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On 22 February 2008, the New South Wales Supreme Court released the decision of Khan as Trustee for The Khan Family Trust v Hadid [2008] NSWSC 119, relating to a mortgagee that was unable to enforce a registered mortgage due to the presence of fraud.

Mr and Mrs Hadid were owners of a property in Punchbowl. On 26 November 2006, the Land Titles Office sent a letter advising them that a caveat had been recorded against their property. It emerged that their signatures had been forged upon mortgage documents. The terms of the forged mortgage provided that the interest created by the said mortgage would be protected by caveat, and the mortgage would be registered only in the event of default.

Ms Palumbo was a business acquaintance of Mr Hadid and the proprietor of a travel agency. When in need of money, Mr Hadid agreed to guarantee a small loan for her and provided personal documents (a copy of his driver’s licence and proof of his assets) for this purpose. No documents were ever signed to this effect. Ms Palumbo subsequently contacted a mortgage broker (Ms Bradaric), who contacted a solicitor (Mr Hancock), who contacted another mortgage broker (Peter Fisher & Co), who in turnapplied to a mortgage manager (Response) acting on behalf of Mrs Khan for a loan of $130,000 on behalf of Mr and Mrs Hadid.

A letter of offer was sent along this same chain of communication (in reverse) and was returned with signatures purporting to be those of Mr and Mrs Haddid. The same occurred with mortgage documents. During the entire process, Mr Hancock represented that he was acting for Mr and Mrs Haddid when in fact he had received no such instructions. Furthermore, the documents were purportedly witnessed by another solicitor, Mr Flammia, when in fact they were never signed by Mr or Mrs Haddid. Both of these facts allowed Mrs Khan’s solicitors to take comfort in the belief that Mr and Mrs Khan had received legal advice and that the transaction was legitimate.

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Mr Hancock gave settlement instructions to Mrs Khan’s solicitors indicating that funds were to be paid (after lending expenses had been deducted) to the travel agency operated

by Ms Palumbo. The reason given for this was that Mr Hadid was purchasing the travel agency. A sum was also paid to a business of which Mr Hancock was a director, purportedly as a fee for his services in acting for Mr and Mrs Hadid.

Upon their failure to make repayments to the mortgagee, Mrs Khan, the mortgage document was registered and notices of default were issued to Mr and Mrs Hadid.

The forged mortgage supposedly secured a loan of $130,000. By the close of the hearing, interest had brought the amount close to $1 million or (on the calculation of another party) over $30 million.

Neither Mrs Khan or her agents were found to have had actual knowledge of fraudulent conduct in relation to the mortgage documents.

Issues: In his judgment, Rothman J gave much consideration to the principle of indefeasibility

Indefeasibility Fails to Rescue Mortgagee..... 1

Poor Workmanship Can Be Grounds For Rescission.... 5

The Margin Scheme - Does It Work The Way We Thought It Did? ........................................ 3

In Brief............................................................................ 6

Court Examines Tension Between Non Est Factum and Unjust Enrichment....................... 4

Legislation Updates....................................................... 6

banking finance &

Indefeasibility Fails to Rescue Mortgagee

BRIEF

March 2008

Banking & Finance Brief - March 08

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Indefeasibility Fails to Rescue Mortgagee (cont.) of title. The principle provides that those with a registered interest in land are guaranteed by the State to the extent of that interest. He commented that adherence to the principle is “so essential, that registered title can be successfully challenged only in the most exceptional circumstances.”

These exceptional circumstances occur only in the case of fraud. The issues to be considered in this case were therefore: (a) What type of fraud (and on whose part) is required to invalidate registered title? (b) Did fraud occur in this case? If so, what type of fraud and to whom was it attributable? (c) If fraud was found to have occurred, was it sufficient to invalidate Mrs Khan’s interest in the land?

Fraud: Rothman J confirmed that the only fraud capable of invalidating registered title is “actual fraud, personal dishonesty or moral turpitude on the part of the registered proprietor... or of that registered proprietor’s agents.” This extends to that which might be commonly termed ‘willful ignorance.’ That is, if a person has reasonable grounds for suspicion and refuses to make further enquiries for fear of learning the truth, this is in law equivalent to actual fraud.

