29 June 2021
In what is now the leading authority on the application of the decision in South Australia Asset Management Corpn v York Montague Ltd [1997] AC 191 (SAAMCO), the Supreme Court has allowed an appeal by a mutual building society in the context of its claim for damages for economic loss against an auditor for (admitted) negligent advice regarding the accounting treatment of interest rate swaps: Manchester Building Society v Grant Thornton UK LLP [2021] UKSC 20. In doing so, the Supreme Court found unanimously that the mutual building society had suffered loss which fell within the scope of the duty of care assumed by the auditor, but that its damages should be reduced by 50% on the basis of its contributory negligence.
The appeal was heard by an expanded constitution of the Supreme Court, in order to provide general guidance regarding the proper approach to determining the scope of duty and the extent of liability of professional advisers in the tort of negligence, including the proper application of the SAAMCO principle. As such, the outcome and reasoning of this decision will be significant for financial institutions faced with claims for economic loss due to alleged negligent advice.
The majority (Lords Hodge, Sales, Reed and Kitchin, and Lady Black) held that the scope of the duty of care assumed by a professional adviser is governed by the purpose of the duty, judged on an objective basis by reference to the purpose for which the advice is being given. In practice, this means that, when looking at the case of negligent advice given by a professional adviser, one looks to see what risk the duty was supposed to guard against and then looks to see whether the loss suffered represented the fruition of that risk. In the view of the majority, this was the point of the mountaineer’s knee example given by Lord Hoffman in SAAMCO.
The majority said the descriptions of “information” case and “advice” case should be dispensed with as terms of art in this area. Cases should not be shoe-horned into one or other of these categories, but rather the focus should be on identifying the purpose to be served by the duty of care assumed by the defendant. In consequence, using a counterfactual test (whereby one asks whether, if the advice or information given by the defendant had in fact been true, the action taken by the claimant would still have resulted in the same loss) should be regarded only as a tool to cross-check the result in most cases, and should not be regarded as replacing the decision which needs to be made as to the scope of duty of care. The majority rejected Lord Leggatt’s emphasis on causation and the counterfactual test, and Lord Burrows’s focus on public policy. However, there was unanimous agreement as to the outcome of the appeal.
In the present case, the majority found that the purpose of the advice given by the auditor was clear: to provide technical accounting advice as to whether the mutual building society could use hedge accounting in order to implement its proposed business model within the constraints of the regulatory environment. As a result of the auditor’s negligent advice, the building society adopted the business model, entered into further 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 building society was exposed to regulatory capital requirements which the use of hedge accounting was supposed to avoid. That was a risk which the auditor’s advice was supposed to allow the building society to assess, and which its negligence caused the building society to fail to understand. Accordingly, the losses suffered by the building society when breaking the swaps were within the scope of the duty owed by the auditor.
By focusing on the purpose to be served by the duty of care, the decision may mitigate some of the difficulties which have arisen in practice in categorising “advice” and “information” cases and in applying the correct counterfactual test on the facts of a given case. In future cases, the court is likely to place greater emphasis on understanding the purpose and commercial rationale for which a party has sought advice and identifying the potential risks from which the party was relying on an adviser to protect it. This may lead to an increased evidential burden on the parties, potentially increasing the time and costs of disclosure and witness evidence, where engagements are not documented properly and fully. Accordingly, the decision highlights the importance for financial institutions to ensure, at the outset of a transaction, that there is clear agreement as to how their advice and work will be used by clients, and the impact it could have if it transpires that their advice or work is flawed in some respect.
The decision is considered in more detail below.
Background
The case involved a claim brought by Manchester Building Society (MBS) against its auditor, Grant Thornton (GT), arising out of negligent advice given by GT regarding the accounting treatment of interest rate swaps relating to its lifetime mortgage portfolio.
GT had negligently advised MBS in 2006 that it would be able to make use of an accounting treatment known as “hedge accounting” which would allow it to reduce the volatility of the mark-to-market value of the swaps on MBS’s balance sheet. In reliance on that advice, MBS acquired and issued lifetime mortgages and entered into swap transactions in order to hedge its interest rate risk.
