Swap close-out costs - causation but no assumption of responsibility by auditors

Publications

21 June 2018

Related people

Russell Butland

Partner

London

Benjamin Scrace

Associate

London

Headlines in this article

Related news and insights

Blog Post: 04 April 2024

EU court’s judgment sheds new light on how the ECB should apply national administrative measures

Publications: 03 April 2024

Plan for the worst, hope for the best: PRA policy on solvent exit planning for non-systemic banks and building societies

Publications: 26 March 2024

Moving the Goalposts: Football Governance Bill introduces Independent Football Regulator to Parliament

Publications: 19 December 2023

UK FCA’s new package of sustainability disclosure requirements, labelling rules and anti-greenwashing rule

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 [2018] 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).

MBS had entered into the swaps to hedge risk arising out of lifetime mortgages offered in the UK and Spain. Hedge accounting benefitted MBS because it did not have to recognise the majority of the volatility of the fair value of the interest rate swaps in its profit and loss accounts. GT gave unqualified audit opinions on MBS accounts for the relevant years.

As a result of the historic falls in interest rates since 2008, recognising the full fair value of those swaps in MBS’s 2011 accounts resulted in a regulatory capital deficit of GBP17.9 million, and a reduction in profit of 180% and net assets of 75%. MBS decided (under regulatory pressure to address its capital deficit) to close out its remaining swaps, incurring GBP32.7 million of closeout costs.

A claim against the auditors

MBS claimed damages for negligent advice from GT, of which the close-out costs formed the largest element. Although GT accepted it had been negligent in advising MBS that the Policy was IFRS compliant, in giving the subsequent audit opinions it:

- 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

Teare J found that GT had known of MBS’s intention to hedge the lifetime mortgages with interest rate swaps when approving the Policy, and that but for GT’s negligence MBS would not have entered into swaps after April 2006 and would not have suffered the costs of breaking the swaps in 2013. The judge rejected GT’s argument that the effective cause of the losses was not its negligence, but MBS’s commercial decision to enter into the swaps and/or the collapse in interest rates since 2008. The negligent advice had been critical to MBS’s decision to enter into the swaps, and was thus an effective cause of MBS incurring the close-out costs when the true accounting position was understood.

But GT did not assume responsibility for closeout costs

Following the Supreme Court’s recent decision in Hughes-Holland v BPE Solicitors [2017] 2 WLR 1029, Teare J identified the key question for the court in determining whether a defendant assumed responsibility for a loss as: “whether the loss flowed from the particular feature of the defendant’s conduct which made it wrongful”. Questions of reliance and reasonable foreseeability were necessary but not sufficient to show that a defendant had assumed responsibility for a type of loss.

Teare J accepted that MBS had relied on GT’s advice in entering into the swaps, and that being forced to break the swaps was a reasonably foreseeable consequence of that advice being negligent. He also thought there was a cogent argument that the close-out costs did flow from the particular feature of the advice that was negligent, ie whether hedge accounting could be used to mitigate the risk of exposure of MBS’s balance sheet to the volatility of the fair value of interest rate swaps. However, viewing the case “in the round”, he concluded that GT did not assume responsibility, for two reasons:

- 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

Therefore MBS could not recover the GBP32.7 million of close-out costs.

Contributory negligence

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.

Comment

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.

Further information

This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication. If you wish to receive this publication, please contact Amy Edwards, amy.edwards@allenovery.com.