When An Unregulated Bridging Loan Falls Within Mortgage Regulation

In the UK bridging finance market, the dividing line between regulated and unregulated credit agreements is sharp. While unregulated lenders enjoy swift underwriting and flexible structures, crossing the regulatory perimeter can happen unintentionally. When an ostensibly unregulated bridging loan is determined to be a Regulated Mortgage Contract (RMC) under Article 61 of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO), the consequences for an unauthorised lender can be severe.

In advising on several recent disputes involving commercial bridging loans, senior litigation Partner at Ronald Fletcher Baker LLP, David Burns notes that some recurring patterns emerge.

Lenders who believe they are advancing short-term, unregulated commercial facilities can suddenly find themselves facing severe consequences by the application of statutory regulation. 

If a Bridging loan company carries on certain activities relating to regulated mortgage contracts by way of business without FCA authorisation, they are committing a criminal offence and agreements may be unenforceable. 

The Legal Framework in summary: When Does a Bridging Loan Become Regulated?

Under the general prohibition in section 19 of the Financial Services and Markets Act 2000 (FSMA), a person must be authorised or exempt to carry on, by way of business, a specified activity in relation to a specified investment. A regulated mortgage contract is a specified investment, and carrying on certain activities relating to regulated mortgage contracts by way of business requires FCA authorisation.

The definition of a Regulated Mortgage Contract

Under Article 61(3) of the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (RAO) a contract is a Regulated Mortgage Contract (RMC) if, at the time it is entered into, the following conditions are met:

1. the contract is one where a lender provides credit to an individual or trustees;
2. the obligation of the borrower to repay is secured by a mortgage on land;
3. at least 40% of the land is used, or is intended to be used:
   • in the case of credit provided to an individual, as or in connection with a dwelling; or
   • in the case of credit provided to a trustee that is not an individual, as or in connection with a dwelling by an individual who is a beneficiary of the trust, or by a related person

Borrowers

Only mortgage contracts entered into with individuals or trustees are regulated. Unless a company is acting as a trustee, a mortgage entered into with a company is not regulated.

If a company (that is not acting as a trustee) borrows money for the purpose of funding the company’s business and the loan is secured by a mortgage over the company’s property, the mortgage contract is not a regulated mortgage contract. However, if the lender makes a loan for business purposes to an individual sole trader or (in England and Wales) a partnership, and the loan is secured on the borrower’s house, the contract will be a regulated mortgage contract (Perg 4.4.2G).

Use as or in connection with a dwelling

A loan secured on property used entirely for business purposes, for example a retail outlet, will not be regulated. However, loans secured on mixed-use property (for example, a flat above a restaurant) could potentially be regulated if the occupier uses at least 40% of the land as or in connection with a dwelling.

Occupation of property

The definition of a regulated mortgage contract means there is no requirement that the borrower should occupy the property. At least 40% of the land should be used as a dwelling, but there is no requirement that it is the borrower that lives there. The following may be a regulated mortgage contract:

• A loan on a property, if the property on which it is secured is to be occupied by the borrower’s relatives as their home.
• A loan on a property if the borrower does not occupy the property on which the loan is secured and instead intends to sell the property to a third party, with the mortgage remaining on the house until then. However, if the borrower is acting on a commercial basis, the loan may be excluded as a loan to a commercial borrower 
• A buy-to-let loan secured on a property to be let. However, such a loan may be excluded as a loan to a commercial borrower in certain circumstances or under the buy-to-let exclusions relating to consumers

Timing, variations and regulated mortgage contracts

PERG 4.4.3G provides that to be a regulated mortgage contract, the contract must meet the relevant conditions at the time it is entered into.

RMCs that meet the conditions at the time they are entered into remain regulated even if there are times when some or all of the conditions are not met.

Contracts that do not meet the conditions of an RMC at the time they are entered into cannot subsequently become regulated mortgage contracts. However, if the contract is varied so that a new contract is entered into, the new contract may qualify as a regulated mortgage contract. The determination of whether a variation to an existing loan constitutes a ‘new contract’ will depend on the precise circumstances of each case but, for example, a new contract may be treated to arise in the following situations:

1. Changes to the parties involved – such as a borrower being added or removed; 
2. The borrower taking on additional borrowing / advances;
3. Changing the security for an existing loan.

Unregulated mortgage contracts 

However, Article 61A(1) or 61A(2) of the RAO lists specific contracts that are excluded from being regulated mortgage contracts (‘Unregulated Mortgage Contracts’) which include, commonly relied upon exemptions in the bridging loan industry;

Lending to commercial borrowers 

Investment property loan

A contract is excluded from the definition of a regulated mortgage contract if it is an investment property loan.

