In brief - The regime applies to small business contracts, credit activities and will soon apply to insurance contracts
In the post-Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry era a significant level of regulatory change is proposed or already taking place.
A regulatory regime for consumer protection that may be underappreciated during this transition is the unfair contract terms regime (UCT regime). The UCT regime has broad industry application as it applies to "a contract that is a financial product" or "a contract for the supply, or possible supply, of financial services" (each a "financial or credit contract"). The term "financial product" is that defined under the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act), with the UCT regime set out in Subdivision BA, Division 2 of Part 2 of the Act.
The UCT regime has applied to contracts for financial products and services since 1 July 2010. From 12 November 2016, the regime was extended to cover “standard form contracts” involving “small businesses”. Under the Treasury Laws Amendment (Hayne Royal Commission Response - Protecting Consumers (2019 Measures) Act 2020 (Treasury Laws Amendment Act), the Insurance Contracts Act 1984 (Cth) and ASIC Act will both be amended to extend the UCT regime under the ASIC Act to capture insurance contracts covered by the Insurance Contracts Act.
Importantly, the UCT regime:
applies to small business contracts and is not limited to consumer contracts
applies to credit activities, and
will soon apply to insurance contracts, as a result of Recommendation 4.7 of the Royal Commission and the Treasury Laws Amendment Act referred to above.
Australian and international application
It is highly important for a financial services business to understand the application of the UCT regime and fairness in contracts.
The UCT regime applies a presumption that if a term of a financial or credit contract is not reasonably necessary in order to protect the legitimate interests of the party who would be advantaged by the term, then the party relying on that term must prove it is otherwise fair in the circumstances. This presumption seeks to address a customer's strength of bargaining position and endeavours to protect their legal and commercial position.
The UCT regime provides for certain terms to be excluded. Terms that define the main subject matter, up front price payable or are required by Commonwealth, state or territory law are not regulated by the regime.
"Main subject matter" exclusion is a key factor in applying the regime
For the current regime, the "main subject matter" is not defined. The explanatory memorandum makes (at paragraph 2.16) reference to the consumer law explanatory memorandum, which provides that (at paragraphs 2.64 to 2.65):
Main subject matter of the contract
2.64 The exclusion of terms that define the main subject matter of a consumer contract ensures that a party cannot challenge a term concerning the basis for the existence of the contract. [Schedule 1, Part 1, item 1, subsection 5(1)(a)] [Schedule 3, Part 1, paragraph 12BI(1)(a)]
2.65 Where a party has decided to purchase the goods, services, land, financial services or financial product that is the subject of the contract, that party cannot then challenge the fairness of a term relating to the main subject matter of the contract at a later stage, given that the party had a choice of whether or not to make the purchase on the basis of what was offered.
For insurance contracts, the Treasury Laws Amendment Act provides for the ASIC Act to be amended so that the main subject matter of an insurance contract is limited to the description of the risk being insured.
Internationally, Europe and the UK have provided consumer protection in the form of an unfair contracts regime for financial products and financial services for a number of years (European Council Directive 93/13/EEC). The regime provides for a similar exclusion for terms that describe the main subject matter of the contract and the quality/price ratio. The explanatory material for the European law states:
Whereas, for the purposes of this Directive, assessment of unfair character shall not be made of terms which describe the main subject matter of the contract nor the quality/price ratio of the goods or services supplied; whereas the main subject matter of the contract and the price/quality ratio may nevertheless be taken into account in assessing the fairness of other terms; whereas it follows, inter alia, that in insurance contracts, the terms which clearly define or circumscribe the insured risk and the insurer's liability shall not be subject to such assessment since these restrictions are taken into account in calculating the premium paid by the consumer.
Complying with the UCT regime will require a financial services business to assess the terms of its financial or credit contracts and to identify which terms form the basis (the main subject matter) of the contract. In doing so, the temptation to apply a broad brush to the contract terms must be managed, as many are unlikely to meet the main subject matter test.
Is the financial or credit contract a standard form contract?
A financial services business will also need to assess if the financial or credit contract is a standard form, particularly where a customer is a small business. The UCT regime presumes that a contract is standard form, unless the financial services provider proves otherwise.