In this case, it was determined that Mrs Khan had given her agents sufficient authority and discretion to act on her behalf such that any fraud on the part of her agents constituted fraud by Mrs Khan. However, neither Mrs Khan nor her agents had actual knowledge that any forgery or fraud had occurred, and did not have sufficient grounds for suspicion to be fraudulent by intentional ignorance (at least until after the caveat was lodged and Mr Hadid called to deny the authenticity of the mortgage). Thus there was no fraud on the part of Mrs Khan in the creation of the equitable mortgage.

However, Rothman J drew a distinction between fraud in the creation of the equitable interest in land and fraud in the conversion of that interest into a legal one through registration. He found that Mrs Khan, through her agents, obtained knowledge that Mr Hadid’s denied signing the mortgage prior to registration, even though they had no such knowledge prior to settlement. Even this, however, was not sufficient to invalidate Mrs Khan’s title on its own.

The second element was a contractual breach. The mortgage provided that Mrs Khan’s interest would be protected by caveat, not registered mortgage, unless the mortgagor should default. The mortgage also allowed a seven day period for the payment of interest beyond the date at which such interest became payable. As the mortgage was registered within this period, the mortgagor was not in default at the time of registration.

Therefore, Mrs Khan’s legal interest in the land was obtained in breach of contract. This, coupled with her knowledge at the time of registration, was sufficient to determine that the mortgage was registered not for the purpose of protecting Mrs Khan’s interest, but for defeating the legitimate interest of Mr and Mrs Hadid.

As such the registration of the mortgage was effected by fraud and the fraudulent conduct of Mrs Khan, through her agents, defeated the indefeasibility of her title.

Mortgagee’s Perspective: The immediate error on the part of Mrs Khan was the failure to personally identify Mr and Mrs Hadid. Identity verification and confirmation of loan conditions with the borrower personally are fundamental components of the lending process, and failure to perform these adequately creates opportunities for ‘middle-man’ fraudsters.

Also important, however, are the implications of fraud in dealings with land revealed in the reasoning of Rothman J. It serves to repeat that Mrs Khan personally was found to have had no knowledge of fraud or even cause for suspicion. The fraud attributed to her was solely as a result of the actions of her agents. It should be understood that by granting sufficient authority and discretion, fraudulent actions of the agent may well become binding upon the mortgagee. As far as is practical, the oversight of those exercising such authority and discretion is therefore desirable. The consequences of fraud, in certain circumstances such as these, carry enough weight to destroy even indefeasible title.

Congratulations Kemp Strang congratulates two of its partners, Scott Hedge and Alex Linden who were listed in the Australian Financial Review on Friday 7 March among Australia’s top insolvency lawyers as prepared by Best Lawyers International. Selection to Best Lawyers is based on an exhaustive and rigorous peer-review survey. www.kempstrang.com.au

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The margin scheme - does it work the way we thought it did?

On 18 February 2008, the Federal Court of Australia delivered its judgment in Brady King Pty Limited v Commissioner of Taxation [2008] FCA 81, a case relating to the entitlement of a taxpayer to implement the valuation method under the margin scheme. This case is of particular importance to property developers as the Courts interpretation of when the margin scheme can be applied was inconsistent with the previous practice of the Australian Tax Office (“ATO”).

Facts: On 22 May 2000, Brady King Pty Ltd (“Brady King”) exchanged contracts for the purchase of an office building for $9,250,000.00. Settlement occurred five months later on 25 October 2000, and the transfer registered on 9 November 2000.

Brady King converted the building to residential apartments (stratum units), and sold most units off the plan between April and November 2001.

Brady King obtained valuations of the stratum units as at 1 July 2000 totalling $23,200,000.00. They then lodged GST returns calculating GST on the margin between the amounts specified in the valuation and the sale price of each unit.

The ATO considered that Brady King was not entitled to use the valuation method to calculate its margin for margin scheme purposes as it did not have a ‘freehold interest’ in the property at the date of the valuation (1 July 2000) as required by s 75-10 (3) of the A New Tax System (Goods and Services Tax) Act 1999 (the “GST Act”).

Accordingly, the ATO issued assessments calculating GST on the margin between the amounts paid for the office building and the sale price of the units.

Issues decided by the Court: Brady King argued that it held, or had acquired the stratum units as at 1 July 2000 and the valuation complied with s 75-10(3) of the GST Act. The ATO argued that as Brady King did not hold and had not acquired the property as at 1 July 2000, it was not entitled to use the valuation method.

