Allens

Banking & Finance

Focus: Mortgagee loses priority to guarantor – drafting of guarantees not wide enough to help it

30 October 2009

In brief: In a recent case1 , the High Court of Australia examined the subrogation rights of guarantors, and applied them to the disadvantage of mortgagees. In this Focus, Partner Diccon Loxton (view CV) analyses the principles in the case. In a separate Focus, he will look at the drafting of guarantees in the light of the decision.

How does it affect you?

  • Lenders will need to look at the drafting of their guarantee documents, particularly the no-competition clause, the clause that is designed to stop guarantors claiming subrogation and other rights against the debtor in competition with the creditor.
  • Secured lenders who receive payments from guarantors will need to take care when distributing the proceeds of security or discharging security.

The facts

A borrower raised loans from a first mortgagee, a second mortgagee and a third mortgagee, giving each in turn mortgages over the same four properties. Two guarantors gave guarantees to each mortgagee in relation to their respective loans.

The borrower defaulted. The guarantors paid to the first mortgagee some of the amounts owed to it. The first mortgagee recovered the balance by enforcing its mortgages and selling two of the mortgaged properties under a power of sale.

When it had recovered the full amount owed to it, the first mortgagee paid the balance of the sale proceeds to the solicitors for the second mortgagee (who were also its own solicitors). It also discharged its mortgages over the remaining two properties, leaving the second mortgagee as the highest-ranking mortgagee.

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The claim

The guarantors claimed the following:

  • Once the first mortgage debt had been paid, they were subrogated to the first mortgagee's securities. That is, they stepped into the first mortgagee's shoes in relation to its rights and security in order to recover from the borrower what they paid to the first mortgagee.
  • As a result, the first mortgagee held on trust for the guarantors the first mortgages over the remaining properties and the balance of the proceeds of sale of the mortgaged properties sold by it. If there was no trust, the proceeds and mortgaged properties were charged to the guarantors. It should have accounted for them, and it owed fiduciary duties.
  • As the guarantors stepped into the shoes of the first mortgagee, their rights ranked ahead of subsequent mortgagees.
  • The second mortgagee was liable to account for the assets received by it. The solicitors were liable as constructive trustees for being knowingly involved in the breach of trust or breach of fiduciary duty by the first mortgagee.

It is not clear from the reported judgments why the guarantors brought this action. If the guarantors managed to get funds in priority to the second and third mortgagees, then that would only increase the potential liability under the guarantees to the second and third mortgagees if their guarantees were still on foot.

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The response

The mortgagees and solicitors said the following:

  • Even if the guarantors had had a right to the remaining sale proceeds and to the remaining first mortgages, those proceeds had been paid away and those mortgages had been discharged. There was nothing to be subrogated to or to be the subject of a trust or charge.
  • There were no trusts or other fiduciary obligations imposed on the first mortgagee, so there was no basis for a constructive trust remedy or obligation to account.
  • They accepted that a guarantor of a first mortgage debt would normally be subrogated to the first mortgage and rank ahead of subsequent mortgagees; but this was different because the guarantors were also guaranteeing the subsequent mortgage debts. It was inequitable to give the guarantors a right of subrogation ranking ahead of the subsequent mortgage debts that they had themselves guaranteed.
  • The right of subrogation was excluded by the terms of the guarantee to the second mortgagee.

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The result and the appeal, in summary

The guarantors lost at first instance and in the New South Wales Court of Appeal, and appealed to the High Court.

The appeal was upheld unanimously by the High Court. Justices Gummow, Hayne, Heydon, Kiefel and Bell issued a joint judgment.

In short, they said that the guarantors were subrogated to the first mortgagee. The existence and terms of the guarantees given by the guarantors to the second and third mortgagees were not enough to prevent that subrogation. The first mortgagee was obliged to account to the guarantors for the proceeds and the mortgages. It owed fiduciary obligations. These obligations were breached and this might give rise to constructive trusts on the other parties who were involved. It didn't matter that the 'trust property' had been passed on or discharged, as the remedies were not necessarily proprietary.

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Detailed reasons

The nature of subrogation

The High Court quoted with approval a statement by Sir Andrew Morritt V-C about subrogation in the context of sureties:

The right operates so as to confer on the surety who has paid the debt in full the rights against the debtor formally enjoyed by the creditor or by imposing on the creditor the obligation to account to the surety for any recovery in excess of the full amount of his debt (emphasis added [by the High Court]).

That right of subrogation was founded upon the fact that the principal is ultimately liable, and must indemnify the surety. 'It would be unconscientious for the debtor to recover back the securities from the creditor while the debtor was obliged to indemnify the surety', the court said.

This applies even when there are subsequent mortgagees.

The drafting of the guarantee to the second mortgagee – interpreted in favour of guarantor

The High Court accepted that a right of subrogation could be excluded by agreement, and that conduct could make it inequitable for the surety to enforce subrogation. They said that in this case the drafting of the guarantee was not sufficient to exclude it.

They said that the settled principle in the interpretation of contracts of guarantee and indemnity is that any doubt in the construction should be resolved in favour of the guarantor. They said doubt may arise not only from the uncertain meaning of a particular expression, but also 'from its apparent width of possible application' – a worry, when guarantees are drafted as widely as possible.

There was nothing in the express drafting that would displace subrogation. We look at the court's analysis of the drafting in a separate Focus.

Crucially, as we will see below, the court did not see anything in the wider circumstances (such as the fact that as between the guarantors and the second mortgagee, the guarantors were taking the risk of a shortfall) that would mean the guarantors should not be entitled to be subrogated to the security proceeds in priority to the second mortgagee.

Other points – the nature of the interest of the guarantor in the first mortgage security and proceeds

The High Court said it did not need to determine whether the first mortgagee was a trustee for the guarantors, or whether there was a charge. However, the first mortgagee did owe obligations 'fiduciary in character'.

