The impact of insolvency on mortgages poses increasingly serious risks for both borrowers and lenders

Speaking to the Council of Mortgage Lenders’ Autumn Update in Leeds today, Georgina Squire, Head of Dispute Resolution at Rosling King LLP, said the consequences of insolvency in the mortgage market will become more far-reaching in the event of interest rate rises.

Squire told the CML:

“It is estimated that up to two million people have never had to deal with an interest rate rise. There is a wide range of pitfalls for both borrowers and lenders in the event of insolvency and the potential fall-out from these should not be underestimated.”

She highlighted forthcoming changes in Insolvency Rules – due to take effect next year – as being potentially important changes.

“We do not know the detail as yet but the changes could be the biggest in 30 years.”

Here Georgina Squire addresses some of the key questions that arise regarding insolvency and mortgages.

What happens when one of a pair of joint borrowers becomes bankrupt?

The effect is that the insolvency severs their joint interest. The bankrupt’s beneficial interest is vested in their Trustee in Bankruptcy. The title remains in both borrower names and is held on trust for both the Trustee and the solvent borrower. The lender is protected as the Trustee can only assign the insolvent borrower’s equitable interest, giving notice of the assignment to the lender.

Is the security at risk in the event of a borrower’s insolvency? 

Any relatively new security is vulnerable and reviewable during the ‘hardening period’, as defined by the Insolvency Act 1986. There is the possibility to set aside the charge as a transaction at undervalue or as a preference which would improve a creditor’s position. In this case, the borrower has to do this knowing they are preferring one over another. Also, this has to happen in the two years prior to personal bankruptcy. A court order is necessary to release or discharge security if preference or transaction at undervalue.

What are the potential consequences of having unperfected security where a borrower becomes insolvent? 

Often an insolvent borrower does not have enough from the proceeds of a sale to pay all charges on the property.

Failure to register with HM Land Registry could prejudice the lender’s security. Basic priority rules mean that legal mortgages rank in priority in the order shown in the Charges Register, not the date of creation, subject to any entry to the contrary.

Further advances by a lender will not always rank in priority with the original charge. They may rank lower and behind all subsequently registered charges.

Security not registered at Companies House is also void against a liquidator, administrator or third party creditor of a corporate borrower.

Can a lender, as mortgage in possession, sell the security property if a trustee in bankruptcy has been appointed? 

Yes. Under Section S104(1) Law of Property Act 1925 – a mortgagee exercising its statutory power of sale has the power to transfer the property by deed free from all interest and rights over which it has priority.

The 1986 Insolvency Act ensures that the estate vests in the Trustee in Bankruptcy on its appointment. It is automatic. The Trustee in Bankruptcy’s interest is subject to any charges on the property. A Bankruptcy Order does not affect a secured creditor’s right to enforce its security. Therefore a mortgagee can take possession.

The mortgagee and the trustee may take own their possession actions. The trustee is unlikely to pursue it if they know the mortgagee is also taking action. The trustee must account to the mortgagee for the total amount of the mortgage debt if they obtain the Possession Order. Also, a mortgagee must send the trustee the bankrupt borrower’s share of any surplus on sale.

Can a mortgagee appoint an LPA Receiver over the security following the borrower’s bankruptcy? 

The trustee’s interest is subject to any charges on the property. Therefore a mortgagee can exercise a power to appoint a Receiver.

However, the Receiver will not act as agent of the borrower when bankrupt. The lender should look at the mortgage deed and discuss with the Receiver whether they can and wish to act. The lender may be liable for the Receiver’s actions. The Receiver will also have greater duties to the lender than to the borrower and may want an indemnity from the lender. As a result, possession is usually favoured where a bankruptcy order has been made against one borrower.

How does bankruptcy affect buy to lets? For example what happens to rental payments? 

The Legal Charge will usually allow rent to be charged to the lender by way of a first fixed charge.

Even though the trustee obtains the bankrupt borrower’s beneficial interest in rental income, it should be subject to the lender’s security and so the lender can demand it is paid to them in full.

Can the lender enforce the security to pay the full mortgage debt once the borrower has been discharged from bankruptcy? 

Yes, but any shortfall is likely to fall within the bankruptcy. Bankruptcy usually lasts one year. At the end the bankrupt is discharged and a lender has no further remedy against them for any debt which was included within the bankruptcy i.e. a shortfall that arose prior to the bankruptcy order.

Forthcoming changes to the Insolvency legislation and how they affect mortgagees 

The most significant forthcoming changes are Insolvency Rules 2016. This is a significant rewrite of 1986 Rules and will likely be the most far-reaching modernisation of red tape and consolidation of amendments since 1986. The transitional provisions are not yet clear but the changes are expected to take effect from October next year.