by Peter Busby and Penny Hubbard
“We suspect that no court would exercise the equitable jurisdiction in such a way as to invalidate a term in the commercial agreement where the parties were at arm’s length. Nevertheless, our impression is that the uncertainty about what the courts will consider to be a clog or fetter on the equity of redemption inhibits development of novel forms of financing the purchase and development of land … we doubt whether applying principles primarily developed in the 19th and early 20th century in a very different context is the best way of deciding whether such mortgages should be enforceable in this country today.”
In Law Commission Working Paper No 99 (1986) Land Mortgages, the commission, in the terms set out above, identified an area where technical rules of equity are inhibiting the development of commercially acceptable forms of value-adding agreements in the modern secured lending market. It is known that the development of participating mortgages in the early 1970s was substantially slowed down by the fear of the rules quoted by the Law Commission and, with the market now moving towards schemes whereby investors may not only participate in equity growth but also convert a loan asset into a real asset, the opportunity for a reform of the law presented by the imminent presentation of a Law Commission report should be grasped.
The cases in point develop from that of Vernon v Bethell (1762) 2 Eden 110, where Lord Northington stated the rule against clogging the equity of redemption as follows:
I take it to be an established rule that a mortgagee can never provide at the time of making the loan for any event or condition from which the equity of redemption shall be discharged from the conveyance absolute. And there is great reason and justice in this rule, for necessitous men are not, truly speaking, free men, but to answer a present exigency, will submit to any terms that the crafty may impose upon them.
The case law developed during the 19th century — typically in the breweries sector where ties and restrictive covenants were imposed — but it should not be imagined that all the law is over 100 years old. Particular reference should be made to Lewis v Frank Love Ltd [1] 1 All ER 446. There, Plowman J, having first reemphasised the common doctrine of equity that the court would look to the substance rather than to the form of the transaction, stated:
the doctrine of the clog on the equity of redemption is a technical doctrine which is not affected by the question whether in fact there has been oppression and which applies just as much where the parties are represented, as they were here, by solicitors.
The judge was at pains to acknowledge that both parties had been separately advised by their own lawyers, and that the matter was an acceptable commercial deal which could have been entered into had this technical rule not existed and interfered. Similarly, in Cityland & Property (Holdings) Ltd v Dabrah [8] Ch 166, Goff J was prepared to interfere in a case where a collateral advantage (see below) was “unfair and unconscionable”.
However, in parallel with the development of the strict rule mentioned above there must be considered a second line of cases. Before 1914 the rule was interpreted as preventing any collateral advantage accruing to the lender if it were to endure beyond redemption. In Samuel v Jarrah Timber & Wood-paving Corporation Ltd [4] AC 323, money was lent on the security of first mortgage debenture stock, subject to the lender, at any time within the following 12 months, having an option to purchase the stock at 40% of value. The advance was repayable by the borrower on 30 days’ written notice. The court rejected the lender’s argument that the option was independent of the mortgage on the grounds that the option, if exercised by the mortgagee, would prevent the mortgagor from getting back his mortgaged property.
By contrast, in De Beers Consolidated Mines v British South Africa Co Ltd [2] AC 52, a single agreement provided (i) that the borrower would issue debentures, to be secured by a floating charge in favour of the lender, and (ii) granted to the lender a licence to carry out diamond excavation on the borrower’s land.
The agreement was construed as imposing a separate, immediate and absolute obligation on the borrower to grant the licence to the lender. The timing of, and the granting of, the debentures was to be determined by the borrower. The loan would remain outstanding until the company issued debentures in satisfaction of the loan. If the borrower refused to do this then the lender was free to call in the loan. The paying-off of the debentures did not release the borrower from the burden of the licence since the property charged by the debentures would include the prior obligation contained in the licence. When redemption took place, everything which had been charged would be restored to the borrower. The two obligations were separate and independent transactions.
C & G Kreglinger v New Patagonia Meat & Cold Storage Co Ltd [4] AC 25 clarified matters. The House of Lords held that in contrast to the strict technical rule of equity there was no similar rule which prohibited a mortgagee from stipulating in the mortgage deed itself for a collateral advantage to subsist beyond redemption provided:
- It was not unfair or unconscionable (ie in breach of the rules against penalties).
- It was not in the nature of a penalty clogging the equity of redemption (ie in breach of the technical rule against clogs).
