This article looks at three recent decisions of the Australian Courts involving unconscionable loans in corporate insolvency:
- Re Free Wesleyan Church of Tonga in Australia Inc (admin apptd); Phoenix Lacquers & Paints Pty Ltd v Free Wesleyan Church of Tonga in Australia Inc (admin apptd);[i]
- Globe Hill Construction & Mining Services Pty Ltd v PHBB Perth Pty Ltd;[ii] and
- Re Medical & Legal Assessments (NSW) Pty Ltd (rec and mgr apptd).[iii]
The last few years have seen an interesting phenomenon: the rise of unconscionable loan disputes in corporate insolvency hearings.
Economists may regard this as a reflection of the state of the economy. For lawyers, it is raising some interesting legal issues.
Curiously, given the traditional dichotomy between God and Mammon, it is interesting that the trend began with a religious, rather than a commercial, operation.
The (expensive) Free Church
The circumstances in Re Free Wesleyan Church of Tonga in Australia[iv] were as follows. The Free Wesleyan Church of Tonga (the Church) was an association incorporated under the Associations Incorporation Act 2009 (NSW). It wanted to build a church for its adherents in Sydney. To obtain funds to enable the completion of that project (having exhausted other sources), the Church borrowed $950,000 from Phoenix Lacquers & Paints (Phoenix).[v]
The Phoenix loan was secured by second ranking securities and personal guarantees. Importantly, the interest rate was “between 5% and 7% per month, compounding monthly”, equivalent to a simple interest rate of 22% per month.[vi] Within three and a half years, the Church owed $9.5 million to Phoenix. By this time, the Church had begun proceedings against Phoenix to have the interest rate declared unconscionable and the loan set aside or the interest rate varied. These proceedings were brought under the Contracts Review Act 1980 (NSW) and sections 12CA, 12 CB and 12GM of the Australian Securities and Investments Commission Act 2001 (ASIC Act).
While those proceedings were pending, the first ranking secured creditor appointed voluntary administrators to the Church pursuant to section 436C of the Corporations Act 2001 (Cth) (the Act).
Phoenix lodged a proof of debt for principal and interest of $9.8 million. Having taken legal advice about the rate of interest, the administrators treated Phoenix’s proof of debt as a “debt the value of which has not been established” (for the purposes of reg 5.6.23(2)(d) of the Corporations Regulations 2001 (Cth)). The administrators made a “just estimate” of the value of the debt of $1.48 million.
At the first meeting of creditors, Phoenix moved a motion to replace the administrators. The motion was passed by a majority in number of the creditors, but rejected by a majority in value. The administrators exercised their casting vote against it, under reg 5.6.21(4).
Phoenix commenced proceedings in the Supreme Court of New South Wales, seeking a declaration that the motion to replace the administrators had been passed, since it should have been allowed to vote for the full $9.8 million it claimed.
Phoenix’s argument was quite simple: its debt had been calculated in strict accordance with the terms of the contract, so there was no basis on which it could be said not to be established.
The court took a different view:
"Phoenix has not persuaded me of its primary position that the value of its debt is established by reference only to the terms of the loan agreements. In my view, once the characteristics of the loan and the fact that the Church has brought proceedings to challenge it are taken into account, this was one of the rare cases where the value of the loan could not be ascertained merely by reference to its terms and substantial further factual inquiries would be required."[vii]
In reaching this conclusion, the court relied upon a number of authorities under the Bankruptcy Act 1966 (Cth). These authorities establish that, notwithstanding the clear terms of a loan agreement, a loan debt may not be “established” if there is doubt about the enforceability of its terms (eg, because defences raised by the debtor may remain undetermined). That principle was invoked in this case because the Church had begun court proceedings to have the loan set aside or varied, and those proceedings were still on foot. The important point to make, therefore, is that the court did not reject Phoenix’s application merely on the basis of its own view of the unconscionability of the loan agreement.
