Emptage v Financial Services Compensation Scheme Ltd

In early 2005 the respondent, Ms Emptage, and her partner, Mr. Ball, were living in a property in Sandhurst, Berkshire held in Ms Emptage’s name and subject to a repayment mortgage with Abbey National. The outstanding amount of the mortgage was £39,633.13 with about ten years to run. Although both Ms Emptage and Mr. Ball had good jobs, their income was moderate and neither had any substantial assets apart from the equity in their home. They decided to see whether there were any steps open to them to reduce the balance of the mortgage and the outstanding period, so they approached their insurance and mortgage broker, Mr. Peter Sharratt, for advice. Mr. Sharratt was employed by Berkshire Financial Services Ltd, a representative of Berkeley Independent Advisers Ltd, itself a body regulated by the Financial Services Authority under the Financial Services and Markets Act 2000.

Following a meeting with Ms Emptage and Mr. Ball in early February 2005, in the course of which the possibility of buying property in Spain was raised, Mr. Sharratt sent them a report in which he set out in some detail the means by which they could buy an apartment in a new development in Spain and the financial benefits to be obtained from an investment of that kind. He indicated that the necessary funds could be raised by borrowing on interest-only terms a sum sufficient to pay off their existing debt to Abbey National and to provide the cash needed to buy a Spanish property. The bulk of the report is set out in the judgment below and need not be repeated here. Suffice it to say that it set out a detailed comparison over a ten year period between the projected outcome under their present arrangements and that which could be expected if they were to make an investment in Spain, which clearly favoured the latter course. In effect, as the judge found, Mr. Sharratt’s advice to Ms Emptage and Mr. Ball was that they should take the latter course, remortgage their home for a much larger sum on interest-only terms, and invest the balance in the purchase of property in Spain.

Ms Emptage and Mr. Ball followed Mr. Sharratt’s advice and in May 2005 Ms Emptage mortgaged their home to Standard Life as security for a loan of £111,810.67 over 15 years on interest-only terms. (In April 2006 Ms Emptage refinanced the Standard Life mortgage with a mortgage from the Woolwich Building Society, also on Mr. Sharratt’s advice, but nothing turns on that.) They invested about £70,000 in the purchase of a property in Spain in the expectation that in due course it would provide sufficient capital to pay off the loan. Unfortunately, however, the Spanish property market collapsed and by 2009 their investment had become virtually worthless. As a result, Ms Emptage and Mr. Ball were saddled with a debt to the Woolwich which they had no means of repaying otherwise than through the sale of their home. Neither Berkshire Financial Services nor Berkeley Independent Advisers was in a position to meet a claim and neither had professional indemnity insurance that would respond. In those circumstances Ms Emptage and Mr. Ball made a complaint to the Financial Ombudsman Service, which referred their case to the Financial Services Compensation Scheme (“FSCS”).

At this point is necessary to refer to the statutory framework under which FSCS operates. The judge set it out in detail in paragraphs [28] – [58] of his judgment, and it will suffice for present purposes to summarise the effect of the relevant provisions in rather simpler terms before considering some of them in greater detail in due course. Since the date of the judgment below the amendments to the Financial Services and Markets Act 2000 (“the Act”) made by the Financial Services and Markets Act 2012 have come into effect. As a result, the regulator, formerly known as the Financial Services Authority (“FSA”), has been re-named the Financial Conduct Authority and some of the provisions of the Act are now to be found in differently numbered sections. It is convenient, however, to describe the position as it was at the time of the events giving rise to the appeal and I shall therefore refer throughout to the FSA and to the terms of the legislation as it existed at that time.

Section 213 of the Act imposes on the FSA a duty to set up a scheme for providing compensation in cases where financial advisers whom it has authorised to act as such are unable to satisfy claims against them in respect of regulated activities and to establish a scheme manager to run it. As Miss Carss-Frisk Q.C. was anxious to emphasise, the Act and the subordinate legislation draw a sharp distinction between activities which are regulated and those which are not. Only persons who are approved by the FSA or exempt may carry out regulated activities. A contract under which a lender provides credit secured by a first legal mortgage on land, at least 40% of which is used as a dwelling by the borrower, is a regulated mortgage contract and accordingly advising a person in his capacity as a borrower on the merits of entering into a particular contract of that kind is a regulated activity. By contrast, advising on the sale or acquisition of land, whether in the United Kingdom or abroad, is not a regulated activity. The compensation scheme applies to regulated activities alone.

