Small business loans: your unfair terms cheat sheet

This month ASIC released a report about how the unfair contract terms regime applies to loans made to small businesses.¹

Although the report focuses on the changes the big four banks have made to their standard small business loan terms as a result of ASIC’s recent reviews, the report is also critical reading for any non-bank lenders who provide finance to small businesses, as well as for small business borrowers.

ASIC has identified several different types of provisions commonly found in loan contracts which may be regarded as unfair and void under the unfair contract terms regime. If your business involves providing finance to small businesses, you should be screening your loan contracts to ensure that they don’t contain unfair terms of this type (as well as other unfair terms generally). If you’re a small business borrower, then you should be aware of your rights under this regime.

As explained below, the consequences of a term of a loan contract being unfair are potentially serious and far-reaching for small business lenders.

When does the unfair contract terms regime apply to small business loans

The unfair contract terms regime applies to standard form small business loans of up to $1 million entered into (or renewed) on or after 12 November 2016.

Broadly, a loan contract will fall within the regime if:

• it is provided to borrowers on a “take it or leave it” basis, with minimal negotiation between the parties;
• at least one of the parties is a business with fewer than 20 employees; and
• the loan amount does not exceed $1 million (or $300,000 if the loan is for 12 months or less).

If the regime applies to a small business loan, any unfair term in the loan contract (and in any identical loan contracts with other parties) will be void and unenforceable.

Unfair loan terms generally

A term in a small business loan contract will be unfair if it:

• would cause significant imbalance in the parties’ rights and obligations;
• is not reasonably necessary to protect the legitimate interests of the benefiting party (usually the lender); and
• would cause financial or other detriment to the other party (usually the small business borrower) if the lender relied on it.

This general description of “unfairness” is obviously capable of applying to a broad range of loan terms. Helpfully, ASIC’s report gives some more specific examples of loan terms that may be unfair under this test.

Examples of unfair small business loan terms

ASIC’s report identifies five categories of terms commonly found in loans which may be unfair in standard form small business loan contracts:

1. Entire agreement clauses: These are clauses stating that the written loan agreement represents the entire agreement between the parties. Such clauses may be unfair if they suggest that the lender is not responsible for its (or its representatives’) conduct, or statements or representations made to the borrower, before or during the loan term.
   For example, if a lender represents to the borrower that it will exercise its discretion in a particular way, the borrower may have rights against the lender stemming from that representation. It may be unfair (and misleading) for the lender to suggest otherwise by using an entire agreement clause.
2. Overly broad indemnities: Lenders often receive the benefit of indemnities from the borrower so that the lender is protected from losses suffered due to the borrower’s actions. Indemnities can be legitimate and reasonable, but they risk being unfair if the borrower is required to indemnify the lender for things outside the borrower’s control.
   For example, in ASIC’s view, indemnities in small business contracts should not require the borrower to indemnify the lender for liabilities caused by the lender’s own fraud, negligence or wilful misconduct.
3. Overly broad events of default: ASIC’s report makes it clear that lenders to small businesses should carefully consider whether the event of default provisions in their loan contracts are overly broad.
   An event of default regime is most at risk of being unfair if it gives the lender broad discretions to determine whether a particular event is treated as a default and also to determine the consequences of the default.
   Some common default provisions which ASIC considers may be unfair include:
   • Material adverse change provisions: These provisions allow a lender to call a default for material adverse changes in the borrower’s circumstances. Such provisions may be unfair if they are broad enough to include events which do not materially impact the borrower’s ability to repay the loan or the lender’s ability to enforce its security.
   • Broad enforcement rights without notice: Some loan contracts contain “shopping lists” of possible actions which the lender may take against a defaulting borrower. These may be unfair if the provisions would allow the lender to take enforcement action which is disproportionate to the borrower’s default. For example, a minor misrepresentation by the borrower about its address details would likely not justify the lender calling a default and demanding repayment of the loan.
     Importantly, lenders also need to consider the default regime as a whole, including how the default provisions in their security documents interact with those in the loan contract. If the loan contract contains “cross-default” provisions allowing a default under a security document to be treated as a default under the loan contract, then these provisions may be unfair if the security document itself contains an overly broad event of default regime.
     ASIC’s report suggests that some of these issues can be addressed by the lender providing a reasonable period to the borrower to remedy a breach, and also by adopting a materiality threshold so that only material breaches can trigger serious enforcement action.
4. Financial covenants: Lenders often require borrowers to maintain specific interest cover ratios, loan to value ratios or to comply with other financial indicators. These requirements may be unfair depending on:
   • the nature and purpose of the loan – for example, a borrower’s compliance with certain financial indicators may be more critical in property development, margin lending or other specialised loan types; and
   • the circumstances in which breach of the financial covenants may trigger enforcement action – for example, if the lender may enforce against the borrower even for minimal breaches of a financial covenant which do not materially affect the borrower’s ability to repay or the lender’s ability to enforce its security, the financial covenant provisions may be unfair.
5. Unilateral variation: Loan contracts often contain provisions allowing lenders to vary certain terms without the borrower’s consent. Such provisions are more likely to be unfair if they:
   • allow a broad range of terms to be varied by the lender in a manner that is left to the lender’s discretion; and
   • do not give the borrower a reasonable opportunity to exit the loan (e.g. by repayment or refinancing) if it wishes to do so before the variation takes effect.

Why should you care?

If you’re a lender to small businesses and your standard form loan contracts contain unfair terms, those terms will be void and unenforceable against the borrower. That’s bad enough for the lender, but it gets worse.

As ASIC outlines in its report:

• if a lender acts in reliance on an unfair term, the lender could be in breach of the loan contract or otherwise liable for damages (for example, by taking possession of security property when it did not have legal right to do so);
• if a court finds a loan term to be unfair and the term is likely to cause loss or damage to persons who are not parties to the proceedings, a court could order the lender to compensate those other persons;
• a court has broad powers in relation to unfair terms in loan contracts – for example, the court could direct a lender to refund money or return property to the borrower; and
• if a court has declared a term unfair and then a lender nevertheless seeks to rely on it, the lender may be the subject of an injunction or liable to compensate small business borrowers under compensation orders.

Next steps

Now that ASIC has completed its review of the big four banks’ small business lending practices, it is likely that ASIC will progress to scrutinising the activities of non-bank lenders to small businesses.

Further, enforcement action taken by a lender in respect of facility arrangements entered into with small businesses on or after 12 November 2016 may be resisted if that action relies on loan terms that could be found to be “unfair”.

It would therefore be prudent for lenders to review the facility documents they use in a small business context to minimise the chances of elements of those documents being challenged as “unfair”.

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1.Australian Securities and Investments Commission, Report 565: Unfair contract terms and small business loans (March 2018). The unfair contract terms regime applies to small business loans under the Australian Securities and Investments Commission Act 2001 (Cth), which deals with financial products and financial services (including loans). The unfair contract terms regime for other types of small business contracts is contained in the Australian Consumer Law.

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