Increasingly, the option appears after the facility is already in breach, as the price of the lender agreeing to hold off rather than enforce. A borrower in default, facing enforcement, has little real choice but to sign.

When the lender is also a shareholder, or holds an option to become one:

• The borrower’s exit gets harder. Any refinance or sale has to deal with the lender’s equity or option first.
• The lender is conflicted on default. The party deciding whether, when and how to enforce may also be the most likely buyer of the business or the assets.
• The lender edges towards the board table, with the shadow director risk that comes with it.

The law is not silent.

In Sun North Investments v Dale [2013] QSC 44, a lender took a call option over the borrower’s shares alongside a $500,000 loan and fixed charge. The Court held the option was part of one integrated security transaction, not a genuinely separate bargain, and declared it void from the outset as a clog on the equity of redemption. The Court declined to follow the more lender-friendly approach in Westfield Holdings v Australian Capital Television (1992, NSW), which would strike down such an option only if it was unconscionable. Even on that test, the option failed, and it was also held to be an unenforceable penalty in the alternative.

Granting the option later doesn’t necessarily save it. English Courts have struck down options and equity interests granted years into a loan, or when a lender takes over a mortgage, where they weren’t truly independent of the security. A borrower signing under that kind of pressure may also have other claims.

The law isn’t settled. Sun North and Westfield are both single-judge decisions and no appellate court has resolved the difference. But lenders should be wary: an option that operates as security for the loan, or is the price of not enforcing it, is at real risk.

A mortgagee who sells to an associate also carries a heavy onus to show it got the best price reasonably obtainable. Unfair contract terms rules now carry penalties where the borrower is a small business.

For Directors: get advice before you sign a standstill or forbearance that hands over equity or an option. It may not be as binding as the lender thinks, but it will shape every exit option you have.

For Lenders: if you want equity, document it as a genuinely separate transaction, price it independently and have a conflict protocol ready for enforcement.

Are others seeing the same?

If you are a business owner negotiating with a lender, or a lender considering taking an equity interest as part of a forbearance arrangement, it is important to understand the legal and commercial implications before signing.

Contact Angelo Conti, Principal angelo.conti@madgwicks.com.au or the Madgwicks team to discuss your position and understand the options available to you.

The information provided in this article is general in nature and cannot be relied on as legal advice, nor does it create an engagement. Please contact one our lawyers listed above for advice about your specific situation.