The Court agreed with the Tax Office’s submission and ruled that Brady King was not permitted to use the

valuation method, as it did not hold the stratum units as at 1 July 2000. The Court went further and stated that in any event, the valuation method could only apply where the same interest in property is acquired and sold.

The Court also concluded that it was necessary for a legal interest on the relevant property to be held at the valuation date, and in this case Brady King, as purchaser under an uncompleted contract, only held an equitable interest in the property.

Implications: Prior to the Federal Court’s finding, the ATO’s longstanding practice was that the margin scheme could be applied where the taxpayer held or had acquired a freehold interest in the parent title, and then subsequently sold subdivided land or buildings derived from that title. This occurs in most residential development projects as they usually involve altering the parent title by subdivision of land or the registration of a strata plan.

In Brady King, the Court found that it was no longer possible to apply the margin scheme on sales of land where the title to the property sold differs from the title to property acquired (the parent title). Middleton J found that the margin scheme can only apply where the same property being acquired is subsequently sold.

The consequences of this decision are two fold – firstly, the margin scheme can no longer be applied whenever the title to property sold is different to the title originally acquired. Secondly, this could mean that many past property transactions under the margin scheme have not been correctly treated and GST may have been underpaid.

The ATO’s Response Brady King has lodged an appeal to the Full Court of the Federal Court against the decision of Middleton J. Whilst the ATO was successful, the ATO acknowledged that the reasoning of the Court is contrary to both its submissions to the Court and its long-standing practice.

The ATO has contended that the appeal should be resolved on the basis of its submissions The ATO has stated that it has no intention to revise its current rulings until the outcome of the appeal is known, and has affirmed that property developers may continue to rely upon those rulings in preparing their Business Activity Statements. www.kempstrang.com.au

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Court Examines Tension Between Non Est Factum and Unjust Enrichment On 1 February 2008, the NSW Supreme Court handed down its decision in Perpetual Trustees Victoria Ltd v Ford [2008] NSWSC 29. This case involved a mortgage dispute between an illiterate and intellectually disabled mortgagor, who had defaulted under a loan agreement with the plaintiff (Perpetual).

The defence of non est factum is only available to those who are blind or illiterate, or are unable to have any understanding of the document in question. To make out this defence, a defendant must show (a) that he or she signed the document in the belief that it was radically different from what it was in fact; and (b) at least against innocent persons, that this was not due to carelessness on his or her part.

This case is significant as the Court found that although the defendant was able to establish the defence of non est factum and the loan agreement and mortgage were void as a result, the defendant was unjustly enriched at the expense of the plaintiff. As such,the Court ordered restitution equal to the dollar amount outstanding on the loan plus interest.

Facts: The defendant, who suffers from a congenital intellectual impairment and is also illiterate, borrowed $200,000 from the plaintiff under a loan agreement secured by a mortgage over the defendant’s home. The defendant had inherited the property from his mother in 1994. At the time of the loan, he was in receipt of a Disability Pension and had no capacity to service the payment of interest on the loan.

The loan was arranged by the defendant’s son, through a mortgage broker, in order that the son could purchase a cleaning business.

The defendant was unable to meet the loan repayments and in seeking to have the mortgage and loan agreement set aside, he argued that he was not liable to the plaintiff because of his serious intellectual impairment.

The defendant argued firstly that he lacked the capacity to contract, secondly, he relied on the doctrine of non est factum (‘not my deed’) and thirdly the defendant alleged that to enforce the contract against him would be unconscionable and/or unfair or unjust within the meaning of s7 of the Contracts Review Act 1980 (NSW).

The defendant also pleaded that the loan agreement and mortgage were signed by the defendant in circumstances of undue influence or duress.

Findings: Harrison J of the NSW Supreme Court found that the defence of non est factum was made out, since the defendant had ‘no understanding at all’ of the transaction he had entered into with the plaintiff.

His Honour described two situations in which the defence can succeed. The first is where the defendant has no positive belief at all about the nature and effect of the document. The second is where the defendant has a positive belief as to the nature and effect of the document, but that belief is radically different from its actual nature and effect.

In this case, Harrison J found that the defendant lacked the capacity to form a judgment about the nature and effect of the documents he was required to sign in order to effect the transaction. He found that the defendant had no positive belief at all about the nature and effect of the documents he was signing.

