The payment of commissions are commonplace in the mortgage lending industry. On the inside, they are an understood and accepted part of doing business. But externally, they are often seen as underhanded and not in the best interest of borrowers, particularly where they are not fully disclosed.

This was the crux of debate at a recent court of appeal hearing concerning two cases where borrowers had defaulted on their mortgages – Wood v Commercial First Business Ltd and Business Mortgage Finance 4 plc v Pengelly. In both cases, it was argued by the borrower that commissions were paid by the lender to the broker without their knowledge – a secret commission – and that this rendered the loan unenforceable and therefore eligible for rescission.

The lender argued, in line with the previous case of Commercial First Business Limited v Pickup and Vernon, that if no fiduciary relationship existed between the broker and borrower, the payment of a secret commission was irrelevant as no duty of loyalty was owed to the borrower by the broker. However, in Wood, it was decided that it was not necessary for a fiduciary relationship to be established in order for it to be found that a payment of a secret commission renders that loan unenforceable.

The court of appeal hearing cleared up this contradiction. It stated that the question to ask when considering the relationship between the broker and the borrower is a simple one: “Was the payee (the broker) under a duty to provide information, advice or recommendation on an impartial or disinterested basis.”

If the answer is yes, then where the payment of a commission has not been disclosed opens up both the broker and the lender to a claim by a borrower and brings a substantial risk that the court will rescind the loan.

While offering some clarity, this ruling leaves the mortgage lending industry scrambling to understand how exposed it is to similar rescission claims.

We can say with some confidence that it is now significantly more likely that a court will rescind a loan where a secret commission was paid. What was still unclear, until recently, was how rescission and counter-restitution in these cases would work in practice.

However, a rescission judgement was handed down in the case of Wood v Commercial First and Other, which at least provides the mortgage sector with a model for how these cases will work and much needed guidance for lenders in assessing what their liability may be in cases where an undisclosed commission was paid.

What is rescission and what is it for?

It has to be remembered that the objective of rescission is to restore both parties to as near to their original positions as possible, rather than overtly punish either side. Sometimes this won’t be completely possible, but the court can make discretionary adjustments to achieve a result which is practically just’.

The starting point is to prepare an account where credit is given to the lender for the amount advanced – plus interest – to the date of rescission. Any payments made by the borrower, and the interest on those payments, is then deducted to arrive at the total amount owed. It should be noted that the applicable intertest rate will be determined by the court, which have a wide discretion to make adjustments. Therefore, it is unlikely that a lender will be awarded interest at the contractual rate.

Where the borrower has had financial difficulties and missed payments, a credit may be due to the lender. However, if the loan is for a relatively short period or the borrower has consistently made payments, or lump sum payments, an amount may be due back to them.

The rescission Judgment in Wood has helpfully clarified a number of points regarding this calculation.

Calculating rescission

The judgment in Wood clarified that there are four key considerations when it comes to calculating rescission:

1. Is the interest simple or compound? Mrs Wood argued that she should be entitled to compound interest on the payments that she had made, while the lender should only be entitled to simple interest on the amount advanced. This was firmly rejected by the court on the basis that only where money has been obtained and retained by fraud, withheld or misapplied by someone in a fiduciary position – neither of which applied in this case – could such a determination be made.
2. The rate of interest. In the case of Wood, the court held that the rate of interest allowed on the loan and the borrower’s payments could be different. The court decided that Mrs Wood would be entitled to 4% above the three-month Libor rate (which was determined by the going market rate at the time), while a lower rate of 2% over the three-month Libor was awarded in relation to the amount loaned. The rationale provided by the court was that this reflected the lender’s ability to borrow at a lower cost.
3. Payment for use and occupation. In a situation where the borrower has enjoyed the actual use and occupation of land, the court can direct that a reasonable user or occupation rent is paid. Mrs Wood already owned the land (the case related to a re-mortgage rather than a purchase) so this did not apply in this case, but the judge commented that the principle was clearly sensible – suggesting this rationale will be taken forward for future cases.
4. Account of profits. Mrs Wood argued that the lender made a profit from the securitisation of her mortgage and that this profit should also be paid to her. However, as Commercial First Business Limited is a dissolved company the court could make no finding either way as to Mrs Wood’s entitlement to seek any such account. Going forward, these arguments are likely to be raised by borrowers in a similar position and lenders will have to incur the costs of defending any such claim.

Bad news is better than no news

 It’s a fact that paying undisclosed commissions is now a riskier proposition – it is easier for borrowers to use them as a reason to argue that a loan is unenforceable albeit the Wood judgment makes it clear that doesn’t mean that the borrower can simply walk away from repaying the capital that was advance.

While this isn’t the news the lending industry wanted to hear, it can take some solace in the clarity the courts have now offered in how such cases will be judged, and the mechanics it will use to calculate rescission of a mortgage. This guidance means the sector can at least start to understand how exposed it is to rescission judgements, and what process needs to be in place to ensure their broker relationships aren’t called into question in future.

Moore Barlow partner Sarah Watley