Scope of duty narrows for accountants
Accountants not liable for transaction losses despite negligent accounting treatment
The recent decision in Manchester Building Society v Grant Thornton UK LLP is likely to provide some considerable comfort for accountants and their insurers.
Following a five week trial (and input from 9 expert witnesses) the Court decided that despite an accountant's negligent use of a specific accounting treatment that caused a foreseeable loss of over £48 million to their client, the accountant was only liable for £315,000.
The case is of importance because of its application of the Supreme Court's decision in Hughes-Holland v BPE Solicitors [2017] 2 WLR 1029 to a claim against an accountant/auditor. The decision clarifies the limited scope of an accountants' duty of care when preparing/auditing accounts; the judge going so far as to say that it would be surprising if an accountant advising on the accounting treatment of a client's business activities should be liable for all the financial consequences of those activities, even if the client can prove certain loss making activities would not have occurred but for the accountant's advice.
Following this case, it will be harder for claimants to assert that all of the losses they suffer in relation to a transaction can be recovered from their accountant where the accountant only advises on accounting treatment, tax implications or other discrete issues. As occurred in this case, this principle will apply even if the claimant would as a matter of fact not have entered into the transaction had the accountant provided correct advice.
In this legal alert we consider the points raised by the court and some of the practical implications that can be taken from the case.
Summary of Case Background
The claimant building society arranged life-time mortgages, which were equity release products under which no repayment was due until after the death of the mortgagor. They were therefore of indeterminate terms but were expected to last for 15 to 20 years. The mortgages were provided at fixed interest rates and the interest was rolled up into the mortgage debt. This posed a risk to the building society as the interest fixed on the mortgage could be lower than the rate the building society had to pay on the funds it borrowed to finance its business. Accordingly, the building society wanted to hedge against that risk and bought interest rate swaps, some of which had terms in excess of the anticipated terms of the mortgages; in fact some were for 50 years in duration.
The building society had to record the swaps it bought on its balance sheet at their fair value. Since the value of the swaps would fluctuate in accordance with changes in interest rates, the value of the swaps in the accounts would go up and down each year. On the other hand, the accounting treatment for the mortgage instruments hedged by the swaps had to be amortised - or recorded at their historic cost.
A critical point, therefore, was that the swap value fluctuated while the mortgage values didn’t. As a result, the profits of the building society, and hence its capital, would fluctuate. As a regulated entity, the building society had to comply with minimum capital adequacy requirements and in these circumstances that became problematic. Accordingly, the building society wanted to use 'hedge accounting’ that would allow for the fair value of the mortgages to be recorded in the accounts in the same way as the swaps were valued. This meant that, in broad terms, as the value of the mortgages went up, the value of the swaps would go down and there would be less volatility in the capital of the building society.
The defendant was the accountant and auditor of the building society. The advice of the defendant was that the building society could use hedge accounting and it was duly used from 2006 until 2013. This advice, however, was wrong: the building society was not entitled to use hedge accounting and this was discovered in 2013. In the meantime, the financial crisis of 2008 had unfolded, interest rates had plummeted and the swaps became a significant liability on the building society's accounts. Not being able to record the fair value of the mortgages against the (now significant) liability of the swaps had a very detrimental effect on the building society’s capital as shown in the accounts.
Having discovered the error and realising that the capital was becoming a problem in light of the regulatory requirements, the building society felt it had to close out the swaps to avoid future losses and generate capital. It did so and sold some books of its mortgage business too. Its ensuing alleged losses amounted to £48 million. The building society therefore made a claim against the accountant arguing that it would not have entered into the swaps and suffered these losses if the accountant had correctly advised it that it could not use hedge accounting in 2006 and thereafter.
The Court's Findings
The accountant admitted that it had made an error in its advice on the accounting treatment of the mortgages. The question for the court was therefore whether the losses suffered by the building society were recoverable from the accountant. To determine this, the court examined four main issues.
- Factual cause of the loss
The first question was whether the loss suffered by the building society was caused by the accountant’s negligence as a matter of fact. This is often called the `but for’ test. That is, but for the negligence, would the loss have been suffered? The court concluded that the accountant's negligence was the cause of the loss: if the accountant had advised the building society it could not use hedge accounting, it was more likely than not that the building society would not have taken out the swaps; and if the building society had not entered into the swaps it would not have closed them out and suffered the losses being claimed.
- Legal cause of the loss
A second question was whether the negligence was a cause of the loss as a matter of law. Here the accountant argued (based on the decision in Galoo v Bright Grahame Murray [1994] 1 WLR 1360) that the negligence only provided the opportunity for the building society’s losses and that the real or effective cause of the losses was the financial crisis and the drop in interest rates. The court did not agree and found that the accountant’s negligence was the effective cause, in law, of the losses.
