Is your loan properly documented?
I recently reviewed two court cases that involved poor loan documentation. Both cases would have cost the parties a significant sum of money to go through court and in both instances, the lender was unsuccessful in recovering their money.
In the first case, the lender made a further advance on a loan arrangement herself (rather than using a solicitor to document the loan) and did not ensure the existing security secured the debt. In the second case, the lender used documentation that had been prepared by a solicitor, but did not pay attention to when interest could be charged.
Many of these issues are sleeping dogs until something dramatic happens, such as one of the parties becomes insolvent, the tax man comes knocking, or there is a marital dispute. You might also be called upon to show your bankers a copy of the loan agreement in some instances, or to produce a copy of the loan agreement when applying for liquor and gaming licences.
Who was borrowing?
The first case mentioned above was an appeal that upheld the Trial Judge’s decision. It involved two loans to develop a childcare centre. The first loan for $250,000 was made to Dr & Mrs Karam’s company. It was documented by a solicitor and the loan agreement included a guarantee given by Dr Karam and Mrs Karam and a charge.
The project ran into financial difficulties. The lender advanced a further $350,000. This time she relied on an unregistered mortgage prepared by Mrs Karam (the remaining guarantor) over the matrimonial home owned by Mr Karam.
A considerable amount of time was spent in court determining what the actual terms of the loan were. The Lender argued that the loan was made to the company and was secured by the guarantee. Mrs Karam argued that the second loan refinanced the first loan and the entire debt was owed by the now bankrupt Dr Karam and the guarantee given by her in the original loan agreement had been extinguished.
The result was that the guarantee by Mrs Karam remained as security for the initial loan of $250,000, but not the further loan of $350,000.
This was significant as Dr Karam had become bankrupt and the borrower had been liquidated. Presumably Mrs Karam held all that remained of the remaining family assets. The end result was the guarantee in the original loan document did not secure the $350,000 advanced to Dr Karam and the only claim the lender had for this money was against the bankrupts estate, but Mrs Karam remained liable to pay the $250,000 as guarantor of the original loan.
We don’t know the outcome of the claim against the Dr Karam’s bankrupt estate, but the securities taken were poor and unlikely to result in much of a debt recovery (see Karam v Varga  QCA 82).
Poor documentation of interest arrangements
The second case, Allen v G Developments Pty Ltd & Ors involved a property developer who defaulted on a loan. The Loan contract provided an interest rate of 25% p.a. to apply during the loan term but made no provision for interest after expiry of the loan.
After considering numerous contractual issues in his judgement, his honour awarded interest on the loan principal of $1 million at the relevant statutory rate from the commencement of proceedings until the loan was repaid. At the time, the statutory rate was 5.5% p.a., being the cash rate plus 4% p.a.
Importantly, the Court did not award interest from the time the loan contract expired until proceedings were commenced. The lender claim for interest and costs in excess of $1.6 million was rejected.
Once the parties reach a commercial agreement in relation to a loan, they should be precise as to the terms of their bargain and make sure the agreement works as intended. Important questions when documenting a loan include:
- Who is the borrower?
- What security is being offered and by whom?
- What is the loan amount, loan term interest rate, repayment amount, and what fees, charges and costs are payable by the borrower?
The loan agreement should include sufficient detail so each party will arrive at the same result for all payments to be made. It should also specify:
- what happens if payments are not made when required to be made;
- when the lender can accelerate payment of the debt;
- how the money is being disbursed; and
- any special conditions that apply to the loan.
The starting point for documenting a loan is to use a good precedent which addresses the relevant points. It takes time to create a good loan agreement and few business executives have the time to think past the creation of a terms sheet or attend to the detail needed to properly document a loan.
If your company is lending to a related entity, you need to consider whether the loan will be caught by the deemed dividend provisions in division 7A of the Income Tax Assessment Act 1936. These provisions deem loans made by a company to (among others) its shareholders taxable as dividends unless the loan falls within one of the exemptions provided under the Act.
We recommend obtaining proper advice from your lawyer or tax accountant about all of your (or your company’s) undocumented loan transactions, particularly those made by your company to you or one of your related entities.
With the end of the financial year fast approaching, now is the time to consider whether you have made loans during the year which should be properly documented to avoid any adverse tax outcomes.
If you are making a loan to your company or family consider whether you need to talk to our banking and finance team first.