Guarantees, priorities and rights of subrogation – a significant new case

Hugh Kettle, Partner | Wednesday 4 November 2009

A recent judgment of the High Court of Australia¹ has significant implications for guarantors, mortgagees, and legal practitioners involved in mortgagee sales and the drafting of guarantees and priority documents.

In particular, lenders will need to consider whether the no competition language in their standard form guarantees is sufficient to prevent guarantors from claiming rights against debtors in competition with lenders.

Facts

Unlike many leading cases, the fact situation was not an unusual one; the basic structure is substantially the same as that used for many property development financings in New Zealand until the recent slow-down in that area.

A company engaged in property development in Sydney borrowed funds from three mortgagees, ranking first, second and third respectively, secured over the same mortgaged properties. A director of the company and his wife provided a guarantee of the company's indebtedness to each of the mortgagees, which was secured by mortgages over property held in the guarantor's names.

After the company defaulted under the loans secured by each of the mortgages,the guarantors sold the properties held in their own names and applied the proceeds towards repayment of the first mortgagee. These sales were completed with the consent of the second and third mortgagees, who were required to discharge their mortgages over the relevant properties. Following these sales, the first mortgagee exercised its power of sale against the property mortgaged by the company. The proceeds of sale were sufficient to repay the first mortgagee in full, and the first mortgagee turned over the surplus to the second mortgagee. The second mortgagee also retained the proceeds of the sale of two final lots in reduction of its indebtedness.

Legal proceedings

The guarantors brought proceedings in the Supreme Court of New South Wales, claiming that they were subrogated to the rights of the first mortgagee, and that the surplus turned over to the second mortgagee should have been repaid to them. They claimed that, in turning over the surplus to the second mortgagee, the first mortgagee had breached a constructive trust in favour of the guarantors. On the same basis, they claimed that the second mortgagee and the solicitors who disbursed the funds were liable for knowing assistance in breach of this trust.²

The Supreme Court of New South Wales, and the Court of Appeal, dismissed this claim.

High Court of Australia decision

The High Court of Australia allowed the appeal and held that the surplus balance should have been paid to the guarantors, who were entitled to be subrogated to the rights of the first mortgagee. The doctrine of subrogation has two limbs. First, it gives a guarantor the right, following enforcement of a guarantee, to step into the shoes of the creditor in enforcing rights against the debtor. Secondly, it imposes on the creditor the obligation to account to the guarantor for any recovery in surplus of the full amount of the debt. Both limbs were relevant in this case.

The High Court held that there was nothing in the guarantee in favour of the second mortgagee that precluded the guarantors from exercising their rights of subrogation against the first mortgagee; in particular, the 'no-competition' clause was not drafted in a manner that would prevent the guarantors from enforcing their rights. The Court accepted that the guarantors subrogation rights could have been excluded by agreement, but that, interpreting the no-competition clause in this case, they were not. On this basis, the first mortgagee should have given effect to the guarantor's subrogation rights, and the first mortgagee should have held the surplus proceeds on trust for the guarantors. While the Court did not decide this point, on the same reasoning, the second mortgagee, and potentially the first mortgagee's solicitors, could have been liable for knowingly assisting in the breach of trust caused by the first mortgagee turning over the surplus to the second mortgagee.

Commentary

From a strict legal perspective, there is nothing controversial about the Court's application of the law. However, the case is significant for a number of reasons:

• The outcome cuts across what would have been the assumed commercial position of all parties to the transaction (most likely including, at the time of entry into the financing documents, the guarantors). In the fact situation outlined above, the lenders would have expected to be paid in descending order of priority, with the guarantors only receiving any surplus once the third mortgagee was paid out in full. The reasoning of some of the lower courts was clearly influenced by this consideration.

• The Court made it clear that the second and third mortgagees could have improved their positions through the drafting of their guarantees, and also through imposing additional conditions at the time they released their mortgages over the guarantors' properties. The wording of guarantees given to second or subsequent mortgagees needs to be considered carefully in light of this case. It would be prudent to ensure that no-competition clauses carve out subrogation rights, including in respect of any prior ranking guarantee or security, until the relevant mortgagee is repaid in full.

• The case does not mean that the guarantors were no longer liable under their guarantee to the second mortgagee. While this was not covered in the High Court's judgment, the likely outcome would be that, even if the cash was returned to the guarantors, they would still have an unsecured liability to pay the second and third mortgagees under their guarantee. This could, however, still have a negative impact on those mortgagees' ability to recover the funds, particularly if the guarantors were bankrupt (or, on similar facts, if a corporate guarantor was in receivership or liquidation).

• This case is also relevant for solicitors acting on mortgagee sales or similar, and their disbursement of the proceeds of sale. If the guarantors had consented to the payment being made to the second mortgagee at the time it was made, they would have been unable to bring this case. Solicitors will need to satisfy themselves that they either have consent from the borrower and guarantors to release the funds, or that there are no competing equities, when faced with a similar fact situation.

For further information contact:

David Craig
Partner

Hugh Kettle
Partner

Murray King
Partner

David McPherson
Partner

Rachel Paris
Partner  

¹Bofinger v Kingsway Group Limited [2009] HCA 44. The judgment was dated 13 October 2009.

²This claim was based on the second limb of liability set out in Barnes v Addy (1874) LR 9 Ch App 244.