Overriding interests have long been a potential source of difficulty in registered conveyancing. Such interests will bind persons acquiring an interest in land even though, by definition, they do not appear on the title register. This being so, the existence of overriding interests necessarily reduces both the reliability and the comprehensiveness of the register. For this reason, the Land Registration Act 2002 (LRA 2002) reduced both the number and scope of overriding interests.

However, we are not yet in a place where overriding interests are redundant. In their consultative document "Land Registration for the Twenty First Century", the Law Commission and the Land Registry acknowledged that abolition of the overriding status could lead to results that are harsh and capricious. This is particularly the case when it comes to the rights of persons in actual occupation.

According to the consultation: "… the law pragmatically recognises that some rights can be created informally and to require their registration would defeat the sound policy that underlies that recognition. Furthermore, when people occupy land they are often unlikely to appreciate the need to take the formal step of registering any rights that they have in it."

The rights of persons in actual occupation of land can take a number of different forms. Examples include an option or right of pre-emption granted to a tenant under a lease, rights acquired under the Limitation Act 1980 ("squatter's rights"), a beneficial interest under a trust and a beneficial interest under an uncompleted contract for sale where the buyer has gone into occupation.

Hazards await the unwary lender, who could find the value of its security adversely affected by a previously unknown overriding interest. In this article we will consider the tension between the rights of those in actual occupation of property and mortgagees who have a legal charge over that property, and examine how that tension has been resolved by the courts.

Rights of every person in actual occupation

Those in occupation of land have long received special protection in the eyes of the law. The position of those in actual occupation of land was historically governed by section 70(1)(g) Land Registration Act 1925 (LRA 1925): "The rights of every person in actual occupation of the land or in receipt of the rents and profits thereof, save where enquiry is made of such person and the rights are not disclosed."

This provision will still apply to determine whether a mortgagee is bound by an overriding interest where the relevant transaction competed before the commencement of LRA 2002. Since this question often does not arise until the charge comes to be enforced, it is not time to recycle old statute books just yet.

Charges taken on or after 13 October 2003 will be governed by the LRA 2002. Under LRA 2002, overriding interests are divided into two categories. Schedule 1 LRA 2002 lists those interests which will override on first registration (including first registration triggered by the granting of a first legal charge over unregistered land).

Under paragraph 2 of that schedule, the list of interests which will override include: "an interest belonging to a person in actual occupation so far as the interest relates to the land of which the person is in occupation, except for an interest under a settlement under the Settled Land Act 1925".

Schedule 3 LRA 2002 lists those unregistered interests which will override a registered disposition. The Schedule 3 list of protected interests is more limited in its scope than the list of interests which are protected by Schedule 1 (and both lists are more limited than the list of overriding interests protected by LRA 1925).

Paragraph 2 of Schedule 3 LRA 2002 mirrors its equivalent in Schedule 1, but with certain additional exclusions:

• An interest of a person of whom inquiry was made before the disposition and who failed to disclose the right when he could reasonably have been expected to do so.

This exclusion, if properly utilised, is the one which is most likely to be of assistance to a lender. As long as appropriate enquiries are made of all occupiers, then in the absence of any positive replies the mortgagee may lend money on the security of the property safe in the knowledge that, in the absence of registration, any rights which those occupiers have will not be binding on it.

The same is not true of interests of persons in actual occupation of unregistered land which is then charged. Schedule 1 does not contain the exception for inquiries in Schedule 3. This is because first registration is not intended to alter priorities. Land may also be subject to an application for first registration without the happening of a trigger event such as the granting of a first legal charge.

• An interest which belongs to a person whose occupation would not have been obvious on a reasonably careful inspection of the land at the time of the disposition and of which the person to whom the disposition is made does not have actual knowledge at that time.

If the mortgagee has actual knowledge of an interest, or even the possibility of such an interest, where possible it should take steps to ensure that any interest is postponed to its charge (e.g. by requiring an occupier with a beneficial interest under a trust to sign the mortgage deed to indicate its consent and always considering potential issues of undue influence). If this is not possible, the mortgagee can at least ensure that the interest has been taken into account in the valuation of the property and any fetter on the mortgagee's ability to realise its security has been carefully considered before the charge is taken.

If the mortgagee does not have actual knowledge of an interest, it will not be binding on a lender provided that the occupation of the person to whom the interest belongs would not have been obvious on a reasonably careful inspection of the land at the time of the disposition. It is the occupation that must be obvious, not the existence of an interest.

Here lies a trap for a lender. The relevant time for satisfying the test of actual occupation is the time of the disposition, i.e. the date of the charge. This may be some weeks after the valuation (and any accompanying inspection) was carried out. The only way in which a lender can safely lend is if it re-inspects the property immediately prior to the charge being granted – which is impractical in almost all cases.

In the case of both Schedule 1 and Schedule 3, actual occupation is required. Receipts of rents and profits will no longer confer the benefit of an overriding interest (subject to transitional provisions).

In a further change from the position under the LRA 1925, an interest is only protected so far as it relates to the land which is actually occupied.

Overriding interests in practice

One area which has given rise to many disputes over the years is an occupier claiming a beneficial interest under a trust. In the case of this type of overriding interest, which usually gives rise to a right to occupy the property, the mortgagee's powers of enforcement may be frustrated as a lender may find that any power of sale exercised is subject to the third party right of occupation. It is for this reason that this area is where the tension between the rights of mortgagees and occupiers claiming overriding interests can perhaps be felt most intensely.

