High Court gives guidance on the interpretation of deeds of priorities and mortgagee duties in property sales

The High Court has handed down judgment in relation to the sale of mortgaged properties which were subject to a deed of priorities in favour of the mortgagor as against the seller: Burns v Bridge & Anor [2024] EWHC 2620. The decision provides guidance on the contractual interpretation of deeds of priorities and the duties of mortgagees when selling mortgaged properties.

In this case, a former property owner, a developer (who had bought the property from the former owner, with consideration being deferred) and a lender executed a deed of priorities for a secured development. Under this agreement, the lender's security was to rank in priority to the former property owner's security, with a maximum of £850,000 plus interest and costs payable to the lender under the deed of priorities. Delays in the development led to the developer defaulting on the loan; the lender took possession, completed the development, and sold the finished property. The lender claimed there was a shortfall, leaving no value in the security for the former property owner (who, as a result, received no payment for the sale of the property to the developer). The property owner disagreed, based on an alternative contractual construction of the deed of priorities, and on the basis that the development was sold at an undervalue.

The court focused on the limit of the priority afforded to the lender against the former property owner, set out in the definition of "Lender's Debt" in the deed of priorities. In this clause, the court held that reference to "interest" was a reference to interest on the capital sum of £850,000 that the lender was entitled to under the terms of the loan agreement, which included compound interest. While the court recognised that the former property owner was not a party to the loan agreement, and not expressly aware of the compound interest provision, it should have been within her commercial contemplation that unpaid interest might have been capitalised. Accordingly, the court concluded that "Lender's Debt" in the deed of priorities included compound interest as per the loan agreement (and costs).

The court also had the opportunity to consider whether compound interest should be treated as interest or capital. It acknowledged that the Privy Council spoke in terms of unpaid interest becoming a principal sum in Imperial Life Assurance Company of Canada v Efficient Distributors Limited [1992] 2 AC 85. However, the court preferred and was bound by the decision of the House of Lords in Inland Revenue Commissioners v Oswald [1945] 1 AC 360, confirming that compound interest does not become capital, and retains its character as interest.

While in a very different context, the present decision aligns with the court's approach to the interpretation of an intercreditor deed of priorities in Mayfair Capital Residential 2 LLP v Reim Katch Securities Ltd [2024] EWHC 1920 (Ch) (considered in this blog post), in which the court employed a strict approach to contractual construction.

We consider the decision in more detail below.

Background

In 2017 Mrs Burns (the claimant), sold a property to Mr Bridge (the second defendant) for development into three houses, with a purchase price of £450,000. They entered into an overage deed, requiring Mr Bridge to pay £100,000 upon completion of each house and an additional £150,000. The £450,000 was treated as a loan repayable by 31 July 2018, such that Mrs Burns did not receive any payment from Mr Bridge for sale of the property upon completion. Mr Bridge secured this loan with a second legal mortgage over the property in favour of Mrs Burns (the Burns Mortgage).

To fund the development, Mr Bridge obtained a loan secured by first legal mortgage over the property, later refinanced in 2018 with PFL (the first defendant), for £650,000. A deed of priorities was executed by Mrs Burns, PFL and Mr Bridge, giving PFL's mortgage priority over the Burns Mortgage in relation to "Lender's Debt", defined as:

"all monies and liabilities now or hereafter due owing or incurred to the Lender [PFL] by the Borrower [Mr Bridge] in any manner whatsoever up to a maximum of £650,000 plus interest and costs". [Emphasis added]

In 2019, Mr Bridge refinanced again with PFL, increasing the loan facility to £807,000, and providing for the payment of compound interest if the loan was not repaid within 9 months (the 2019 Loan Agreement). A new deed of priorities (again, entered into by all three parties) set the "Lender's Debt" at £850,000 plus interest and costs (the 2019 Deed of Priorities).

PFL's loan was not repaid on time, which resulted in interest being compounded at a default rate. By January 2021, PFL took possession of the property, completing and selling the houses for net proceeds of almost £1.3 million. PFL claimed the outstanding loan with interest amounted to over £1.3 million, plus costs of almost £500,000 (including interest), leaving no value for the Burns Mortgage.

