October 18, 2018

Negligent solicitors firm cannot rely on illegality defence despite mortgage fraud by the claimant

The Court of Appeal has ruled that there was a genuine public interest in ensuring a conveyancing solicitors' client could recover damages for negligence on the facts of this case despite the client instructing the solicitors as part of a plan to commit mortgage fraud.

Ms Maria Grondona v Stoffel & Co [2018] EWCA Civ 2031

Background

The defendant solicitors, Stoffel & Co, admitted failure to register the relevant forms (a transfer of the property, cancellation of existing charges and registration of the new charge) at the Land Registry when acting for the claimant purchaser, Maria Grondona, of a flat in Surrey.   Grondona defaulted on her mortgage payments and the lender, Birmingham Midshires, sought to enforce its security but was unable to do so as a result of the registration error.

Birmingham Midshires brought proceedings against Grondona in order to obtain a money judgment. She defended the claim and brought a Part 20 claim against Stoffel & Co for an indemnity and/or a contribution. The law firm defended the Part 20 claim on the basis that although it was negligent and in breach of contract, Grondona could not recover damages because the purpose of the mortgage transaction was fraudulent and therefore the illegality principle known as ex turpi causa applied.

The background to the transaction was as follows. The property was owned by a business associate of Grondona's, a Mr Cephas Mitchell.  Grondona and Mitchell entered into a contract which provided that Grondona would have a mortgage loan for the property in her name and Mitchell would pay the mortgage and deal with all other financial matters on the property. In return she would receive 50% of any profit on the future sale of the property. Grondona then purported to purchase the property from Mitchell for three times the amount that he had paid for it just a few months earlier. She did this with the assistance of an advance from Birmingham Midshires. In effect Grondona was obtaining further finance for Mitchell on a property he already owned and on terms that he would not personally have been able to obtain due to his poorer credit history. It was nonetheless the intention of all parties for the advance to be secured by a charge over the property.

High Court judgment

At first instance, the judge, HHJ Walden-Smith, held that Grondona had participated in a mortgage fraud to deceive Birmingham Midshires. She misrepresented on the mortgage application form that the purchase was not private (it was private), the deposit monies were from her own resources (they came from Mitchell) and that she was managing the property (Mitchell was managing the property). The judge also found that the contract between the pair meant Mitchell remained the owner of the property and the mortgage agreement was a sham because its purpose was not to enable Grondona to purchase the property.

However, the judge rejected the illegality defence on the basis that, following Tinsley v Milligan [1994] 1 AC 340, the correct test to apply was whether Grondona relied on the illegality to establish her claim. The judge held that this test was not met. Grondona had lost the benefit of the property as providing security for the mortgage advance because her title had not been registered. This was a direct result of Stoffel & Co's negligence. The claim against the law firm was entirely separate from the fraud. Grondona did not have to rely on the illegality in order to prove her claim.

Court of Appeal judgment

Giving the leading judgment in the Court of Appeal, Gloster LJ overturned two of the judge's key findings of fact even though Grondona had not appealed them. The judge had described the mortgage application and agreement as a sham. However, Gloster LJ found that, despite the transaction being fraudulent because it was based on misrepresentations, there was a genuine arrangement as between Grondona and Birmingham Midshires.

The judge had also said there was no genuine intention to transfer legal ownership of the property. However, Gloster LJ found that, regardless of the intentions of Grondona and Mitchell as to the beneficial ownership of the property, the whole purpose of their arrangement was to transfer legal title to Grondona so that she could grant a charge in Birmingham Midshires' favour to secure finance.

Patel v Mirza: new criteria for illegality principle

The parties agreed that the reliance test applied by the High Court had now been overruled by the Supreme Court in Patel v Mirza [2016] UKSC 42. The Court of Appeal therefore had to apply the criteria set out in Patel v Mirza (which was a claim for the return of money advanced for the alleged purpose of insider dealing, not a professional liability case) as to whether allowing a claim tainted by illegality would be contrary to the public interest.  The Supreme Court set out the following three considerations:

  1. the underlying purpose of the prohibition which has been transgressed;
  2. conversely, any other relevant public policies which may be rendered ineffective or less effective by rejecting the claim; and
  3. the possibility of "overkill" unless the law is applied with a due sense of proportionality.