In 2013, MBS discovered that GT’s advice had been incorrect and it could not in fact make use of hedge accounting. This meant that MBS’s balance sheet was exposed to volatility as a result of changes in the value of the swaps and, in particular, to the full losses suffered on the swaps following the fall in interest rates in the aftermath of the 2008 financial crisis. Once MBS’s accounts were corrected, it no longer held sufficient regulatory capital and was required to close out the swaps. In doing so, MBS incurred a mark-to-market loss of £32.7m.
High Court decision
The High Court’s reasoning is considered in our previous blog post: High Court applies SAAMCO principle to find no assumption of responsibility for losses flowing from market forces.
The High Court concluded that MBS had established causation both in fact and in law in respect of the break costs i.e. (a) but for the negligent advice, MBS would not have bought the swaps; and (b) if GT’s advice had been correct, it would not have needed to break the swaps in 2013. However, GT escaped liability because the High Court found it had not assumed responsibility for MBS being “out of the money” on the swaps. Rather, the mark-to-market losses suffered by MBS for terminating the swaps flowed from market forces. The High Court held that only the sum of circa £300,000 was recoverable (reflecting the transaction costs of breaking the swaps and certain other costs).
MBS appealed the High Court’s decision.
Court of Appeal decision
The Court of Appeal’s reasoning is examined in our previous blog post: Court of Appeal decision in Manchester Building Society v Grant Thornton: clarification of “advice” vs “information” distinction when applying the SAAMCO principle.
The Court of Appeal upheld the decision of the High Court, but did so on different grounds. The Court of Appeal said that the High Court had erred in approaching the issue of liability by asking in general terms whether the auditor had assumed a responsibility for the mark-to-market losses. It said that the correct approach to be taken in cases involving the application of the SAAMCO principle was to consider at the outset whether it is an “advice” or an “information” case, and that in determining which category a case falls within, what matters is the “purpose and effect” of the advice given.
In applying that distinction, the Court of Appeal found that the present case was an “information” case, and so the auditor was responsible only for the foreseeable consequences of the accounting advice being wrong. This required MBS to prove the counterfactual, that the same loss would not have been suffered if the advice had been correct, i.e. if MBS had not exercised the break clause early and continued to hold the swaps. Here, MBS was unable to prove its loss on the counterfactual as the discovery of the negligent advice merely crystallised mark-to-market losses on swaps which would have been suffered anyway if the swaps had been held to term.
MBS appealed the Court of Appeal’s decision.
Supreme Court decision
The Supreme Court allowed unanimously the appeal, finding that MBS had suffered a loss which fell within the scope of the duty of care assumed by GT, but that damages should be reduced by 50% on the basis of its contributory negligence.
The reasons given for reaching this conclusion differed between the majority (Lord Hodge and Lord Sales, with whom Lord Reed, Lady Black and Lord Kitchin agreed) and the minority judgments of Lord Burrows and Lord Leggatt. The reasoning and key distinctions are discussed further below.
The scope of duty question: how it fits within the tort of negligence
As a preliminary consideration, the majority put the “scope of duty” principle in context within the tort of negligence, setting out a series of questions which will need to be considered in each case.
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Is the harm (loss, injury and damage) which is the subject matter of the claim actionable in negligence? (the actionability question)
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What are the risks of harm to the claimant against which the law imposes on the defendant a duty to take care? (the scope of duty question)
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Did the defendant breach his or her duty by his or her act or omission? (the breach question)
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Is the loss for which the claimant seeks damages the consequence of the defendant’s act or omission? (the factual causation question)
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Is there a sufficient nexus between a particular element of the harm for which the claimant seeks damages and the subject matter of the defendant’s duty of care as analysed at stage 2 above? (the duty nexus question)
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Is a particular element of the harm for which the claimant seeks damages irrecoverable because it is too remote, or because there is a different effective cause (including novus actus interveniens) in relation to it or because the claimant has mitigated his or her loss or has failed to avoid loss which he or she could reasonably have been expected to avoid? (the legal responsibility question)
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The central question in the appeal was stage (2), which addresses the discussion in SAAMCO regarding the scope of a defendant’s duty. The majority noted that, depending on the case, this question may be considered either at stage (2) or stage (5). In some cases, the scope of duty question will be relevant to the extent of the losses claimed, and whether they fall within the scope of the duty assumed by the defendant, e.g. in SAAMCO and Hughes-Holland. In such cases, it may be appropriate to identify losses on a simple “but for” basis first and then ask the duty nexus question at stage (5), as a practical approach to working out the implications of the scope of duty concept, which arises (in principle) earlier in the analysis at stage (2).
