this would give rise to circumstances of substantial hardship. Again, one cannot say that as a matter of necessity this can be discerned from the declared living expenses by themselves.

78:

The fact that the consumer spends $100 per month on caviar throws no light on whether a given loan will put the consumer into circumstances of substantial hardship. Nor for that matter does knowing that the consumer spends $500 per week on basic food items. For that to be relevant to the hardship question posed by s 131(2)(a) one would need to know at least the following matters:

(a)          that the loan repayments would require the consumer to cut their budget by a certain amount, say for the sake of argument, $200 per week;
(b)          that the $200 would have to be cut from the amount the consumer spent on food (i.e. $500 per week); and
(c)          if the consumer cut the amount spent on basic food from $500 per week to $300 per week then this would place the consumer in circumstances of substantial hardship.

79:

With those additional facts, one may be able to say that the declared living expenses must necessarily be relevant to the second … questions

As a consequence, the Court concludes that declared living expenses by themselves do not necessarily have to be relevant to the credit assessment process. If declared living expenses do not necessarily have to be relevant to the answering the 2 questions then it cannot be said that declared living expenses must be taken into account in performing an assessment of unsuitability. (paragraph 80)

In conclusion (and as a final blow), the Court states that:

82:

The policy of the statute that unsuitable loans should not be made is explicitly and directly given force by ss 131 and 133. Given that statutory fact, what purpose can be served by prescribing how a credit provider goes about the assessment process? Sections 131 and 133 make that the problem of the credit provider. A credit provider may do what it wants in the assessment process, so far as I can see; what it cannot do is make unsuitable loans. ASIC’s argument creates a whole new range of implied rules which appear altogether unnecessary in light of ss 131 and 133.

7. The case as a test of HEM?

This case was hailed to be a test of use of HEM (Household Expenditure Measure) – it was not.

At paragraph 36:

36:

Both parties made oral and written submissions about the HEM benchmark but by the trial’s conclusion it was of marginal relevance. This is because, as finally articulated, ASIC’s case did not turn on the fact that Westpac had used the HEM benchmark but instead on the alleged fact that it did not use any of the consumer’s declared living expenses in answering the s 131(2)(a) Questions. Indeed, ASIC accepted that it was lawful for Westpac to use the HEM benchmark to answer those questions. What it could not do was to answer them without taking into account any of the consumer’s declared living expenses.

8. Classic Quotes

There are a number of classic quotes used in the judgement which already have consumer advocates up in arms on the basis that the Judge is out of touch with the average punter. Mind you they are great quotes and should be acknowledged.

76:

…I may eat Wagyu beef everyday washed down with the finest shiraz but, if I really want my new home, I can make do on much more modest fare…

78:

The fact that the consumer spends $100 per month on caviar throws no light on whether a given loan will put the consumer into circumstances of substantial hardship.

71:

I do not, however, accept ASIC’s contention that all of the financial circumstances of the consumer can be such a mandatory matter. ……………… Questions of whether the consumer could in absolute terms afford the repayments; so too, the fact that the consumer takes an annual first class holiday to the United States is not relevant to assessing whether the repayments will put the consumer into circumstances of substantial hardship.

Far from being out of touch, The Honourable Justice Perram is thinking deeply about how the responsible lending rules might apply to him.

For me, it might be the difference between a bottle of “Wirra Wirra Church Block” and a bottle of “Jacobs Creek”. For my kids, it might be the difference between “plain label” and “branded products” at the supermarket.

While the rules around responsible lending affect us all in different ways – the rules around responsible lending do still affect us all, each in our own way.

For the consumer lobby to argue about the validity of this judgement as they appear to already be doing is really not helpful.

