Accounting firm Grant Thornton has been ordered to pay around £315,000 to small mortgage lender Manchester Building Society for incorrect advice.
The building society had been claiming as much as £48.5m.
The order was made in a judgment handed down at the high court in London this week, following a five-week trial earlier this year.
The building society claims that inaccurate advice from its auditor, Grant Thornton, led to the lender unintentionally reporting a financial position very different from the truth.
When the mistake was uncovered and rectified, the building society became loss-making almost overnight.
Change in accounting standards
The lawsuit is another example of how the global financial crisis of 2008 turned investments that were considered benign into damaging balance-sheet liabilities.
In this case, the investments in question are so-called ‘lifetime mortgages’. These are mortgages that are designed to release the equity of a house to its owner on terms that the loan and interest were not repayable until the owner entered into a care home or died.
The building society acquired and issued these mortgages between 2004 and 2009, using hedges and swaps to mitigate risk.
According to the ruling, prior to 2005 the UK’s generally accepted accounting principles (GAAP) did not require swaps to be included on the building society’s balance sheet.
However, this changed in 2005 as the accounting standard changed to IFRS, which required derivatives to be put onto the balance sheet.
This can be mitigated by a process known as hedge accounting, which the building society adopted from 2006, with Grant Thornton as auditor.
“Hedge accounting is complex,” the judge, Mr Justice Teare, said in his ruling.
“Moreover, the hedge must be determined to have actually been effective in practice.”
Dramatic result
The problem occurred in 2013 when, after updated advice from Grant Thornton and a second opinion from PwC, the building society discovered that it could not, in fact, use hedge accounting.
The result was “dramatic”, the judge said.
Properly reported, Manchester Building Society’s position was wholly different from that which it had previously stated in its audited accounts.
A profit for 2011 of £6.35m became a loss of £11.44m, and its net assets were reduced from £38.4m to £9.7m.
It also simultaneously reduced the lender’s regulatory capital and increased its regulatory capital requirement due to the its exposure to increased volatility.
The lender was “forced” to close out the swaps.
It reduced its new lending and stopped lending in December 2013. Its book of UK lifetime mortgages was sold.
The lender sued Grant Thornton to recover losses abused by Grant Thornton’s advice.
The largest part of the £48.5m claimed is the £32.7m cost of closing the swaps, many of which had a 50-year duration.
“The claimants case it that the decision to close the swaps and the resulting loss were cause by the defendants negligence,” the ruling said.
“The lender also alerted negligent auditing between 2006 and 2011.”
Misleading advice
While Grant Thornton accepted it gave misleading advice, in a complicated, 60-page ruling, the judge said that Grant Thornton’s mistake didn’t leave it liable for the full losses.
Advising on the accounting treatment of business activities does not make the adviser liable for the activities themselves if the advice is flawed, the judge said.
In addition, the swaps were a consequence of the dramatic fall in interest rates following the credit crunch.
“It seems to me 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,” he said.
“I do not consider that the objective bystander, or indeed the parties themselves, viewing the matter in 2006 would have concluded that the defendant had assumed responsibility for the claimant ‘being out of the money’ on the swaps in the event of a sustained fall in interest rates.
“The loss flowed from market forces for which the defendant did not assume responsibility. Just as the defendant had not assumed responsibility for the losses which would have been incurred had a counterparty exercised its right to terminate a swap, so the defendant had not assumed responsibility for the very same losses which were incurred when the claimant decided to close the swaps out, notwithstanding that that decision was taken because the advice given by the defendant had been wrong.”
Even so, while Grant Thornton was not liable for the building society’s “over-hedging by purchasing 5–year swaps” – and both parties were at fault for using an impermissible accounting method – “the defendants blameworthiness was, overall, much grater than that of the claimant,” because Grant Thornton was a specialist, and the building society was seeking advice.
The judge ruled that Manchester Building Society was entitled to £315, 345 plus interest in damages from Grant Thornton.
Manchester Building Society v Grant Thornton UK LLP
QBD (Teare J) 2 May 2018