Lord Burrows departed from the majority view on where the scope of duty question sits within the tort of negligence. He did not consider it necessary or helpful to depart from a more conventional approach to the tort of negligence which begins with the duty of care, treats the SAAMCO principle as being concerned with whether factually caused loss is within the scope of the duty of care, and avoids the novel terminology of the “duty nexus”.
The scope of the duty of care in professional advice cases
The majority underlined that the scope of the duty of care assumed by a professional adviser is governed by the purpose of the duty, judged on an objective basis by reference to the purpose for which the advice is being given.
This was confirmed as the proper approach in SAAMCO itself and in the other leading authorities, including Caparo Industries plc v Dickman [1990] 2 AC 605, Aneco Reinsurance Underwriting Ltd (in liquidation) v Johnson & Higgins Ltd [2001] UKHL 51 and Hughes-Holland v BPE Solicitors [2017] UKSC 21).
In the view of the majority, when looking at the case of negligent advice given by a professional adviser, one looks to see what risk the duty was supposed to guard against and then looks to see whether the loss suffered represented the fruition of that risk. The majority said that this was the point of the mountaineer’s knee example given by Lord Hoffman in SAAMCO, where a doctor is consulted by a mountaineer concerned about his knee, and who negligently pronounces the knee fit. The mountaineer goes on an expedition and suffers an injury which is a foreseeable consequence of mountaineering but has nothing to do with his knee. Lord Hoffman said that the doctor will not be liable, even if the mountaineer would not have gone on the expedition if he had been told the truth, because the injury would have occurred even if the pronouncement as to the state of the knee had been correct. Rather than highlighting the distinction between a duty to provide “information” and a duty to “advise” (which distinction should be avoided following the decision in the present case, as discussed in the following section), the majority suggested that this example supports the purposive approach to determining the scope of the duty of care.
Lord Burrows agreed that the scope of duty principle focuses on the purpose of the advice or information provided by the defendant, but added that this is underpinned by the policy of achieving a fair and reasonable allocation of the risk of the loss that has occurred. The majority did not agree that the analysis should involve reference back to policy.
By contrast, Lord Leggatt held that the scope of duty principle was based upon causation and suggested that the correct approach was to assess whether the loss claimed was caused by the particular matters which made the defendant’s advice incorrect, and not by other matters unrelated to the subject matter of the defendant’s negligence. However, in the view of the majority, the principle can more readily be understood without placing emphasis on causation, which distracts attention from the primary task of identifying the scope of the defendant’s duty.
Distinction between “advice” cases and “information” cases
Lord Leggatt proposed to dispense with the descriptions “information” and “advice” as terms of art in this area.
This was welcomed by the majority, who said the distinction drawn by Lord Hoffmann in SAAMCO had not proved to be satisfactory, agreeing with Lord Sumption in Hughes-Holland that the distinction was too rigid and liable to mislead. They endorsed Lord Sumption’s view that the whole varied range of cases constitutes a spectrum, with pure “advice” cases at one end of the spectrum (where the adviser assumes responsibility for every aspect of a transaction for their client) and, at the other extreme, cases where the professional adviser contributes only a small part of the material on which the client relies in deciding how to act. They also agreed with Lord Sumption’s observation that both “advice” and “information” cases involve the giving of advice.
