A big win for small business

It was a long time coming. That is what Australian Small Business and Family Enterprise Ombudsman Kate Carnell said after the major banks finally agreed to make a series of changes to their small business loan contracts.

Ms Carnell, who had led an inquiry into small business loans, called for these changes in a report published in December 2016, which followed the passing of unfair contract terms legislation earlier that year.

Among others, the report recommended that where a small business had met loan payments and acted lawfully, the bank must not default a loan for any reason.

In August 2017, the big four banks agreed to implement this rule as well as eliminate other unfair terms in their contracts.

And while there is more work to be done in terms of creating a fair environment for small business borrowers, these moves are a step in the right direction, Ms Carnell says.

“It’s great news for small business operators that ASIC worked with the banks to introduce these changes, which will be backdated to November 2016 for new loans and renewals,” she says.

“It shouldn’t have taken so long, but we finally have a situation where banks will treat small business clients as partners and share some of the risk. Previously, the contractual relationship was one-sided and unfair.”

The news is also positive for accountants who look after small business enterprises.

Jessica Kinny, principal of Sydney-based boutique commercial law firm Kinny Legal, says the changes mean small businesses will now be in a better position to understand their legal obligations and plan their business activities.

However, she does urge accountants and SMEs to remain vigilant, as there are some exceptions to the new rules and not all lenders operate alike.

“The recent changes are an improvement,” she says. “But for SMEs, the best is yet to come.”

The changes

According to ASIC, the big four banks have agreed to make four main changes.

The first one revolves around bank responsibility. It states that loan documents cannot contain “entire agreement clauses” that pardon the bank from responsibility for conduct, statements or representations they make to borrowers outside the written contract.

The second change significantly limits the banks’ indemnification clauses, which means the banks will not be able to require their small business customers to cover losses, costs and expenses incurred due to the fraud, negligence or wilful misconduct of the bank, its employees or a receiver appointed by the bank.

The third change is intended to protect SMEs from surprise defaults by stripping the banks from their powers to be able to terminate a loan for any negative change in the circumstances of the small business borrower.

Finally, the banks are now restricted in their ability to alter contracts in specific circumstances. And if such a variation would cause a customer to want to exit the contract, the banks will allow 30 to 90 days for the customer to find an alternative. This is what has been agreed with ASIC, but the changes do not end here.

In October 2017, NAB announced its business standard loan form contract will be re-written to include simpler clauses and language as well as a reduction in document length. Terms and conditions have also been chopped by a third.

All four banks have limited the use of financial indicator covenants to certain classes of loans, including property development and specialised lending such as margin loans.

The banks have also agreed that financial indicator covenants will not be applied to property investment loans, according to ASIC.

Ms Kinny says the improvements to notice periods for key lending milestones will allow SMEs to better plan their business and lending activities.

The changes also limit the circumstances in which banks can take enforcement action against borrowers, she says.

“This latter change includes a requirement that the borrower has the opportunity to remedy a non-serious breach of the contract before the lender can take enforcement action in response to the breach,” Ms Kinny says.

A move in the right direction

Before these changes, there were many issues in loan contracts for small businesses.

Depending on the lender, some SMEs were signing up for loans that were complex and non-negotiable, Ms Kinny says, and due to the insufficient notice period of key loan milestones, many businesses struggled with planning and implementing strategies.

Small businesses were also at risk of default for matters outside of their control, she says.

In March 2017, the findings were published from a joint review of small business standard form contracts undertaken by ASIC and the ASBFEO. The review found that the banks were using terms that led to loan defaults in a very broad range of circumstances, instead of just for significant breaches.

Other terms were found that absolve the lender from responsibility for conduct, statements or representations that the lender makes to borrowers outside of the contract.

Contracts also included clauses that too broadly protected the lender against losses, costs, liabilities and expenses.

“ASIC is committed to ensuring that the unfair contract terms provisions help to raise small business lending standards,” ASIC deputy chairman Peter Kell said at the time.