An “investment property loan” is a contract that, at the time it is entered into, meets the conditions in paragraphs (i) to (iii) of article 61(3)(a), as set out above, and the following conditions—

(a) less than 40% of the land subject to the mortgage is used, or intended to be used, as or in connection with a dwelling by the borrower or (in the case of credit provided to trustees) by an individual who is a beneficiary of the trust, or by a related person; and

(b) the agreement is entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower;

Under article 61A of the RAO, a borrower is to be regarded as entering into an agreement for the purposes of a business carried on, or intended to be carried on, by the borrower if the agreement is a buy-to-let mortgage contract and either:

All the following conditions apply:

• the borrower previously purchased, or is entering into the contract to finance the purchase by the borrower of, the land subject to the mortgage;
• at the time of the purchase the borrower intended that the land would be occupied as a dwelling on the basis of a rental agreement and would not at any time be occupied as a dwelling by the borrower or by a related person, or where the borrower has not yet purchased the land the borrower has such an intention at the time of entering into the contract; and
• where the borrower has purchased the land, since the time of the purchase the land has not at any time been occupied as a dwelling by the borrower or by a related person.

Or

• The borrower is the owner of land, other than the land subject to the mortgage, that is:
• occupied as a dwelling on the basis of a rental agreement and is not occupied as a dwelling by the borrower or by a related person; or
• secured by a mortgage under a buy-to-let mortgage contract.

Second charge business loan

There is an exclusion for loans to commercial borrowers secured by a second or subsequent security

A second charge business loan is defined in Article 61A(6) of the RAO:

a contract that, at the time it is entered into, meets the conditions in paragraphs (i) to (iii) of article 61(3)(a), set out above, and the following conditions—

(a) the lender provides the borrower with credit exceeding £25,000;

(b) the mortgage ranks in priority behind one or more other mortgages affecting the land in question; and

(c) the agreement is entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower.

Business purpose declaration

The two exclusions for loans to commercial borrowers depend on the borrower not being a consumer. For these purposes, an agreement is presumed to have been entered into by the borrower wholly or predominantly for the purposes of a business if it contains a declaration that:

1. Is made by the borrower.
2. Includes:
   • a statement that the agreement is entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower;
   • a statement that the borrower understands that the borrower will not have the benefit of the protection and remedies that would be available to the borrower under FSMA if the agreement were a regulated mortgage contract; and
   • a statement that the borrower is aware that if the borrower is in any doubt as to the consequences of the agreement not being regulated by FSMA, then the borrower should seek independent legal advice.

Purpose of the loan – a question of fact

The important point for bridging lenders is that the purpose of the loan is ultimately a question of fact. If the bridging loan contains an appropriate declaration by the borrower, that raises a rebuttable presumption that the loan was for business purposes, but if the lender knows or has reasonable cause to suspect that the agreement is not entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower, the presumption does not apply.

Inadvertently entering into a regulated mortgage contract

Bridging lenders can inadvertently cross the regulatory boundary and enter into a Regulated Mortgage Contract (RMC). This is a severe legal trap under the FCA’s PERG 4 guidance. If a lender accidentally enters into an RMC without the proper FCA permissions, the loan agreement can be deemed unenforceable under Section 26 of FSMA 2000, and the lender risks criminal charges for conducting unauthorised regulated business.

Bridging lenders typically stumble into this situation through several common avenues:

1. Blind Reliance on Business Purpose Declarations

Lenders frequently rely on a signed “Business Purpose Declaration” to satisfy the condition for ‘Investment property loans’ and ‘Second charge business loans’ that the agreement is entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower

The Trap: While a signed declaration creates a legal presumption that the loan is unregulated, the presumption is rebuttable.

The Risk: The exemption fails if the lender knows or has reasonable cause to suspect that the loan is actually for personal use. If the underwriting file contains emails indicating the borrower intends to use the money for non business purposes, by way of example,  for a divorce settlement or personal debt, then lender will face serious difficulty if they simply seek to rely on the business purpose declaration. The presumption could be rebutted. 

Il caso di Wood v Capital Bridging Finance Ltd [2015] EWCA Civ 451 is an example of where a court will look beyond a borrower’s business declaration. 

The Facts: A 75-year-old shopkeeper, Mrs. Wood, was persuaded by her son-in-law to take out a £64,000 bridging loan secured against her home. The son-in-law used the money for his own purposes and subsequently absconded. Mrs. Wood was required to sign a declaration stating that the loan was purely for business purposes.

