Guidance on the measures necessary to protect a lender where a borrower’s close relative acts as cautioner of business debts

Following the decision by the House of Lords in The Royal Bank of Scotland plc v Etridge (No 2) [2001] 3 WLR 1021, The Law Society of England and Wales (LSEW) has recently produced guidelines for solicitors acting in cases where one party to a "non-commercial" relationship, usually, but not exclusively, a wife, is standing as guarantor of the other party’s business debts. The LSEW guidelines are closely based on the Etridge "core minimum requirements" detailed later in this note.

It should be stressed that the recent Court of Session Inner and Outer House cases Clydesdale Bank plc v Black, and Thomson v The Royal Bank of Scotland plc, both decided in May 2002, make it clear that at least so far as the substantive law of Scotland is concerned the "core minimum requirements" detailed in Etridge (No 2) do not apply in this jurisdiction. However, it is equally clear that the principles originally stated by the Lords on this issue in Barclays Bank v O’Brien [1994] 1 AC 180 were imported into Scots law by the House in Smith v Bank of Scotland 1997 SC (HL) 111 and reaffirmed in the Black and Thomson cases.

In Barclays Bank v O’Brien the House of Lords decided that lenders seeking security from a third party for the indebtedness of a borrower must take "reasonable steps" to bring home to the third party the risks of the transaction. This duty applies in every case where the cautioner is in a non-business relationship with the primary obligant for repayment of the debt and not necessarily in a subservient position relative to the principal debtor. Failure on the part of the lender to take these reasonable steps could result in the obligations undertaken by the third party being set aside by the courts, always provided – and it is a very important proviso – that the third party can establish that he/she entered into the obligation as a result of undue influence, misrepresentation or other legal wrong perpetrated by the borrower. While O’Brien set out the general principle of the requirement for lenders to take reasonable steps to point out to the third party the risks of undertaking a particular transaction, Etridge (No 2) is important to the extent that the Lords laid down specific guidelines, or core minimum requirements, which apply to lenders and their legal advisers in all non-business third party security cases. It is worth noting that Lord Clyde, who sat and delivered speeches in both O’Brien and Etridge (No 2), appeared in Etridge to dissociate himself from the detailed guidelines, stating that some courses of action could be suggested which should meet the requirements of the law but "these should not be matters of ritual, the blind performance of which would secure the avoidance of unenforceability".

Applying the O’Brien principles

Sandwiched between O’Brien and Etridge (No 2) was Smith v Bank of Scotland, in which the leading opinion was again delivered by Lord Clyde, the only other opinion of substance being that of Lord Jauncey, then the other Scottish Law Lord. Lord Clyde made it clear that the principles underlining O’Brien should in the interests of consistency be extended to Scotland without, however, the need to apply the English principles of equity which form the basis of that decision to the effect that Barclays Bank had received constructive notice of the relationship between borrower and surety. In arriving at that decision Lord Clyde said at page 120 of the report:

“Counsel for the bank cautioned against the imposition of a change in the law of Scotland where, as was recognised in Invercargill City Council v Hamlin, a monolithic uniformity might be destructive of the individual development of a distinct common law system. But in the present case we are dealing with an area of the law whose development has for a long time been influenced by decisions on the other side of the border. I am not persuaded that there are any social or economic considerations which would justify a difference in the law between the two jurisdictions in the particular point here under consideration.

“I have not been persuaded that there are sufficiently cogent grounds for refusing the extension to Scotland of the development which has been achieved in England by the decision there in Barclays Bank plc v O’Brien. On the contrary I take the view that it is desirable to recognise a corresponding extension of the law in Scotland.”

While effect to the decision in O’Brien could be given in Scotland by applying the principle of constructive notice, "it seems to me preferable to recognise the element of good faith which is required of the creditor on the constitution of a contract of cautionary and find there a proper basis for decision. The law already recognises ... that there may arise a duty of disclosure to a potential cautioner in certain circumstances. As a part of that same good faith which lies behind that duty it seems to me reasonable to accept that there should also be a duty in particular circumstances to give the potential cautioner certain advice. Thus in circumstances where the creditor should reasonably suspect that there may be factors bearing on the participation of the cautioner which might undermine the validity of the contract through his or her intimate relationship with the debtor the duty would arise and would have to be fulfilled if the creditor is not to be prevented from later enforcing the contract."

At page 122 Lord Clyde went on to say: “All that is required of him [the creditor] is that he should take reasonable steps to secure that in  relation to the proposed contract he acts throughout in good faith. So far as the substance of those steps is concerned it seems to me that it would be sufficient for the creditor to warn the potential cautioner of the consequences of entering into the proposed cautionary obligation and to advise him or her to take independent advice”.

