Over the past five years lenders have suffered staggering losses on residential mortgage lending. Many lenders have sought to mitigate these losses by taking legal action against third parties – often valuers and solicitors – alleging that the losses (at least in part) were caused by the negligence of these professionals. In more extreme cases of loss, lenders have taken action against fraudulent borrowers involving injunctions and recoveries litigation extending into foreign jurisdictions.
In almost all cases where lenders have sought recoveries against professionals, these professionals have countered with defences based on contributory negligence – in other words arguing that damages fall to be reduced because the losses are caused partly (or largely) by poor lending decisions.
Now comprehensive reform of the mortgage market is on the way. In this article we look at the proposed reforms and ask how these reforms might impact on future recoveries litigation brought by lenders.
TODAY’S RECOVERIES ENVIRONMENT
Before turning to the impact of the reforms, it is worth looking at how allegedly poor lending has impacted on lender recoveries in the current round of lender litigation.
At Eversheds, we have acted on substantial volumes of cases brought by lenders against third-party professionals. Both we and our lender clients are all too aware that allegations around contributory negligence have formed the main battleground in both this and previous rounds of lender driven litigation.
Broadly, lenders have been attacked for the following:
- loan to value (LTV) ratios
- failure to investigate the borrower’s credit worthiness
- failure to spot discrepancies in the mortgage application
- failure to pass on information
- breach of the lender’s own guidelines
Reductions for contributory negligence have ranged from a modest 10% to a massive 90%.
By way of example, on LTVs, in Arab Bank Plc v John D Wood (Commercial) Ltd [1999] the court found that the lender was imprudent in lending at 90% LTV and should have limited the LTV to 70%. The court made a reduction of 33% from the basic loss as a result.
Similarly, in relation to investigating the borrower’s credit worthiness, some useful guidance from the court was provided in the generic judgment in Balmer Radmore [1999]. In Nationwide Building Society v JR Jones [1999] the failure of the lender to obtain bank references, credit references and accounts led to a 40% reduction for contributory negligence. The courts could be more brutal still when it came to failures by the lender to identify discrepancies in the mortgage application form. In Nationwide Building Society v Archdeacons [1999] the employer’s reference showed a lower income than the borrower had claimed in his application, the interviews with the borrower were unsatisfactory and the internal recommendation not to make the loan had been overlooked. A 90% reduction was made.
In the recent case of Paratus AMC Ltd v Countrywide Surveyors [2011] the Judge concluded that, had he found in favour of Paratus, he would have applied a discount of 60% for contributory negligence. The Judge was particularly critical of gaps in the mortgage application form and the operation of Paratus’ automated underwriting system, which effectively caused a status application to be underwritten on a non-status basis.
Perhaps more comforting for lenders were the comments by the Judge in Paratus that steered clear of criticising whole classes of lending: ‘the courts… should… be slow to hold that entire classes of transaction are imprudent for those who undertake them.’
However such comments are slim pickings for lenders who have seen substantial reductions for contributory negligence in recent years and who will now be looking closely at the proposed reforms with half an eye to future recoveries litigation. Will these reforms protect lenders if loans go bad in the future? Do the reforms go far enough? Are there any gaps in the reforms?
PROPOSED REFORMS
The Financial Services Authority’s (FSA) Mortgage Market Review (MMR) (December 2011) makes wide-ranging proposals for reform to lending practices. In essence, the proposed reforms aim to balance the need for ongoing mortgage credit for borrowers that can afford to service a mortgage commitment while curtailing lending to those who cannot.
Sitting alongside the MMR is the FSA’s Review of Mortgage Fraud Against Lenders, published in June 2011. With at least £1bn lost to UK lenders as a result of fraud in the past year, the focus, again, is on prevention – reducing poor lending and underwriting while maintaining the flow of credit to good borrowers.
Both reports have been (and continue to be) heavily debated and a final template for reform is some way off. The genesis of both reports is, however, clear – both lenders and consumers have suffered greatly as a result of a lending market that made lending to the ‘wrong’ borrowers too easy and left lenders exposed to fraud.
