Dispute Resolution Update – Measuring Loss in Negligent Advice Cases
Claim against Accountants for negligent advice.
On 18 June 2021, the Supreme Court gave its judgment in the case of Manchester Building Society v Grant Thornton UK LLP. The significance of the judgment is that it provides clarification of the scope of a professional adviser’s duty of care in cases involving allegations that the advice was negligently provided.
The case concerned advice given to a small building society by its accountants from about 2006 onwards that its annual accounts could be prepared according to a method known as “hedge accounting”. Relying on that advice, the society entered into long term interest rate swaps to hedge against the cost of borrowing money, at variable rates, to fund its lifetime mortgages business. As a lending institution, the society was subject to regulation – at the time the regulatory authority was the FSA. One aspect of the regulatory regime was that the society was required to maintain a substantial level of capital to ensure its continuing viability should it come under stress. The more the society’s financial activities were subject to volatility, the higher the level of regulatory capital it was required to have in place as a safeguard. Application of the hedge accounting convention in the society’s accounts had the effect that swaps were matched with the society’s mortgage book, thereby greatly reducing the appearance of volatility in the society’s profits and greatly reducing the level of capital which it would be required to maintain to meet regulatory requirements.
Unfortunately the disruption of financial markets in the financial crash of 2008 resulted in a sharp fall in interest rates and this led to a severe mismatch between the negative value of the swaps and the value of the mortgages which the swaps were supposed to hedge. In 2013, the accountants realised their error and the result was that the society had to restate its accounts, showing substantially reduced asset values. This meant that it now had insufficient capital under the regulatory regime applying at the time. To resolve this, the society closed out the interest rate swap contracts early, at a cost of over £32m.
The scope of duty principle is that a defendant is only liable for losses falling within the scope of his/her/its duty of care to the claimant. The scope of duty assumed by a professional adviser is governed by the purpose of the duty, judged objectively in relation to the reason why the advice was given. What risk was the duty supposed to guard against? Was the loss suffered the result of that risk?
The lower court had determined that the accountants understood the regulatory capital issue and the importance for the society of being able to use hedge accounting as a key tool in avoiding the profit volatility caused by recognising hedging instruments at fair value. In the circumstances in which the accountants gave their advice, the purpose of the advice was clear. They advised that the society could employ hedge accounting in order to reduce the volatility on its balance sheet and keep its regulatory capital at a level it could afford in relation to swaps to be held to term on the basis that they were to be matched against mortgages. In other words, the society looked to the accountants 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 the accountants advised that it could. That advice was negligent. It had the effect that the society adopted the business model, entered into 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 the accountants advice was supposed to allow the society to assess, and which their negligence caused the society to fail to understand. The loss suffered by the society therefore fell within the scope of the duty of care assumed by the accountants in light of the purpose of their advice. The blow for the accountants was softened to a degree by a finding that on the precise facts of the case, a reduction in the damages award should be made to reflect certain contributory negligence on the part of the society itself.
The decision represents a helpful clarification of the relevant legal principles, in particular for professional advisers and their indemnity insurers.
Disclaimer: this article is not to be relied upon as legal advice. The circumstances of each case differ and legal advice specific to the individual case should always be sought.