Between 2004 and 2010 Manchester Building Society (MBS) purchased and issued lifetime mortgages to homeowners in the UK and Spain aged 50 or over. The loans were designed to release equity in the borrower’s home and had to be repaid on the borrower’s death (or earlier at the borrower’s election). Whilst MBS charged interest at a fixed rate, it funded the loans by borrowing at variable rates of interest. This created the risk that MBS could suffer a loss if the variable rate exceeded the fixed rate. MBS decided to hedge its position by purchasing interest rate 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 that would require MBS to hold additional regulatory capital. In response to this issue MBS’ auditor, Grant Thornton (GT), advised MBS to apply hedge accounting rules to limit balance sheet volatility. On this advice, MBS bought further swaps.
The post-2008 financial crisis meant that interest rates plummeted and the swaps became a liability rather than an asset. This was hidden on MBS’ balance sheet by the accounting treatment.
In 2013, GT advised MBS that it was never entitled to utilise hedge accounting and a subsequent reconciliation of MBS’ accounts revealed that it was significantly undercapitalised. To extricate itself from the situation MBS closed the swaps and crystallised its losses at a cost of over £32m.
MBS sought to recover this sum from GT. MBS argued that upon receipt of non-negligent advice in 2006, it would have closed its position and not have purchased more swaps. GT admitted that its advice in 2006 was negligent; however, it argued that MBS’ losses fell outside the scope of the duty of care that GT owed to MBS.
First instance decision
Mr Justice Teare accepted that ‘but for’ GT’s advice in 2006, MBS would not have purchased more swaps. However, following principles established in South Australia Asset Management Corporation v York Montague Ltd  (SAAMCO) he reached the conclusion that (a) MBS’ decision to purchase the swaps was taken for commercial reasons on which GT gave no advice and (b) GT did not assume “responsibility for the financial consequences of those business activities”. As a result, GT was not liable for the losses that MBS sustained when closing out the swaps. However, in case he was wrong, the judge took the view that he would have applied a 50% discount for MBS’ own contributory negligence.
The appeal: MBS appealed Mr Justice Teare’s decision on the basis that it was reached without considering whether this was an “advice” or “information” case in accordance with SAAMCO principles.
Court of Appeal's decision
The Court of Appeal concluded that:
- It was wrong to follow the “assumption of responsibility” test. Instead, the court should have considered whether this was an “information” or an “advice” case.
- This was a “Category 1 information” case where GT’s advice did not guide MBS’ decision making process but contributed only a limited part of the material that MBS considered when it chose to purchase more swaps.
- As a result, GT was only responsible for the foreseeable financial consequences of its advice being wrong but MBS could not prove that the loss would not have been suffered if the information (ie that hedge accounting could be used) was correct.
- MBS’ decision to purchase and hold the swaps was a commercial decision and the losses suffered when it closed the swaps early resulted from market forces that GT did not owe duties to protect MBS against.
The Supreme Court's decision
Whilst the appeal was unanimously allowed and MBS was awarded its losses (less a credit for benefits received and a 50% deduction for contributory negligence), there was some divergence between the Judges as to the correct approach when applying SAAMCO.
The view of the majority was that:
- The “information” and “advice” labels are misleading “terms of art” that create confusion. Instead of “trying to shoe-horn a particular case into one or other of these categories” the labels should be dispensed with.
- The correct starting point when seeking to answer the scope of duty question (assuming the claim is actionable) is to focus on the “purpose of the duty, judged on an objective basis by reference to the reason why the advice is being given” (para 13). Identifying the scope of the duty of care by reference to its purpose is a reasonably determinate test, applicable in principle from the outset of the parties’ relationship. In claims for professional negligence therefore it is necessary to look to see what risk the duty was supposed to guard against and then whether the loss suffered represents the fruition of that risk (para 17).
- When analysing the scope of duty principle in the tort of negligence, the following questions arise:
- The actionability question: Is the harm (loss, injury and damage) which is the subject matter of the claim actionable in negligence?
