Can substance escape a black hole?

29 Nov 2016

Lenders claims are again in the spotlight following two recent Court of Appeal decisions. The first, a claim against accountants (Swynson Ltd v Lowick Rose LLP), has just been heard on appeal in the Supreme Court and judgment is awaited. It remains to be seen whether the second, a claim against valuers (Tiuta International Ltd v De Villiers Surveyors Ltd), reaches the Supreme Court. The cases examine complex issues about recoverability of loss following refinancing and dissenting judgments were delivered in both. Below, we explore the current position.

Swynson Ltd v Lowick Rose LLP [2015] EWCA Civ 629

In this case the Court of Appeal examined the concept of avoided loss.

Facts

The claimant lender, Swynson, alleged negligence by accountants Lowick Rose in respect of their due diligence conducted in relation to its borrower, Evo Medical Solutions Limited (EMSL), which was pursuing a management   buyout of a US company Evo.  Swynson advanced to EMSL a loan of £15 million in 2006 for this purpose. A further loan of £1.75 million was made to EMSL in 2007 to assist with cash flow problems within Evo. By 2008, both loans were outstanding and substantially in arrears. This led to a final advance in 2008 to Evo, via EMSL, of £3 million. Each advance was made in reliance upon Lowick’s negligent report.

What then happened in 2008 was a refinancing of the 2006 and 2007 loans (which by that stage totalled just over £17 million). Mr Hunt, who indirectly owned Swynson, made funds available to EMSL to enable it to pay off those two loans to Swynson, leaving just the 2008 loan of £3 million outstanding. That decision was not entirely altruistic: Mr Hunt had by now become the majority owner of EMSL, such that it and Swynson had become connected entities, a situation giving rise to adverse tax consequences if the earlier loans remained outstanding.

Evo’s troubles were not resolved and ultimately it was wound down without either the 2008 loan or Mr Hunt’s refinance monies ever being repaid. Lowick argued that its liability was limited to the 2008 advance of £3 million, the earlier loans having been discharged entirely through Mr Hunt’s refinance in 2008.

First instance

The case involved consideration of the extent to which a loss which has in fact been avoided (whether through positive steps taken by a claimant in mitigation or through collateral matters, such as insurance payments) should reduce a claimant’s recoverable loss. The court found that where loss has been reduced through a transaction which arises out of the consequences of the breach of contract and in the ordinary course of business, it should serve to reduce the extent of the recoverable loss. Where an entirely collateral transaction reduces the loss, the entire loss should nevertheless remain recoverable.

On that basis Lowick’s argument was rejected. The judge considered that Swynson was in no position to mitigate its loss and Mr Hunt was under no obligation to meet EMSL’s debt. His stepping in was mere good fortune as far as Swynson was concerned and was not something which it brought about in the ordinary course of its business by way of mitigation. 

On appeal

The Court of Appeal agreed. Against Lowick’s argument that any repayment received from a borrower (even if facilitated by the benevolent act of a third party) must serve to reduce the recoverable loss, the Court of Appeal was concerned about form triumphing over substance. It would have made no difference to Swynson’s claim if Mr Hunt had met EMSL’s liability by making a direct payment to Swynson. Why, then, should Swynson’s claim be reduced simply because that payment was channelled through the borrower?

The majority of the Court, following the authority of Parry v Cleaver [1970] A.C. 1, focussed on the need to disregard technicalities and to consider “practical reality and basic justice” as between the parties involved. That requires the court to look at the substance of the matter: not merely at the source of the repayment to Swynson (here the borrower EMSL itself) but the intrinsic nature of the repayment. In this case, the material consideration was that Mr Hunt, a third party under no contractual obligation to Swynson, had elected to meet EMSL’s debt. The fact that the repayment was channelled via EMSL was a mere technicality and one from which Lowick should not stand to benefit.

Davis LJ saw the matter very differently. EMSL met the liability which it had to Swynson under the 2006 and 2007 loans. That Mr Hunt enabled it to do so without appreciating that such action would nullify any claim by Swynson against Lowick in relation to those earlier loans was simply irrelevant. Observing that “the form here is the substance”, he noted that Mr Hunt was acting not benevolently but through “hard-headed commercial considerations” and that one could not overlook, but should rather respect, the corporate structures involved. It was not as argued a case here of the claim against the accountants “disappearing down some “black hole”” but simply a case that no loss in fact flowed from the negligence.

Tiuta International Ltd v De Villiers Surveyors Ltd [2016] EWCA Civ 661

In this case the Court of Appeal has revisited the approach to losses sustained by a lender in property refinancing transactions.

Facts

On the claimant lender Tiuta’s instructions De Villiers (DV) valued a partly completed residential development in Sunningdale Berkshire:

  • in February 2011 at £3.25 million (current state) and £4.9 million (when completed)

  • in December 2011 at £3.5 million (current state) and £4.9 million (when completed)

On the basis of the February 2011 valuation Tiuta advanced £2.22 million to the developer. Later and on the basis of the December 2011 valuation an extended facility was agreed up to £3.1 million. Tiuta’s case was that it redeemed the first loan in full with the second advance, took a fresh charge over the property and opened a new account for the second facility. It advanced £2.56 million to repay the balance of the first facility along with further amounts as the development progressed. When the terms of the second facility expired £2.84 million remained outstanding. The property was sold realising £2.1 million.

