Legal

Let the lender beware

October 2007

Nearly 30 per cent more homes were repossessed in the first half of this year than last, and this trend is set to continue. A significant number of possession properties will therefore be coming onto the market for resale over the next few months. It will be increasingly difficult to achieve decent resale outcomes in these conditions and some secondary lenders are bound to suffer shortfalls in realising their security.

How will lenders make up these losses? In times of downturn, insured professionals have historically found themselves in the firing line.

The law of professional negligence in mortgage finance cases is now well settled. Parties have a ready-made blueprint to work from when litigating cases of this type.

In the last few years, mortgage transactions have been going through at a frenzied pace.To compete for instructions, professionals have had to offer faster and faster turnaround times. Lenders will now be looking to see whether, in the clamour to complete, their advisers have cut corners or failed to spot issues of concern.

Auditing for adviser error

These days, lenders can very easily run an audit for adviser error and ‘flag’ questionable reporting. Take valuers, for instance. Completed transaction evidence – detailing sale values of comparable properties – is now largely available in the public domain. Valuation exposures can be identified quickly and many lenders may start to run audits of this sort as soon as their borrowers start to default on repayments.

Contributory negligence: the 1990s claims experience

Professional indemnity (PI) insurers still harbour painful memories from the 1990s, when lender litigation was rife and their policyholders (mainly solicitors and valuers) were badly mauled. This time around, PI insurers will be determined not to pick up the tab as the consequences of the recent easy money era start to unravel.

By the end of the 1990s claims period, professionals were starting to cross-claim, more and more, for contributory negligence on the part of the lender. In the event, lenders emerged from those contests relatively unscathed. The courts did find some degree of imprudent lending but typically, this would be reflected in a discount only of 10 or 20 per cent on the lender’s total damages recovery.

Some basic principles emerged from the 1990s cases about assessing lending practice for negligence.

The first of these involved the interplay between borrower suitability and the adequacy of security given. In the 1990s cases, many lenders were criticised for taking information supplied by applicants at face value and for not ‘digging deeper’. The courts tended to support those lenders but only where a comfortable margin of equity was available.

Even with the most generous provision of security, however, lenders would not be entitled to ignore something striking about an applicant’s status or circumstances, as Wright J made clear in HIT Finance Ltd v Lewis & Tucker Ltd (1993):

”I am not suggesting that the prudent lender, merely because he had the comfort of more than adequate security, is entitled to shut his eyes to any obviously unsatisfactory characteristics of the proposed borrower. Plainly a lender would not be acting prudently if he made a loan in circumstances where he had substantial reason for suspecting the honesty of the borrower.”

A number of other contributory negligence allegations in the 1990s centred on lenders’ departures from their own published underwriting guidelines.

This sort of problem drew a mixed response from the courts. PI insurers argued that a lender’s failure to follow its own internal controls (having taken the trouble to formulate them in the first place) was prima facie evidence of imprudence.

The courts tackled this sort of issue on a case-by-case basis. In Housing Loan Corp v William H Brown (1999), for example, the lender’s criteria required that – where two valuations were supplied at the application stage – underwriters should always adopt the lower figure for the lending decision. The Court of Appeal approved the following approach:

I fully accept that it is not necessarily negligent for an autonomous body to step outside self-imposed controls. What matters is whether or not the controls were in place for a sensible purpose. I judge it to be a sensible precaution to act upon the lower of two valuations. It is a precaution which acknowledges the difficulty in making an accurate valuation of certain properties and it is intended to safeguard the interests of the lender. In my judgment, it was foolish in the extreme to ignore [the lower] valuation.”

Interestingly, the Financial Services Authority’s (FSA) recent review of behaviour in the sub-prime sector revealed departures from lending policies to be a major failing. This issue is likely to be rekindled as a key indicator of imprudent lending in contributory negligence claims to follow.

Sub-prime lending and negligence

Towards the end of the 1980s, centralised lenders had arrived on the scene for the first time. Lawyers for PI insurers argued that non-status lending was, by its very nature, inherently imprudent. Some judges agreed with that analysis. Here is what Sir John Vinelott had to say in the 1996 case of Birmingham Midshires v Parry:

A new type of lender, the centralised lender with no high street presence and with ready access to finance, was attracted to the field. To establish a position in the market the centralised lender was willing to lend money on a non-status mortgage – that is to rely to an excessive extent on the value of the security and, as regards the personal covenant, to rely on self-certification. That was, in my judgment, a risky course.”

Sound familiar? One might readily take a similar view about the growth, in more recent times, of the sub-prime sector and adverse credit lending generally.

In practice, however, the courts will be a little more permissive. Lender behaviour is likely to be judged relatively. That is to say, a lender’s practice and procedures will be assessed by reference to the standards of those operating in the same niche sector. It would be inappropriate, in most cases, to judge sub-prime lending against mainstream underwriting principles.

