A step too far – restrictions on the right of a second tier lender to redeem a prior mortgage

• Where a person has borrowed money from a second or third tier lender, very often the money will be secured by a mortgage or other security that ranks behind the existing security of a prior lender, such as a mainstream bank.
• In such circumstances, the second mortgage will often include a clause to the effect that, in the event of default, the second tier lender is entitled to use its facility to pay out the existing bank loan on the borrower's behalf.
• Such a transaction may have the practical effect of converting the interest rate of the bank loan—which may have been quite modest—to the interest rate of the second tier loan, which would usually be significantly higher.
• In a decision of the Supreme Court of New South Wales handed down on 9 September 2021, the court upheld an objection to such a clause. The second tier lender's reliance on the clause to charge 60% interest on a first-ranking loan was slammed as "offensive to conscience", and unfair to the borrowers.
• In the event, the lender was still permitted to pay out the prior bank loan, but only on condition that it charge the borrowers the same interest rates as had been charged by the bank beforehand.

Case summary: First Mortgage Capital v Westpac

In First Mortgage Capital Pty Ltd v Westpac Banking Corporation Ltd [2021] NSWSC 1143, First Mortgage Capital (FMC), a moneylender, had advanced money to two borrowers at a rate of 30% per annum, automatically increasing to 60% if the facility fell into default.

FMC's facility was secured by second mortgages over seven properties owned by the borrowers, all of which were subject to pre-existing mortgages to mainstream banks:

• two properties at Hamish Road, Darley, Victoria (already mortgaged to the CBA);
• a property at Albion Park Rail (mortgaged to Westpac);
• two properties at Fairy Meadow (Westpac);
• a property in Point Cook, Victoria (Westpac); and
• a property in Belmont, Victoria (Westpac).

Clause 18.3(h) of FMC's mortgage terms and conditions provided that, if the borrowers fell into default, FMC was entitled to pay out any prior mortgagee on their behalf, "and any money so paid by the Lender will form part of the Secured Money and will be secured by this Mortgage".

This clause had the impact of allowing FMC to advance money at 60% to pay out a bank loan that had been accruing interest at a much (much much much) lower rate.

After the borrowers fell into default (and, in fairness, appear to have been given a number of opportunities to sort themselves out), FMC eventually utilised this contractual right to pay out the CBA mortgage over the Darley properties, and to pay out the Westpac mortgage over the Albion Park Rail properties. It paid $487,297.96 to the two banks, and later sold the properties for around $850,000.

Later, FMC took steps to do the same thing in respect of the Fairy Meadow properties. This time, the borrowers resisted. Proceedings were commenced and, when the matter came on, the borrowers argued, in a nutshell:

• that FMC's interest rates were extortionate and unconscionable, and should be reduced; and
• that clause 18.3(h) was unfair, and should be set aside.

The court rejected the proposition that FMC's interest rates were inherently unfair, giving brief reasons in paragraph 55 of the decision. These reasons will be familiar to anyone familiar with commercial lending; in essence, they turn on notions of freedom of contract and informed consent.

The court also observed that, although FMC had the legal right to charge compound interest, it had instead (deliberately) chosen only to charge simple interest, seemingly as a concession to the borrowers.

However, with regard to FMC's proposed exercise of its powers to pay out Westpac's prior mortgages of the Fairy Meadows properties, and its previous realisation of the three properties already sold, the court was less sympathetic.

The court observed (as noted above) that the practical effect of clause 18.3(h) was to permit FMC to pay out a first-ranking mortgage with a low interest rate, thereby dropping down into first position itself, but still continue charging like a wounded bull (although the court exercised somewhat more restraint in its language – see paragraph 66).

The court concluded that FMC's approach:

• had "no?apparent?commercial justification";
• was not reasonably necessary for the protection of the legitimate interests of FMC as mortgagee;
• fell "well below accepted community standards";
• involved "moral deficiency";
• enabled FMC "to extract an unjustifiably high return in respect of a portion of debt that remains secured by a first ranking mortgage";
• resulted in FMC obtaining a collateral advantage;
• amounted to a clog on the borrowers' equity of redemption; and
• was unfair to the borrowers.

The court reached the conclusion that what FMC had done with the Darley and Albion Park Rail properties, and what it was seeking to do with the Fairy Meadow properties, was wrong:

I consider that it is unfair that large amounts of debt, hitherto subject to standard rates of interest charged by banks lending on first?mortgage security, be effectively converted into loans at very high rates. The unfairness lies not in the paying out of the mortgages per se, or in adding the amount paid to the total required to be repaid by the mortgagors, but in the charging of the Higher Rate of 60% p.a. on the amount.?

The court concluded that FMC must adjust its interest rate for the bank facilities already redeemed to the rates previously charged by the respective banks, and refund or credit the difference to the borrowers.

The court said that FMC would be allowed to proceed to redeem the two Fairy Meadow Westpac facilities, "save that it ought not be permitted to charge the mortgagors interest at 60% p.a. on any amount paid to effect the redemption. First Mortgage should be confined to interest at the rate?provided for in the redeemed mortgage".

Upshot and ramifications

The New South Wales Supreme Court has made clear that the exercise of rights by an enforcing lender in the way that occurred in this case will be considered to be a step too far.

Although each case (including this one) turns on its own facts, some of the principles set out by Justice Darke are of general application.

Second tier lenders seeking to avail themselves of pay out/step in/subrogation rights such as those in clause 18.3(h) will very likely be hit over the head with this decision by lawyers representing defaulting borrowers. The decision significantly affects the commerciality of this enforcement tool.