Undue influence over guarantors - new requirements for lenders in New Zealand?

The Court of Appeal has discussed the likely requirements for a defence of undue influence in lending cases in New Zealand.

Facts

The Court of Appeal(1) heard arguments on behalf of Mr Hogan, a director and former shareholder of his son's company, that a guarantee from Mr Hogan in support of funding for the company from Commercial Factors was given subject to undue influence.

Three step test for undue influence

In its judgment, the Court stated that a guarantor's liability will only be avoided on the basis of undue influence if the following test is satisfied:

1. the guarantor was subject to undue influence (e.g. the exploitation of a relationship of trust and confidence);



2. the circumstances as known to the creditor were such as to put the creditor on inquiry as to the risk of undue influence; and



3. the creditor did not act in such a way as to insulate itself from the consequences of such undue influence.

New Zealand approach

In considering the circumstances in which a creditor would be on inquiry as to undue influence and what steps such a creditor should then take (the second and third points above), the Court of Appeal explicitly suggested that a creditor seeking a guarantee should allow for the possibility that the principles set out in the English case of Etridge(2) would be applied in New Zealand banking cases (although the Court was unwilling to express a definitive view on the point).

The Court of Appeal made no mention of a previous New Zealand High Court decision(3) that did not adopt the Etridge rules for determining what steps a bank must take to discharge its duty in relation to the risk of undue influence (although that case did apply the Etridge test for establishing when a bank is put on inquiry). The safest approach for New Zealand banks is now to assume that the Etridge principles apply in full.

Etridge principles

In Etridge, the House of Lords held that banks should regulate their affairs on the basis that they are put on inquiry in every case where the relationship between the guarantor and the borrower is non-commercial, and must always take reasonable steps to bring home to the individual guarantor the risks that he or she is running by standing as guarantor.

Those reasonable steps are:

1. checking directly with the guarantor the name of his or her solicitor, and communicating directly with the guarantor that the creditor requires (for its own protection) written confirmation from that solicitor that the guarantee and its implications have been fully explained to the guarantor;



2. providing the guarantor's solicitor with the financial information needed for that purpose;



3. if the bank believes that the guarantor has been misled by the borrower and is not entering the transaction of his or her own free will, informing the guarantor's solicitor of the facts giving rise to that suspicion; and



4. obtaining written confirmation of the above from the guarantor's solicitor.

These principles go further than current New Zealand banking practice, by requiring creditors to make direct contact with potential guarantors. Previously, it has been sufficient for creditors to insist that a guarantor be given independent legal advice and to obtain a solicitor's certificate that the implications of the guarantee have been explained to and understood by the guarantor.

Result

The Court of Appeal found in this case there was no evidence of any person exercising undue influence over Mr Hogan (rather, he appeared to have been the driving force behind the funding transaction), nor any factors that put Commercial Factors on inquiry as to the risk of undue influence. The Court was satisfied that the transaction was a commercial one from Mr Hogan's point of view. However, it also noted that Commercial Factors did little to ensure that the guarantors were not subject to undue influence, although it wrote to the company strongly recommending independent legal advice for the guarantors.

 

(1) Hogan v Commercial Factors Limited (CA225/03, 10 November 2004 )

(2) Royal Bank of Scotland plc v Etridge (No.2) [2002] 2 AC 773

(3) Lee v Damesh Holdings (CA77/03, 30 September 2003)

Enquiries and information

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