The court said that it didn't matter that there was no longer any subject matter of a trust or constructive trust.

They quoted Justice Crennan in Jones v Southall & Bourke Pty Ltd,2 where she said that the authorities:

make plain [that] the term 'constructive trust' covers both the trusts arising by operation of law and remedial trusts. Furthermore, a constructive trust may give rise to either an equitable proprietary remedy based on tracing or, whether based on or independently of tracing, an equitable personal remedy to redress unconscionable conduct. The equitable personal remedies include equitable lien or charge or a liability to account.

The first mortgagee could be required to account as a defaulting fiduciary. Breach by the first mortgagee of the fiduciary obligations would, the court said, be sufficient to engage the principles associated with the second limb (knowing assistance) in Barnes v Addy3 (which would mean that it was possible that the second mortgagees and solicitors might be constructive trustees).

Consideration of the judgment of the Court of Appeal

The three judges had given three different sets of reasons, and the High Court dealt with each in turn.

Giles JA had said that it was important that the guarantors had given guarantees not only to the first mortgagee but also to the second and third mortgagees. He said that there was a plain intention that the second mortgagee was to have resort to its security after the first mortgagee but before anyone else. By issuing guarantees to the second mortgagee, the guarantors had undertaken obligations which were inconsistent with their getting any prior entitlement. The High Court took a narrower view of the arrangement, and said that the terms of the guarantee did not manifest any such intention. There was no displacement of priority. There was nothing in the circumstances rendering it inequitable for the appellants to enjoy the right of subrogation.

Handley AJA had relied upon estoppel by convention and an extension of the rule in Otter v Lord Vaux.4 That rule provided that when a mortgagor acquired a mortgage over its own property there was an automatic merger of the mortgage into its title to the property. The High Court said that there was no estoppel by convention in this case because the agreed facts would fall far short of what was necessary to establish the priority of the second mortgagee, and merger wasn't available because they were Torrens title mortgages.5

Sackville AJA, according to the High Court, said that subrogation would not apply because there is nothing unconscionable or unjust in the first mortgagee applying surplus proceeds to the second mortgagee. The High Court criticised that approach and said that, in any event, that reasoning does not allow for the fact that the surplus payable to the second mortgagees only arose after payment had been made by the guarantors.

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The Third (or fourth or fifth) Blast of the Trumpet Against the Monstrous Regiment of Unjust Enrichment

The High Court again took the opportunity6 to keep up its vigorous defence of traditional equitable jurisprudence, and its resistance to 'top-down' judicial reasoning and to the notion of unjust enrichment as a definitive unifying legal principle.

'Unjust enrichment', a concept initially borrowed from civil law, has been promoted by English and other academics and writers in the field of the law of restitution as a theory to explain and systematise the law. It has been percolating into judicial reasoning. Proponents have varying views on the breadth of its reach, and on its content, but many would see it as imposing strict liability. Once it was established that the defendant was 'unjustly enriched' at the expense of the plaintiff, the defendant would be liable subject only to standard defences like change in position. It is perhaps a concept more beloved of academics seeking to systematise than of practitioners seeking to predict.7

The court said that the concept of unjust enrichment may 'provide a means for comparing and contrasting categories of liability' (for example, between subrogation and contribution, which have different foundations and different results). It also 'may assist in the determination by ordinary processes of legal reasoning of the recognition of obligations in a new or developing category of law' (like money paid under mistake of law), but subrogation was not such an area, and equity gave sufficient vitality for its development.

They said, 'All-embracing theories may conflict in a fundamental way with well-settled doctrines and remedies'. The High Court in particular and Australian courts in general have long had a focus on the traditional doctrines and remedies of equity, with their emphasis on the conscience of the defendant. The High Court was particularly provoked by (and addressed in their judgment) statements by the late Professor Birks, who had criticised what he saw as the lack of firm rules in equity and the vagueness of conscience as a guiding principle.

They also differed from the approach taken in the House of Lords, particularly Lord Hoffman, in Banque Financi?e de la Cité v Parc (Battersea) Ltd.8 They had seen subrogation as founded on unjust enrichment. The High Court did not agree, seeing the doctrinal basis for subrogation in Australia as settled. In the case of sureties, it would be unconscientious for the debtor to recover back securities from the creditor while the debtor is obliged to indemnify the surety. In this case, the unjust enrichment approach would probably produce a different result – it is hard to see who is unjustly enriched.

This is an example of the drift of Australian and English jurisprudence from each other, influenced by different currents: in England by European Community law and some interaction with civil law; in Australia by the greater regard paid to traditional equity scholarship, and by the greater propensity for parliaments to legislate to create new or expanded private rights and obligations, such as prohibitions on misleading or deceptive conduct or unconscionability.

Footnotes
  1. Bofinger v Kingsway Group Limited [2009] HCA 44.
  2. (2004) 3 ABC (NS) 1 at 17.
  3. (1874) LR 9 Ch App 244. It is curious that the court did not mention, at least in relation to the second mortgagee and the mortgage proceeds, the possibility of the first limb applying, that is, a recipient liability.
  4. (1856) 2 K&J 650 [69 ER 943].
  5. This raises the question of what would have happened had they been other forms of security.
  6. See Farah Constructions Pty Limited v Say-Dee Pty Limited (2007) 230 CLR 84-89, and Lumbers v W Cook Builders (2008) 232 CLR 635 at 664-665. See also the reasoning of Justice Gummow in Roxborough and Others v Rothmans of Pall Mall Australia Ltd (2001) 185 ALR 335 at 353.
  7. Though maybe not those who want to throw 'unjust enrichment' in with a kitchen sink of claims.
  8. [1999] AC 221 at 223.

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