Under section 64 of the Act the FSA has power to issue statements of principle with respect to the conduct expected of approved persons and, where it does, to issue a code of practice for the purpose of helping to determine whether a person’s conduct complies with that statement of principle. In addition, under section 138 of the Act the FSA has the power to make rules governing the way in which authorised persons carry on regulated activities. In the exercise of those powers the FSA published a sourcebook entitled Mortgages and Home Finance: Conduct of Business (“MCOB”), which contains rules (“R”), guidance (“G”) and evidential provisions (“E”) relating to the provision of financial services in connection with home loans. They include the following rule (MCOB 4.7.2R):

“A firm must take reasonable steps to ensure that it does not make a personal recommendation to a customer to enter into a regulated mortgage contract, or to vary an existing regulated mortgage contract, unless the regulated mortgage contract is, or after the variation will be, suitable for that customer.”

A “personal recommendation” for these purposes includes advice on a home finance transaction which is presented as suitable for the person to whom it is made. A transaction will be “suitable” in this context only if, having regard to the facts disclosed by the customer and other relevant facts about her of which the firm is, or should reasonably be, aware, the firm has reasonable grounds to believe that she can afford to enter into it, that it is appropriate to her needs and is the most suitable of those which the firm has available to it for the purpose. A mortgage will not be suitable for the customer if she does not have the means to repay the loan on the terms proposed.

As part of the duty to assess whether a transaction is appropriate to the needs and circumstances of the customer, a firm is required to consider, among other things, whether she should have an interest-only mortgage, a repayment mortgage, or a combination of the two: MCOB 4.7.11(E).

Section 213 of the Act also imposes a duty on the FSA to formulate rules governing the payment of compensation. These have been published in the form of the Compensation sourcebook (“COMP”). COMP 12.4.17(R) provides:

“The FSCS may pay compensation for any claim made in connection with protected home finance mediation only to the extent that the FSCS considers that the payment of compensation is essential in order to provide the claimant with fair compensation.”

This provision provides considerable scope for the FSA to exercise a measure of judgment about the way in which compensation is to be assessed, but its judgment must be exercised in a consistent and principled manner. Accordingly, in July 2009 the FSA approved a statement of policy, known as “MAA/3”, on the payment of compensation, which sets out its policy on the assessment of compensation for what are described as “protected home finance mediation claims” (claims arising out of regulated mortgage transactions). In relation to compensation for negligent or bad advice it provides:

“The underlying principle is to provide the level of compensation which is essential in order to be fair. Generally the basis of compensation will seek to return claimants to the position they would be in had the negligence or bad advice not occurred, as far as is possible or practicable under the Scheme's rules and the complementary polices approved by the Board of Directors.”

As the judge pointed out, there are two questions which FSCS has to determine when considering claims for compensation under the scheme: (i) whether there has been a breach of MCOB; and (ii) if there has, what sum would constitute fair compensation for that breach. In the present case FSCS accepted that Mr. Sharratt had been in breach of MCOB 4.7.2R in failing to take reasonable steps to ensure that the mortgage which he recommended was suitable for Ms Emptage, bearing in mind that he knew that she was unlikely to have the means of repaying the principal amount of the loan on maturity unless the value of her investment in Spanish property provided the necessary funds. The only question to be determined, therefore, was what sum would provide fair compensation for that breach.

A brief examination of the exchange of correspondence between FSCS and the solicitors acting for Mr. Ball and Ms Emptage, Manley Turnbull, sheds light on the way in which FSCS approached the assessment of compensation in this case. The following account is taken almost verbatim from the judgment below:

The decision to assess compensation in the sum of £11,522.98 left an outstanding balance on the mortgage of over £98,000, which Ms Emptage and Mr. Ball are unable to pay otherwise than by selling their home. That led them to start proceedings for judicial review of the decision of FSCS not to increase the amount of compensation following the completion of the final stage of the complaints review procedure.

