Could lending to small business end up like consumer lending?

These days, small businesses are often seen by governments as a vulnerable class like consumers who need to be protected by regulation. Assistance to small business has been a priority for the Coalition Federal Government. It has gone so far as to create a taxpayer funded advocate for small business interests: the Australian Small Business and Family Enterprise Ombudsman, which commenced operations earlier this year. There are new tax breaks for small business, and changes proposed to the competition laws on misuse of market power are intended to assist small businesses dealing with big businesses.

Small business is a popular market segment for many new entrants in the finance industry such as receivables financiers. At the moment, small business lending is relatively unregulated, compared to consumer lending. That could be one reason why new entrants are attracted to lending to small business customers. But small business lending is not immune from increasing regulation. New laws coming in later this year will affect small business loan contracts, and politicians in Canberra are discussing other possible changes which could further tighten the regulation of small business finance.

Consumer and non-consumer

If small business lending was like lending to consumers, it would be a whole new ball game. With consumer finance, you are not allowed to lend at all unless ASIC agrees to licence you. Then there is “responsible lending”, which essentially makes the lender rather than the borrower responsible for deciding whether a loan is suitable for the borrower. There are many detailed disclosure and conduct obligations set out in the National Credit Code. There are even price controls which dictate how much a lender can charge (except if the lender happens to be a bank or other authorised deposit-taking institution). Consumer lending is also regulated by laws on unfair contract terms.

The dividing line between consumer and non-consumer lending has historically been based on the purpose of the loan. Credit that is wholly or mainly for “personal, domestic or household purposes” is regulated, although lending to a company is always exempt, regardless of the purpose, unless the company is a body corporate in a strata plan or similar. The problem with unequal legislation – laws that treat people differently – is that there will always be anomalies.

For example, people asked why mum and dad investors who borrow for an investment property should not be protected by the credit legislation, just because the purpose of the loan was not “personal, domestic or household”. So in 2010, the dividing line was moved and the National Credit Code was extended to credit for residential property investment. After this change was introduced, the Federal Labor Government toyed with the idea of moving the line further to include small business under the national credit laws. This was floated in a consultation paper in 2012. The proposal was later shelved, but the idea might not be dead and buried.

Unfair contract terms

One piece of consumer protection legislation which has now been extended to small business is the law on unfair contract terms. In the 2013 election the Liberal National coalition included in their platform a policy to extend the legislation on unfair contract terms to small business contracts. The policy was put into effect in the last Parliament so that from 12 November 2016, small business contracts (including loan contracts) will be subject to the unfair contract terms legislation. (Existing contracts as of 12 November 2016 are affected only when they are renewed or varied from that date.)If a term in your small business contract is unfair, the effect is quite serious: it will be void, which means you can’t enforce it.

A small business contract is one where at least one of the parties is a small business and the upfront price payable under the contract is no more than $300,000 (or $1 million if the contract is for more than 12 months). A “small business” is one that employs less than 20 people. The contract must also be “standard form” – in other words, a contract prepared by one party and where the other party has limited or no ability to negotiate the terms.

A term in a small business contract will be unfair if it meets three conditions. First, it would cause a “significant imbalance” in the parties’ rights and obligations arising under the contract. Second, it is not reasonably necessary to protect the “legitimate interests” of the party advantaged by the term. Third, it would cause detriment (financial or otherwise) to a party if it were to be applied or relied on.

Contract terms that may be unfair include terms which permit only one party to terminate or vary the terms, or terms which permit one party to vary the upfront price without the right of another party to terminate.

Contract terms will be exempt where they define the main subject matter of the contract (e.g. the amount that the small business is borrowing) or set the upfront price payable under the contract (e.g. the interest rate).Loan contracts are traditionally quite one sided in favour of the lender. After all, the lender is primarily at risk from the transaction. If you are lending to small business, it’s therefore a good idea to review your standard terms to see if any may be unfair.

More possible changes

In another development, a recent Parliamentary report has recommended that the “responsible lending” requirements for consumer loans be extended to small business. The Joint Committee on Corporations and Financial Services conducted an inquiry into impaired loans and handed down its report on 4 May. The inquiry looked at the alleged practice of lenders deliberately reducing the value of securities they hold to raise the loan to value ratio and so cause the borrower to be in default. As well as recommending “responsible lending” obligations for small business loans, the Committee recommended legislation to prohibit conflicted remuneration for all bank staff and to require bank officers to act in the best interests of small business customers. The Government is yet to announce its response to the Committee’s recommendations.

And that’s not all. In April the Government announced that it believed there would be advantages in extending the jurisdiction of the Financial Ombudsman Service (FOS) to include a wider range of small businesses loans. The Government has asked ASIC to work with FOS on a review of FOS’s small business jurisdiction under its Terms of Reference.

Small business lending is not like consumer lending – not yet. But the trend in regulation seems clear. It’s likely that the regulatory challenges of small business lending are only going to grow.

Patrick Dwyer

Legal Director