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No Way Out: When consumer protections have the opposite effect - A consideration of the impact of the Mortgage Credit Directive on s271 of the Insolvency Act 1986

  • United Kingdom
  • Corporate

10-08-2017

Key Points

  • The Mortgage Credit Directive (2014.17/EU) (“MCD”) is a piece of EU consumer protection legislation which, after adoption in England, amended the rules relating to the grant of security by individuals over residential property.
  • s271(3) Insolvency Act 1986 (“IA”) provides the court with an option to dismiss a bankruptcy petition if the debtor has offered reasonable security to the petitioning creditor.
  • The implementation of the MCD by the government means that it will be difficult for certain individuals to benefit from the protection afforded to them under s271(3) IA and could result in increased costs of security (through charging orders) or an otherwise avoidable bankruptcy.

To view and download the PDF please click here

Introduction

Consumer protection legislation is a necessary legislative tool of the modern state. It acts to put the onus of doing the right thing on the persons making the profit and who are usually best placed to absorb that cost. It seeks to prevent the exploitation of the vulnerable or naïve by the unscrupulous and untrustworthy, and is founded on good intentions.

On the other hand, consumer protection legislation limits what individuals can contract for and can undermine the fundamental English law principle of freedom of contract. Therefore, as with much legislation, there is a balancing exercise to be conducted between the harm legislation seeks to prevent and the harm caused (or freedoms lost) by the legislation itself.

The legislation and secondary legislation implementing the regulated mortgage regime (the “Regime”) is complex and contains many exemptions (e.g. for secured bridging loans and second charge business loans). Accordingly, this article does not seek to consider the full Regime, but instead looks at the specific problem caused by the inclusion of second ranking mortgages over residential property within that Regime and the impact it can have on certain individuals seeking to avoid a court action or bankruptcy in relation to a personal (non-business) debt. Specifically, the article considers debts arising pursuant to personal guarantees (“PG”).

Implementation of The Mortgage Credit Directive

The Regime was established by the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI2001/544). Prior to 21 March 2016 the Regime did not apply to second ranking mortgages. The theory being that once a person had entered into the first mortgage that person had received all the warnings about the consequences and enforcement rights needed and that provision of the same information for a second mortgage was unnecessary. Therefore a person who owed an unsecured PG debt could secure that debt against a residential property already subject to a mortgage without the need for the mortgage to comply with the Regime. This meant that individuals owing a debt could enter into an arrangement with a creditor to offer second ranking security over their residential premises and thus avoid facing a bankruptcy petition or the creditor’s court fee (which can be up to £10,000). As most residential home purchases are funded by mortgages, it meant that most people were in a position to provide a creditor with second ranking security to back up agreed payment terms, settlements or just to buy some time to get affairs in order in anticipation of repayment.

Upon implementation of the MCD on 21 March 2016, second ranking mortgages granted by individuals over residential properties (being land where at least 40% is a dwelling) were brought within the Regime. The definitions used to give effect to this are wide and comprehensive meaning that pretty much every kind of securing “credit” over residential property is caught. To counter the wide definitions, specific and well defined exemptions are provided. Each of these exemptions should be considered in detail before security is refused to see if one can be made to fit circumstance. However, the key point is that where previously many individuals were able to grant valid second ranking security, the options to do so have now greatly reduced.

As stated above there are numerous exemptions to the Regime, in particular the second charge business loan exemption stands out as an exemption which could be applied by practitioners acting for commercial creditors to permit certain second ranking mortgages. However, one of the mandatory requirements for applying the business loan exemption is that the mortgage is entered into wholly or predominantly for the purposes of a business carried on by the borrower. In most cases where a PG is called upon the underlying business has (i) ceased and (ii) is not anyway carried on by the borrower (being a third party providing the PG). This means that the most likely exemption one would look to rely upon when attempting to secure a PG debt cannot be applied.

The consequences of breaching the Regime include imprisonment and the unenforceability of the mortgage means that taking a mortgage without complying with the Regime is not an attractive option for any responsible business.

The unintended effect of The Mortgage Credit Directive

Effectively, this now means that a person owing a PG debt and who has sufficient equity in their home cannot grant security over that property. Creditors are left in the unenviable position that when faced with an unreliable debtor they must either (i) sue for the debt and seek a charging orders for security (and the apply for an order for sale) or (ii) issue a statutory demand and petition for the debtor’s bankruptcy to enable the trustee to take control over the debtor’s property.

Suing for the debt

Bankruptcy is usually a last resort and if the debtor has assets, normal creditors (dealing with honest debtors) would prefer voluntary payment terms backed up by security in the majority of cases. However, the implementation of the MCD has effectively removed the option of voluntary security. This means that unless the creditor is willing to take a risk on the individual’s further default/bankruptcy, the creditor must issue a claim against the individual in order to obtain the benefit of security by way of a charging order. Since the new court fees came into force, this can mean that the creditor must incur a court fee of up to £10,000 (for claims over £200,000) which would be added to the amount owed by the debtor. Obviously, both parties being in agreement would prefer a voluntary charge over property and save the debtor the court fee. Further, even if the debtor consented to all actions in the proceedings the creditor would still incur legal costs which would almost certainly be more than putting voluntary security in place. That said, a well advised creditor in a strong position would be advised to pursue the charging order option, particularly if there is doubt as to the debtor’s solvency. In such a case the detriment is borne heavily by the debtor who previously could have granted a voluntary charge without having his equity position eroded by unnecessary court fees and legal costs.