However, it is arguable that the courts have developed the case law in a way which leans in favour of the lender and away from the rights of such occupiers. While this case law pre-dates LRA 2002, subject to the differences listed above, the principles are equally applicable under the Act.

Take, for example, a client who is purchasing a vacant property with the assistance of a mortgage as a home for herself and her mother. Although the mother makes a financial contribution towards the purchase price, the house is conveyed into the sole name of the daughter. Neither the financial contribution nor the fact that the home is to be shared is disclosed to the mortgagee. It is well established that, in this situation, the client's mother will have an equitable interest in the property under a resulting trust by virtue of her financial contribution to the purchase price.

The question is whether her equitable interest is binding on the mortgagee as an overriding interest, with the result that she can take her share of the proceeds of sale in preference to the lender or, in a worst case scenario, set up her right of occupation against the lender to prevent sale on a subsequent attempt by the lender to enforce its charge.

Abbey National Building Society v Cann [1991] 1 AC 56 considered a similar situation. In this case, decided under LRA 1925, the House of Lords held that although the general date for determining the existence of overriding interests under the 1925 Act was the date of registration of the relevant disposition, the definitive date for ascertaining actual occupation of land as the basis of a claim to an overriding interest was the date of disposition.

Where a property is being bought with a mortgage, the creation of the trust (here, the mother's equitable interest) and the mortgage are contemporaneous. Section 29(1) LRA 2002 now provides that, if it is to override, an interest must exist both immediately before the charge is taken and when it is registered. In this way Cann continues to apply to acquisition mortgages taken after the commencement of LRA 2002. Therefore, there can be no overriding interest which can take priority over the grant of the mortgage.

What of remortgages? Here the position is different, because the person claiming a beneficial interest in the property is already in occupation. Here, the interest will bind the lender unless enquiries were made of the person and their interest was not disclosed (Williams & Glyn's Bank Ltd v Boland [1981] AC 487). As mentioned above, lenders have standard documentation which they require occupiers to sign, postponing their rights to that of the lender.

However, this can only be carried out where the lender is aware of the existence of the occupier. The position of the mortgagee is improved slightly in respect of charges taken on or after 13 October 2003. Under LRA 2002, if the person's occupation was not reasonably obvious on an inspection at the time of the creation of the charge, the lender will not be bound. However, the practical difficulties to which this gives rise have already been outlined.

Notwithstanding this, even if the occupier can prima facie claim an overriding interest by application of the principles in the Land Registration Acts, the mortgagee may be safe if the person claiming the competing interest had contemporaneous knowledge of the mortgage. Such knowledge effectively estops the occupier from launching a claim in priority to the lender (Paddington Building Society v Mendelsohn (1985) 50 P&CR 244 (registered land); Bristol and West Building Society v Henning [1985] 1 WLR 778 (unregistered land)).

Even if the occupier did not know about the remortgage, provided he or she knew about the first mortgage then they will be deemed to have consented to the remortgage to the extent of the amount (plus accrued interest) of the first mortgage (Equity & Law Home Loans Ltd v Prestidge [1992] 1 WLR 137). However, if the remortgage is for a greater sum than the first mortgage, the current lender will not be able to enforce its security against the occupier for any sum greater than that of the original mortgage advance (plus accrued interest).

Bank of Baroda v Dhillon [1998] 1 FCR 489 offered further assistance for lenders struggling to enforce charges against persons in actual occupation. In this case, the court refused to allow the overriding interest of a wife in actual occupation to prevent an order for sale in favour of the mortgagee. The result was that the lender was able to realise the value in what remained of its security over the husband's share in the home.

Finally, consider the case of the married couple who jointly own the marital home. The house was bought with a mortgage along with the help of a financial contribution towards the purchase price from the parents of one of the couple, since the house is also to provide a home for them in their old age. The parents will not have an overriding interest on the purchase of the property (Abbey National v Cann), but what if it is subsequently remortgaged?

Although both parents have a beneficial interest in the property, which is protected by actual occupation, this interest is capable of being overreached where capital monies are paid over to two or more trustees. Since the mortgage advance on the remortgage is paid to the couple, the interest of the parents in the property will be overreached and the lender takes free (City of London Building Society v Flegg [1988] AC 54).

It follows that the typical problematic scenario is a post-acquisition mortgage by a single legal owner where a person with a beneficial interest in the land is in evident occupation at the time of the mortgage, and that person was unaware of the existence of a mortgage.

Protecting the lender

A lender must make sure that, when taking security, it is aware of all occupational interests. An inspection of the property should be made and detailed enquiries should be raised of the chargor. Overriding interests are necessary while the system of land registration in England and Wales continues to evolve. As we move towards a system of total registration, the scope of overriding interests will diminish. But in the meantime, any lender taking security without having made appropriate enquiries runs a risk of finding an occupant with an interest that will have priority to its legal charge.

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For further information about this published aticle, contact Kathryn Hobbs on +44 (0)121 213 2397, Alexa Highfield on +44 (0)121 213 2396 or Amie Ryalls on +44 (0)121 213 2360

This published article may contain information of general interest about current legal issues, but does not give legal advice.