English Supreme Court holds that the Etridge protocol applies to hybrid loan transactions

In answering this question, the Supreme Court considered the correct test to determine whether a lender is on inquiry of undue influence in a non-commercial hybrid transaction.  The Supreme Court decision confirms that a lender will be on inquiry in this context if, on the face of the transaction, there is a more than de minimis element of borrowing which is for the purpose and benefit of only one of the parties.  In such a situation the Etridge protocol should apply.  

What does “de minimis” mean? The Supreme Court indicated that the threshold is very low in practice.  As such, the Etridge protocol seems likely to apply to the vast majority of hybrid transactions.  On a practical level (and if they are not already doing so) lenders would be well-advised to implement the Etridge protocol for all hybrid transactions, obviating the need for them to make judgement calls on what constitutes “de minimis”. This may require some work to recalibrate existing Etridge processes to incorporate hybrid transactions.

Throughout the judgment the Supreme Court refers to the relationship of husband and wife, with the wife as the vulnerable party (since that mirrored the fact pattern in the case, which concerned an unmarried heterosexual couple). However, the principles apply equally to other non-commercial relationships in which one individual may be susceptible to undue influence or exploitation by another.  As such, the judgment strengthens the legal protections afforded to an individual entering into a non-commercial financial transaction that is not wholly to their benefit.  The decision also plays a part in reinforcing the role that the lending sector has in supporting victim-survivors of economic abuse, as set out in UK Finance's Financial Abuse Code.

In this article, we first set out the existing law relating to when a lender is on inquiry of undue influence and what it is required to do in such a situation, before moving on to an analysis of the case. 

When is a lender on inquiry of undue influence? O'Brien, Pitt and Etridge

The cases of Barclays Bank plc v O'Brien², CIBC Mortgages plc v Pitt³ and Royal Bank of Scotland plc v Etridge (No 2)⁴ established that, in a non-commercial scenario:

• Where, on the face of the transaction, one party is standing as guarantor for the other party's debts, the law regards the lender as having been put on inquiry that the guarantor's agreement to the transaction may have been obtained by undue influence.

• Where, on the face of the transaction, the lending is advanced to both parties jointly for the parties' joint purposes, the lender is not put on inquiry.

The rationale for the above principles is the recognition that, in a guarantor scenario, the transaction is more likely to be tainted with undue influence as the party acting as guarantor assumes a legal liability that they would not otherwise have had, but receives no apparent benefit in return.  By contrast, in a joint borrowing transaction, the risk of wrongdoing is low, as both parties benefit from the loan.

In all cases, whether of guarantor or joint borrowing, the proposed transaction must always be considered from the lender's perspective; it is the lender's perception of the nature of the transaction, and what is apparent to the lender “on the face of the transaction”, that is critical.  So, for example, a lender will not be put on inquiry of undue influence in a joint borrowing transaction unless there are particular facts which put the lender on inquiry that the transaction is not what it seems to be on its face (i.e. the lender becomes aware that the joint loan is actually being made for one party's purposes, and not for both parties' joint purposes).

What should a lender do when on inquiry of undue influence?

When a lender is on inquiry of undue influence, it must follow the Etridge protocol, meaning it must take steps to ensure that the party acting as the guarantor obtains independent legal advice explaining the nature and effect of the transaction and the potential risks of becoming liable for the other party's debt if not repaid.  If the lender does not take these steps, and the party acting as guarantor alleges undue influence, the transaction may be set aside.

As can be seen, the steps outlined in the Etridge protocol do not involve the lender aiming to establish whether or not undue influence is in fact taking place. Rather, the steps are aimed at minimising the risk that such a wrong may be committed in the first place.

That said, the adoption of the Etridge protocol does not mean that lenders can simply close their eyes to red flags that indicate, in a particular case, there has been, or may have been, undue influence.  In such a case, further inquiry by the lender is required.  

Turning now to the facts of the case in question.

Waller-Edwards v One Savings Bank Plc

In 2011, the appellant commenced a relationship at a point in her life when she was emotionally vulnerable but financially independent as the sole owner of her mortgage-free home with substantial savings. Her partner, Mr Bishop, persuaded her to exchange her home and savings for a property he was building, which was already subject to an existing charge (“the Property”).

In 2013, Mr Bishop re-mortgaged the Property with the respondent (“the Lender”). The Lender understood that the loan would be a buy-to-let mortgage, and that the Property would be let out at a rent sufficient to repay the instalments on the loan. (This became a condition of the borrowing).  The Lender understood from Mr Bishop that, of the £384,000 advanced by the Lender, some would go towards paying off an existing mortgage debt and some would go towards buying a home for the couple to live in (given that the Property would be rented out). The Lender also required Mr Bishop to use the funds advanced to pay off his other existing debts so that £25,000 would be used to pay off the loan for his car and £14,500 to pay off his credit card. (In fact, but unknown to the Lender, the loan was used by Mr Bishop to make a divorce payment to his ex-wife and pay off the existing charge on the property).

