DOCTRINE OF EXONERATION
The Doctrine of Exoneration is one of those long standing principles of law that does not arise often and is not generally well known by people who have never had to consider it before. The doctrine only applies in limited circumstances, usually being found in bankruptcy estates and in disputes between co-owners of real property or in a trust situation. It is certainly an area that most lawyers and accountants would not encounter every day, or even every year.
The equity of exoneration is a relatively obscure remedy in property disputes. It is based in equity, but it is not found in a lot of texts on equity law. Authorities on the doctrine go back three centuries - Huntington v Huntington (1702), Taite v Austin (1714), Parteriche v Powlet (1742),Clinton v Hooper (1791) - so the legal concept is long established if not well known. But there are a number of authorities from the last 10 years, so it remains a well contested area.
The doctrine usually applies in the event of a party mortgaging their property to secure payment of another party’s debts. As this is the most common circumstance we see arise, we will focus this article on that aspect. The doctrine also applies if a trustee of a trust incurs or pays a debt of the trust by virtue of their acting as trustee. In that case, they are entitled to be exonerated from the assets of the trust. In short, the trustee can access the trust’s assets to indemnify the trustee for the money the trustee was obliged to pay.
The doctrine presumes a relationship between the co-mortgagors of surety and principle debtor. It is well established that a person who has mortgaged his property to secure or pay the debt of another stands in the position of a surety and is entitled to be exonerated by the principal debtor. This principle is most commonly encountered when a third party offers their property as security for another's debt. The principle is essentially the same for a co-owner who has mortgaged their share of a property to secure money borrowed by another co-owner.
Application of the Doctrine
The doctrine applies in cases where a number of people borrow money and that loan is secured against a jointly owned property, but where the borrowed money is for the sole purpose and benefit of only one or some of the parties. Often the parties are a husband and wife and the mortgaged property is the family home, but the doctrine may apply to any parties that jointly own and mortgage any property. The relationship of husband and wife is not necessary.
[Caldwell v Ridge Wholesale Acceptance Corporation (Australia) Limited (1993)]
[Caldwell v Ridge Wholesale Acceptance Corporation (Australia) Limited (1993)]
Often the family home is the only significant asset that people own jointly with another party. It is also common that business owners will offer the family home as security when seeking finance for business ventures. Sometimes only one or some of the owners are 'involved' in the business. Creditors and bankruptcy trustees will look towards this asset when the business has gone bad, resulting in cases involving bankruptcy trustees and co-owners disputing the distribution of sale proceeds of the house.
The doctrine can destroy the hopes of bankruptcy trustees and creditors of realizing anything from what often is a bankrupt's only significant asset. Therefore bankruptcy trustees take a great interest in the doctrine when they think that it may apply to property that has vested in an estate.
The Principles
In its most simple terms, the doctrine dictates that a loan solely to one party's benefit should firstly be paid out of that party's share, that the other party to the mortgage should be considered only as a surety, and their share should only be used in the case of any subsequent shortfall. The practical effect and the legal reasoning behind the doctrine are not that simple.
The doctrine of exoneration historically recognized that, when a married woman allowed her property to be mortgaged or charged in order to raise money for the benefit of her husband, it was presumed that she meant only to act as a surety. She was entitled to be indemnified by the husband and to have the first call for the debt primarily put on his estate to the exoneration of her own. If the husband's share of the property was sufficient to pay the secured debt, the wife's share was not reduced. If the share was not sufficient, the wife's share was only used to satisfy the shortfall, as surety.
The doctrine provides a presumption of the intentions of the two parties and their roles in the transaction - who is the principle and who is the surety - even though both have the same legal obligation under the mortgage and the entire property (both shares) is mortgaged. The principle of exoneration is that the co-owner is not to blame for the loan - they did not receive the benefit of it - so they should not be held to be primarily responsible for its repayment. That primarily responsibility should rest with the party to whose benefit the loan was made.
Sole Benefit of the Loan
The over-riding factor is that the loan must be used for an individual purpose, separate from and not involving the other co-owner. If the husband and wife both stood to benefit from the loan, the husband should not alone bear the initial responsibility of repaying it. Obviously a bankruptcy trustee of one of the parties will want to know whether both parties benefited from the loan and to what extent the estate's interest in the property is exposed to the debt. Any portion of the secured debt used for a joint purpose will not have the benefit of the principle.
One example of this principle is: Mr. Farrugia and his wife were the joint owners of their matrimonial home. They borrowed an amount of $23,000 and gave a first mortgage over that land as security for the entire loan. An amount of $12,500 was applied in discharging a previous joint mortgage over the land. The remaining $10,500 was used by Mr. Farrugia in a building business which he carried on and in which Mrs. Farrugia had no direct financial interest.
[Farrugia v The Official Receiver (1982) 43 ALR 700]
[Farrugia v The Official Receiver (1982) 43 ALR 700]
The presumption of principle and surety may be defeated by evidence to the contrary. So, whether the doctrine applies or not will need a determination of who received a benefit from the loan. In effect the co-owner claiming protection of the doctrine will have to prove that they received no benefit from the loan, and the other party will be trying to prove otherwise.