The Court of Appeal looked behind the signed paperwork. Briggs LJ, giving the lead judgment, decided that the credit agreement was a regulated credit agreement under the CCA (and not exempt) and his reasons included the following:

The burden of proving whether a credit agreement is an exempt agreement falls on the lender.

The purpose of the provisions of section 16B(2) of the CCA (now article 60C(5) of the RAO) is to give a lender an “easy method of discharging that burden by way of presumption, where the creditor obtains a declaration in the prescribed form”.

However, if the lender or any person who acted on its behalf in connection with the entering into the loan knew, or had reasonable cause to suspect, that the loan was not entered into by the borrower wholly or predominantly for the purposes of a business carried on, or intended to be carried on, by the borrower, then the burden falls back on the lender.

In this case the employee was specifically told, before the parties entered into the credit agreement, that the loan’s purpose was to provide funds to Mr Johnson’s (and not Mrs Wood’s) business. The result of that knowledge was that the presumption did not apply. Instead, and given the knowledge the lender had, it could not discharge the burden of proof meaning the credit agreement was regulated under the CCA.

CBFL’s argument that Mrs Wood should, because she signed a declaration in the prescribed form saying the agreement was entered into wholly or predominantly for the purposes of her business, be estopped had to fail. Such an argument was, in essence, one saying that it was possible for the parties to contract out of the CCA (which they could not do because of section 173 (Contracting-out forbidden) of the CCA).

Because the lender knew, before entering into the loan, that the funds were to be used for Mr Johnson’s business (and not Mrs Wood’s business), any attempt to rely on the exemption was going to be unsuccessful. It therefore serves as a clear warning to lenders that if they wish to take advantage of the exemptions (now contained in the RAO), they must ensure that they are strictly satisfied.

2. More than 40% of the secured land is being used the borrower or a related person at Inception of a First Charge Mortgage

As set out above, a contract is excluded from the definition of a regulated mortgage contract if it is an investment property loan.

However, if more than 40% of the land secured by the mortgage is used, or intended to be used, as or in connection with a dwelling by the borrower or (in the case of credit provided to trustees) by an individual who is the beneficiary of the trust, or by a related person, then the exemption fails and the mortgage would become a regulated mortgage contract.

This issue can become a common source of dispute between lenders and borrowers and the lender places itself at significant risk if it has not carried out its due diligence properly. There is no general business purpose exemption for a first charge residential mortgage.

Even if 100% of the funds go directly into a business, if the lender takes a first charge over a home where the borrower’s family lives, the loan is fully regulated. 

On some occasions lender may check that the borrower is not using more than 40% of the land secured by a mortgage as a dwelling but fail to check whether there are any ‘related persons’ using more than 40% of the land secured by a mortgage as a dwelling.

A related person, with regard to the borrower or, in the case of credit provided to trustees, a beneficiary of the trust, means either:

• That person’s spouse or civil partner.
• A person (whether or not of the opposite sex) whose relationship with that person has the characteristics of the relationship between husband and wife.
• The borrower’s, or beneficiary’s, parent, brother, sister, child, grandparent or grandchild.

3. The Mixed-Use / Multi-Unit “40% Mathematical Trap”

When a lender takes a charge over a mixed-use commercial asset (like a shop with flats above) or a small multi-unit residential block, they often assume it is safely commercial or a standard buy-to-let asset.

The Risk: If a borrower owns a freehold building consisting of three flat units, and they decide to move into one of the flats while letting out the other two, a first-charge bridge secured against the whole freehold could cross the threshold of being a regulated mortgage contract if the borrower’s flat constitutes 40% or more of the overall square footage. Lenders sometimes fail to conduct precise square-footage calculations on mixed assets, crossing the 40% boundary by accident.

4. The “Future Intent” Dwelling Trap

A bridging lender does not necessarily avoid an agreement becoming a regulated mortgage contract simply because a property is currently vacant or derelict at inception. 

The Trap: By way of example, under the Investment property loan exemption, if 40% or more of the land is used or is intended to be used as a dwelling by the borrower or a related person. 

The Risk: If an investor takes out a first-charge bridge to buy an empty property to renovate, but their ultimate ‘exit strategy’ is to move into it as their primary residence once complete, the “future intent” triggers immediate regulation at day one. If the underwriting file contains any indication that the borrower intends to live in the secured property later, treating it as an unregulated development bridge could amount to an immediate regulatory breach.

Contattaci – David Burns, socio senior del dipartimento contenzioso  

Senior Litigation Partner David Burns has extensive experience dealing with disputes relating to bridging loans. For enquiries on this topic, please contact David Burns via email d.burns@rfblegal.co.uk or direct dial 0207 467 5751.