The extent of the proposed reforms is comprehensive. As and when implemented, the reforms will herald a grass roots reform of the mortgage market.
The MMR contains three core principles of good mortgage underwriting:
- Mortgages and loans should only be advanced where there is a reasonable expectation that the customer can repay without relying on uncertain future house prices. Fundamentally, lenders will be responsible for assessing affordability.
- The affordability assessment should allow for the possibility that interest rates might rise in future. Borrowers should not enter into contracts that are affordable on the assumption that low interest rates will last forever.
- Interest-only mortgages should be assessed on a repayment basis unless there is a believable strategy for repaying out of capital resources that does not rely on the assumption that house prices will rise.
Looking at the more detailed proposals, these show a greater emphasis and responsibility on the lender for assessing affordability and verifying the consumer’s income. The proposed reforms also seek to curtail the more risky areas of lending. The key proposals are perhaps the following:
- Effective removal of self certification and fast-track mortgages from the market.
- A fundamental principle that the borrower’s income must be verified in every case and lenders take regulatory responsibility for this.
- The lender will have full responsibility for assessing whether the consumer will be able to repay the sums advanced. The lender will have to be able to demonstrate that the mortgage is affordable for the consumer. This involves income verification, stress testing and assessing expenditure by taking into account the committed expenditure of the applicant and the basic expenditure of the household and consideration to the basic quality of living costs and a ‘view of any foreseeable changes to income’.
- Tighter regulation of ‘niche markets’, potentially resulting in further contraction in those areas.
- A rebalancing between volume lending and the costs of lending. In short, costs will rise and the focus on volume will reduce.
- A renewed focus on better quality products released into the market.
BARRIERS TO REFORM
There is a compelling case for reform of the mortgage market. That said, reform is usually contentious and the MMR is no exception.
The Council of Mortgage Lenders (CML), in their March 2012 response to the MMR, raised particular concerns with regards to the effect of the MMR proposals on innovation in the market and on competition. Further, in May 2012, the House of Commons Treasury Committee hearing of the MMR proposals also raised issues around innovation.
The implication is clear. On the one hand there is a strong case for the ready flow of credit to a wide cross section of borrowers. This flow encourages new products and innovative lending but at the expense (sometimes) of risk management.
This dichotomy is reflected in recent recoveries litigation. The greater the flow of credit became, the looser the checks and balances. The results are known to all – large losses in the residential lending market and lenders being held partly (sometimes wholly) to blame for these losses.
FUTURE RECOVERIES LITIGATION
So, if the reforms are implemented, what might the impact be on future recoveries litigation?
The first point to make is that the reforms are clearly aimed at reducing the need for such litigation. If the reforms work, then the incidents of arrears, repossession and lender losses should reduce. Consequently the need for lenders to look at third-party recoveries against professionals will also reduce.
It seems likely that the reforms will achieve this, at least in part. There is no doubt that some of the recent losses have been caused by a lending boom that perhaps should have been curtailed. That said, and as the CML stresses, market forces must be allowed to operate and lending cannot be overly restricted. Home ownership should not become the providence of the privileged few.
It is probable that over time we will see a more tightly regulated market. We will see the introduction of more comprehensive guidelines on lending practices aimed at reducing the likelihood of lending to unsuitable borrowers. However innovation in the market will continue to exist and will no doubt flourish over time. The hope must be that the potentially competing aims of innovation and regulation will find a balance over time (though history might suggest that innovation will win any long-term battle).
What is also certain is that no amount of reform will eradicate the need for recoveries litigation by lenders. A proportion of loans will always go bad. Some valuers, especially in a rising market, will over-value the security property and leave themselves open to a professional negligence action. Similarly, solicitors will continue to make errors as new products are introduced and unscrupulous borrowers find ways of exploiting an (eventually) rising market.
Where the reforms will be of most interest (at least to the lawyer) will be on the impact they have on allegations of contributory negligence.