The UCT regime prescribes factors that a court must take into account in determining if a contract is a standard form contract, including whether the financial services provider has all or most of the bargaining power, whether the contract was prepared by the financial services provider before any discussions and whether the customer was, in effect, required to accept or reject the terms of the contract. It is evident that the level of meaningful negotiations which may occur between the financial services provider and their customer will inform an assessment as to whether the product contract is standard form.
Importantly, UCT involves a prospective and retrospective analysis:
Prospectively, when engaged in product design, as a matter of good risk management and in view of the section 912A obligations and the forthcoming product design and distribution obligations. Such an analysis is necessarily somewhat abstract as an issuer may not be able to anticipate how the product and its terms will be applied in all circumstances involving a customer.
Retrospectively, by a court if a complaint or ASIC brings proceedings for breach of the UCT regime, when the court will be presented with evidence of how the particular product or practice was applied (see for comparison, the differing views of the various courts in the Kobelt litigation, where ASIC sought declarations that certain practices by a general store in a remote community breached relevant financial conduct rules).
ASIC: regulatory findings
ASIC's 2018 review of certain lending contracts in the banking sector, Report 565: Unfair contract terms and small business loans, identified a number of contract terms that may be likely to contravene the UCT regime.
The thematic findings in ASIC's Report are still topical, and for financial services businesses further inquiry into the form and fairness of contracts is particularly relevant in the post-Royal Commission era given the heightened focus on regulatory and enforcement action.
While the review involved lending to small business, many of its themes can be translated to insurance and other financial products.
Table 1 of ASIC's report, which relates to small business loans, is summarised below and highlights the nature and breadth of the terms of a financial or credit contract which might generally be captured by the UCT regime.
Table 1: Loan Term Type
Nature of the underlying regulatory risk which is addressed in the changes made by the banks
Entire agreement clauses
Clauses that prevent lenders from being held contractually responsible for conduct, statements or representations made to small business borrowers outside the written contract are likely to be unfair.
Broad indemnification clauses
Clauses that require borrowers to cover losses, costs and expenses incurred due to the fraud, negligence or wilful misconduct of the bank, its employees or agents or a receiver appointed by the bank are likely to be unfair.
Event of default clauses
Material adverse change events of default—Clauses that allow lenders to treat a loan as being in default because of any unspecified "material adverse change" are likely to be unfair. These clauses gave the banks a very broad discretion to call a default against the borrower without giving the borrower any clarity about what types of change could result in a default. The banks have confirmed that these clauses have been removed or will no longer be applied to their small business loan contracts.
Specific events of non-monetary default— The wording of these specific events may still be broad enough for an event to trigger a disproportionate enforcement action by the lender. For example, even though "misrepresentation" is listed in small business loan contracts as a specific event of default, if a minor misrepresentation by the borrower such as an incorrect date of birth, led to a default and enforcement under the loan contract, this could be a disproportionate enforcement action.
Financial indicator covenants
The use of a breach of some financial indicator covenants such as loan-to-valuation ratio (LVR) in small business loans to trigger a default and enforcement of the loan could be unfair where a breach of a particular covenant by a small business borrower does not present a material credit risk to the lender.
Unilateral variation clauses
Clauses that give lenders a broad ability to vary contracts without agreement from the small business borrower have a high risk of being unfair as they cause a significant imbalance in the rights of the lender and small business borrower (in favour of the lender) and are unlikely to be reasonably necessary to protect the legitimate interests of the lender if they can be used in a broad range of circumstances to make a broad range of variations to the contract.
As a guide to the potential scope of terms in a financial or credit contract which may be captured by the UCT regime, the UK Financial Conduct Authority has also published examples of potentially unfair contract terms under the UK unfair terms in consumer contracts regime. The FCA guidance comments on insurance contracts, and contracts in other financial product sectors, and may be a useful point of reference for starting compliance and legal reviews.
Implications of the unfair contract terms regime
The UCT regime potentially has far-reaching application to financial services and credit and, depending on the circumstances, may apply to:
standard service agreements
consumer and small business loans and credit contracts
equity release products, such as reverse mortgages
new technology agreements, such as blockchain based arrangements
custody or wallet services
consumer insurance contracts and "business pack" insurance for small businesses
Financial services businesses should conduct a compliance review
The UCT laws apply to most financial products and services regulated by the ASIC Act and should form part of the product governance compliance framework for a financial services business.
Where a standard form financial or credit contract is proposed to be marketed or issued in a consumer or small business context, the product review process should include a review for compliance with these laws.
This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2024.