The loan fell into the category of a hybrid transaction given that, as it was understood by the Lender, part of it was for the couple's joint purposes (i.e. to pay off mortgage debts on the Property and to buy a home) and part of it was for Mr Bishop's sole purpose (i.e. to pay off his personal debts).

In October 2013, the relationship between the couple ended. The appellant remained living in the Property, now heavily mortgaged. The couple fell into arrears and, in November 2021, the Lender commenced possession proceedings, but the appellant argued that the loan should be set aside on the basis that the Lender was on inquiry of undue influence and had not followed the Etridge protocol. 

The issue

The question at the heart of the case concerned the correct test for deciding whether the Lender was on inquiry of undue influence in the context of a non-commercial hybrid transaction so as to trigger the requirement to follow the Etridge protocol.

The Court of Appeal: The fact and degree test

The Court of Appeal (agreeing with the lower courts) held that the test to be applied to ascertain whether the Lender was on inquiry of undue influence in a non-commercial hybrid transaction was one of fact and degree.  Sir Geoffrey Vos, giving the leading judgment, explained that the court is required “to look at a non-commercial transaction as a whole and to decide, as a matter of fact and degree, whether the loan was being made for the purposes of the borrower with the debts, as distinct from [the borrowers'] joint purposes”⁵. 

Applying this test, the Court of Appeal (again, agreeing with the lower courts) held that the loan here was, when looked at as a whole and from the point of view of the Lender, a joint borrowing made for the parties' joint purposes.  As such, the Lender was not on inquiry of undue influence, and the Etridge protocol did not apply.

The Supreme Court: The bright line test

The appellant contended that the Court of Appeal's approach was wrong in law, and appealed to the Supreme Court.  She advocated that the proper test is “a bright line test”; namely, that the lender is put on inquiry in any non-commercial hybrid transaction where, on the face of the transaction, there is more than a de minimis element of borrowing which serves to discharge the debts of one of the borrowers and so might not be to the financial advantage of the other.  In other words, one party is standing as guarantor to a more than de minimis extent for the other party.

Lady Simler, who gave the leading judgment⁶, agreed with the appellant and held that this is the correct test.

As to what amounts to “de minimis”, Lady Simler referred to a description from case law of matters which are “trifling, insubstantial, inconsequential, immaterial, irrelevant or negligible”⁷ and said that the principle is of such long standing that it could not be regarded as a source of unworkable uncertainty.

Lady Simler addressed arguments against the bright line test as follows:

• Spectrum of risk

The Lender contended that, given non-commercial hybrid transactions can come in different shapes and sizes (i.e. the ratio of joint borrowing to guarantee may vary significantly from one transaction to another, and it may also be that both parties use some of the borrowing to pay off their respective personal debts) and, as such, given they cover a spectrum of risk, the fact and degree test adopted by the Court of Appeal would be a more appropriate test.

Lady Simler rejected this argument.  She agreed that, while there may be a spectrum of risk posed by different types of hybrid transaction, it is not for the lender to judge the level of risk on a fact-specific basis.  Rather, the approach adopted by established case law (O'Brien, Pitt and Etridge) is a binary one: either there is, on the face of the non-commercial transaction, a more than de minimis guarantee element giving rise to a heightened risk of undue influence (in which case the Etridge protocol must be followed) or there is not (and the lender need not take any further steps). Ultimately, the level of risk presented by a guarantee transaction is the same whether or not accompanied by joint borrowing.

• Purpose for which the loan is used

There may also be situations where a party's personal borrowing may also benefit the other party (i.e. a car may be in the name of one party but be used by both parties - or household expenses may be in the name of one party).  The Court of Appeal had placed weight on this but Lady Simler said that it was not a relevant consideration.  Aside from the fact that such details would not be apparent to the lender, it is not a question of who benefited from the loan.  Rather, it is a question of whether a party has, for no consideration, taken on a more than trivial legal liability that is not theirs and for which they are otherwise not responsible, in return for nothing - and this legal liability should be made apparent to them.

• Added burden on lenders

Lady Similar did not accept that extending the application of the “modest steps” required by the Etridge protocol to in-scope hybrid transactions would be onerous on lenders or add unnecessary cost and friction into the lending process. She said that it was not a radical departure from the present position and some lenders may in fact already be operating this way.

• Litigation risk for past transactions

Lady Simler recognised that, while it is likely that adoption of a bright line test in hybrid transactions may have the effect of opening up more historic transactions to legal challenge than a test based on fact and degree, there was no evidential foundation for the Lender's assertion that it will have profound implications for the lending industry.

Conclusion

Applying the bright line test to the present case, Lady Simler held that the guarantee component of the hybrid transaction, which amounted to £39,500 and represented Mr Bishop's personal debts, easily passed the de minimis threshold.  She remitted the case to the County Court for further consideration of the question of remedy.

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Authored by Daniela Vella and Whiston Bristow.