Tiuta brought a claim against DV to recover the shortfall on the basis that the December 2011 valuation had negligently overvalued the property. At no time did Tiuta claim that the first valuation was negligent. However, rather than limiting the claim to the amount by which its exposure had been increased in reliance on the second valuation (a relatively modest £280,000), Tiuta claimed the entire shortfall in its lending against the property of some £900,000.

First instance

DV made an application for summary judgment on the issue of causation which proceeded on the assumption that the original loan and charge had been redeemed as Tiuta has asserted. However, DV’s case was that even if the entirety of the sum ultimately advanced was in consequence of the allegedly negligent second valuation, by December 2011 Tiuta could not have suffered a greater loss than the amount by which the indebtedness had merely increased further.  

The difficulty for Tiuta on its pleaded case was that in using the majority of the second facility to discharge the balance on the first, it was unable to assert that it had sustained any loss on the earlier facility. Consequently it did not allege negligence in relation to the first valuation.  That course was in all likelihood adopted in light of the Court of Appeal’s decision in Preferred Mortgages Ltd v Bradford & Bingley Estate Agencies Ltd [2002] EWCA Civ 336 where it was held that where an initial mortgage has been redeemed in full by a subsequent advance, no claim can lie in respect of the original valuation since the referable loan has been discharged without shortfall and the valuer could not be said to have assumed a duty of care extending to any subsequent, unforeseen loan transaction.

In Preferred Mortgages, no claim had been advanced against the later valuer, seemingly on the basis that their duty of care would have been limited to the amount of the additional lending, rather than extending to the full amount of the new advance. This left Tiuta with a problem: in discharging the initial loan entirely, it forfeited any larger, inchoate claim on the original valuation, yet at the same time its claim in respect of the later valuation had to concede that there was already in existence a substantial and unavoidable debt. Accordingly Tiuta argued that a substantial amount of its loss fell into a black hole if the usual “but for” test was applied.

Despite Tiuta’s arguments the court found that indeed the usual “but for” test of causation applied, thereby limiting DV’s liability to any loss caused by the additional lending. Comparing Tiuta’s position with how it would have been had a second, non-negligent valuation been provided and the subsequent transaction not proceeded, it was found that it would still have remained exposed to substantial losses on the current balance of the mortgage.

The court recognised that the outcome was superficially unattractive (seemingly allowing a valuer to escape liability for an earlier negligent valuation merely as a result of how the lender had classified the later advance) but observed that in fact there was no ”black hole” here (and no negligence had been alleged in relation to the first valuation in any event). If the later, negligent valuation had caused the lender to enter into a fresh transaction as a result of which it forfeited a claim in respect of an earlier negligent valuation, application of the ‘”but for” test would allow the value of that inchoate claim to be recovered. This, however, was not Tiuta’s pleaded claim. Tiuta appealed.

On appeal

The majority of the Court of Appeal disagreed with the lower court on the basis that it had misapplied the “but for” test as it failed to take account of the fact that the transaction was structured in such a way that the second loan was used to pay off the first. But for the second valuation, Tiuta would not have redeemed the existing loan thereby releasing DV from any potential liability in respect of the first valuation in February 2011. That Tiuta had structured the second advance as it chose to did not affect the extent of the valuer’s liability and there was no unfairness where a valuer values the property itself in the expectation that a lender would advance funds up to its full reported value in reliance on its valuation. Adopting this analysis the court concluded that assuming DV’s December 2011 valuation was negligent it would be liable for the entirety of the loss flowing from the loan made, based on that valuation.    

In his dissenting judgment, McCombe LJ expressed reluctance to adjust the law of causation in order to protect a lender where the loss of a potential claim on the original valuation arose solely from the way it chose to structure the later transaction.

What now?

The cases reveal a majority in the Court of Appeal seeking to address a perceived injustice to claimants where otherwise valid claims against professionals appear nullified by subsequent refinancing arrangements.

However compelling arguments the other way were made in dissenting judgments in both cases. In Swynson, Davis LJ cautioned against dismissing the commercial form “designedly” adopted to achieve what may appear to some as a just result. In Tiuta, McCombe LJ expressed concern that disregard for how a claimant structures its affairs could cause injustice to a defendant in making them liable for certain losses which the claimant would have sustained in any event.

The Court of Appeal decision in Preferred Mortgages featured in both cases, most prominently in Tiuta. We await to see whether substance will continue to triumph over form when the Supreme Court judgment in Swynson is available and how that decision may affect how Preferred Mortgages continues to be applied in refinancing cases such as Tiuta.

 

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Disclaimer: This document does not present a complete or comprehensive statement of the law, nor does it constitute legal advice. It is intended only to highlight issues that may be of interest to customers of BLM. Specialist legal advice should always be sought in any particular case.

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