Manchester Building Society v Grant Thornton UK LLP
| Jurisdiction | England & Wales |
| Judge | Lord Justice Hamblen,Lord Justice Males,Dame Elizabeth Gloster |
| Judgment Date | 30 January 2019 |
| Neutral Citation | [2019] EWCA Civ 40 |
| Docket Number | Case No: A4/2018/1354 |
| Court | Court of Appeal (Civil Division) |
| Date | 30 January 2019 |
[2019] EWCA Civ 40
Lord Justice Hamblen
Lord Justice Males
and
Dame Elizabeth Gloster
Case No: A4/2018/1354
IN THE COURT OF APPEAL (CIVIL DIVISION)
ON APPEAL FROM BUSINESS AND PROPERTY COURTS
OF ENGLAND AND WALES
QUEEN'S BENCH DIVISION
COMMERCIAL COURT
Mr. Justice Teare
Royal Courts of Justice
Strand, London, WC2A 2LL
Justin Fenwick QC, Rebecca Sabben-Clare QC and Harry Wright (instructed by Squire Patton Boggs (UK) LLP) for the Appellant
Simon Salzedo QC, Adam Rushworth and Sophie Shaw (instructed by Taylor Wessing LLP) for the Respondent
Hearing dates: 15/16 January 2019
Approved Judgment
Introduction
This appeal concerns the liability of an auditor for losses incurred on long term interest rate swap agreements which were entered into in reliance upon negligent accounting advice and which were closed out at a loss when the negligent advice came to light.
In summary, an auditor negligently advises its client that it can apply an accounting treatment (hedge accounting) that will reduce the effect in its accounts of the volatility of the mark-to-market (“MTM”) value of swaps.
In reliance on that advice the client enters into a programme of fixed rate mortgages hedged against long term swaps under which the client pays a fixed rate and receives a variable rate.
As a result of the financial crisis and the consequent fall in interest rates the swaps go heavily “out of the money”. In other words, their MTM value becomes negative because the market's expectation is that the client will suffer losses over the lifetime of the swaps because of the net payments it is expected to have to make under those contracts.
The auditor's negligent error comes to light and the client is advised that it cannot continue to apply hedge accounting. The client then closes out the swaps and, in order to do so, it has to pay the MTM losses on the swaps (the “MTM losses”) and transaction fees for breaking the swaps early.
The essential issue raised in this appeal is whether the auditor is liable for the MTM losses as well as the transaction fees.
The trial judge, Teare J, held that the auditor, Grant Thornton (“GT”) was not so liable as it had not assumed responsibility for those losses, which were market losses due to the fall in interest rates.
The client, Manchester Building Society (“MBS”), appeals against that decision.
MBS contends that GT is responsible for the MTM losses because these losses flowed from the need to close out the swaps following the correction of the negligent advice as to the technical accounting treatment. In particular, in reliance on the SAAMCO line of authority recently reviewed by the Supreme Court in Hughes-Holland v BPE Solicitors [2017] UKSC 21 [2107] 2 WLR 1029, it contends that this is an “advice” case with the consequence that GT is liable for all the foreseeable consequences of MBS entering into the swap transactions in reliance on GT's negligent advice. Alternatively, if this is an “information” case then GT is liable because, as the judge found, the MTM losses would not have been incurred if GT's advice that hedge accounting could be applied had been correct.
The factual background
The factual background is set out in detail at [3]–[120] of the judgment. That factual summary is not challenged. It is not necessary to repeat it in this judgment and only the most salient facts relevant to the appeal will be referred to, with references being given to applicable paragraphs in the judgment.
MBS is a small mutual building society [3]. GT is a well known firm of accountants which audited MBS's accounts from 1997–2012 [20].
Between 2004 and 2009 MBS issued a number of fixed interest lifetime mortgages. These were designed to release the equity in a house to its owner on terms that the loan and interest were not repayable until the owner either entered a care home or died. Until that time, which is necessarily uncertain, interest compounded. These lifetime mortgages were issued to UK owners (“UK lifetime mortgages”) and also to owners of homes in Spain (“Spanish lifetime mortgages”) [3] and [7].
MBS needed to hedge its interest rate risk (the risk that the variable rate of interest which it paid to acquire funds would exceed the fixed rate which it received from borrowers) and it did so by purchasing interest rate swaps [4].