It therefore seems that we can take it as firmly established that so far as lenders in Scotland are concerned, the sole legal obligation on them is to act in good faith throughout the proposed transaction, that good faith being demonstrated by warning the cautioner of the consequences of entering into the obligation and advising him or her to take independent advice.

Putting the lender on notice

The other element which requires to be present before the lender’s obligations as outlined above are triggered, is that the lender is put on notice that the cautioner may have entered into the transaction as a result of undue influence having being brought to bear by the borrower, most usually the cautioner’s businessman husband. It should be emphasised that there is no judicial authority that simply because one party to a transaction is gaining no personal benefit from it and indeed prima facie may be putting his or her assets at risk of attachment by the other party’s creditor, there is a presumption that the transaction was entered into as a result of undue influence. The writer has not been able to find in any of the cases cited in Lord Clarke’s exhaustive opinion in Thomson v The Royal Bank of Scotland an express definition of what amounts to undue influence, although as long ago as 1879 Lord Shand in Gray v Binny 7R 332 at p 347 identified four components, i.e.

  1. A relationship which created a dominant and ascendant influence;
  2. Confidence and trust arising from that relationship;
  3. A material and gratuitous benefit given to the prejudice of the granter;
  4. That the granter had entered into the transaction without the benefit of independent advice or assistance.

It will be seen that if these four components are prima facie present the lender should be put on notice. Whether undue influence has in fact been exerted and the transaction entered into as a result, thus rendering the guarantee or security unenforceable, will be a matter of fact in every case to be decided on the evidence. Put another way it is highly unlikely that the courts would grant decree of reduction of any particular transaction without testing the strength of the averments at a proof.

That said, and bearing in mind that the decision in Etridge (No 2) did not extend the law on undue influence in England let alone seek to extend the law of Scotland, the court nonetheless set down a number of situations where a bank or other lender should be put on notice that there is a possibility of undue influence being exerted. The major banks and building societies have branches and lend frequently on both sides of the border, and in an understandable wish not to have separate sets of procedures operating in Scotland and England have all taken on board the Etridge guidelines or "core minimum requirements".

LSEW has issued to its members not only guidelines to solicitors detailing the Etridge core minimum requirements but also a proforma letter to be sent by the solicitor acting for the wife in an inter-spouse guarantee transaction. For that reason and also because, as already mentioned, the major banks and building societies are in practice applying the Etridge core minimum requirements in Scotland as well as in England and Wales, the Conveyancing Committee of The Law Society of Scotland ("the Committee") has decided to promulgate similar guidelines together with a proforma letter to be sent by solicitors to their clients following the meeting referred to in the guidelines. These form the appendix to this note.

Obviously the matter of conflict of interest is of major importance in this area of practice.

Nevertheless the LSEW guidelines envisage the possibility of the same solicitor acting for both borrower and cautioner, and in some cases for the lender as well. The Committee takes the view that while in many cases it may be appropriate for the same solicitor to act for both lender and borrower, the same solicitor should never act for both parties to the contract of guarantee for the following reasons.

In the view of the Committee a solicitor who acts for both borrower and cautioner would prima facie be in breach of the Solicitors (Scotland) Practice Rules 1986 (the conflict of interest rules), rule 3 of which baldly states that "a solicitor shall not act for two or more parties whose interests conflict". While a wife who agrees to guarantee her husband’s business borrowing and grants a standard security over her interest in the matrimonial home in security of that borrowing may be fully aware of and have accepted the implications of doing so and may in numerous cases be personally involved in the business either as a director or shareholder, the Committee considers that the interests of husband and wife are in conflict in every instance where the wife is standing surety for her husband’s business borrowing. Rule 3 therefore applies.

It is also the Committee’s view that the exceptions to the absolute prohibition under rule 3 specified in rule 5 do not apply despite the parties being obviously related by marriage and the fact that both may be established clients of the same firm of solicitors. The derogation in rule 5 from the strict prohibition in rule 3 is restricted to acting for both parties to a conveyancing transaction and it refers to purchaser and seller, lender and borrower etc.

Of course if a solicitor is acting for the lender and the borrower as well as for the wife and the latter are joint owners of the security subjects, rule 5 obviously applies to the grant of the standard security in favour of the bank as that is a conveyancing transaction. But as between the husband and wife the contract is one of caution which is not covered by the derogation in rule 5 from the absolute prohibition in rule 3.

In every case, therefore, the wife should be introduced by the husband’s solicitor to another solicitor who will provide her with the requisite independent advice, and that notwithstanding that she may be an established client of her husband’s solicitor and wishes him or her to act on her behalf. Failure to decline to act in such circumstances on the part of the husband’s solicitor could result in a complaint against that solicitor in respect of his or her breach of the 1986 Rules which may be treated as professional misconduct for the purposes of Part IV of the Solicitors (Scotland) Act 1980.

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