Harrison J held that the non est factum defence had been made out, and the loan agreement and mortgage were void and unenforceable as a result.

HOWEVER, Kemp Strang acting for the Plaintiff successfully argued that the money advanced to the defendant was advanced on the basis of a mistaken belief that the loan agreement was valid and enforceable against the defendant according to its terms. This was a mistake of fact.

The plaintiff also contended that there was a failure of consideration. The plaintiff had bargained for a binding promise from the defendant to repay the loan in accordance with the agreement, secured by a mortgage over the defendant’s property. The plaintiff did not receive this, since the Court found that the loan agreement and mortgage were void and unenforceable due to the defendant’s successful non est factum defence.

Harrison J acknowledged that there was some tension between the notion of an incapacitated defendant being able to establish a defence that avoids the contract on one hand, and nonetheless remaining liable for the ‘benefits’ (that he neither understood nor agreed to) that had passed to him on the other.

Nevertheless, Harrison J found that the defendant had been unjustly enriched at the expense of the plaintiff and ordered that the defendant repay the full amount of the loan plus interest. www.kempstrang.com.au

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Poor Workmanship Can Be Grounds For Rescission On 15 February, the New South Wales Supreme Court delivered its judgment in Vella v Ayshan [2008] NSWSC 84, a case relating to a purchaser’s entitlement to rescind a sale contract where the property provided was not as described.

Facts: On 7 July 2004, Mr Vella and another (the purchasers) entered into a contract for the sale of land with Mr Ayshan and others (the vendors).

On 26 April 2005, the purchasers refused to complete the purchase on the grounds that the vendors had failed to cause the residence to be constructed in a proper and tradesmanlike manner and in accordance with the plans.

On 2 May 2005, the purchasers gave notice of termination of the contract and sought a refund of the deposit. The vendors treated the notice of termination as a repudiation and themselves purported to terminate the contract and forfeit the deposit.

The purchasers relied on two special conditions (“SC”) which required the vendors to: 1) erect the residence in a proper and tradesmanlike manner and to provide the purchaser with an Occupational Certificate under the Environment Planning and Assessment Act (SC 15); and 2) rectify any faults due to faulty materials or workmanship if the purchasers gave notice within a period of ninety (90) days after the date of completion of the agreement (SC 16).

Issues: Issues before the Court included: • Whether SC 15 was a term of the contract, which if breached, would entitle the purchasers to rescind the contract; • Whether SC 15 would only be breached if the residence were not fit for habitation; • Whether the purchasers, if successful, were entitled not only to a return of their deposit but also damages for legal fees. Conversely, if the vendors were successful, whether they could claim as damages the loss on resale but also claim additional moneys spent on the property at the purchasers’ request.

Decision: The vendors argued that SC 15 was not a term of the contract, as it was inserted to amend the contract after the two-week cooling-off period had expired. The Court held that the SC15 formed part of the contract, as the variation to the contract (along with the inclusion of the terms of the SC 15) potentially extended the time by which the vendors were required to complete the work, therefore, providing consideration for the vendors’ promise.

Additionally, had the variation to the contract been concluded prior to the expiry of the cooling-off period, the purchasers’ forbearance to exercise their right to rescind would have amounted to consideration. Further, if SC 15 was not inserted into the contract, similar terms would

have been implied from the common law into to the contract, albeit that the purchasers’ contractual right to rescind had expired.

The Court concluded that SC 15 was an essential term, any breach of which would entitle the purchasers to rescind. The emphasis here was on the subject matter to be conveyed being substantially identical with the subject matter described in the contract. SC 15 was used as both a further description of the subject matter of the sale and as a term relating to the quality of the residence. Therefore, any substantial departure from the description of the subject matter found in SC 15 entitled the purchasers to a return of all moneys paid.

The purchasers contended that at all times there were five defects in the construction of the residence that had not been rectified. The purchasers were found to have notified the vendors of the defects in accordance with SC 16. Notwithstanding the defects in construction, there was no question that the residence was fit for habitation. Therefore, the purchasers could only terminate the contract if the defects were serious enough, as a court may overlook defects that are isolated or are trivial departures from a building standard.

