Equity of exoneration – joint mortgagors do not necessarily have joint responsibility for the secured debt

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It is a not uncommon situation – the family home is jointly mortgaged to secure the debts of a family member’s business. In these situations, it is presumed that person A who has mortgaged his/her property to secure the debt of another, person B, is a surety (only) and is entitled to be exonerated by person B, the principal debtor. B’s secured debts must be discharged, so far as is possible, out of B’s equitable interest in the property.

In March 2002 Mr and Mrs Shaw jointly mortgaged their property to Barclays to support a loan made by Barclays to Mr Shaw’s company Avon Independence Limited (Avon), which he co-owned with the couple’s daughter. On the same day, Mr Shaw and his daughter entered into a joint and several guarantee in favour of Barclays in relation to sums Avon owed to Barclays. Five years later another unsecured loan to Avon became repayable. The creditor of that loan, Mr Day, was granted a charging order against Mr Shaw’s interest in the property, as security for a judgment debt of £22,000. Avon was put into liquidation and the daughter filed for bankruptcy. The property was sold. After repayment of the mortgages, the remaining proceeds of sale totalled £45,000.

The Shaws argued that Mrs Shaw was entitled to be indemnified by her husband in relation to her liability under the mortgage, meaning that liability under the Barclays charge would fall first on Mr Shaw’s share before any liability fell on Mrs Shaw’s share. Should the court agree that the wife was entitled to the equity of exoneration, the £70,000 due under the second mortgage would be paid entirely by Mr Shaw’s half share leaving nothing left to settle Mr Day’s judgment debt.

Mr Day argued that Avon, not Mr Shaw, was the principal debtor and as such the equity of exoneration could not apply. Although Mrs Shaw was neither a director nor involved in the running of Avon, her joint financial position was tied up with the prosperity of Avon and so the borrowings for Avon’s business were indirectly for the joint benefit of Mr and Mrs Shaw.

The court held that Mr Shaw and his daughter were guarantors or sureties for the debt of Avon to Barclays. As mortgagors of the property, Mr and Mrs Shaw were sub-sureties of Avon’s debt. The guarantors were liable to pay the debt first or to indemnify the sub-sureties if they did not. As both a guarantor and a mortgagor Mr Shaw had both an obligation to indemnify and the benefit of the indemnity, while his wife had the benefit of an indemnity from him and their daughter. Mrs Shaw had the right to require her husband to exonerate her by repaying the debt out of his assets first. Moreover the court held that this right was a proprietary right, making Mrs Shaw a secured creditor in relation to her husband’s share, ranking in priority to Mr Day’s charging order.

Going further
Although the decision did not require a discussion of the rights of the Shaws in a situation without the guarantee, the court proceeded to do so. In obiter, Mr Justice Morgan considered that if Mr and Mrs Shaw were the mortgagors to Avon’s principal debt, prima facie, each would be liable to the same extent and required to contribute an equal share of the liability, but neither would be liable to indemnify the other. However, this default position could be affected by the circumstances of the case. If a wife was persuaded by the husband to join in a mortgage of a jointly owned house to secure the debt of a company that was owned and controlled by the husband, the debt should be considered the responsibility of the husband and the wife would have a proprietary right to an indemnity against the husband’s share of the house, by virtue of the equity of exoneration. In summary, if the co-mortgagor can show that the debt was incurred for the other’s sole benefit, the right of indemnity and equity of exoneration could apply.

This decision confirms that, as sub-surety, a mortgagor has a right of indemnity by the guarantor, a proprietary right over the guarantor’s share of the property.

The obiter comment goes further to suggest that a co-surety can have the same right if the secured debt benefits only the other co-surety.

An unsecured creditor will find himself behind the co-surety in priority of settlement out of the other’s share, which, as Mr Day found, can leave little or nothing left for his charging order to bite on.

But, does this reflect all arrangements where married couples mortgage their homes to support the family business? What about the current case trend to treat the family as a unit which shares the ups and downs of a family business jointly? In October 2013 the Chief Registrar in Lemon v Chawdha claimed that despite the couple’s home being mortgaged to enable Mr Chawdha’s business to purchase a property, the circumstances negated the equity of exoneration. The couple jointly mortgaged the property, operated joint bank accounts and credit cards, jointly received property rent and all their and the company’s income went into jointly controlled joint bank accounts.

Unfortunately in Shaw there was no examination of whether Mr and Mrs Shaw should be considered a family unit taking the financial ups and downs of the family business together, so as to prevent the equity of exoneration from arising. Similarly, there was little investigation as to whether Mrs Shaw benefitted directly or indirectly from the lending, for example, whether the income from the company funded normal living expenses. It had already been concluded that Avon made no profit so there was no further discussion on whether the exoneration was rebutted due to indirect benefits.

Practical tips
Lenders that are faced with borrowers’ claiming the operation of the equity of exoneration should review all loan documentation carefully. Is there anything within the information provided that shows that the husband and wife contribute to the family finances as a unit and share the benefits and risks of the family business jointly? What do the borrowers’ accounts show? Do they share the risks jointly? Does the company income finance normal living expenses? Has the wife benefitted indirectly from the company’s profits?

Such evidence may be sufficient to bar or rebut the equity of exoneration and prevent the spouse having a proprietary right of exoneration.

For more advice on the equity of exoneration, contact Real Estate and Banking Litigation Partner, Richard Sandford.