Risks Facing Solicitors on Buyer Funded Developments

30 May 2019

We are seeing a rise in the number of claims against solicitors relating to failed buyer funded development schemes. Claimant buyers will often look to pin the blame for the loss of their deposits (or sometimes the full purchase price) onto their solicitor and other insured professionals.

We are pleased that Joe Eizenberg, partner at Beale & Co has written the following bulletin to examine the risks for conveyancers who advise on these schemes, which arise when acting for either the purchaser or the developer.   

WHAT ARE THEY?

Prospective purchasers are usually introduced to the development either directly by the developer through a presentation day or, alternatively, indirectly through an estate agent. Buyers pay reservation fees for the privilege of investing (we have seen reservation fees as high as £5,000). The reservation fee is often paid before buyers obtain legal advice and particularly before they have seen the legal documentation. The up-front costs and deadlines mean that interested parties will almost always be ‘cash buyers’ i.e. there is no lender. 
Developers offer buyers a number of incentives including:

  • Guaranteed interest payable on sums advanced by the buyers (sometimes as high as 4%).
  • Guaranteed buy-back schemes.
  • Guaranteed rental payments where the property is a buy-to-let.
  • A competitive price, often slightly below the market rate for other properties of that type. 

The downside for purchasers is that the developer will request them to exchange sale contracts (or in some cases exchange and complete) within a short period, often within a few months. The deposit payable on exchange is usually significant and far greater than the usual 5% or 10% deposit in conventional residential transactions, sometimes up to 80%. The developer then uses this money to fund or part fund the development, or to repay other liabilities (rather than exclusively using their own funds or bank financing). 

Although the sale contract usually provides that the reservation fee is subtracted from the sums payable on exchange / completion, if a buyer fails to pay the deposit by the developer’s deadline then they risk forfeiting their reservation fee. 

In some cases the developer will have a small panel of solicitors who they recommended as already being familiar with the development and who, as a result, will be able to meet the strict deadlines they impose. Buyers are encouraged to use the developer’s preferred solicitor, sometimes through additional incentives. 

Many of these schemes have been sophisticated frauds that have caught out innocent investors who then seek to blame their solicitors. 

We have seen developments where a Single Purpose Vehicle (“SPV”) is set up on behalf of the buyers to take a charge over the freehold to the development. The intention is that the buyers are members of the SPV pending practical completion. On practical completion the SPV will release its charge over the freehold. On those developments, deposits are paid direct to the SPV and released in tranches, including payments to purchase the development/repay the lender. 

THE AREAS OF RISK

The key point to convey to any purchaser when acting on a buyer-funded development is the risk of losing the deposit through the developer’s fraud or insolvency – which means the building is not completed before the money runs out. 

The SRA have issued a number of notices and warnings about these and other investment schemes. On 23 June 2017 the SRA issued a warning notice on these types of scheme – which provides that professionals “should ensure that clients fully understand the risks and it may well be necessary to strongly advise clients against entering into the transaction”. 

That notice also makes it clear that “if you are not acting for investors, you must make that absolutely clear and strongly advise them to take their own independent advice from professionals they choose themselves...solicitors must rigorously assess the transaction and refuse or cease to act if, applying all warnings we have issued and considering past cases, there is any doubt about its propriety or whether buyers or investors are being misled in any way”. 

The risks to solicitors include: 

  • The regulatory risk arising from a failure (or perceived failure) to follow SRA guidance.

  • A claim from the purchaser in professional negligence for the sums they have lost.  

 

REGULATORY RISK

Solicitors should be comfortable that they have carried out their own due diligence on the nature of the development and transaction. A solicitor should ensure that they understand the rationale behind the way in which the transaction is structured and the incentives provided to the purchaser. These matters should never be presented as routine conveyancing (particularly given the risk of fraud) and this should be made clear to any purchaser irrespective of client. .

PROFESSIONAL NEGLIGENCE RISK

The risk of claims in professional negligence is higher when acting for buyers. We are seeing a number of claims against solicitors from buyers who allege some or all of the following: 

  • The buyer was not properly informed of the risks of proceeding.
  • The deposit payable on exchange should have been flagged as unusually high.
  • The way in which the transaction was structured and the effect this had on the buyer’s security was not sufficiently explained.
  • A failure to advise on or adequately put in place security in the event of a developer default. 
  • The risks of these types of development (including the risk of fraud) should have been spotted by the solicitor and/or red flags should have been brought to the buyer’s attention prior to exchange. 

In all matters the buyer alleges that they would not have proceeded had they been suitably advised. 

A conveyancing solicitor’s retainer will usually be on an information basis. As a result, they may be able to argue that they are unlikely to be held responsible for all losses associated with the investment but only the difference in value between the information provided alongside the information it is claimed should have been provided. 

MITIGATION 

The most straightforward way to mitigate exposure to risk therefore is to ensure that the Report on Title contains information on all matters affecting the risk of investing. A belt and braces approach would be to flag the potential ways (or lack thereof) by which the purchaser could try to recover their money in the event of the developer suffering an insolvency event. We consider that a solicitor should err on the side of caution when asked to act as a director of an SPV and should carefully review any additional exposure they might have, either from a regulatory perspective or because of additional duties owed to the company / its members. 

Unfortunately, the above may not always go hand in hand with developer demands that matters move quickly, particularly where those deadlines are accompanied with the threat of the purchaser losing both their chance to invest and ‘non-refundable’ reservation fee. Moreover, by the time purchasers arrive at the legal stage they will have already grown attached to the investment and will not want to delay matters further or risk losing that opportunity.  

 

In Summary

The key point to take away is that these developments are not only risky from the purchaser’s point of view. Where money has been lost there will always be a danger of a claim or regulatory investigation, even more so where there is potential fraud. What we are seeing is that ‘scoped’ retainers do not always offer the protection solicitors intend and the most straightforward way to mitigate risk will be to ensure that the structure of any off-plan transaction (including existence of SPVs or other corporate vehicles) is understood and the rationale and risks of proceeding conveyed to the buyer in the Report on Title. 

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  • James Frost

    James Frost has been an insurance broker for 30 years. He is a specialist in arranging Professional Indemnity Insurance for solicitors and has been focused on the legal profession since 2000. He manages insurance programmes for a portfolio of mid-tier regional firms and top 100 firms. Prior to joining Marsh JLT Specialty, James spent 15 years at AON in their professions division where he was the national subject matter expert for Solicitors Professional Indemnity. James is a regular speaker at regional and national Law Society seminars and is a regular contributor to SRA consultations where these affect professional indemnity insurance.

    If you would like to talk about any of the issues raised in this article, please contact James Frost on +44 (0)121 626 7841