In considering the terms of SC 15, the Court rationalised that a house fit for human habitation did not necessarily equate to a house constructed with proper materials and in a proper and workmanlike manner. Therefore, the Court concluded that the obligation to erect the residence in a proper and tradesman like manner was not to be read down as meaning merely to erect a residence that was fit for habitation. Whilst the vendors had erected a residence that was fit for habitation, the inherent defects were not trivial as they involved departures from mandatory building standards. Consequently, the vendors were held liable for breaching both limbs of SC 15.

The Court found the purchasers were entitled to a return of their deposit.

Relevance: New clauses, which vary a contract after exchange, are enforceable if supported by consideration. If the cooling-off period has expired, consideration supporting a new clause can be derived from contractual amendments that have the potential to extend the time by which a party has to perform a promise. If however, the new clause is included in the contract within the cooling-off period, the forbearance to exercise a right to rescind a contract during this period can amount to valuable consideration. www.kempstrang.com.au

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In Brief • The Australian Prudential Regulation Authority (APRA) has released its reporting requirements for authorised deposittaking institutions (ADIs) under the new Basel II capital adequacy regime. The Basel II reporting standards come into effect on 1 April 2008 and the first submission of data will cover the period 1 January 2008 to 31 March 2008. The full range of reporting standards, forms and instructions are available on APRA’s website (www.apra.gov.au) • In Franks v Equitiloan Securities Pty Ltd [2008] NSWSC 33, the Supreme Court of NSW considered the construction of a mortgage; whether a higher rate of interest is payable unless the mortgagor satisfies certain conditions obliging the mortgagee to accept the lower rate and where the mortgagee represents that nothing will happen on the expiry of the loan, whether the mortgagee is estopped from charging a higher interest rate. The Court held that the mortgagor was entitled to pay interest at lower rate until a certain date on the basis of construction but that upon expiry of the loan, they were no longer eligible for the lower rate as a matter of strict legal right. However, because of its representation, the Court found the mortgagee was estopped from insisting on its strict legal right to charge higher rate interest.

• The Australian Securities and Investments Commission (ASIC) has responded to the Treasurer’s initiatives around switching fees on home loans. ASIC plans to examine the level of exit and entry fees on home loans, the industry rationale for charging them, how they work in practice and the current disclosure of these fees. ASIC has also committed to enhancing the complaints mechanisms available to consumers on banking products and services to ensure consumers are directed to the right regulator or disputes scheme if they feel they have problems.

Legislation Updates The following bills have been proposed for introduction in the Autumn 2008 sittings of parliament: Corporations (Miscellaneous Amendments) Bill: Rectify anomalies and drafting errors and makes various minor miscellaneous amendments to the Corporations Act 2001 and the Australian Securities and Investments Commission Act 2001 Cross-Border Insolvency Bill: Provide better mechanisms for dealing with cases of insolvency where the debtor’s assets and creditors are located in multiple jurisdictions Encourage greater cooperation between Australian courts and foreign courts and between Australian insolvency practitioners and foreign insolvency practitioners Financial Sector Legislation Amendment (Review of Prudential Decisions) Bill: Introduces measures to enhance the mechanisms for reviewing prudential decisions under financial sector legislation, improving the efficiency, transparency and consistency in the process for disqualifying individuals from operating a financial sector entity and clarifying the accountability of the regulators for administrative decision-making Reserve Bank (Enhanced Independence) Bill: Provide for the positions of Governor and Deputy Governor of the Reserve Bank of Australia to be appointed by the Governor-General in Council and for the termination of these appointments to require the agreement of both houses of Parliament Trade Practices Amendment Bill (No. 1): Amend section 46 of the Trade Practices Act 1974 (the Act) to address the role of recoupment and clarify the meaning of “take advantage” Extend the powers of the Australian Competition and Consumer Commission’s powers under section 155 of the Act Repeal the threshold for unconscionable conduct cases under section 51AC of the Act Trade Practices Legislation Amendment Bill (No. 2): Require traders to include a prominently displayed single, all-inclusive figure when quoting or advertising products or services

Contacts: Michael Joseph, Partner

E. josephm@kempstrang.com.au

T. +61 2 9225 2575

Rory Nott, Partner

E. nottr@kempstrang.com.au

T. +61 2 9225 2509

Kemp Strang BANKING & FINANCE BRIEF is intended to keep readers abreast of current legal and firm developments. It is not to be used or relied upon as a substitute for professional advice. Before acting on any matter, readers should consult with their advisors.

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