If All Else Fails, The Property Can Be Sold, Right?

A borrower who signed a loan application that falsely recorded his income has successfully appealed to have his loan contract and mortgage set aside. He had borrowed the money, using his family home as security, to invest in the failed business ran by Karl Suleman.

The NSW Court of Appeal decision – handed down yesterday – highlights the risks faced by a lender who fails to properly assess a borrower’s capacity to repay the loan, and nevertheless proceeds with the loan and takes security.

In late 2000, Mr & Mrs Khoshaba decided to borrow money to invest in Karl Suleman Enterprises (KSE).

The Khoshabas, with the assistance of their broker, completed a loan application form.

Mr Khoshaba signed the loan application without reading it. The loan application falsely recorded that Mr Khoshaba was a courier driver earning $43,000 per annum. The loan application attached a letter from Mr Khoshaba’s supposed employer and employment payslips – both these documents were discovered at the time of the hearing to be forged by persons unknown. It was also discovered that Mrs Khoshaba’s signature had been forged.

The broker submitted the loan application, employer letter and payslips to a mortgage introducer. The introducer collated other records, such as a valuation and credit reference checks, before sending the application and supporting records to the lender.

The mortgage introducer was obliged to comply with the lender’s guidelines for loan introduction and management. These guidelines required the mortgage introducer to verify the income stated in the loan application by phoning both the loan applicant and the employer.

The mortgage introducer failed to verify the income as required by the guidelines. In further breach of the guidelines, the loan application did not disclose the purpose of the loan.

At the time of the application, the borrowers were, in fact, pensioners.

The borrowers understood the nature of the transaction, namely that they were borrowing money to invest in KSE, secured against their family home. Further, their investment decision was made independently of the lender.

The borrowers lost money on their investment in KSE.

In August 2003 the borrowers commenced proceedings against the lender in the District Court, seeking relief under the Contracts Review Act.

The trial judge found that the loan agreement and mortgage were unjust because the lender failed:

• to follow its own lending guidelines in assessing the loan application (contrary to prudent lending practices); and

• to recommend to the borrowers that they obtain independent legal advice.

The Court of Appeal overturned the trial judge’s findings in both respects.

In relation to the former, the Court of Appeal found that it was not open to the trial judge to conclude that the lender’s own internal guidelines should set the benchmark for what constitutes prudent lending practices.

In relation to the latter, the Court of Appeal distinguished between the loan and the KSE investment agreement. The Court found that a lender’s failure to recommend that a borrower take advice on an investment should be afforded little or no weight when considering whether the lender’s conduct was unjust.

The Court of Appeal proceeded to inquire whether there were any other grounds for concluding that the circumstances surrounding the loan application were unjust.

The Court of Appeal held that there were.

In particular, the Court found that it was unjust for a lender to be solely focused on the loan security as being the means by which a loan, secured against a family home, would be repaid. The Court inferred that, in this instance, the lender was solely focused on the loan security to repay the loan because the lender (through the mortgage originator who had been appointed to carry out these tasks):

• had failed to ascertain the loan purpose; and

• had failed to verify that the income attributed to the loan applicants in the loan application was correct.

Both these failings indicated to the Court of Appeal that the lender was not concerned with whether the borrowers could afford to repay the loan, but rather was solely concerned with whether the value of the property security was enough to repay the debt.

The Court of Appeal drew this inference despite:

• the existence of documentation (payslips and a letter from the employer) that on its face supported the income recorded in the loan application; and

• the lender being let down by a mortgagor originator, who had failed to carry out the verification tasks that were prescribed in the lender’s own guidelines.

The judgment is of particular concern for "low-doc" lenders.

The decision means that lenders who choose not to (or fail to) properly assess the credit of a loan applicant, may lose the benefit of any security taken for the loan, particularly in circumstances where:

• had the credit been properly assessed, it would have become apparent that the borrower(s) could not afford the loan; and

• the security in question comprises of a mortgage over the family home.

Unfortunately the judgment contains no guidance for lenders on what steps are sufficient to verify income ascribed to borrowers in loan applications. The fact that the lender had not complied with its own guidelines was sufficient for the Court of Appeal, in this instance, to draw a negative conclusion.
By Justin Bates, Sydney.

This publication is provided to clients and correspondents for their information on a complimentary basis. It represents a brief summary of the law applicable as at the date of publication and should not be relied on as a definitive or complete statement of the relevant laws.