The judge considered that in the light of COMP 12.4.17, MAA/3 and the decision in R. v. Investors Compensation Scheme Ltd, ex parte Bowden [1996] 1 A.C. 261, to which it will be necessary to refer a little later, the principles applicable to the assessment of compensation were straightforward: FSCS had a broad discretion to pay compensation to claimants with valid claims to the extent that it considered that essential in order to provide fair compensation; it had a discretion to decide which elements of the claim should be accepted in order to achieve that; in this context fair compensation meant compensation which fairly compensated for the loss caused by the particular breach of duty; fair compensation for negligent or bad advice required that the claimant be restored as far as possible to the position she would have been in if the advice had not been given. He held that FSCS had failed to apply those principles properly in the present case, first, because it had considered that Ms Emptage’s claim related to advice in connection with an unregulated activity, namely investment in property, and secondly, because it had approached her claim as having both protected and unprotected elements and had failed to view Mr Sharratt's negligent advice as an indivisible package which included investment advice as an essential element, given that the mortgage was not feasible without it.

Despite the complexity of the legislative and regulatory provisions, this appeal ultimately turns on whether the FSCS was required or entitled to ignore the part played by the investment in Spanish property when assessing compensation for the admitted breach by Mr. Sharratt of his duty as a mortgage adviser under MCOB 4.7.2R. That depends on a correct understanding of COMP 12.4.17R and MAA/3. Miss Carss-Frisk submitted, rightly in my view, that the provisions of COMP have to be interpreted against the background of the Act. She placed considerable emphasis, as had the FSCS itself in correspondence, on the distinction between regulated and unregulated activities. She submitted that as far as the property purchase was concerned Mr. Sharratt did not give advice to Ms Emptage in her capacity as a borrower, but in her capacity as an investor and that the loss she has suffered flowed from the failure of that investment, not from his advice about the mortgage. These different submissions inevitably tended to merge into each other, but they were based on the following three main propositions: (i) that the bulk of Ms Emptage’s loss fell outside the scheme because it flowed from bad advice about investing in property rather than entering into a mortgage; alternatively, (ii) that FSCS had a broad discretion in deciding what losses should be taken into account when deciding how much it was essential to pay to provide fair compensation in this case and that in the exercise of its discretion it was entitled to exclude losses arising from the failure of the Spanish investment; and (iii) that in any event FSCS could properly require Ms Emptage to give credit for the amount she had received under the mortgage in accordance with the decision in R v Investors Compensation Scheme Ltd, ex parte Bowden.

Mr. Cannon Q.C. for Ms Emptage argued, however, as Manley Turnbull had in correspondence, that Mr. Sharratt’s advice that she should re-mortgage her home to secure a loan of £110,000 on interest-only terms inevitably put her at risk of losing her home if the proposed investment did not live up to expectations. Although Mr. Sharratt knew that it was her intention to invest the proceeds in property in Spain, the same would have been true whatever form of investment she had had in mind. It would not have been possible to invest the proceeds in a way that would produce a greater monthly income than the interest payable on the mortgage without some degree, possibly a considerable degree, of risk. In a nutshell, he submitted that Mr. Sharratt’s advice was bad because it inevitably involved putting her home at risk when she did not need to do so. It was the exposure to that risk which rendered the mortgage unsuitable and Ms Emptage’s loss was caused by the occurrence of that risk. Mr. Cannon submitted that FSCS had wrongly thought that it had no power to pay compensation for a loss caused in that way. He accepted that FSCS had a broad discretion in assessing a claimant’s loss, but submitted that it did not extend to excluding the very loss flowing from the breach of duty and that in any event FSCS did not purport to exercise any discretion in the matter. As to giving credit for the funds received under the mortgage, he argued that the position was quite different from that in ex parte Bowden.

