Manchester Building Society appealed a decision of the English Court of Appeal that it could not recover the cost of closing out the contracts early from Grant Thornton LLP as the loss was not foreseeable. It argued that its loss fell within the scope of the duty of care owed to it by the firm.

The appeal was heard by the President of the Supreme Court, Lord Reed, and the Deputy President, Lord Hodge. With them sat Lady Black, Lord Kitchin, Lord Sales, Lord Leggatt, and Lord Burrows. The appellant’s legal team was fronted by Rebecca Sabben-Clare QC, and the respondent’s by Simon Salzedo QC.

Concealed volatility

The respondent had audited the accounts of the appellant from 1997 until 2012. In 2006, it advised the appellant that it could prepare its accounts using the “hedge accounting” method in order to give a fair view of the society’s financial position. Under International Accounting Standard 39, this was only permitted if there was a formal designation of the hedging relationship, and the hedge was expected to be “highly effective” in achieving offsetting changes in fair value attributable to the hedged risk during the period for which the hedge was designated.

Relying on the respondent’s advice, the appellant entered into a strategy of long-term interest rate swaps on lifetime mortgages it acquired or issued to homeowners in the UK and Spain as a hedge against the cost of funding the mortgage loans, which concealed the volatility of its capital position and the mismatch between the negative value of the swaps and the value of the mortgages.

In 2013, the respondent realised it had given this advice to the appellant in error. As a result, the appellant had to restate its accounts to show substantially reduced net assets and insufficient regulatory capital, which in turn required it to close out its interest rate swap contracts early. The process of doing so cost the appellant over £32 million.

The appellant sought to recover the cost of settling the contracts from the respondent, but both the trial judge at first instance and the Court of Appeal held that it could not as it did not come within the scope of the duty of care in respect of professional advice by accountants, as laid down in South Australia Asset Management Corp v York Montague Ltd (1997) (SAAMCO), but rather from market forces for which the respondent did not assume responsibility.

Counsel for the appellants submitted that the correct approach to the duty of care was to identify the nature and purpose of the auditor’s duties and to analyse in a qualitative way whether the loss sustained falls within the scope of those duties. On a proper analysis, the costs incurred in breaking the swaps were the very kind of loss which the respondent had a duty to protect it from.

Failed to understand

The lead judgment, with which Lord Reed, Lady Black, and Lord Kitchin agreed, was delivered by Lord Hodge and Lord Sales. Addressing the duty of care in professional advice cases generally, they said: “The scope of the duty of care assumed by a professional adviser is governed by the purpose of the duty, judged on an objective basis by reference to the reason why the advice is being given (and, as is often the position, including in the present case, paid for).”

Examining the purpose of the respondent’s advice in this case, they noted: “The society looked to Grant Thornton for technical accounting advice whether it could use hedge accounting in order to implement its proposed business model within the constraints arising by virtue of the regulatory environment, and Grant Thornton advised that it could.”

They continued: “That advice was negligent. It had the effect that the society adopted the business model, entered into further swap transactions and was exposed to the risk of loss from having to break the swaps, when it was realised that hedge accounting could not in fact be used and the society was exposed to the regulatory capital demands which the use of hedge accounting was supposed to avoid. That was a risk which Grant Thornton’s advice was supposed to allow the society to assess, and which their negligence caused the society to fail to understand.”

In his own judgment, Lord Leggatt added: “The cost of closing out the swaps which constituted the society’s basic loss resulted from a risk (of the lack of an effective hedging relationship between the swaps and the mortgages) to which, if Grant Thornton’s advice had been correct, the society would not have been exposed and which Grant Thornton owed a duty of care to protect the society against. Accordingly, the loss was within the scope of Grant Thornton’s duty.”

Lord Hodge and Lord Sales concluded: “It is not in dispute that the loss in issue formed part of the society’s ‘basic loss’ flowing from Grant Thornton’s negligent advice. Examination of the purpose for which that advice was given shows that the loss fell within the scope of their duty of care. Having regard to that purpose, we consider that Grant Thornton in 2006 in effect informed the society that hedge accounting could enable it to have sufficient capital resources to carry on the business of matching swaps and mortgages, when in reality it did not.”

For these reasons, the appeal was allowed. The court considered that contributory negligence should be assessed at 50%, with Lord Hodge and Lord Sales explaining: “The contribution by the society to its own loss arose from the mismatching of mortgages and swaps in what was an overly ambitious application of the business model by the society’s management.”