- Remoteness of the loss
The third issue was whether the losses were too remote to be recoverable. The court concluded that, if the accountant could be found to have assumed responsibility for the type of loss being claimed, it could not be said that the losses incurred were too remote – by definition, they would be foreseeable losses and so would be recoverable.
- Scope of the accountant's duty
The fourth, and most crucial, issue that the court examined was whether the losses claimed by the building society fell within the scope of the accountant’s duty of care.
In this context, the judge considered the Supreme Court's decision in Hughes-Holland v BPE Solicitors [2017]. In BPE the Supreme Court drew a distinction between those cases where a professional gives advice on the full range of risks and issues involved in the client entering into a certain transaction and those cases where the professional provides information or advice on only limited aspects of the transaction. The Supreme Court held that where a professional gives advice on all the risks involved, it is likely to be liable for all foreseeable losses the client suffers having entered the transaction. However, where a professional gives information or advice on a limited aspect of the transaction (even if that is found to be a crucial aspect from the client's perspective), the professional will not necessarily be liable for all of the client's losses, even if they were foreseeable. Instead, the professional will only be liable to the extent that losses fell within the scope of the more limited duty assumed.
In this case, the judge concluded that the accountant only provided one piece of the information on which the building society based its more general commercial decision as to whether to enter the swaps (i.e. the accounting treatment of the swaps, not whether they should be entered into at all or what overall risks might be involved). Therefore the accountant was only concerned with the manner in which the swaps and the mortgages were presented in the accounts and not with protecting the building society from losses which would flow from its purchase of the swaps in the face of a sustained fall in interest rates. As such, the judge concluded that the accountant did not assume responsibility for the building society’s losses on the closing out of the swaps, which therefore fell outside of the accountant's duty of care and were not recoverable.
The judge’s reasoning behind his decision on this issue was complex, but he specifically noted:
"Ultimately, as with so many questions with which courts must wrestle, it is necessary, having examined the evidence and the opposing arguments, to stand back and view the matter in the round. Having done so it seems to me 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."
Accordingly, the judge found that the vast majority of the claimed losses did not fall within the scope of the accountant's duty of care; only £420,000 of losses did fall within the scope of the accountant's duty of care and so were potentially recoverable.
Contributory Negligence
The decision is also of interest as the court additionally concluded that the building society had been contributorily negligent and so could not, in any event, recover in full from the accountant.
The judge decided that the building society's decision to buy 50 year swaps, when the expected lifetime of the mortgages was only 15-20 years, was an unnecessary and imprudent risk to take. He then considered the relative blameworthiness and the causative potency of each party's negligence. He decided that the fault of the accountant was more blameworthy but that the building society's acquisition of the 50 year swaps had more causative potency, at least in respect of the losses incurred on closing the swaps. As a result, the judge held that if he had awarded the building society all of its claimed losses, including the losses on closing the swaps, it would have been 50% contributorily negligent. However, because the losses on closing the swaps were not recoverable, the building society should only bear 25% of the damages for which the accountant was liable - so the building society was eventually only awarded £315,000 plus interest.
Statutory relief
One last point to note is that the accountant argued that it was entitled to rely on s.727 of the Companies Act 1985 and on s.1157 of the Companies Act 2006 and sought relief from the court from liability. These provisions set out that in relation to any claim of negligence against an auditor (amongst others) and where the auditor may be liable for negligence but acted honestly and reasonably, the court has a broad discretion to release the auditor in whole or in part from liability. It was accepted that the accountant acted honestly but the court concluded that it had not acted reasonably. Although the judge acknowledged that in theory a professional could act negligently but still reasonably, the accountant's negligence in this case was not minor in character but was "pervasive and compelling", therefore the judge did not have the discretion to allow relief.
Practical Implications
On paper the claim against the accountant had the makings of a good case. The accountant's advice on accounting treatment was negligent. Had correct advice on accounting treatment been given, the loss making transactions would never have been entered into. As a result, the judge found that the accountant's negligence had caused (in fact and in law) the building society's foreseeable losses. However, the losses were not recoverable as the accountant had not assumed responsibility for the financial consequences of the building society's business activities. A case of being so close and yet so far.
The court's ruling is likely to provide further armoury in the defence of claims against accountants as it indicates that, in order to recover all losses incurred on a transaction entered into in reliance on an accountant's advice, claimants will need to demonstrate that the accountant specifically assumed responsibility for all the financial consequences of that transaction. This is likely to be a high hurdle to overcome in most cases given that, generally speaking, accountants will not advise on all aspects of a commercial transaction but only discrete elements, such as accounting treatment or tax implications.
The decision may also prompt claimants to take a sobering look at their own responsibility for transactional losses when seeking to bring a claim against an accountant or other professional. In this case the judge said that had he been minded to award the claimant all of their losses he would have reduced the damages by 50% due to the claimant's contributory negligence in any event.