Why is it important?
It’s important for two reasons, one commercial and one legal:
- Manchester Building Society (MBS) is an example of yet another financial institution that is too undercapitalized. Its hopes of recovering an award for damages of £49m from Grant Thornton (GT) now formally dashed, it no longer has capital to engage in new lending. It is in talks with the Prudential Regulatory Authority over its next steps;
- legally, it applies “SAAMCO” principles to an accountants’ negligence claim.
In this article we explain what that means.
MBS entered into lifetime mortgages with borrowers, under which equity was released and no payments were due until the owner entered a care home or died.
From 2002 to 2005, it hedged the risk of interest rate rises by purchasing swaps. Grant Thornton did not advise on the swaps.
New reporting standards in 2005 required MBS to account for the swaps (at fair value) on its balance sheet. Doing so would reveal volatility (requiring additional regulatory capital). GT advised MBS (i) to apply hedge accounting rules to the interest rate risk; and (ii) that this method of accounting would limit balance sheet volatility and was appropriate for a building society.
On this advice, MBS bought more swaps.
The post-2008 financial crisis meant that interest rates plummeted and the fair value of the interest rate swaps losses became a liability rather than an asset. The change was hidden on the balance sheet by the accounting treatment which disguised the true losses sustained by MBS.
However, in 2013, GT advised MBS that hedge accounting was not applicable and, following a reconciliation of its accounts, it became clear that MBS was significantly undercapitalised. As a result, MBS closed out its swaps and suffered losses of c£49m.
The finding at First Instance
The nutshell judgment was that GT’s advice to adopt the accounting treatment known as “hedge accounting” was negligent. The bigger question was: what losses flowed from this? Did GT owe (or assume) a wide duty to protect MBS from the swap transaction or a more limited duty, to protect MBS from the financial consequences of its advice as to hedge accounting being wrong? Mr Justice Teare, found that:
- But for GT’s negligence MBS would not have taken out more swaps from 2006, and would have cut its losses by closing existing swaps;
- GT’s negligence was an effective cause of the losses, as opposed to providing the occasion/ opportunity for the losses to be incurred, and they were reasonably foreseeable;
- Between 2006-2011 GT knew that MBS intended to hedge lifetime mortgages by entering into long-term swaps.
- The key issue was the extent to which GT owed a duty of care to protect MBS from the losses which arose from the swaps. The judge concluded that GT’s advice was limited to how the swaps could be treated in the accounts. The decision to purchase the swaps was taken for commercial reasons on which GT gave no advice. Therefore, GT did not assume “responsibility for the financial consequences of those business activities”.
- That decision was reached without considering whether this was an “advice” or “information” case in accordance with the principles established in South Australia Asset Management Corporation v York Montague Ltd  (known as the “SAAMCO” case).
The Court of Appeal
The Court of Appeal concluded that:
- This was clearly a case in which SAAMCO applied. It was a classic “Category 1 information” type of case in which the professional adviser contributes a limited part of the material on which his client will rely on in deciding whether to pursue a particular commercial transaction but the process of identifying the other relevant considerations and the overall assessment of the commercial merits lie with the client.
- In an “information” case, the adviser is only responsible for the foreseeable financial consequences of the information or advice being wrong. In order to determine what are the foreseeable financial consequences of the information or advice being wrong it is necessary to exclude all losses which would have been suffered if the information or advice had been correct.
- By contrast, an “advice” case is where the adviser is “guiding the whole decision making process”. His duty is to consider what matters should be taken into account when deciding whether or not to enter into the transaction and so extends to the decision itself and all foreseeable losses flowing from it.
- the closing out of the swaps crystallised the loss but did not cause it. The losses were real, regardless of the hedge accounting, and flowed from the mark to market (“MTM”) valuation of the swaps, when MBS closed them out. Receiving fair value does not give rise to a loss.
- If, for example, the swaps had been “in the money” at the time that GT’s negligent advice had been discovered, the swaps would probably still have had to be closed out because of the unacceptable accounting volatility involved in continuing to hold them. In such circumstances the closing out of the swaps at fair value would not have given rise to any loss.
There were two reasons why GT won:
- GT’s advice was limited to “hedge accounting is ok, and will make your balance sheet appear less volatile”. That advice was wrong, but it was MBS’ decision to buy the swaps – how many, when, etc; which caused the loss. GT did not assume responsibility for the swap transactions but only for the financial consequences of its advice as to hedge accounting being wrong.
- This was squarely an “information” case but MBS was unable to prove that the losses would not have been suffered had it continued to hold the swaps. It was wrong of Mr Justice Teare to find at first instance that the MTM losses would not have been incurred had the information or advice been correct.
This is good news for accountants. As the trial judge noted at first instance, and as the Court of Appeal re-quoted, it would have been: “a striking conclusion to reach that an accountant who advises a client as to the manner in which its business activities may be treated in its accounts has assumed responsibility for the financial consequences of those business activities.”