When her daughter's business collapsed, Carolyn Flanagan faced the prospect of losing her home. She had become a guarantor for the business and signed a personal guarantee and mortgage with Westpac. But at the time of signing, Ms Flanagan had very poor eyesight, significant health problems and she was on a disability pension.

She could not recall whether she was given any legal advice on the loan and claimed to misunderstand the extent of her guarantee obligations, which she remembered being read to her by two people in a side room at a Westpac branch in Sydney.

The case was recently highlighted at the banking Royal Commission but it is far from unique; it represents the tip of the iceberg when it comes to the difficult issues raised by family guarantees of small business loans.

In our ageing society, it is increasingly elderly parents who are exposed to a range of factors that undermine their ability to safeguard their own interests; these include misrepresentation and mistakes, undue influence, illegitimate pressure and downright unconscionable conduct.

The Flanagan case also flags the importance of good banking practice to help reduce the risk of these factors, and to support elderly Australians to make independent and informed judgments that benefit themselves and their families.

Misrepresentation, misinformation and mistake

The Westpac lending policy discussed in Ms Flanagan's case requires its bankers to take steps to ensure that guarantors make a "fully informed decision" and are "fully aware" of their potential liabilities. This also appears in the industry-wide Banking Code of Practice.

But risks of misrepresentation and error are particularly acute in cases of domestic sureties. As the High Court of Australia explained in the seminal case of Garcia v National Australia Bank, it is easy for misunderstandings to arise when difficult legal concepts and obligations are discussed informally between trusting family members.

With no ill-will intended, the size of the debt, the degree of exposure and the implications of default can end up minimalised or misrepresented. The optimism of borrower and guarantor about the future success of the business can also cloud the picture.

Where the bank knows the guarantor does not receive any real benefit from the loan and is a close family member of the primary debtor, the bank must take steps to reduce the risk of mistake to a level that makes it reasonable for the bank to proceed.

This is easily done.

The Bank can send the guarantor to get independent legal advice. Whether or not the advice is effective, a certificate from the lawyer stating that the loan and guarantee documents have been explained and that the guarantor appears to understand them gives the bank comfort and makes any subsequent lending decision seem far more reasonable.

Undue influence?

But guarantors in personal relationships with a would-be borrower are often subject to subtle pressures and influence, and these can't necessarily be addressed fully or effectively by telling a guarantor to seek legal advice.

After mistakes, the leading reason why courts commonly set aside domestic guarantees is because the guarantor's consent was undermined or vitiated by the 'undue influence' of the child or primary borrower. As reported, Ms Flanagan's story suggests this might also have been a problem in her case.

The ancient and judge-made concept of 'undue influence' does not imply wrongdoing, rather the law's emphasis is on the lack of independent judgment on the part of one party with respect to another more dominant party. The critical feature is 'excessive' rather than 'wrongful' influence arising from an implicit relationship of trust and confidence, which undermines the vulnerable party's independence in decision-making.

The doctrine is commonly engaged when people are in close personal relationships and when one person is in the (trusting) habit of deferring judgment to the other. None of this is inherently wrongful - relationships of trust and influence are part of a full and rewarding life - however, the risk of excessive influence poses significant challenges in the context of family guarantees for small business loans.

In the past, courts have taken a pragmatic approach to the problem. The bank is protected provided it is satisfied that the guarantor has received appropriate and independent legal advice.

However, simply telling the guarantor to get legal or financial advice (as the current and proposed banking codes require) may not be enough to protect the bank where it knows advice was not in fact obtained, and where the guarantor's circumstances suggest a significant risk of undue influence.

Nor may it be sufficient (as the Commission transcript suggests in Ms Flanagan's case) for a bank simply to obtain a statement signed by the guarantor that she has received legal advice. The statement gives no indication of the nature or content of that advice or whether she understood it. And if the guarantor is signing the guarantee under the influence of the borrower, is there not a danger that the same influence explains her signature to the statement?

Getting the balance right

Proposals like the introduction (by Section 107 of the new Banking Code) of a three-day cooling off period in cases where no legal advice is received are also unlikely to relieve a vulnerable parent from the ongoing influence of a child.

And where a guarantor does get effective legal advice (and so the bank's position is traditionally regarded as protected), this does not mean the guarantor has been freed from the borrower's influence and can reach a decision independently.

As the High Court of Australia explained in the leading case of Thorne v Kennedy, a person's decision to proceed with a transaction against the good advice of her solicitor may be evidence of undue influence in operation, working to undermine the person's judgement.

We hear echoes of that in Ms Flanagan's declaration that "I'd have signed anything for her".

The banking sector, the Commission and the courts continue to face a difficult balancing act in ensuring fairness in this field. Banks must guard against the danger of undue influence in the case of family guarantees.

But the law must also avoid making small business loans too difficult and expensive to get. A critical piece in the puzzle will be to find better ways of supporting guarantors' decision-making, including those with cognitive disabilities.

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