A statutory demand
The issue of unconscionable loans arose again less than 12 months later, in Globe Hill Construction & Mining Services Pty Ltd v PHBB Perth Pty Ltd.[viii]
This was a hearing of an application to set aside three separate statutory demands, including one based on an unpaid debt under a loan agreement. It appears that the company was applying to have the demand set aside under section 459H(1)(a) (genuine dispute) and/or section 459J (other grounds). The company argued, inter alia, that a demand may be set aside under section 459J if, in the words of the court, there has been “conduct that may be described as unconscionable, an abuse of process or which gives rise to substantial injustice”.[ix] The case cited by the court in support of this proposition was Arcade Badge Embroidery Co Pty Ltd v Deputy Commissioner of Taxation.[x]
The court ultimately held that the demand should be set aside for two reasons. The first was that the demand was in the name of a company that had not existed at the date of the loan agreement. The second ground was that:
… there is in my view a question of whether a loan at the interest rate provided for in the agreement would be enforceable. The agreement may be unconscionable. It is not appropriate to explore this issue further on this application. Suffice it to say I am satisfied there is a serious question to be tried on this issue.[xi]
It is unclear whether this latter holding relates to section 459H or section 459J. There is nothing in the judgment to illuminate the basis of the company’s argument that there was a genuine dispute within the meaning of section 459H. The only judgment cited in relation to that issue was Eyota Pty Ltd v Hanave Pty Ltd.[xii]
Eyota did concern a dispute about a loan debt. However, the demand in that case was set aside on the grounds that there was a genuine factual dispute about the terms of the loan. In Globe Hill, there is no indication that the company was disputing the debt claimed in the demand on the basis that the loan was unenforceable because the interest rate was unconscionable.
Unfortunately, the alternative explanation, section 459J, is even more problematic.
As noted above, the court in Globe Hill cited Arcade Badge as authority for applying section 459J where “there has been conduct that may be described as [inter alia] unconscionable”. A few paragraphs later, the court used the word “unconscionable” in relation to the interest rate charged under the loan. At first blush, it may appear that this language indicates a belief on the part of the court that an “unconscionable” interest rate provides grounds to set aside a demand under section 459J. However, an examination of Arcade Badge shows that that could not be what the court intended.
In Arcade Badge, it was said that:
What is contemplated by section 459J(1)(b) is a discretion of broad compass which extends to conduct that may be described as unconscionable, an abuse of process, or which gives rise to substantial injustice: Hoare Bros Pty Ltd v Commissioner of Taxation (1996) 62 FCR 302 at 317 to 318.[xiii]
In Hoare Bros, the Full Federal Court said:
It would be unwise to attempt to mark out the limits of the discretion conferred by section 459J(1)(b). Paragraph 687 of the Explanatory Memorandum provides illustrations of circumstances that might constitute appropriate reasons for setting aside the demand. Another illustration, which was given by the Australian Law Reform Commission in a discussion paper (General Insolvency Inquiry (DP 32, 1987), para 114), is the situation in which a creditor unreasonably refuses the company’s offer to meet the debt. The circumstances of Norper may well afford a further illustration. In the present case, Olney J implied that he would have been prepared to exercise the discretion in the Company’s favour, had it been shown that the Commissioner’s conduct was unconscionable, was an abuse of process, or had given rise to substantial injustice.[xiv]
When one looks at para 687 of the Explanatory Memorandum, it is clear that section 459J(1)(b) is directed at the conduct of the statutory demand process itself (or, possibly, the creditor’s debt recovery processes):
This … power would enable the Court to take account of matters such as improper or invalid service and mistakes or misstatements in the notice of demand, in circumstances where this would significantly prejudice any party.
The same point emerges from the relevant material in the Harmer Report, which is in virtually identical terms to the Explanatory Memorandum. Accordingly, it is probably safe to suggest that section 459J(1)(b) applies to unconscionability in the debt recovery/statutory demand process, rather than to unconscionability in the preceding contractual relations between the parties.
Accordingly, we are left with the conclusion that the demand in Globe Hill was set aside because, as well as the loan agreement misnaming the creditor, the interest rate charged under the loan agreement was so unconscionably high as to create a genuine dispute about the quantum or existence of the debt claimed under the demand.
Although attractive, this conclusion does have some problems. As mentioned above, there is nothing in the judgment to indicate the basis on which the company disputed the debt, and certainly nothing to indicate that it had asserted that the interest rate was unconscionable. Equally interestingly, there is nothing in the judgment to indicate whether the company had, like the Free Wesleyan Church of Tonga, taken any legal steps to have the loan agreement set aside or modified because of the interest rate. In Globe Hill, it appears that the company’s concerns (if any) about the interest rate did not manifest themselves in legal form before the service of the statutory demand (compare Free Wesleyan Church, where the Church began proceedings to attack the interest before the appointment of the administrators).
