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The Law on Bank Loans for SMEs

It is common practice for small business owners to apply for business loans from banks who will grant a loan provided that the loan is secured, often by a mortgage over the borrower’s home. Indeed 95% of businesses in the UK are classified as small and finance raised by a second mortgage is a significant source of capital for the start-up of small businesses[1]. However, as the borrower’s home is often jointly owned by a spouse, the lender would require that both the borrower and the borrower’s spouse, normally the borrower’s wife, to agree to the bank taking a charge over the property. This situation resulted in a multitude of cases where the borrower’s spouse subsequently contested the charge on account of alleged undue influence that has been exerted on the wife by the husband. Lenders were faced with an unsatisfactory amount of uncertainty as to the validity of the charge and, if the bank wanted to call on it s security, the lender faced the danger of court action by a disgruntled wife as well as the possibility of losing money if the court accepted the wife’s argument. This situation was neither business efficacious nor sustainable. Even if a lender were to introduce a procedure whereby it sought to protect the charge over matrimonial property by informing wives of the implications of the transaction, the lender’s position was not secure and its internal procedures were often judged by the court to be insufficient.

In the case of Royal Bank of Scotland v Etridge[2] (No. 2) and others [2001] UKHL 44, the House of Lords had the opportunity to clarify the situation by setting out a number of minimum requirements that a bank should comply with to ensure that it can enforce its security and that the guarantor has not been coerced to agree to the security. The Etridge case was comprised of eight cojoined appeals with similar facts; the respective wives had agreed to the husband’s request to grant a mortgage over their house in favour of the bank and the wives were now seeking to contest the validity of the security on account of their husbands’ undue influence. As a result of the judgment in Etridge which will be discussed below, the law is now settled in this area as the House of Lords has succeeded in creating a relatively checklist of steps which is effectively a code of practice for banks to follow. Prior to Etridge, the dicta in Barclays Bank v O’Brien[3] provided the leading House of Lords authority for banks who wished to ensure that they could enforce security notwithstanding an undue influence claim. Lord Browne-Wilkinson gave the leading judgment which set out the circumstances where a bank would be put on inquiry as to the risk of undue influence. The House emphasised that a bank was put on inquiry where a relationship of trust and confidence arose either as a matter of law by virtue of the type of relationship (referred to as Class 2a) or due to particular circumstances, namely a transaction that called for an explanation (Class 2b).

The decision in O’Brien was subjected to criticism by some legal commentators who opined that the decision led the law astray and was not concerned with protecting a wife from undue influence but rather from minimising the risk once the wrong had been committed. Although O’Brien sought to proscribe minimum steps that could be taken by the bank, the decision did not sufficiently clarify the law. A unanimous House of Lords clarified the law in the Etridge case and the judgment given by Lord Nicholls, with whom the rest of the judges agreed although there were some differences of expression and approach, raised some important points that banks should adhere to. The burden of proving that the lender had constructive notice of possible undue influence lies on the guarantor but is prima facie discharged if the claimant demonstrates that the bank knew that the relationship between the guarantor and the debtor was non-commercial. If the lender knows that a wife is living with her husband and the proposed transaction, on the face of it, is not to the wife’s advantage because the loan is not being made for joint purposes, the lender will bear the evidential burden of showing that reasonable steps were taken to satisfy the bank that the wife’s consent was freely given with full knowledge of the implications of the transaction. The judgment in Etridge was welcomed because it acknowledged the need to provide a workable process that would protect those who are vulnerable to undue influence as well as protecting banks and other financial institutions who want to make loans to small businesses without having to concern themselves with whether any security charged would be valid in the future. The decision in Etridge established the following minimum requirements that should be followed by the lender before it will be held to have discharged its obligations:

1. The lender should obtain from the wife the name of the solicitor she wishes to act for her

2. The wife should be informed that for the lender’s own protection it will require written confirmation from a solicitor that is acting for her that the solicitor has fully explained the nature of the documents and the practical implications have been explained to her in a meaningful way.

3. The wife should be told that the purpose of this requirement is so that “thereafter she should not be able to dispute she is legally bound by the documents once she has signed them”[4].

4. The wife should be advised that she can instruct the same solicitor as her husband but she should be told that if she is already using the same solicitor, she should be asked if she would prefer a different solicitor to act for her

5. If the lender does not receive an appropriate response from the wife, it should not proceed with the transaction.

6. The bank should provide the wife’s solicitor with the financial information he needs to explain the implications of the transaction to the wife.

7. If the lender believes or suspects undue influence on the part of the husband it must inform the solicitor of its belief or suspicion.

In Part A of the scenario there is an example of a partner, Jill, agreeing to use her own property as security for a loan that her partner is taking out to raise finance for his business. The lender has not followed the requirements set out in Etridge. The bank manager merely asked Jill if she had sought independent legal advice. The bank manager had no way of knowing whether Jill had actually received legal advice and, even if she had, the manager did not know whether the advice was accurate and whether Jill fully understood the nature and the practical implications of the transaction. Therefore, the bank would be susceptible to a successful undue influence claim by Jill as it did not comply with the minimum requirements set out in Etridge.

It is clear that, due to the decision in Etridge, the House of Lords has found a satisfactory balance between the need to protect those vulnerable to undue influence and the need to ensure that lenders are willing to lend money to small businesses. This is particularly important due to the buoyancy of the loan market at present. Provided that a lender follows the minimum requirements given in Etridge, a person in Jill’s situation would only have recourse against the solicitor based on the quality of the advice he has given. In effect, Etridge has transferred the risk from the lender to the solicitor and this seems to be a more acceptable situation as a client is entitled to expect accurate and complete advice from a solicitor and a lender is entitled to assume that a solicitor has fulfilled the requirements stipulated by Etridge. In Etridge, their lordships emphasised the need to strike a balance between the competing interests of the banks, small businesses and those vulnerable to undue influence. Lord Nicholls confirmed that the role of a lender is not to seek to establish whether a person is acting under undue influence but to ensure that a guarantor has had the practical implications of the transactions explained in a meaningful way. Lord Nicholls acknowledged that the risk of undue influence is not wholly eliminated when a lender complies with the minimum requirements set out in Etridge, however the requirements do ensure that the wife or other vulnerable guarantor has received all of the relevant information which will enable them to understand the consequences of agreeing to provide security.

Bibliography

J. Beatson & Sir W. Anson, “Anson’s Law of Contract”, 2002, 28th ed. OUP


Footnotes

[1] Royal Bank of Scotland v Etridge (No. 2) and others [2001] UKHL 44, per Lord Nicholls at 801

[2] ibid

[3] [1994] 1 AC 180

[4] supra note 1, per Lord Nicholls at para 79(1)


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