In the Farrugia case the amount of $12,500 used to satisfy the joint mortgage was not subject to the doctrine as both co-owners received the benefit of that part of the loan. But the balance of $10,500 used by Mr Farrugia in his business was found to fall under the protection of the doctrine and Mrs Farrugia's share of the property was only to be used as surety for that part.
The courts have had to determine the extent that a benefit can be attached to the loan. This is easy in cases like the Farrugias', but in other cases it is not. It is almost certain that a wife will benefit to some extent from the husband taking a loan for his own business, if by no other means than he will bring home money from that business to put food on the table. But do these benefits have a close enough association to the loan to void the presumption?
The courts have decided that the benefit to the surety must have come directly from the loan itself. Benefits received just as a consequence of the loan are too remote to exclude the inference of the doctrine. In Parsons v McBain [2001] FCA 376 the Full Federal Court decided that the presumptions and protection of the doctrine could not be defeated by a benefit that could not be valued and was unlikely to bear any relationship to the amount of the loan. The husband keeping the family from the profits of the business is not close enough. The position would be completely different if the wife was a co-owner of the business.
Trusts create a different question. What is the case if the loan was to the husband, but he only acted as trustee of a trust and both the husband and wife were beneficiaries? The benefit of the loan is not to the husband as trustee, it is to the trust and the therefore the beneficiaries. In these cases the application of the doctrine is likely to fail as the husband and wife both received the same level of benefit.
Protection of Surety
From a practical point of view, the party getting relief under the doctrine has a charge over principle's share of the property to support an indemnity from the principle. Therefore, unless there is sufficient equity in the husband's share to satisfy the secured debt, any surplus that the husband would otherwise have received after a notional 50/50 split of the equity (or as appropriate) would remain charged to the wife and would not be available to the husband or his bankruptcy trustee.
Naturally this only applies if the secured debt is owed less than the value of the secured property. If a $200,000 house is supporting a $300,000 secured loan, there is no surplus to argue over. This is one reason why these cases are not that common. There has to be equity in a property after satisfaction of the secured debt, and this is not common when the property supports both a loan to purchase the property and a loan - and possibly other debts - from a failed business.
Example of Doctrine
Take for example, a husband and wife that own the family home as joint tenants. The house is worth $400,000. They bought the house with a joint loan mortgaged on the property and still owe $100,000 under that loan. The husband ran a business, and the wife has no interest in that business. At a later time he borrowed another $200,000 for that business and this was secured over the jointly owned property - with the consent of the wife.
The husband goes bankrupt automatically turning the ownership into tenants in common. The house is sold for $400,000, but what happens to the money?
The doctrine of exoneration does not affect the rights of the secured creditors. The original mortgagee will be paid $100,000 from the proceeds under their first mortgage. The second mortgagee will be paid $200,000 from the surplus. This will leave $100,000 (assuming no costs) to distribute between the husband's bankrupt estate and the wife.
The first thought is that the husband's bankrupt estate will get $50,000 and the non-bankrupt wife will get $50,000. But this is not automatically correct. The business loan was solely for the benefit of the husband and the doctrine (assuming it applies) will presume that the wife only stood as surety. The distribution will be calculated from the position after the satisfaction of the joint loan.
In effect the joint first mortgage will be paid from both interests, leaving $300,000 to notionally divide between the bankrupt estate and the wife - assuming a 50/50 split - at $150,000 each. The $200,000 loan will first be applied to the husband's share, extinguishing his equity. The balance of loan - $50,000 - will be applied to the wife's share.
The husband's one-half interest is used to partially satisfy the secured debt, and the wife's one-half interest is then used to satisfy the shortfall. The entire $100,000 surplus would then be paid to the non-bankrupt wife. The bankrupt estate would get nothing.
Conclusion
Trustees and creditors should not be too excited at the prospect of recovering money solely based on finding a property registered in a bankrupt's name. If there is a mortgage and the doctrine of exoneration applies, the equity available to an estate may not necessarily equal the legal share of any surplus after any secured debt has been satisfied.
Trustees in bankruptcy must first determine how the secured debt was used and adjust equity calculations accordingly. As right of exoneration is a presumption only and may be rebutted, the trustee will look for evidence to rebut that conclusion. The actual business structure (whether there are trusts involved) may affect the position.
Whether the doctrine applies or not often rests with proving who received the benefit of the loan. When using a jointly owned asset as a security, business owners should ensure that business loans are not mixed with non-business joint loans, even if they are secured against the same asset. Proof of the separation of loans and their use may be the only evidence that the doctrine should apply for some of the loans.
Disclaimer
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.
The enclosed information is of necessity a brief overview and it is not intended that readers should rely wholly on the information contained herein. No warranty express or implied is given in respect of the information provided and accordingly no responsibility is taken by Worrells or any member of the firm for any loss resulting from any error or omission contained within this fact sheet.
Last Updated: 04.05.2011
