Mortgagees need to beware of guarantors

11 November 2009

Introduction

The recent High Court decision in Bofinger v Kingsway Group Limited [2009] HCA 44 allowed the guarantors to claim equitable compensation from the first mortgagee and in so doing placed them ahead of the second and third mortgagees.

The facts

B & B Holdings Pty Ltd (“Borrower”) carried on business as a real estate developer. The Borrower obtained finance from three lenders, all of whom took mortgages over the same real properties owned by the Borrower. A first ranking mortgage was granted to Kingsway Group Pty Ltd (“Kingsway”), a second ranking mortgage to Reckley Pty Ltd (“Reckley”) and a third ranking mortgage to John Skehan (“Skehan”).

Each of the three loans was guaranteed by Mr and Mrs Bofinger (the “Bofingers”), both were directors of the Borrower. Each guarantee was in turn secured by first, second and third mortgages over the family home and an investment unit owned by the Bofingers. The court made no reference to any priority or inter-creditor agreement between the mortgagees.

Following default by the Borrower, the Bofingers voluntarily sold their properties, applying the net proceeds of sale (in the vicinity $1.5 million) to Kingsway to reduce the first loan. All three mortgages over the Bofingers’ properties were discharged upon settlement.

Thereafter, Kingsway exercised its power of sale over some of the properties mortgaged by the Borrower in order to satisfy the amount outstanding under the first loan.

Having satisfied the balance of its debt, Kingsway paid the surplus sale proceeds to Reckley as second mortgagee. Kingsway also delivered to Reckley the certificates of title to the two unsold properties of the Borrower together with a discharge of Kingsway’s mortgage for each of the unsold properties.

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The claim by the guarantors

Kingsway did not, as the Bofingers contend it should have done, account to the Bofingers so that they might recoup what they had paid as sureties of the Borrower’s indebtedness. The primary case of the Bofingers was that Kingsway has distributed the surplus in breach of the constructive trust in which the surplus was held for them as sureties.

The Bofingers, by reason of the fact that they had sold their own properties and applied the proceeds in reduction of Kingsway’s debt, claimed to be entitled, as guarantors of that debt, to the benefit of the security (i.e. the surplus proceeds and unsold properties) held by Kingsway after its debt had been discharged in priority to Reckley (and Skehan) pursuant to the principles of subrogation in equity and s 3 of the Law Reform (Miscellaneous Provisions) Act 1965 (NSW).

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The decision

The High Court overturned the Court of Appeal’s decision and accepted that the surplus money was held by Kingsway on constructive trust for the Bofingers. Citing as its authorities Giumelli v Giumelli (1999) 196 CLR 101 and Jones v Southall & Bourke Pty Ltd (2004) 3 ABC (NS) 1, the court held that the constructive trust included the obligation of a defaulting party to make restitution by personal rather than a proprietary remedy.

The High Court concludes at [49] – [50]: “On 8 February 2006 the first mortgagee was obliged in good conscience both to account to the appellants for surplus moneys and securities it held and not to undertake or perform any competing engagement in that respect without prior release by the appellants. These obligations were fiduciary in character … In respect of its misapplication of the surplus moneys and securities and the consequent loss to the appellants the first mortgagee is to be treated as a constructive trustee to the extent that it must account to the appellants as a defaulting fiduciary. It is unnecessary to seek to determine upon the agreed facts whether the first mortgagee was a trustee in a fuller sense which afforded the appellants a beneficial interest in the assets in question”.

The High Court further found that the terms of the second guarantee did not constitute a waiver of the rights to the surplus moneys although it appears that more specific drafting could have done so.

Finally, the High Court rejected the line of English authority on the law of subrogation in the context of its relationship to the doctrine of unjust enrichment.

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Implications

In view of the decision:

  • mortgagees holding surplus funds need to enquire as to the potential entitlement of guarantors before making any payment to the next ranking mortgagee;
  • mortgagees need to consider widening the terms of their current priority and inter-creditor documents to ensure that guarantors’ rights are waived and, most importantly, to ensure that all guarantors are parties to these documents; and
  • second and subsequent mortgagees need to consider expanding the waiver provisions in their guarantee documents to ensure that the guarantors waive any rights of subrogation in respect to prior mortgages and charges.
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