It is convenient to consider first the decision in R v Investors Compensation Scheme Ltd, ex parte Bowden. The case concerned so-called “home income plans” under which investors were persuaded to take out mortgages on their homes to enable them to invest capital sums in income-producing bonds. The interest on the mortgage was rolled up with the capital and the contract provided that no payments would become due provided the total of the outstanding capital and interest did not exceed a certain percentage of the value of the property. The expectation was that rising markets would ensure that the bonds would produce income and increase in value, thereby ensuring that it would not become necessary to redeem the loan during the lifetime of the borrower. However, a fall in the markets and a rise in interest rates rendered the scheme unsustainable and investors found themselves saddled with debts secured on their homes which they could not repay from the proceeds of the bonds. They made claims against the Investors Compensation Scheme (a precursor to the FSCS) alleging that their financial advisers had been negligent in advising them to take out these plans. One question that arose for determination was whether claimants had to give credit for sums withdrawn as lump sums or regular payments. ICS decided that they did and that sums claimed in respect of professional fees should be limited to £500.

In that case the rules governing the payment of compensation were similar in terms to COMP 12.4.17(R) and provided that, subject to certain exceptions, applications for compensation were to be met only where the management company considered that that was essential in order to provide fair compensation to the investor. The House of Lords held that ICS had a broad discretion to decide what elements of a claim should be taken into account when deciding how much it was essential to pay in order to compensate an investor fairly. Their Lordships also held that it was not Wednesbury unreasonable for ICS to decide that credit should be given for money received under the scheme in order to avoid a double recovery. That is not surprising, in my view, when one realises that the prima facie measure of the investor’s loss was accepted to be the difference between the amount of the debt and the current value of the bond.

In the light of that authority I can return to consider Miss Carss-Frisk’s submissions. She relied on the decision in ex parte Bowden as authority for the proposition that under the Act and the rules governing the scheme FSCS has a similarly broad discretion to decide which elements of a claim should be taken into account when assessing compensation and had exercised its discretion in a way that was not open to challenge. She also relied on it as authority for the proposition that the money received by the Ms Emptage under the mortgage could be taken into account. I accept that COMP 12.4.17R does give FSCS a broad discretion to decide how fair compensation is to be assessed, but claimants have a right to expect that the exercise of that discretion will reflect the policy set out in MAA/3, unless good grounds are shown for departing from it. As the judge noted, however, the first step must be to identify the breach of duty which has given rise to the claim, because without that it is impossible to make any principled assessment of what it is essential to pay in order to provide fair compensation. In the course of argument it became increasingly clear that, from whatever angle the problem was approached, the central question was whether the breach of duty was to be characterised as giving bad advice in relation to a mortgage or giving bad advice in relation to an investment in land. However, although it may be said that Mr. Sharratt’s advice related to both kinds of transaction, FSCS accepted liability on the grounds that he was in breach of MCOB 4.7.2R because the Standard Life interest-only mortgage was unsuitable for Ms Emptage. It was unsuitable, not because she could not meet the monthly interest payments, but because she had no prospect of paying back the loan if her investment failed to live up to expectations. Mr. Sharratt’s bad advice in relation to the mortgage was given to Ms Emptage in her capacity as a borrower and exposed her to a risk which later came about, causing her to lose her capital and with it her home. Although the extent of the loss may have been unforeseen, the nature of the risk, and therefore the kind of loss likely to occur if it happened, was clear.

It follows that I cannot accept Miss Carss-Frisk’s first submission. The loss suffered by Ms Emptage flowed from Mr. Sharratt’s bad advice in relation to mortgaging her home, which was a regulated activity. FSCS had power under the Act and the rules made under it to pay fair compensation in respect of that loss. I think the judge was right in finding that it was at this point that FSCS went wrong.