At its widest, therefore, Globe Hill can be read as authority for the proposition that a court can set aside a demand based on a loan agreement if, in the court’s view, there is a serious question to be tried that the interest rate renders the loan agreement unconscionable (perhaps even in the absence of any argument to that effect by the company itself). Such an argument will have an even better chance of success if a company has, before receiving a statutory demand, already begun proceedings to challenge the interest rate (as in Free Wesleyan Church).
Finally, mention should be made of Re Medical & Legal Assessments (NSW) Pty Ltd (rec and mgr apptd).[xv] This concerned an application pursuant to section 418A(2) of the Act for an interlocutory injunction to restrain receivers who had been appointed by a lender to the company.
The original basis of the application appears to have been that the lender had engaged in misleading or deceptive conduct in relation to the circumstances in which the debtor entered into the loan. However, the court held that that claim would not support an interlocutory injunction in this case. It appears that the court itself then drew the parties’ attention to Free Wesleyan Church. Again, it is unclear but it appears that the company then indicated that it would seek to maintain a “statutory unconscionability” claim under section 12CB of the ASIC Act[xvi] in relation to the loan (on which the quarterly interest rate was a “discount” interest rate of 25% per quarter, or a higher rate of 35%, with late payment fees and rollover fees of $10,000 potentially arising every three months).
The court then held that these interest rates established that there was a serious question to be tried that would support the company’s claim for interlocutory relief.
While there was a serious question to be tried, the interlocutory injunction was rejected on the balance of convenience ground. Put briefly, the company was unable (or had failed) to pay sufficient money into court and had failed to provide an undertaking as to damages to protect the lender’s position should the appointment of the receivers ultimately be upheld.
The requirement for an undertaking as to damages (or other measures to address the balance of convenience) will, in practical terms, render the unconscionable loan argument a nullity for many companies in this situation. It is, in effect, a Catch 22: a company which has had recourse to a lender charging quarterly interest of 25% or 35% is, almost ipso facto, not a company which has sufficient funds to indemnify a lender against its potential damages.
These three cases deal with very different legal and factual circumstances.
Together, they arguably demonstrate that a court will, where possible, take allegedly unconscionable interest rates on loans into account when exercising its discretion in an insolvency matter.
Separately, however, the cases show that the court’s ability to give effect to its concerns about unconscionably high interest rates will depend upon both the facts before it and the statutory or legal context in which the matter has arisen.
Not every company that simply cries “unconscionable loan” will find relief from the court. It appears that actions taken by a company — prior to the relevant insolvency event — to have the interest rate reviewed under the legislation established for that purpose will assist in the court’s consideration of the terms of the loan in the overall factual matrix.
This article was first published in Insolvency Law Bulletin, Vol 15 No 2, April/May 2014
[i] Re Free Wesleyan Church of Tonga in Australia Inc (admin apptd); Phoenix Lacquers & Paints Pty Ltd v Free Wesleyan Church of Tonga in Australia Inc (admin apptd) (2012) 260 FLR 348;  NSWSC 214. [back]
[ii] Globe Hill Construction & Mining Services Pty Ltd v PHBB Perth Pty Ltd  WASC 417. [back]
[iii] Re Medical & Legal Assessments (NSW) Pty Ltd (rec and mgr apptd)  NSWSC 1622. [back]
[v] According to media reports, Phoenix, an industrial paint company, had “a sideline in short-term finance”: Sydney Morning Herald 28 January 2012. [back]
[vi] Above, n 1, at  (emphasis in the original). [back]
[vii] Above, n 1, at  per Black J. [back]
[ix] Above, n 2, at  per Master Sanderson. [back]
[x] Arcade Badge Embroidery Co Pty Ltd v Deputy Commissioner of Taxation (2005) 157 ACTR 22;  ACTCA 3.[back]
[xi] Above, n 2, at .[back]
[xii] Eyota Pty Ltd v Hanave Pty Ltd (1994) 12 ACSR 785; (1994) 12 ACLC 669. [back]
[xiii] Above, n 10, at  [back]
[xiv] Hoare Bros Pty Ltd v Deputy Commissioner of Taxation (1996) 62 FCR 302; (1996) 135 ALR 677. [back]
[xvi] As amended by the Competition and Consumer Legislation Amendment Act 2011 (Cth). [back]