Impact of the FCA’s new Consumer Duty on mortgage book deals in the UK

November 2022 | SPOTLIGHT | BANKING & FINANCE

Financier Worldwide Magazine

November 2022 Issue

Mortgage book deals have continued apace in the UK in recent years. With the number of books changing hands over this period, parties on all sides of these transactions have made strides in reaching a relatively common understanding of the key sensitivities to be explored in due diligence and the relative risk allocation for historical mortgage products. This article explores whether the introduction of the Financial Conduct Authority’s (FCA’s) new Consumer Duty may impact parties’ approach to due diligence and risk allocation in respect of such products.

Following two consultations in May and December 2021, the FCA published policy statement PS22/9 on 27 July 2022 which, together with its ‘Final non-Handbook Guidance for firms on the Consumer Duty in FG22/5’, establishes the final rules and guidance in respect of the new Consumer Duty. This new regulatory regime will require firms dealing with ‘retail customers’ to act to deliver good outcomes for these customers.

The new Consumer Duty is intended to impose a higher standard of conduct on regulated firms. It has very broad application and most UK authorised firms will be impacted in some way. From a distribution perspective, the new Consumer Duty will apply to firms higher up the chain even where they do not have a contractual relationship with the end ‘retail customer’. Importantly, the new Consumer Duty will also not only apply prospectively to new products and services, but will also have implications for firms engaged in the administration or servicing of ‘closed products’.

Bank and non-bank residential mortgage lenders, servicers and administrators are squarely in the regulator’s sights for this new duty and this may influence their approach to new mortgage book transactions.

Overview of the new Consumer Duty

The new Consumer Duty is proposed to have three components. First, a new Principle 12, which will require firms to ‘act to deliver good outcomes’ for retail customers. Second, three cross-cutting rules designed to support the new Consumer Principle. And third, four outcomes setting out more detailed expectations for how firms can meet the new Consumer Principle.

Principle 12 encapsulates the underlying, high-standard of behaviour that the FCA expects of regulated firms in connection with the provision of products and services to retail customers. The new Consumer Duty establishes this through three cross-cutting rules which require firms to: (i) act in good faith towards retail customers; (ii) take reasonable steps to avoid causing foreseeable harm to retail customers; and (iii) enable and support retail customers to pursue their financial objectives.

For lenders of record and third-party servicers in respect of UK regulated mortgage contracts, there will be a keen focus on the ways in which the new Consumer Duty will apply to historic portfolios of regulated mortgages in particular. To demonstrate compliance with the new principle 12, these firms will need to act to deliver four outcomes set out in the new rules and extensive guidance. In addition, however, the new package of rules and guidance will include specific requirements which apply in connection with the sale and purchase of product books.

What will this mean in practice?

The new Consumer Duty applies to products and services offered to ‘retail customers’. For regulated mortgage contracts, the application provisions therefore follow the position in the Mortgage Conduct Business Sourcebook (MCOB) and will apply to regulated activities carried on in connection with regulated mortgage contracts but not, for example, unregulated buy-to-let contracts or commercial lending. Where the owner of a mortgage book is unregulated and the regulated party is an administrator, the new Consumer Duty would apply in an appropriate and proportionate manner to the administrator’s functions.

The new Consumer Duty does not have retrospective effect and does not apply to past actions by firms. However, it will apply, on a forward-looking basis, to closed book products and services (products and services that are no longer on sale to new customers or available for renewal by existing customers). This will include portfolios of regulated mortgage contracts (we refer to these as ‘mortgage books’).

Implications for transactional processes

The new rules will require specific diligence to be performed by both purchasers and sellers in connection with the purchase and sale of mortgage books. Importantly, the new rules will only apply where a mortgage book is sold for the first time after 31 July 2023. However, in such circumstances new rules will require purchasers to conduct sufficient diligence to ascertain the following.

First, whether any group or groups of retail customers have characteristics of vulnerability or as a group have in common a specific protected characteristic in the same form (for example customers of the same sex or race).

Second, the outcome of the seller’s product approval process for the mortgage book and the outcome of any product reviews carried out by the selling firm in accordance with the new products and services outcome.

Third, the benefits the product is intended to provide and the costs the retail customer pays for the product.