- The scope of duty question: What are the risks of harm to the claimant against which the law imposes on the defendant a duty to take care?
- The breach question: Did the defendant breach his or her duty by his or her act or omission?
- The factual causation question: Is the loss for which the claimant seeks damages the consequence of the defendant’s act or omission?
- The duty nexus question: Is there a sufficient nexus between a particular element of the harm for which the claimant seeks damages and the subject matter of the defendant’s duty of care as analysed under “the scope of duty question”?
- The legal responsibility question: Is a particular element of the harm for which the claimant seeks damages recoverable because it is too remote, or because there is a different effective cause in relation to it or because the claimant has mitigated his or her loss or has failed to avoid loss which he or she could reasonably have been expected to avoid?
- Applying this test, the majority took the view that MBS’ loss fell within GT’s scope of duty. Whilst GT was not asked to provide commercial advice about MBS’ business model, GT was aware, when they advised in 2006 and thereafter (ie by signing an audit opinion which stated that MBS’ accounts – drawn up on the basis of the hedge accounting policy – gave a true and fair view of its financial position) why the advice was being sought and why this was fundamental to MBS’ decision to engage in the business of matching swaps and mortgages. The reason was the impact of hedge accounting on MBS’ regulatory capital position. The use of hedge accounting allowed MBS to make the decision (within the constraints of the regulatory framework within which it had to operate) that it had the capacity to proceed with its business model whereas otherwise it did not (ie if the balance sheet volatility required MBS to hold more regulatory capital).
If non-negligent advice had been given, MBS would not have purchased more swaps or issued lifetime mortgages at all. It would not therefore have suffered the losses it did. Examination of the purpose for which GT gave the advice shows that MBS’ losses fell within the scope of GT’s duty of care.
The Counterfactual Test has the potential to confuse rather than assist, which is what had happened in the earlier decisions. It should be used as a tool to cross-check the result but it should not be used in substitution for the test at 3, above. Applying the Counterfactual Test here, if GT’s advice had been correct and the swaps had provided effective hedging (ie. and MBS did not have to hold additional regulatory capital), the loss would have not occurred and was, therefore, recoverable.
Whilst agreeing with the outcome, the view of Lord Burrows was that scope of duty should be underpinned by the policy of achieving a fair and reasonable allocation of risk of loss. The other judges disagreed a policy-based analysis was necessary.
Whilst also agreeing with the outcome, Lord Leggatt placed his emphasis on the Counterfactual Test (rather than purpose of duty). Whilst he accepted there were cases where it would not be helpful or necessary, this was not one. The issue here had been the Court of Appeal’s use of incorrect assumptions, which was caused by the way MBS’ case had been argued.
In light of this decision, when there is a question of scope of duty, the focus of the parties should now be on identifying the risks the professional was supposed to guard against, objectively speaking.
So where does that leave the Counterfactual Test? It is worth bearing in mind that its origin, the SAAMCO decision, was a valuer’s negligence claim, where it was relatively easy to determine the situation if the advice (ie the valuation) had been correct.
Whilst the Counterfactual Test remains a cross-reference checking tool, it appears that it is seldom likely to be helpful in claims against accountants and auditors given (i) the advice provided is often complex and multi-faceted (ii) determining the appropriate assumptions, including which part of the advice it should be assumed was correct, is fraught with difficulties. As the Supreme Court commented:
“the more one moves from the comparatively straightforward type of situation in the valuer cases, as illustrated by SAAMCO, the greater scope there may be for abstruse and highly debatable arguments to be deployed about how the counterfactual world should be conceived”.
Given that an accountant’s role is often to review, comment and report on the economic activities and condition of a business it is now more important than ever for accountants to avoid “retainer creep” and record precisely what services they are (and are not) providing. Not only that but it will be essential for the accountant to consider and keep under review the ‘reason’ that the advice or service is being sought and its purpose. This might not always be immediately obvious and so it will be important to ask further questions and record in writing “why” the client is seeking the advice? This should lead to further questions about the purpose of the advice and what the client is seeking to protect against or avoid.
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