Grant Thornton gave Manchester Building Society incorrect advice about hedge accounting. When the error came to light, the society had to close interest rate swaps at a loss. The dispute was whether the purpose of the accountants’ advice made them responsible for that loss, even though market movements had affected its size.
Background
Manchester Building Society made lifetime mortgage loans, funded by variable-rate borrowing and hedged with long-term interest rate swaps. From 2005 its accounts had to comply with International Financial Reporting Standards, under which swaps were recognised at fair value. Interest-rate movements therefore made its reported results volatile and increased the regulatory capital it had to hold. Hedge accounting could reduce that volatility, but only if the hedge met strict conditions, including an expectation that it would be highly effective.
Law Teacher writing support
Writing a law essay?
We choose a writer who is an expert in your area of law and qualified to at least the academic level you select. Most of our writers hold a master’s degree or PhD, have teaching experience, or both.
Send us your question and, if you wish, any marking criteria. We’ll write an essay to your instructions.
In April 2006 Grant Thornton advised that hedge accounting was available and that redeemed mortgages could be replaced by others. The society relied on that advice in entering into further swaps and in preparing its accounts. Each year from 2006 to 2011 Grant Thornton gave an unqualified audit opinion that the accounts showed a true and fair view, repeating the hedge-accounting advice. After interest rates fell following the 2008 financial crisis, the swaps had a large negative value. In 2013 Grant Thornton accepted that hedge accounting had not been permitted. Restatement of the accounts revealed a regulatory capital deficit, and in June 2013 the society closed out the swaps at a cost of £32,682,610. It also made gains of about £5.96 million on its mortgage books.
The courts below
Grant Thornton admitted negligence. Teare J found that, without the advice, the society would not have kept the swap positions and would not have incurred the closing cost. He held the loss foreseeable and caused by the negligence, but outside the scope of the duty because it flowed from market movements for which the accountants had not assumed responsibility. He assessed contributory negligence at 50 per cent. The Court of Appeal dismissed the appeal, treating the case as one of “information” rather than “advice” and holding that the society had not proved it was worse off by closing the swaps in 2013 than by holding them to maturity.
Scope of duty
The appeal was heard with Khan v Meadows so that the court could give general guidance. Lord Hodge and Lord Sales, with whom Lord Reed, Lady Black and Lord Kitchin agreed, held that the scope of a professional adviser’s duty is governed by the purpose of the duty, judged objectively by the reason the advice is given. The distinction between “advice” and “information” cases should not be applied rigidly. A counterfactual test asking whether the same loss would have occurred had the information been correct is only a cross-check and must not replace the purpose analysis.
The trial judge had found that Grant Thornton understood the regulatory-capital importance of hedge accounting and that the society needed the advice before deciding whether to implement its business model. The purpose of the advice was to let the society assess whether it could carry on matching swaps and mortgages within the regulatory constraints. The negligent advice caused it to adopt that model and later to incur the cost of breaking the swaps when the true accounting position, and its effect on regulatory capital, became clear. That loss was the fruition of the risk the advice was meant to guard against and therefore fell within the duty. The judge’s contrary reasons could not be supported. The 50 per cent reduction for contributory negligence, arising from the society’s imprudent mismatching of swaps and mortgages, was upheld.
The concurring judgments
Lord Leggatt agreed with the result. He put the society’s basic loss, after credit for the mortgage gains, at about £26.7 million. An auditor’s responsibility is limited to the consequences of what made the advice wrong. Here the accounts had incorrectly represented that an effective hedging relationship existed. Had that been true, the negative value of the swaps would have been offset by the mortgages and the closing loss would not have arisen. He rejected a formulation that treated the loss simply as the cost of early termination: that loss had not been proved, and the duty did not make the accountants insurers of the society’s commercial strategy. Lord Burrows also allowed the appeal. He emphasised the purpose of the advice and the misstatement of the hedging relationship, treating the counterfactual test as a subordinate cross-check on a fair allocation of risk rather than as a test of causation.
Verdict: The Supreme Court unanimously allowed the society’s appeal. The net loss on the swaps fell within Grant Thornton’s duty. After a 50 per cent reduction for contributory negligence, the society could recover approximately £13.4 million in addition to the sum awarded at trial, with the precise figure to be agreed.
Source: Manchester Building Society v Grant Thornton UK LLP [2021] UKSC 20