Fourth, the basis on which the product has been assessed as providing fair value in accordance with the new ‘price and value outcome’.

From a diligence perspective, purchasers will need to obtain much more customer-centric information, as well as information on the internal judgments and analysis undertaken by the seller in respect of its own compliance with the new Consumer Duty.

Equally, sellers will be under an obligation to provide ‘relevant information’ to the purchasing firm to enable the purchasing firm to comply with principle 12 from the date of purchase. This obligation bites, however, on the relevant ‘Authorised Firm’ and there may therefore be some debate, at least in the early stages of application of the rules, on where this obligation will sit in practice, and how dependent that analysis is on the specific structure by which the relevant mortgage book is actually held (e.g., if the legal and beneficial titles in the book are already split).

Purchasers will wish to consider the new requirements around diligence of mortgage books within the context of the wider package of rules and guidance making up the new Consumer Duty. In the context of diligence for closed products, the FCA will expect that purchasers consider the extent to which they (or their chosen servicers) are equipped to service portfolios of regulated mortgage contracts where the customer base is different to their own in these terms.

Purchasers are likely to be expected not only to obtain information relating to vulnerability with the customer base of the relevant portfolio, but to interrogate the methodologies through which these assessments were made by sellers. In some cases, sellers may be less willing to provide this information, and it is likely that this will be an area of negotiation within the diligence process itself, as will be the extent to which sellers are required to provide this information pursuant to the new rules.

Clearly, there will be a degree of heightened interrogation of the ways in which the seller, and any third-party servicer, has complied with regulatory requirements concerning the origination and ongoing servicing of portfolios of mortgage books. We would expect this to cover not only compliance with the new Consumer Duty by the sellers and servicers, but also a renewed focus on historic compliance and some of the well-known industry-wide conduct risks in such portfolios.

It is likely that new categories of regulatory risk will emerge in connection with transactions in the sector. Assessments around price and value by sellers, and administrators, are likely to be one such area. The new package of rules allow for a degree of interpretation, assessment and analysis by firms in this regard, and it is possible for firms to reach different conclusions relating to similar products and services depending on internal and external factors.

In parallel, firms considering the sale of a mortgage book after the new Consumer Duty comes into force must provide relevant information to the purchasing firm to help it achieve the above. The information should enable the purchaser to monitor on an ongoing basis if the product or service meets the needs, characteristics and objectives of the target market and offers fair value. Note that firms will need to have due regard for data protection and competition laws when sharing this information.

The FCA has recognised that purchasers of mortgage books before the new Consumer Duty takes effect may not have developed those products and so will not have all of the relevant information to conduct ongoing reviews under the products and services outcome and the price and value outcome. A best endeavours standard of such firms is therefore expected to meet these requirements. Considering any relevant complaints from customers that indicate problems with the product or service design and value is an example of a review that would help meet this threshold.

Concluding remarks

On 31 July 2023, the Consumer Duty will apply to all new products, and to all existing products that remain on sale or open for renewal. On 31 July 2024, it will apply to all closed products.

The FCA has been clear that the new Consumer Duty will be a step change in the UK regulatory framework. The ways in which firms meet these new obligations will be critical to being able to demonstrate to the FCA that they have effectively implemented the new Consumer Duty into their organisational framework when they acquire books of closed products in scope of the new Consumer Duty.

Given the context and knowing that the FCA is going to take a proactive approach, purchasers will want to conduct fulsome, meaningful diligence across these areas; to understand underlying methodologies and compliance with the applicable rules by the seller.

Both sellers and purchasers should prepare for a greater interrogation of conduct risk relating to the required areas of diligence, and broader thematic issues as part of diligence going forward, recognising that this will not just be a matter of contractual liability but also more focused regulatory risk.

Matthew Gregory is counsel and Alan Bainbridge is a partner at Norton Rose Fulbright LLP. Mr Gregory can be contacted on +44 (0)20 7444 2467 or by email: matthew.gregory@nortonrosefulbright.com. Mr Bainbridge can be contacted on +44 (0)20 7444 3279 or by email: alan.bainbridge@nortonrosefulbright.com.

Matthew Gregory and Alan Bainbridge

Norton Rose Fulbright LLP