Auditor does not assume responsibility for the financial consequences of its client’s business activities

02/05/18

In Manchester Building Society v Grant Thornton UK LLP, Teare J considered the application of the principles of causation, scope of duty and remoteness to losses allegedly arising from the negligence of its auditor. The auditor’s breach of duty was admitted from the outset of the case, which was therefore focussed on the question of the recoverability of the claimed losses, totalling £48.5 million. In the event, the claim was dismissed save only for some £315,000.

Between 2004 and 2009, the Society had acquired lifetime mortgages (also known as ‘equity release’), the terms of which did not require repayment of capital or interest until the borrower died or entered residential care. Interest accrued on the lifetime mortgages at a fixed rate. The Society entered into long term interest rate swaps ostensibly to hedge the risk that fixed rate interest accruing on the lifetime mortgages would be less than the floating rates that it predominantly paid for funding. However, many of the swaps were taken out for periods far longer (many were for 50 years) than the mortgages were expected to last (some 15 to 20 years).

From 2005, accounting standards required the Society to include the swaps at their fair value on its balance sheet. On the other hand, the mortgages were carried at historic cost. Changes in the fair value of the swaps could therefore lead to volatility in the Society’s results and regulatory capital. This volatility was mitigated by the the Society applying an accounting treatment known as ‘hedge accounting’, which permitted changes to the fair value of the lifetime mortgages owing to interest rate movements to be included in the balance sheet to set against the opposite changes in the fair value of the swaps.  

The Society failed to comply with the rules that permitted hedge accounting to be applied. Grant Thornton as its auditor failed to identify this error for several years, until early 2013. When it did so, hedge accounting had to be reversed. Since the swaps were heavily out of the money, the Society’s regulatory capital was reduced below the required level. Among other things, the Society broke the long term swaps at a cost of some £32.7 million which mostly represented the negative mark to market value of the swaps at that date. The Society also sold some of its lifetime mortgages and undertook various other restructuring measures.

The Society claimed from Grant Thornton the £32.7 million cost of breaking the swaps and various other alleged losses, totalling £48.5 million.

Teare J held that although the swap break costs were caused both in fact and in law by the auditor’s negligence and satisfied the remoteness test, such losses fell outside the scope of the auditor’s duty. In reaching that conclusion, Teare J held that it would be a “striking conclusion…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.”

Teare J also dismissed most of the other claims for loss and ultimately held that the recoverable sum was £315,345. This reflected the transaction costs of breaking the swaps and certain restructuring and advisory costs and a 25% reduction for contributory fault.

The judgment can be found here.