That brings me to the alternative submission, namely, that FSCS was entitled in the exercise of its discretion to exclude losses which it considered flowed from the failure of the Spanish investment. The first difficulty with this argument is that, although Miss Carss-Frisk submitted that FSCS had exercised its discretion to exclude that part of the loss, it is clear in my view that it did no such thing. The policy governing the approach to assessing compensation was set out in MAA/3, which proceeds on the principle of seeking to return the claimant to the position he would have been in had the bad advice not been given. If it had been the intention of FSCS to depart from that policy in this case, that would no doubt have been reflected in the contemporaneous documents, but what one sees in them is a reflection of a belief on the part of FSCS that it had no power to pay compensation for the full loss suffered by Ms Emptage because the major part of it related to unregulated business. The internal debate was not about how to exercise a discretion but about whether the loss fell within the scope of the scheme at all. In a different context the use in correspondence of expressions such as “FSCS cannot offer compensation” might be viewed as nothing more than a euphemism designed to soften the blow, but it is clear from the correspondence as a whole and from the internal documents produced by FSCS that in this case “cannot” meant “cannot” rather than “will not”. That appears most clearly from the letter of 13^th January 2011. There is in reality nothing to support the conclusion that FSCS thought that it had a discretion in the matter or that it purported to exercise any such discretion in reaching its decision on the assessment of compensation in this case. In those circumstances I agree with the judge that in assessing compensation solely by reference to the additional costs incurred by Ms Emptage in connection with the Standard Life mortgage FSCS proceeded on a false basis.

Miss Carss-Frisk submitted that even under the terms of MAA/3 Ms Emptage had no right to expect her claim to succeed in full, because, in a passage which supplements the statement of general principle to which I referred in paragraph 10, it provides as follows:

“Where a claimant has been advised to borrow more than was necessary, resulting in unnecessary costs:

Where the monies borrowed were passed to the claimant, and where the claimant is in a position to use some or all of those monies to reduce their borrowing, claimants should be compensated for the unnecessary mortgage interest charged and charges incurred in relation to the monies the claimant is able to repay.

The claimant should not receive compensation in relation to any monies received that they are unable to repay to the lender (on the basis that they have had the benefit of those monies).”

The judge is said to have overlooked those paragraphs, but I do not think that is a fair criticism because in my view they are concerned with the case in which as a result of bad advice the mortgagor borrows more than he needs. The present case, by contrast, is concerned with advice to enter into an interest-only mortgage, which was unsuitable because it exposed Ms Emptage to the risk that she would be unable to repay the principal when it fell due.

Nor am I able to accept the submission that Ms Emptage must give credit for the money she received under the Standard Life mortgage. The decision to require the claimants in ex parte Bowden to give credit for the amount they had received rested on two factors: first, that the measure of loss was the difference between the amount of the mortgage debt and the value of the bonds and, second, that the funds they had received were proceeds of the investment and to that extent represented value which they had drawn from the original property. It was not unreasonable in those circumstances for ICS to take the view that, if the investors received compensation based on the agreed measure of loss there would be a double recovery. In the present case Ms Emptage would no doubt have been obliged to give credit for the residual value of the Spanish property, but it has no value. In her case the loss is represented by a substantial loan secured on her home, a loan which, because of an unfortunate turn of events, she has no prospect of re-paying. Although the funds released by the mortgage represent in part value released from her property, she ought not to have been advised to take that loan precisely because of the risk it entailed. There is therefore no comparable double recovery in this case.

In the course of her submissions Miss Carss-Frisk drew our attention to the regulatory objectives set out in sections 2 – 5, which include maintaining market confidence and securing the appropriate degree of protection for consumers. In the course of doing so she reminded us that when deciding what degree of protection it is appropriate to provide for consumers the FSA must have regard to the general principle that consumers should take responsibility for their decisions (section 5(2)(d)). These provisions form an important part of the general background to Part XV of the Act which provides for the establishment of the FSCS, but I do not think that they have a direct bearing on the question raised by this appeal. Nor, for that matter, does the fact that part of the function of FSCS is to hold the ring between consumers and providers of financial services and between different sectors of the financial services industry on whom the levy necessary to provide financial compensation falls. Once it is accepted (as it was) that the breach of duty consisted in recommending a mortgage which was unsuitable because it exposed Ms Emptage to the risk of being unable to repay the loan at maturity, it is difficult to see how it is possible to assess fair compensation without taking into account the loss caused by the occurrence of that risk. Failure to do so inevitably resulted in an award of compensation which bore no relation to the breach of duty or the reason why the mortgage was unsuitable. I do not think that any of the grounds so far put forward by FSCS for rejecting the claim can be justified in terms of an exercise of its discretion.

For these reasons, which are essentially the same as those of the judge, I would dismiss the appeal.

I agree.

I also agree.