“Where we identify a potentially unfair term, we will work with the lender to remove or amend them, and we have already started to raise issues with lenders. If the lender refuses to do so, we will consider all regulatory options, including taking the matter to court as ultimately a court can decide whether or not a term is unfair.”

While the banks have since agreed to implement the changes, it was not without initial push back.

Back in March during a parliamentary committee, Ms Carnell said it was not “a reasonable approach” for banks to able to default on small business loans “when people are compliant financially”.

But NAB had argued that there were risks to removing financial indicator covenants, and that doing so would put up the costs of the loans.

Ms Carnell responded: “That’s not the feedback we’ve had from experts. Remember the banks already put a premium on top of small business loans to take into account a higher level of risk, so you can’t have it both ways.

“You can’t have a contract that allows the banks to move all the risk to the borrower, while also having a higher interest rate.”

“Our recommendations in this area – indeed all of our recommendations – are not unreasonable. These are not new issues, these are not unrealistic expectations.”

Not over yet

Despite the positive changes, Ms Kinny warns accountants and SMEs that the industry has not taken a uniform approach to small business loan contracts.

“When comparing loan contracts, SMEs must be vigilant and not assume that a favourable change adopted by one lender has been adopted by any other lender,” she says.

“SMEs and their accountants should also be aware that recent changes only apply to small business loan facilities up to $3 million, rather than the $5 million cap recommended by the ASBFEO, and only if the loan was made or renewed on or after 12 November 2016.”

That $3 million cap is now the focus for Ms Carnell, who described in a LinkedIn post recently her disappointment in the limited threshold.

“Despite repeatedly asking, we have never received a properly justified explanation of why $5 million is such a problem, even when the banks have acknowledged the higher threshold captures a very small percentage of small business loans,” she wrote.

“Many of these will be capital-intensive businesses such as manufacturers and primary producers. It’s incongruous of banks to imply that ethical standards and fairness can only apply up to a certain limit when it should be standard practice.

“We’ll continue talking to the government, opposition, crossbench MPs and the banks about raising the threshold to $5 million.”

In the meantime, the changes agreed to by the banks will also be enforced under a new Code of Banking Practice.

A spokesperson for the Australian Bankers’ Association (ABA) said the new code “will have a greater focus on small business lending and there will be significant changes that will make a real difference to small business”.

For example, banks will be required to simplify loan contracts so they’re written in plain English and are easier to understand, the spokesperson says, as well as provide a longer notice period to customers about changes to loan conditions or decisions on rollover, which will help businesses with future planning.

Banks will also need to provide small businesses with at least three months to arrange alternative finance when a facility is not going to be renewed, the ABA says.

“Banks are also reducing the number of non-monetary covenants that could result in enforcing a loan. Banks will no longer be able to call in a loan when a small business is acting lawfully and making their payments on time, other than in exceptional circumstances,” the spokesperson says.

“The remaining covenants will be explained in plain English and summarised in loan contracts for small businesses.”

As for the future of the lending landscape, Ms Kinny says while it is impossible to predict, she does expect further changes to come.

“This time next year, lenders will be operating under the revised Code of Banking Practice and the banking royal commission will be well underway, which will most likely include investigation of any unconscionable conduct towards SMEs and strategies to improve business lending practices,” she says.

"We are in the middle of what could prove to be a major overhaul.”

The big four’s big four changes

The big four have agreed to the following:

1. Bank responsibility – removal of clauses to pardon banks’ conduct outside of contracts

2. Limits of banks’ indemnification clauses – small businesses cannot be required to cover losses due to misconduct of the bank

3. Remove power to terminate loans – no longer able to terminate loan for any negative change in circumstances of SME borrowers

4. Restrict ability to alter contracts – if a customer would like to exit as a result of a variation, the bank must allow 30-90 days for them to find an alternative