If the reforms are introduced and lenders abide by them, then many of the key arguments that defendants have used to reduce damages may fall away. The 90% reduction in Archdeacons and the 60% reduction in Paratus will be a thing of the past. Lenders will be forced to address the issues that have caused them to accept substantial reductions in damages in the last two rounds of mortgage litigation. So recoveries litigation will reduce in volume but, of the cases that are pursued, lenders might expect higher recoveries.
Conversely, lenders that fall foul of a more tightly regulated environment, can expect harsh treatment by the courts. Under the current regime, contributory negligence is largely a matter of impression and judgment by the courts. There is frequently scope for argument one way or the other on whether a lending decision was reasonable. That is likely to change. In a more regulated environment, it will be far more difficult for a lender to justify a departure from the norm. Lenders will do well to bear this in mind in the event of another housing boom (however distant that may feel at present).
A TIP FOR IN-HOUSE COUNSEL
As we have said above, alongside the MMR sits the FSA’s report on mortgage fraud.
It is apparent that a significant proportion of lenders’ current losses have come about as a result of mortgage fraud. This too is an issue that needs to be addressed. In many ways it overlaps with the MMR – fraud, the argument goes, is harder to perpetrate in a more regulated environment. That may well be correct but it remains to be seen whether fraudsters manage to circumvent the safeguard created by additional regulation. The likelihood is that they will.
Lenders should therefore be prepared for ongoing losses caused by fraud notwithstanding the current proposed reforms.
In this regard, can any lessons be learnt from the current crisis that might help lenders in future fraud recoveries?
The most obvious answer to this is to heed the contents of the FSA’s report, which contains comprehensive guidance on good practice in avoiding fraud.
However, if we could offer one tip to in-house counsel, it would be to look beyond the FSA’s proposals and to examine how recoveries can be increased in the event that a fraud is committed.
It is a sad fact that fraud all too often involves not just the borrower but the solicitor too. Where this is the case, the lender’s primary remedy may well be against the professional (the borrower often having disappeared or dispersed the funds).
In the current round of litigation lenders’ losses on fraud have increased because lenders have often found that fraudulent solicitors are uninsured. The incidence of this has severely curtailed successful recoveries litigation.
Solicitors’ insurers can refuse cover where all of the partners in a firm have been fraudulent. However if one partner is innocent of the fraud then cover is still provided. This has caused particular problems recently where banks have relied on a supposedly innocent partner who has turned out not to be a partner at all, but an employee. If this happens, the bank will need to show that it relied on the solicitor being a partner rather than an employee in making the loan. This in itself can be problematic.
Lenders can therefore protect themselves by using larger firms for their lending work since this increases the chance of there being an innocent partner where a fraud is committed. Care will need to be taken in going down this route, as HSBC recently discovered when it sought to set up its own panel of just 43 law firms for its work. Following a large number of complaints from home buyers and lawyers about long delays and the breakdown of property chains, the bank resiled from its position and now allows all 1,419 members of the Law Society’s Conveyancing Quality Scheme to undertake its work.
If a reduced law firm panel is not a possibility, then our tip is for in-house counsel to look carefully at the format of the instructions it sends to solicitors. These instructions will clearly define the terms of the retainer. They might also specify that the bank is relying on the firm having a certain number of partners in making the loan. This will afford valuable protection where the firm actually has fewer partners than first appears.
CONCLUSIONS
Wholesale reform of the mortgage market is now inevitable. This reform may well reduce lending to unsuitable borrowers. However some loans will still go bad and, when they do, lenders will want to be in the best position to maximise recoveries. This will require them to heed carefully the proposed reforms to avoid substantial findings of contributory negligence.
In the fraud arena, dishonest borrowers are likely to become more sophisticated as regulation increases. In-house counsel would do well to review now the panel arrangements and the instructions sent to solicitors to offer maximum protection. This is all the more important because the vast majority of fraud happens in a rising market.
As and when the property market recovers, lenders will wish to be well prepared.