LEGAL CHANGE

Why valuations and refinancing don’t always mix well – a timely reminder for lenders

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About the author

Stephan Smoktunowicz is a banking & finance partner at the London office of the international law firm, gunnercooke. He helps businesses & people in the UK and across the world to achieve their commercial objectives and safely navigate issues that arise throughout any transaction lifecycle. He also provides training and mentoring to businesses, professionals and students on related topics.

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In this issue

Valuations are an important part of many financings. But if a valuer gets things wrong, how much value can a lender safely attribute to a potential negligence claim?

In an economic climate which could see a rise in refinancings, there are specific risks that lenders need to be alive to before attributing any type of value to a future negligence claim on a refinanced facility. Not doing so could result in a material impairment.

In this issue of Legal Change, I examine why valuations and refinancings do not always mix well and provide some practical considerations for lenders on how to mitigate risk.

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POINTS TO NOTE

• If a lender has a shortfall in loan recoveries following enforcement, then even if it has a valid negligence claim against a valuer, there is a risk that the claim will not realise sufficient proceeds to address the whole shortfall.
• In a refinancing scenario, that risk may materially increase and a lender’s actual recovery will depend on the facts and circumstances.
• Lenders should be careful before placing any specific value on a hypothetical future claim, not only in relation to original financings and refinancings, but on facilities that have been amended or changed too.

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INTRODUCTION

With 2024 now well underway and the Bank of England recently holding interest rates at 5.25%, speculation around where rates will head next is never far from the headlines. Whether borrowers will benefit remains to be seen, but if rates fall, it could increase the demand for refinancings.

Refinancings can pose various risks and questions for lenders. One key question is will my security realise sufficient proceeds if the borrower can’t pay me back and I need to enforce?

To assess what value a lender may be able to realise from its security, professional valuations are usually obtained. But if the enforcement proceeds of a lender’s security realise less value than expected and the valuer was negligent in providing its valuation, will a negligence claim allow a lender to recover any shortfall it incurs from the valuer?

This article considers:

• what recourse lenders generally have to valuers under valuation negligence claims;
• why refinancings can materially impair how much lenders can claim from a negligent valuer; and
• six connected practical considerations for lenders when refinancing or making changes to existing facilities.

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WHAT DAMAGES CAN A LENDER RECOVER ON A NEGLIGENT VALUATION CLAIM?

If a lender has suffered loss because of the valuer’s negligence, then it should typically be able to bring a negligence claim against the valuer for recovery of the loan amount it advanced and incidental costs. This assumes the lender can show that it would not have advanced the loan if the valuation had been accurate.

However, there are some important caveats to this:

1. any interest charged on the loan Itself is not generally recoverable;
2. how this plays out financially if the loan is refinanced by the same lender who advanced the original loan requires separate, important analysis (see ‘*Valuations on refinancings with the same lender’* below); and
3. in any event, the lender will not be able to recover more than the amount of the overvaluation, unless there has been fraud.

As these claims look at the loss caused by the negligent valuation, any repayments and interest paid by the borrower or recovered from the sale of the valued property will usually be deducted from any claim. Other factors such as whether the lender took sufficient steps to mitigate its loss may also reduce the actual net recoverable claim value.

Depending on the facts of any specific claim, the proportion of the lender’s shortfall recoverable from the valuer may vary, but the Figure 1 above illustrates the possibility that the final value of a net recoverable claim may not necessarily cover the full post enforcement shortfall and outstanding interest.

What if the lender would still have advanced, but at a lower amount?

There may be scenarios where if the valuation had been accurate, then rather than not lending at all, a lender may have instead, advanced a lower amount than it did. In those circumstances, the difference between the actual amount advanced and that lower amount will be used as the starting point for any claim.

Allocation of responsibilities – lender vs. valuer

One key thing for lenders to understand under a valuation negligence claim is that the valuer Is not responsible for the consequences of the lender’s underlying commercial decision to make the loan. Instead, if it is negligent in making its valuation, has breached its duty of care to the lender and the lender has suffered loss as a result, then it is responsible for the consequences of that negligence. A subtle, but significant difference.

As explained next, valuation negligence claims brought where the lender has refinanced its own loan best illustrate how this subtlety can produce undesirable results for a lender, particularly if it has placed too much reliance on a negligence claim seeing it good for any borrower shortfall.

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VALUATIONS ON REFINANCINGS WITH THE SAME LENDER

Where a lender:

• has provided an existing loan and refinances it by way of a new loan;
• takes a fresh valuation in support of that refinancing; and
• the fresh valuation is made negligently,

a lender might think that it can make a claim against the valuer in respect of any unrecovered shortfall of the new loan amount, on the basis that it would not have advanced the new loan if the fresh valuation had not been negligently provided.

However, as seen in a decision of the UK’s Supreme Court in 2017 in In the case of Tiuta International Limited (in liquidation) (Respondent) v De Villiers Surveyors Limited (Appellant) [2017] UKSC 77, the amount a lender will actually be able to recover will be fact specific and the way loss is assessed in this particular scenario is something that lenders refinancing loans will need to remain alive to – particularly before placing any hypothetical or potential value on what they might recover from a valuer if the valuation Is wrong.

Let us visualise the potential risks by looking at the example In Figure 2 below:

In the above refinancing scenario, assuming the lender would not have refinanced had it known the second valuation was wrong, under a negligence claim for the second valuation which was provided for the purposes of Loan 2:

• the lender could only seek recourse against the valuer in respect of the net £0.75M cash advance made to the Borrower under Loan 2;
• the lender could not make a negligence claim in relation to the full £3.75M advanced under Loan 2.

This could result in an outcome where the lender’s maximum claim In negligence is materially less than Its shortfall, for example:

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What is the rationale behind this outcome?