The Court of Appeal applied the three considerations in Patel v Mirza as follows:

  1. The underlying purpose of the prohibition transgressed – Gloster LJ made clear that she saw mortgage fraud was a "canker on society" but found nonetheless that there was "no public interest in allowing negligent conveyancing solicitors (or, in financial terms, their insurers), who are not party to, and know nothing about, the illegality, to avoid their professional obligations simply because of the happenstance that two of the clients for whom they act are involved in making misrepresentations to the mortgage financier". In Gloster LJ's view it is more likely that mortgage fraud will be avoided if solicitors appreciate the need to be alive to, and question, potential irregularities in any particular transaction.
  2. Any other relevant public policies which might be less effective by rejecting the claim – Gloster LJ held that there was a genuine public interest in ensuring that clients who use the services of solicitors are entitled to seek civil remedies for negligence/breach of contract arising from a legitimate and lawful retainer in circumstances where the client was not seeking through that retainer to profit or gain from her mortgage fraud, but merely to ensure that the chargee's security was adequately protected by registration.
  3. Proportionality – Grondona's misrepresentations to Birmingham Midshires were held to be "reprehensible", but Gloster LJ concluded that it would be "entirely disproportionate" to deny her claim bearing in mind the following considerations: (a) Birmingham Midshires had adopted the transaction rather than complain on the grounds of the fraud; (b) Stoffel & Co had not alleged fraud in its witness statement;  (c) Grondona was not seeking to evade her obligations under the charge but accepted responsibility and was trying to pay; (d) the illegal conduct was not central to or indeed relevant to the solicitors' retainer but was simply "part of the background story"; (e) Grondona's intention in pursuing the negligence claim was not to profit from a fraud, but rather to obtain funds to reduce or discharge her liability to Birmingham Midshires; and finally (f) in the circumstances there was no risk that the enforcement of her claim would undermine the integrity of the justice system.

Applying the Patel v Mirza criteria, the Court of Appeal therefore found there was no reason to depart from the judge's conclusion that Grondona was entitled to sue her solicitors for negligence in failing to register the transfer form which would have ensured she had legal title.

Comment

The Supreme Court judgment in Patel v Mirza was welcomed for removing some of the confusion which existed in prior case law about how the illegality defence should be applied, but its public policy based approach has made it difficult to predict how it will be applied to the facts of a particular case.    That said, although the outcome in this case will have come as a disappointment to Stoffel & Co and its insurers, it was perhaps not a great surprise given the facts of the case. 

As Lord Toulson had observed in Patel v Mizra, in "considering whether it would be disproportionate to refuse relief to which the Claimant would otherwise be entitled as a matter of public policy various factors may be relevant …Potentially relevant factors include the seriousness of the conduct, its centrality to the contract, whether it was intentional and whether there was a marked disparity in the parties' respective culpability" (emphasis added).  This formulation and the overall approach of the Supreme Court suggested that the "overkill" of striking down an otherwise valid claim on the basis of illegality would be a relatively rare thing.

In Grondona the Court of Appeal was able to separate the mortgage fraud from the mechanics of the conveyancing transaction which the solicitors had been employed to undertake.  As Gloster LJ put it, "the illegal features of the agreement between the Claimant and Mr Mitchell were irrelevant to [Stoffel & Co's] obligation".  In other words, there was a marked lack of centrality to the solicitors' retainer of the illegality complained of.  In public policy terms, the protection of the innocent lender, Birmingham Midshires, (which was likely to benefit from the success of the claim) is also likely to have been a factor in the court's decision.

Patel v Mizra made it clear that given the infinite variety of possible circumstances, a prescriptive or definitive test for when liability will be excluded on the grounds of illegality is not possible and the Court of Appeal in Grondona did not try to identify one. Each case will require careful scrutiny. It seems safe to conclude, however, that for illegality to succeed as a defence to a professional liability claim there will need to be a closer connection than existed in Grondona between the illegality with which the underlying transaction/claim is tainted and the nature of the professional retainer said to have been breached. 

The degree of the connection required remains to be worked out in future cases and may depend on the interplay with the other factors which the court will need to take into account in carrying out its balancing act, such as the nature and seriousness of the illegality. It will be interesting to see how the courts apply Patel v Mizra to the facts of future professional indemnity cases and the weight placed on the degree of centrality of the illegality when taken alongside other competing factors. 

One thing which can safely be said, and not for the first time, is that when the necessary public policy analysis is undertaken the perceived deep pocket of the professional’s insurers will be an obstacle in  establishing an illegality defence.