- It was not inconsistent with or repugnant to the contractual or equitable right to redeem (ie in breach of the right to redeem).
Types of collateral advantage contained in a mortgage may thus be analysed as either those the performance of which is made a term of the contractual right to redeem or those the performance of which is not made a term of such contractual right. The latter will, provided the lender has not acted unfairly or oppressively, be upheld by the court as being a collateral advantage not clogging the equitable right to redeem.
Kreglinger made it clear that a right of preemption relating to property not specifically charged (in this case the borrower was obliged to continue to offer sheepskins at a discount to the lender) could validly subsist after the loan had been paid off. The obligation was a collateral contract and a right in personam which survived after the mortgage had been discharged. While it was accepted that on redemption of the charge the borrower would not get back its business as free from obligation as it was before the date of security, this was not because of one of the terms of the mortgage, but because of the contemporaneous — but collateral — contract. The preemption right formed part of the consideration for the mortgage, but did not form part of the mortgage itself and therefore represented no impediment to complete redemption.
Since Kreglinger the court thus now has no basic objection to the lender obtaining a collateral advantage from the terms of his loan provided it is not unconscionable or unfair. Multi-service Bookbinding v Marden [9] Ch 84 distinguished an unconscionable or unfair term from one which is unreasonable but nevertheless allowable. There, the obligation to repay was linked to the uplift in the Swiss franc and resulted in the interest rate being high. It was held that this was not unfair or oppressive as it was not morally reprehensible, even though it might be unreasonable by the standard which the court would adopt if it had to settle the terms of the contract itself. A collateral advantage is not objectionable merely because it is unreasonable.
Thus it can now be said that the basic principle of allowing the mortgagee a share in the profits to be derived from the use of mortgaged property is not objected to and does not infringe the doctrine. Indeed since Bradley v Carritt [3] AC 253 and the repeal of the usury laws there cannot be any objection to a stipulation as to share of profits during the term of the loan. It is interesting to note that in that case there was a further stipulation that the share of profits should continue to be paid after the mortgage was paid off that caused the problem.
“Across the Pond” in various American jurisdictions similar principles as to clogging of the equity of redemption and matters of collateral advantage have been considered, although it is important to note that the American courts have begun to look also at the overall commercial realities of the transaction. The leading case in America is that of MacArthur v North Palm Beach Utilities Inc 202 So 2d 181 (Fla 1967). The case dealt with an option contained in a loan transaction, described as:
a complex business transaction, not uncommon to the financial community (whereby) as a part of the overall transaction, a vendor received an option from the purchasers to purchase the subject-matter of a loan for its construction cost.
The court emphasised that the parties were all independently advised, that there was no allegation of fraud and agreed that the borrower would be entitled to redeem the mortgage, but that the burden of the option would remain. A case contrary to this, Humble Oil & Refining Co v Doerr 303 A 2d 898 (NJ 1973), has been distinguished many times in various American jurisdictions because of the presence of inequality of bargaining powers between the parties.
The matter is still of such uncertainty within American jurisdictions as to require statutory clarification. For example, in both the Californian Civil Code sections 2906 and 1917 and the law of New York Gen Oblig L 5-334, specific legislation has been enacted to validate transactions where options are granted.
Participation mortgages whereby the lender receives a return which is linked to the income produced from the property are now regularly used in the market-place. It is the convertible mortgage which entitles the lender to alter its interest in the property from that of debt to equity in respect of which there is considerable doubt.
A traditional convertible mortgage as used in other jurisdictions (and under consideration in the English market) consists, typically, of an interest rate at less than the market rate with an option to convert the security interest into either the whole or part of the charged asset according to various conversion formulae, at a price the whole or part of which is satisfied by the application of the debt. This is fundamentally different from an allowable collateral contract, as it prohibits a borrower from repaying the entirety of the loan and receiving the asset back unencumbered. Accordingly — albeit that all parties may have been separately commercially, financially and legally advised, and have entered into the transaction on a completely “eyes open” basis — the technical rule of equity discussed in this article may be enforced to prevent such arrangements being legally binding, and thus render them worthless for all intents and purposes as new financial instruments.
It is for this reason that it is to be hoped that, Lord Northington’s “necessitous men” being adequately protected by laws relating to consumer credit, the financial markets may be freed by specific statutory reform along American lines to develop new types of instruments which are particularly attractive to foreign investors.