This outcome on a refinancing may come as a shock to lenders who are unfamiliar with the Supreme Court’s decision. On the face of it, the whole of Loan 2 is made off the back of the second valuation, so if the second valuation has been provided negligently, why does a lender not have recourse to the valuer in respect of the whole Loan 2 amount?

The underlying reason for this goes back to the allocation of responsibilities mentioned earlier (see ‘Allocation of responsibilities – lender vs. valuer‘ above) and that the valuer is responsible for its negligence, rather than the underlying commercial decision to refinance.

Taking that into account, the English courts will look at the position had the refinancing not happened and compare that with the position as a result of the refinancing. In our example scenario at Figure 2 above:

• if the lender had known the valuation was defective and had decided not to refinance, the lender would still have had the original loan (Loan 1) of £3M outstanding;
• because Loan 1 was provided on the basis of an accurate valuation, the lender would have had no recourse to the valuer via a negligence claim for any shortfall In recovery of the £3M advanced under Loan 1;
• as a result of entering into Loan 2, Loan 1 is now repaid, but the only financial difference for the lender between:
  • its pre-refinancing position (the outstanding £3M million under Loan 1); and
  • the position as a result of the refinancing (an outstanding £3.75M under Loan 2),is the additional net £0.75M advanced to the borrower under the new Loan 2.

Because the valuer is responsible for the consequences of its negligence, but not for the consequences of Loan 2 being made, the valuer only has responsibility in relation to the new net £0.75M advance – i.e. the difference in the lender’s position as a result of entering into Loan 2.

It is important to stress that any actual outcome will be fact specific and if the original valuation in Figure 2 had also been wrong, there could be a different outcome. However, this illustrates the possibility that on a refinancing, the lender could find itself with its recourse to a negligent valuer capped at the amount of net additional lending, rather than the repayment shortfall incurred on the full amount of the new loan.

Lender beware: the over-reliance trap

Lenders could be excused for thinking that this all defies logic. However, under English law and as demonstrated by the Supreme Court back In 2017, damages claims are assessed through long established principles.

Unfortunately, depending on the fact pattern, if a lender places too much value on a possible future professional negligence claim when making its lending decisions, that could result in the lender suffering a loan book impairment down the line.

So, how can lenders approach this topic on refinancings and other facility changes and minimise risk?

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SIX PRACTICAL CONSIDERATIONS FOR LENDERS

Number one: Maintain awareness and keep expectations realistic

Always be aware that the amount recoverable from a valuer on a negligence claim will not necessarily be the same as the shortfall in your total recoveries and in some circumstances could be materially less.

Number two: Attributing value to future claims Is not an exact science

Tread extremely carefully before placing or attributing any type of ‘security value’ on what might be recoverable from a valuer should things go wrong. How claims for negligence (or alternatively for breach of contract) actually play out will be fact specific and professional advice should be sought if considering the consequences of them at any stage of the financing life cycle.

This article has focused on a particular type of refinancing scenario as set out at Figure 2 above. Other refinancings may have different fact patterns and any risk should be considered on a case-by-case basis. Whether a lender recovers its shortfall in full under a valuation claim could also depend on whether the valuer is adequately insured.

Number three: Be vigilant in other facility change scenarios

There may be other scenarios in which lenders take professional valuations and where the topics discussed in this article may come into play, for example:

• new loan tranches;
• increases in facility amounts;
• build and grow facilities;
• facility amendments; and
• covenant resets.

Placing any value on how much a lender can seek recourse to a valuer for if connected valuations prove to be wrong will in each case require careful analysis.

Number four: Keep records of lending decisions

Lenders should give some thought to how they can demonstrate that they would not have lent at all, or would only have lent a lower amount had they known a valuation was defective at the outset. As we have seen, this will affect the starting figure against which a negligence claim can be made.

Facility agreement draw stop mechanics may assist (but should be carefully thought through). Well documented risk and credit approval minutes and records may also provide helpful supporting evidence.

Number five: Recovery of interest

We saw earlier that interest payable by the borrower is not generally recoverable on valuation negligence claims. However, a lender may be able to recover interest that it could have otherwise earned on monies it advanced to the borrower. To do so, the lender will need to demonstrate how it would have gone about achieving the interest it seeks to recover. Well documented business records may also help to maximise recoveries here.

How interest payment profiles are structured on a loan or refinancing could also play into overall recoverability of interest.

Number six: Assess overall security cover

How a claim in negligence plays out financially could be left to the courts to decide. Therefore, trying to crystal ball gaze the monetary outcome whilst interesting, is probably not the best use of lenders’ time when risk-assessing refinancings and changes to facilities.

Ultimately, if the borrower does not repay, then the realisable value of all security and guarantees (taking into account worst case scenarios insofar as possible, competing creditors’ claims and priority positions) needs to provide sufficient headroom to allow a lender to make a full recovery.

New or supplemental security and/or guarantees should be considered where necessary to avoid the risk of old security not catching the amended or refinanced position and to ensure that lenders are not placing over-reliance on shortfalls being paid out in full via negligence claims if things go wrong. That can sometimes also prove to be an inexact science and appropriate professional guidance should be considered to ensure that any collateral is fit for purpose.

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CONCLUSIONS

In an environment where interest rates might fall, demand for refinancings could increase. As volumes rise and lenders’ risk and transactional refinancing teams become busier, lenders need to remain vigilant to the risks of attributing specific value to future professional claims – particularly on refinancings and on facility changes.

If the sale of property via a security enforcement route does not realise enough cash to address a lender’s shortfall, a lender will be glad that it took sufficient additional security or guarantee cover to plug the gap, rather than having to wait and see whether it has a viable negligence claim to see it good.