The test of negligence, therefore, will be: “did this sub-prime lender behave in a way that no other prudent lender, in the same market, would have done?”

Defining the standard

Staying with this sub-prime model, an immediate difficulty arises. The secured lending market has changed greatly since the 1980s and 1990s and there has been no significant litigation in this area for many years. At the moment, no one can reliably say where, in law, the relevant standard of acceptable sub-prime lending practice prevails.

Some work needs to be done on the testing ground before relevant parameters of lending behaviour can be gauged and set. Lending practice experts will play a key part in this process. Seasoned experts with experience of mainstream lending and also of operations at the bottom end of the market are likely to be most sought after.

To understand the sector properly, the courts will need to have something of a history lesson about developments in the market since 2000 (when the last wave of lender litigation petered out). Again, expert witnesses will be at the forefront of marking out respective lenders’ positions on the prudential behaviour chart.

Who’ll be first ‘over the top’?

To recover their security shortfalls, lenders do need to be making claims. However, as we have seen, uncharted territory lies ahead. Who will be brave enough to make the first move? Lenders must be sure that their own house is in good order first of all, before contemplating recovery litigation against others.

A heavy price for starting these recovery actions will be transparency. The Civil Procedure Rules (CPR) were introduced just around the time that the last phase of lender litigation ended. The CPR professional negligence pre-action protocol encourages openness between litigants and information-sharing is expected (if not required).

Rightly or wrongly, those outside the market (many will be prospective recovery targets) believe that sub-prime lending has been awash with imprudence. The results of the recent FSA investigation have only reinforced this perception.

Defendant lawyers have their fine-tooth combs at the ready. They will insist on disclosure of and then scrutinising everything from lenders’ full operational procedures through to regulatory compliance and performance histories.

No stone will be left unturned. This is more so the case in light of new rules about electronic disclosure. Lenders will be expected to hand over many records that are stored electronically. This may well extend to giving defendants access to application processing and arrears management programs, opening up IT systems in an unprecedented way.

Many lenders might feel uncomfortable about such a prospect, quite understandably.

FSA principles

The importance of the FSA’s role, as regulator in all this, cannot be stressed enough. For sub-prime lenders, the news is particularly bad. Almost certainly, the FSA impact means that the risk of contributory negligence claims (from borrowers, professionals and other quarters) is markedly higher now than it was in the 1990s.

Faced (for now) with a dearth of authority on what amounts to imprudent sub-prime behaviour in law, defendants are likely to adopt the FSA’s principles and outcomes-based tests to serve as the relevant standard of non-negligent lending practice.

There was no real regulatory dimension to speak of in the 1990s cases. The FSA imposes a much stricter and more extensive regime than the law of negligence ever did.

Professionals (and other would-be recovery targets) are now poised to use the FSA’s recent investigation into the sub-prime sector as a springboard for counter-attacking claimants from that camp. There may well be evidence in this vein that customers have not been treated fairly. It is only a short stretch from there to argue that lenders should bear more personal responsibility for their own losses, when loans default.

The FSA enquiry did not reveal widespread mis-selling in the sub-prime market; nevertheless, it is easy to predict that the main focus for any counter-claims will be in the realms of application plausibility and affordability issues.

Building on the 1990s claims experience, this is essentially an issue over the depth of enquiries required into a borrower’s creditworthiness on any given application.

To what extent are lenders expected to protect (sometimes desperate) borrowers from themselves? Turning a blind eye to obvious discrepancies will readily be regarded as negligent behaviour. But where a borrower has, perhaps, ‘over-egged the pudding’ in his application, there must be limits on a lender’s duty to act as private detective and look behind the paper presentation.

Whether through the Ombudsman Service or the courts, we need to see some decided cases on these points before any reliable principles can bed down.

In the 1990s, there was some doubt that the issue of internal underwriting criteria could ever have a bearing in lending negligence assessments. Now, however, fuelled by the FSA’s recent concerns, defendants are likely to seize on the point once again.

Even if not negligent in itself, a lending guideline breach is likely to put defendants on the suspicion trail, to trawl for other more serious failings lurking underneath the surface.

Looking ahead

There has not yet been a surge in UK sub-prime borrower default, but those days may soon be upon us. If and when it happens, lenders will need to consider their options for clawing back security shortfalls.

The traditional routes of recovery – principally, against professional advisers – may be more hazardous this time around. Prospective recovery targets are ready to go on the counter-attack. The FSA regime, sweeping disclosure rules and the uncertain legal position could all work to the counter-claimant’s advantage.

Lenders really must be sure of a ‘whiter than white’ showing if they are to launch recovery actions with confidence.

Nik Carle is a partner with law firm Browne Jacobson specialising in financial and professional risks (www.brownejacobson.com)