Mrs Burns brought proceedings against Mr Bridge and PFL, claiming that she was entitled to repayment from the proceeds of the sale of the houses based on a different interpretation of "Lender's Debt" in the 2019 Deed of Priorities and claiming the houses were sold at an undervalue.

Decision

The court concluded that "Lender's Debt" in the 2019 Deed of Priorities included compound interest as per the 2019 Loan Agreement and PFL's costs; and that PFL had not failed in its duty to take reasonable care to obtain the best price reasonably available for the development. 

Definition of interest

Mrs Burns submitted that the cap of £850,000 in the 2019 Deed of Priorities included interest payable under the 2019 Loan Agreement, as this fell within the phrase "all monies and liabilities" at the beginning of the definition of Lender's Debt. On that basis, the separate reference to "interest" at the end of the definition of "Lender's Debt", should be interpreted to mean some other form of interest, which should be an implied "reasonable rate" of interest.

The court cited well-established authority setting out the correct approach to contractual construction (including Wood v Capita Insurance Services Ltd [2017] UKSC 24). In the court's view, the definition of "Lender's Debt" more logically read as an all-embracing cap to limit the priority afforded to PFL against Mrs Burns. If "interest" in this context was not interest due under the 2019 Loan Agreement, then the 2019 Deed of Priorities would have expressly provided for this, or at least specified the rate at which such interest was to be paid.

The court accepted that the terms of the loan and mortgage documentation between Mr Bridge and PFL were not admissible evidence of the relevant factual background known to all parties, since Mrs Burns was not party to the documentation (including the 2019 Loan Agreement providing for the payment of compound interest). However, considering the matter objectively, it must have been within the reasonable contemplation of any party to the 2019 Deed of Priorities (including Mrs Burns) that the provision of development finance on a commercial basis by PFL to Mr Bridge "at least might have included provision for the capitalisation of unpaid interest".

In the alternative, Mrs Burns argued that under the 2019 Loan Agreement, unpaid interest was capitalised. On the basis that the maximum of £850,000 was a cap on the recoverable capital, this should be taken to be cap not just on the loan facility, but also the capitalised interest. The court considered a number of authorities looking at whether compound interest should be treated as interest or capital. Mrs Burns sought to rely on the decision in Imperial Life Assurance Company of Canada v EDL, in which the Privy Council spoke in terms of unpaid interest becoming a principal sum. However, the decision of the House of Lords in IRC v Oswald, was binding on the court, and confirmed that compound interest does not become capital, and retains its character as interest. Accordingly, this alternative submission failed.

Proper construction of "costs"

The court found that "costs" in the context of the 2019 Deed of Priorities should be interpreted broadly to include all costs, charges and expenses that PFL was entitled to recover as a mortgagee. The court noted that this interpretation aligned with commercial common sense and the broader language used in other clauses. PFL was therefore entitled to deduct such costs from the gross proceeds of sale.

Alleged sale at an undervalue

The court found that PFL had not failed to take reasonable care to obtain the best price reasonably obtainable for the houses. It first noted that the duty on a mortgagee to obtain the best price reasonably obtainable is an equitable duty, the breach of which requires the mortgagee to account for the difference between the price obtained, and that which it would have obtained had the mortgagee acted in accordance with his duty (see Silven Properties Ltd v Royal Bank of Scotland plc [2003] EWCA Civ 1409).

The court heard evidence that there was a difference of around 12.9% between the market value in 2021 (as was the subject of expert evidence) and the sale price actually achieved by PFL at that time. The court noted that there was relevant case law on the appropriate margin of error between a valuation and a price achieved on the market, for example a margin of error of 5% for a standard residential property, usually being plus or minus 10% for a valuation of a one off property, which might be around 15% or higher for properties with unusual features (K/S Lincoln v CB Richard Ellis Hotels Ltd [2010] EWHC 1156 (TCC)). Mrs Burns' expert witness accepted that his own valuation was likely to have a margin of error of up to 10%.  The court concluded that Mrs Burns had not proved that there had been a sale at an undervalue where the price achieved by PFL was only 3% less than the bottom end of the valuation range provided by Mrs Burns' expert witness