Swap close-out costs - causation but no assumption of responsibility by auditors
21 June 2018
A building society sued its auditors for the close-out costs of interest rate swaps entered into on reliance on advice that they could be accounted for as hedges. The High Court found negligence, which was the cause of the loss and that the close-out costs were reasonably foreseeable loss. However, applying the Supreme Court’s recent decision in Hughes-Holland v BPE Solicitors, the High Court found that there was no assumption of responsibility for losses of the type of the close-out costs, and so the auditors were not liable: Manchester Building Society v Grant Thornton UK LLP  EWHC 963 (Comm), 2 May 2018.
A faulty hedge accounting policy
In 2013, the Manchester Building Society (MBS) discovered that it could not apply hedge accounting to certain long-dated interest rate swaps under the International Financial Reporting Standards (IFRS). It had been doing so for five years (2006-2011), in accordance with its hedge accounting policy (the Policy), which had been incorrectly approved as being IFRS compliant by its auditors, Grant Thornton LLP (GT).
A claim against the auditors
- denied it knew of MBS’s intention to hedge the lifetime mortgages with interest rate swaps when approving the Policy
- argued that its negligence was not the effective cause of MBS’s losses
- argued that the losses were not within the scope of GT’s duty of care or in accordance with the principles of South Australia Asset Management Corp v York Montague Ltd
- alleged that MBS’s losses had been substantially caused by its own contributory negligence
Negligent advice caused loss
But GT did not assume responsibility for closeout costs
- it would be “a striking conclusion to reach 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”
- neither an objective bystander nor the parties themselves would have said that GT had assumed responsibility for MBS being out of the money on the swaps in the event of a sustained fall in interest rates. That loss ultimately stemmed from market forces for which GT did not assume responsibility. A critical element of Teare J’s reasoning was that the same losses would have been sustained by MBS if a counterparty closed the swaps, and GT could not be said to have assumed responsibility for the very same losses that would flow in that circumstance
Teare J allowed recovery of certain other heads of loss, but found MBS to have been contributory negligent on two counts: (i) in deciding to buy 50-year swaps, exceeding the likely duration of the lifetime mortgages; and (ii) deciding to enter into 50-year rather than shorter dated interest rate swaps on the basis that they were cheaper, assuming interest rates would remain constant. Teare J thus reduced the remaining heads of damages by 25%, awarding MBS 75% of GBP420,460.
This case serves as a reminder that an assumption of responsibility for the claimed damages is vital for a successful damages claim, even if negligence can be straightforwardly established.
It is also a sharp illustration of how the law on the recoverability of damages in tort can simultaneously point to one conclusion and contain enough flexibility to allow a judge to reach the exact opposite conclusion. Teare J’s summary of the relevant legal principles led him to the conclusion that they could be cogently applied to award the close-out costs to MBS, but viewing the case “in the round” he came to the opposite conclusion.
It also shows that an argument that fails on one element of the tests for causation and remoteness may succeed on another. In relation to the effective cause, GT submitted that a distinction should be drawn between the accounting treatment of an interest rate swap and its economic consequences, arguing that it was the latter (ie the effect of a fall in interest rates on the swap economics) that was the effective cause of the close-out costs. Teare J rejected that argument at that stage, but essentially accepted it at the assumption of responsibility stage, finding that GT did not assume responsibility for the economic risks of the swaps.
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