Building a case for regulation

When the Financial Services Authority takes over mortgage regulation, product providers must meet new criteria, report Philip Ryley and John Virgo

The consultation process on mortgage regulation has followed a long and tortuous road.

The background events leading to the current proposals to bring 'regulated mortgage contracts' within the scope of regulatory control by the Financial Services Authority (FSA) began with the Treasury's invitation in July 1999 for public consultation in respect of mortgage selling.

In January 2000, the Treasury published its consideration of the responses received to the consultation, identifying four key areas of 'consumer detriment' in relation to mortgages - poor information, disadvantageous product features, gaps in regulatory control, and unsatisfactory treatment of arrears.

This led in January 2000 to the government's indication that it was proposing to bring mortgage lending and administration of mortgages within regulatory control.

By December 2001, the government had proposed to extend regulation of mortgages to include advising on and arranging mortgages.

The current timetable schedules FSA mortgage regulation to commence on 31 October 2004.

On implementation of the proposals, mortgage providers will require authorisation (in the form of a part IV permission) from the FSA to enter into regulated mortgage contracts.

This will require the product providers and intermediaries, among other things, to demonstrate that they have in place appropriate systems to comply with the FSA's principles for business, principles and code of practice for approved persons, and the rules and guidance on senior management arrangements, systems and controls.

Therefore, many individuals engaged in the provision of mortgages will only be permitted to continue in employment if they are granted 'approved person status' by the authority.

This will extend to those exercising a senior management function within product providers and those exercising a significant influence over the conduct of the lenders' business (including the money laundering officer, the appointed actuary, the compliance officer, and the director responsible for apportionment and oversight) and to those responsible for dealing with customers (for example, mortgage advisers).

The Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (as amended) SI2001 No544 defines the type of mortgage product attracting regulatory control and the activities to be specified for the purposes of requiring FSA authorisation.

By article 61(3)(a) of the order, a regulated mortgage contract is defined as a contract satisfying:

- That the contract is one where a lender provides credit to an individual or trustees ('the borrower');

- The obligation of the borrower to repay is secured by a first legal mortgage on land (other than timeshare accommodation) in the UK;

- And at least 40% of that land is used or is intended to be used as or in connection with a dwelling by the borrower (or where trustees of the borrower, by an individual who is a beneficiary of the trust) or by a related person.

The regulated activities for which authorisation will be required will include: making arrangements for another person to enter into a regulated mortgage contract as borrower (article 25A(1)), for example, mortgage brokers; advising on regulated mortgage contracts (article 53A); entering into a regulated mortgage contract (article 61(1)); administering a regulated mortgage contract (article 61(2)), for example, notifying a borrower of changes in interests rates/payments and taking any steps to collect or recover payments scheduled under the contract from the borrower.

Article 67 excludes any activity carried on in the course of carrying on any profession or business which does not otherwise consist of regulated activities and may reasonably be regarded as a necessary part of other services provided in the course of that profession or business.

The advice of solicitors about a particular mortgage contract will not come within article 53 (advising on investments), provided it does not extend to making a recommendation to a client to enter into a different particular regulated mortgage contract.

The rationale behind the proposed regime is to promote 'transparency' of transactions.

The current proposals differentiate between three types of mortgage selling processes and identify three risk categories of mortgage.

The different selling processes are described as those amounting to: 'advised sales', that is to say, giving advice on the merits of entering into a particular mortgage; 'non advised sales' involving filtering questions, that is, where a firm uses filtering questions to narrow down the selection of mortgages on which it provides a consumer with information but does not make a recommendation; and 'non-advised execution only sales', that is, where the customer has decided which mortgage he wants and no filtering questions are used by the firm and no advice is given.

The different product risk categories are: high risk, that is to say, equity release schemes or 'lifetime mortgages'; medium risk products (flexible mortgages, current account mortgages, bridging loans, foreign currency mortgages, deferred interest mortgages and shared appreciation mortgages); and low risk mortgages, that is, interest-only loans for less than 12 months or loans for less than 10,000.

Mortgage advisers in respect of 'advised sales' or high risk products will be required to be qualified, for example, to have CeMAP (Certificate in Mortgage Administration and Practice) or be FPC (Financial Planning Certificate) or CeFA (Certificate for Financial Advisers) qualified, or have the MAQ (Mortgage Advice Qualification) or the CeMAP 'bridge' paper.

The scope of the advisory duty involves: first, that the mortgage sold must be suitable - that is to say, affordable; second, the mortgage must also be the most suitable and not the best of the lender's options.

The promotion of transparency is secured by requirements for: provision of pre-application illustrations (containing great detail in respect of the mortgage product being offered); disclosure of further information between entering into the regulated mortgage contract and the date of first payment under the contract; provision of event-driven information - for example, changes in interest rates; and provision of an annual statement of accounting information.

The Mortgage Sourcebook (MORT) contains detailed rules relating to these requirements.

Four particular features may be noted.

First, there is an obligation to provide information about any 'early repayment charge' which must be so described and reveal the cash sum involved, which must itself be a reasonable pre-estimate of the charge(s) caused to the lender by early redemption.

Secondly, any 'arrears charge' must be confined in an amount to a reasonable estimate of the costs of additional administration caused by the arrears situation.

Third, exorbitant charges are made unlawful.

And fourth, the lender must also operate a defined 'arrears policy', which must be approved in content by the governing body.

It must be satisfied that the policy satisfies the principles for business.

A breach of the rules may give rise to a right to claim compensation on the part of the 'private investor', that is to say, a borrower who suffers any loss as a result.

Thus MORT 13.3.3 provides that a lender should ensure that its written policy and procedures include:

- Using reasonable efforts to reach an agreement with a customer over the method of repaying any payment shortfall;

- Liaising with any third party source of advice where arranged by the customer;- Adopting a reasonable approach to the time over which the payment shortfall should be repaid;

- Agreeing to a customer's request to change the date on which the payment is due;

- Giving consideration to allowing the customer to remain in possession to effect a sale;

- Repossessing the property only where all other reasonable attempts to resolve the position have failed.

Precise information about any arrears must be given in the form of a letter within 15 days of the lender becoming aware of default; at the same time, an FSA information sheet on mortgage arrears must be provided to the borrower.

Before taking action for repossession the lender must: provide a written update of arrears information and supply a copy of an FSA fact sheet; ensure the customer is informed of the need to contact the local authority to establish if he may be eligible for local authority housing; and clearly state the action that will be taken with regard to repossession.

Where the proceeds of sale are less than the debt, the lender must inform the customer in writing of the shortfall debt and where relevant state that it may be pursued by another company (for example, a mortgage indemnity insurer).

If a decision is made to recover the shortfall, the firm must ensure that contact is made with the customer within six years.

This will have the effect of imposing a six-year time limit for recovery of the shortfall.

Bearing in mind proposed consultation, it is unlikely that the project management by lenders and intermediaries to adapt to the regime change will be plain sailing.

One thing is certain and that is statutory regulation will significantly change the landscape of the mortgage market.

Philip Ryley is an associate and head of the compliance and training consultancy at commercial Bristol-based law firm TLT Solicitors, and specialises in financial services.

John Virgo is a barrister specialising in financial services law and regulatory issues from Guildhall Chambers, Bristol, and at 5, Stone Buildings, Lincoln's Inn, London