Between February 2006 and February 2012 MBS entered into 14 interest rate swaps to hedge the UK lifetime mortgages. They had a notional value of £74.2m. Most had a period of 50 years [9] and [72–77].
Between July 2008 and January 2011 MBS entered into 14 interest rate swaps to hedge the Spanish lifetime mortgages. They had a total value of €57m [10], [94].
Before 2005 the UK Generally Accepted Accounting Principles (“UK GAAP”) did not require swaps to be included on a balance sheet [11]. From 2005 onwards MBS was required to prepare its accounts in accordance with the International Financial Reporting Standards (“IFRS”) [12]. This meant that swaps had to be brought on to its balance sheet, valued at fair value [13]. The fair value of a swap is its MTM value at that date, which is the market's assessment at that date of the future payments that will be made over the entire term of the swap between the counterparties, discounted to a net present value.
Accounting for the swaps at fair value meant that MBS's financial position, as stated in its accounts, would be at the mercy of movement in the fair value of the swaps, which would cause volatility in MBS's reported financial position [13].
Hedge accounting provided a potential solution to this problem of volatility. Where hedge accounting is permitted, adjustments can be made to the carrying value of the hedged item (here, the lifetime mortgages) which partially offset the changes in the fair value of the swap, thus reducing accounting volatility [13–15].
In April 2006, GT advised MBS that it could apply the hedge accounting rules under International Accounting Standard 39 (“IAS 39”) to the interest rate risk under the lifetime mortgages and corresponding swaps [61]. As a result of GT's advice, MBS applied hedge accounting when preparing its financial statements for the years ending 31 December 2006 to 2011.
GT audited MBS's financial statements for these years and in each case signed an unqualified audit opinion. This confirmed GT's view that the financial statements gave a true and fair view of MBS's financial position. Each audit repeated GT's advice that MBS was able to apply hedge accounting [95].
GT admitted in its Defence that its advice and audits were negligent. There were various reasons why MBS was not entitled to apply hedge accounting, including that the long duration of the swaps did not match the lesser duration of the mortgages and the proposed substitution of mortgages was impermissible [22–26]. In summary, GT was negligent in failing to advise MBS in April 2006 and on the occasion of each audit thereafter that it could not apply hedge accounting [27].
From April 2006, MBS relied on GT's advice on the applicability of hedge accounting when entering into further lifetime mortgages and the swaps. In particular, had GT advised that hedge accounting could not be applied, MBS would not have taken out any more long-term swaps from April 2006 and would have broken the swaps it held at that point [127].
In March 2013 GT informed MBS that hedge accounting may not be applicable. This was confirmed by PwC. The consequent changes to the accounting position meant that MBS did not have sufficient regulatory capital [115]. Accounting for the fair value of the swaps meant that MBS's profit for 2011 of £6.35 million became a loss of £11.44 million, and its net assets were reduced from £38.4 million to £9.7 million.
The fair value of the swaps was heavily “out of the money” at this point because the variable rate of interest had dropped since the financial crisis, leading the market to forecast that the variable rates would be less on average than the fixed rates payable by MBS over the unexpired period of the swap, so that MBS would be the net payer. By the third quarter of 2012 MBS had already had to provide £32.29 million in cash collateral to the swap counterparties as a result of the swaps being “out of the money” [111].
Because of the volatility to which MBS's balance sheet was now exposed, the decision was taken, with the encouragement of the regulator, to close out the swaps [119], [143]. They were broken at their fair value on 6 and 7 June 2013 of £32.7 million [119]. Transaction costs of £285,460 were also incurred [211].
MBS incurred various other losses, such as costs of advice and redundancy [120], [223–225]. Some of these were the subject of claims, but only the MTM losses are in issue on this appeal. MBS contends that its losses go well beyond anything ever claimed in the action. The re-stated financial position was so bad that the regulator would not permit MBS to continue new lending.
The judge's decision
The judge made a number of findings relevant to the issues on appeal.
The judge found that cause in fact or “but for” causation was established [124–128]. He accepted MBS's case that but for GT's negligence MBS would not have entered into further long-term swaps after 11 April 2006 and would have closed out those it had entered into before then.
The judge further found that cause in law had been established and that GT's negligence was an effective cause of the loss [140–149]. In particular, the judge found at [146] that:
“146. To say that the Defendant's negligence merely provided the opportunity for the Claimant to suffer loss caused by the financial crisis of 2008 and the...
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