Interestingly, the MCD provides that a mortgage may be exempted from its provisions if it is granted in pursuance of a court settlement, but this does not seem to have been translated into the Regime. In any event, such a provision would not prevent the situation that a creditor needs to incur (and debtor ultimately pay) the court fee to obtain such exemption. Indeed, once a creditor has paid the court fee it may anyway be preferable to obtain a charging order over the property, since a charging order debt is not subject to the Limitation Act 1980 in the same way as a mortgage debt, for example as to interest. One would have to balance the better enforcement provisions in a mortgage against the absolute protection against limitation obtained by a charging order.

Bankruptcy and avoidance of it using 271(3) IA

It is not uncommon for debtors to “find” assets when presented with a bankruptcy petition. It does not matter whether this is a result of debtor procrastination, personal circumstances, juggling creditors or any other number of reasons. The result is the same. Namely, a debtor facing bankruptcy suddenly presents the petitioning creditor with a proposal so as to avoid the need for the bankruptcy order.

Section 271(3) IA states that a court can dismiss a petition if the debtor is able to pay all his debts or the court is satisfied that:

  • the debtor has made an offer to secure or compound the petition debt;
  • the acceptance would require dismissal of the petition; and
  • the offer has been unreasonably refused.

Of course, a debtor may be able to prove that he has guaranteed incoming funds in the near future and so would be able to seek dismissal upon the grounds of compounding for the debt. However, when considering whether the dismissal could be grounded upon a grant of security, one would need to consider the impact of the Regime.

If the security offered is acceptable to the creditor on usual grounds such as sufficient value/equity, enforceability and, ultimately, timely saleability, then one would usually expect a reasonable creditor to accept. However, sometimes it is reasonable for a creditor to reject the offer of security. When it does the court has to decide whether to exercise its discretion in the debtor’s favour and dismiss the petition on the grounds that security has been offered but unreasonably rejected. The reasonableness test applied by the court when determining if a creditor has unreasonably refused is summarised as establishing that the refusal is one that no reasonable hypothetical creditor would have rejected. Obviously, when applying that test the court (and the creditor) needs to be aware whether the security offered is in contravention of the Regime (and the corresponding consequences). If security would contravene the Regime then it would be unacceptable to any reasonable creditor due to the lack of an ability to enforce it.

Following the implementation of the MCD and the impact on second ranking mortgages, it now appears that the use of s271(3) IA discretion in relation to the offer of security will be extremely rare. The result being that a valuable route to avoid bankruptcy has been eroded.

Simply take the charge and ignore the Regime?

Some creditors (or other beneficiaries of a guarantee such as a landlord) may decide to ignore the Regime on the basis that once security is registered at the Land Registry it is unlikely to be challenged by any trustee and that it acts to pressure an unadvised debtor to keep up repayments. They may take the view that an unenforceable mortgage is better than no mortgage and possibly ignore the threat of criminal sanctions. However, this is not an option to the vast majority of lenders who will themselves be regulated by the Financial Conduct Authority and for whom the consequences of ignoring the Regime would be embarrassing in an isolated accident, but calamitous if done other than by accident.

Conclusion

The pre-MCD Regime limited the ability for creditors to take mortgages over individual’s residential properties, and so much of what is said above was applicable prior to March 2016. However, now that the Regime extends to second ranking mortgages the scope for discretion under s271(3) IA is much reduced and the need for a creditor (and debtor) to put up the costs of a court fee to obtain security has increased.

Where consumer protection legislation is used well it is a valuable tool of the state, a function of its role to protect its citizens. However, where consumer protection legislation extends to prevent informed (and advised) individuals from taking steps to or freely contract in order to protect their property, it could be said to defeat its own purpose, namely to protect individuals.

A review of the Regime to provide further exemptions for mortgages over residential properties if granted to a part of a settlement in existing or envisaged court proceedings (including for the avoidance of doubt bankruptcy petitions) would be welcome. To provide protection for the individual the application of such exemption could be conditional upon the inclusion of an independent legal advice statement in the mortgage and a supporting independent legal advice certificate.

Further reading:

  1. LexisPSL Restructuring and Insolvency: Practice note: How to present a bankruptcy petition and the documents you need to complete
  2. LexisPSL Restructuring and Insolvency: News: Law changes required to implement EU mortgage rules, 5 September 2014
  3. RANDI blog: Mortgagees, statutory remedies and the unfair terms directive, 23 May 2014

To view and download the PDF please click here

 

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