9. Our view back in 2016

Back in 2016, we thought that the distinction between “ability to meet repayments” and “credit risk” was thought to be a feature of the new responsible lending regime, which required lenders to go further. Refer to our article published in January 2016 – Responsible Lending Obligations: Saving Borrowers from Themselves

In that article we commented that:

Saving borrowers from themselves

Traditionally the credit assessment process for lenders was aimed at avoiding losses to lenders. Initially, this was done by way of ensuring there was sufficient equity in any security so that moneys lent could be recovered in circumstances of default. Now, lenders look at the credit assessment process in terms of capacity of the borrower to repay the amount lent from their own resources rather than realisation of any security. That was always the case in relation to unsecured loans – the difference now is it applies to secured loans as well. But, it does not really matter how robust a lender’s credit assessment procedures are, a lender can still fall foul of the responsible lending obligations set out in the National Credit Act.

Why is this so?

This is so because credit assessment procedures are no longer about protecting the position of the lender – instead, the responsible lending provisions under the National Credit Act are all about protecting the borrower – “saving borrowers from themselves”.

If lenders and credit assistants do not recognise this paradigm shift they will continue to get into trouble in the area of compliance with responsible lending provisions. And that trouble will not only come from ASIC. More and more now it is the external dispute schemes that are leading the charge in this area.

If one were to take a cynical view on matters one could form the view that in order to comply with responsible lending obligations nothing a prospective borrower says on the loan application is to be accepted on face value.

It seems now that the distinction we identified at that time might not be all that significant.

10. The recommendations of the Royal Commission

Recommendation 1.1 of the report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry was:

Recommendation 1.1 – The NCCP Act

The NCCP Act should not be amended to alter the obligation to assess unsuitability.

That recommendation was predicated in part on the fact that at the time of issue of the Report of the Royal Commission the subject Westpac Case had not yet been decided. As a consequence, the Report made the following observations about the pending case (starting at page 54):

It is necessary for me to say something about two developments relating to benchmarks that followed the Interim Report.

First, in November 2018, Perram J of the Federal Court refused to accept a proposal made jointly by ASIC and Westpac to resolve proceedings brought by ASIC alleging that Westpac had contravened section 128 of the NCCP Act.

The parties proposed that the Court impose a civil penalty of $35 million on Westpac for contravening the NCCP Act in assessing the suitability of home loans for customers in the period between 12 December 2011 and March 2015. 19 Westpac had used the HEM in its assessment of the loan applications.

In his reasons for refusing to make the orders the parties had proposed, Perram J said that the conduct expressed in a declaration proposed by the parties was not conduct that ‘could possibly be a contravention’ of section 128…

The proceedings remain undetermined and, absent some different agreement being reached and resulting in final orders disposing of the proceeding, await trial and judgment. That being so, it would not be right for me to offer any view about the conclusions reached by Perram J or to say anything at all about the reasons that have been published. At the time of writing, the proceedings between ASIC and Westpac remain on foot and may well go to trial.

The court processes must play out without commentary from me.

If the court processes were to reveal some deficiency in the law’s requirements to make reasonable inquiries about, and verify, the consumer’s financial situation, amending legislation to fill in that gap should be enacted as soon as reasonably practicable.

Let’s see what view the Government takes on any perceived “deficiencies revealed by the law by this judgement.

11. The Way Forward

The way forward is unclear.

How can ASIC in all honesty continue with its prescriptive guidance as to how to comply with responsible lending obligations in the light of the decision of the Federal Court? In particular at paragraph 82:

82

The policy of the statute that unsuitable loans should not be made is explicitly and directly given force by ss 131 and 133. Given that statutory fact, what purpose can be served by prescribing how a credit provider goes about the assessment process? Sections 131 and 133 make that the problem of the credit provider. A credit provider may do what it wants in the assessment process, so far as I can see; what it cannot do is make unsuitable loans. ASIC’s argument creates a whole new range of implied rules which appear altogether unnecessary in light of ss 131 and 133.

The way forward will be revealed with time.

Legislative change could be on the table, but it is unclear whether that would gain traction given the current economic environment.

12. What should Lenders now do?

In the interim, lenders would be unwise to unwind their current practices and procedures around responsible lending – it is certainly not open slather.

“Steady as she goes” is the best advice.

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