In the view of the majority, rather than starting with the distinction between “advice” and “information” cases and trying to shoe-horn a particular case into one or other of these categories, the focus should be on identifying the purpose to be served by the duty of care assumed by the defendant. In this context, they emphasised the importance of linking the focus of the analysis of the scope of duty question and the duty nexus question back to the purpose of the duty of care assumed in the case in hand.
Application of SAAMCO-style counterfactual analysis
The majority referred to the use of the counterfactual analysis set out by Lord Hoffman in SAAMCO. This was proposed as a way to assist in identifying the extent of the loss suffered by the claimant which falls within the scope of the defendant’s duty, by asking in an “information” case whether the claimant’s actions would have resulted in the same loss if the advice given by the defendant had been correct, i.e. if the facts or position had in fact been as represented by the defendant. This procedure generates a limit to the damages recoverable which has been called the SAAMCO “cap”.
However, the majority agreed with Lord Burrows that the counterfactual test should be regarded only as a tool to cross-check the result in most cases, and should not be regarded as replacing the decision which needs to be made as to the scope of duty of care. Lord Burrows described this as a policy decision, whereas the majority thought that it reflected more fundamental issues of principle.
In the view of the majority, linking the use of the counterfactual analysis to “information” cases in the “advice” and “information” framework is unhelpful, because of the problems associated with that framework. There was also a danger of manipulation, in argument, of the parameters of the counterfactual world; one therefore had to take care not to allow the counterfactual analysis to drive the outcome in a case. For example, in this case, Lord Burrows expressly noted, the first instance judge and Court of Appeal had not applied the “most helpful counterfactual test”. To continue the use of the counterfactual analysis would create a risk of litigation by way of contest between elaborately constructed worlds advanced by each side, which would become increasingly untethered from reality the further one moved from the relatively simple valuer case addressed in SAAMCO.
By contrast, examination of the purpose of the duty provides an appropriate and refined basis for identifying, out of what may be a wide range of factors which contribute to the claimant’s loss, the factors for which the defendant is responsible.
The scope of the duty of care in the present case
The majority held that MBS had suffered a loss which fell within the scope of the duty of care assumed by GT, having regard to the purpose for which it gave its advice about the use of hedge accounting.
The majority commented that the purpose of the advice given by GT was clear: to advise MBS whether it 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. As a result of GT’s negligent advice, MBS adopted the business model, entered into further 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 MBS was exposed to regulatory capital requirements which the use of hedge accounting was supposed to avoid. That was a risk which GT’s advice was supposed to allow MBS to assess, and which its negligence caused MBS to fail to understand.
The majority said that for the purposes of analysing whether the losses suffered by MBS fell within the scope of the duty of care assumed by GT, it was important to have regard to the commercial reason (as appreciated by GT) why advice was being sought about whether there was an “effective hedging relationship” between the swaps and mortgages being entered into and why this was fundamental to MBS’s decision to engage in the business of matching swaps and mortgages. That reason was the impact of hedge accounting on MBS’s regulatory capital position. Use of hedge accounting allowed MBS to make the assessment that, in terms of the constraints imposed on it by the regulatory capital requirements to which it was subject, it had the capacity to proceed with that business whereas otherwise it did not. Having regard to this purpose, GT in effect informed MBS in 2006 that hedge accounting could enable it to have sufficient capital resources to carry on the business of matching swaps and mortgages, when in reality it did not.
Reduction for contributory negligence
However, the Supreme Court held, unanimously, that MBS’s damages should be reduced by 50% on the basis of its contributory negligence.
In the Supreme Court’s view, MBS’s contribution to its own loss arose from the mismatching of the mortgages and swaps in what was an overly ambitious application of the business model by MBS’s management. The Supreme Court considered that the trial judge was entitled to make the assessment that MBS’s damages should be reduced by 50% on the basis of its contributory negligence.
Accordingly, the Supreme Court allowed MBS’s appeal. The overall net loss of (approximately) £26.7m was held to be recoverable, subject to a 50% reduction for contributory negligence by MBS.
For further information, please contact:
Simon Clarke, Partner, Herbert Smith Freehills
simon.clarke@hsf.com
