The Supreme Court has held that the loss suffered by a lender due to its accountants' breach of duty was extinguished when the loan was repaid by the borrower. It unanimously allowed an appeal against the majority judgment of the Court of Appeal, which had held that the repayment did not need to be taken into account on the basis that it was collateral to the loss, as it was not made in the ordinary course of business: Lowick Rose LLP (in liquidation) v Swynson Ltd and another [2017] UKSC 32.

The repayment was funded by the lender’s indirect owner, who had acquired an interest in the borrower. The Court of Appeal and Supreme Court agreed that if the owner had provided funds directly to the lender, to make up the shortfall caused by the borrower's failure to repay the loan, this would have been a collateral payment that should be ignored in assessing damages. The majority of the Court of Appeal considered that to hold differently because the payment was made through the borrower would be a triumph of form over substance (see our blog post on the Court of Appeal decision here).

The Supreme Court disagreed, finding that the repayment could not be regarded as collateral, because it discharged the very liability whose existence represented the lender's loss. The fact that the funds came from the owner was not relevant. The court also rejected alternative arguments based on transferred loss and equitable subrogation.

The decision indicates that the Supreme Court will adopt a strict approach to applying the legal principles involved in the assessment of loss, even in circumstances where this may result in a windfall to the defendant. As a practical matter, where a claimant is considering taking any steps that could potentially affect its loss, the decision highlights the importance of considering the consequences of how any transaction is structured and the distinct legal identities of the parties involved.

Tamsin Baird, a senior associate in our dispute resolution team, considers the decision further below.

Background

The claimant lent money to a borrower (“EMSL”) in reliance on a due diligence report prepared by the defendant firm of accountants.

The claimant’s owner, Mr Hunt, later became the majority owner of EMSL. This meant that the debt between the claimant and EMSL became a debt between two connected entities, resulting in unfavourable tax treatment for the claimant. Because of this, and to avoid the claimant having an impaired debt on its books, Mr Hunt arranged for EMSL to repay the loans (the "Refinance"), using monies lent to EMSL by Mr Hunt. The loan provided by Mr Hunt to EMSL to fund the Refinance was not repaid.

The claimant brought proceedings against the defendant seeking damages for the full amount of the loans. The defendant admitted negligence but argued that the claimant’s damages must be reduced by the extent to which the loans had been repaid.

At first instance, the judge (Mrs Justice Rose) awarded damages for the full amount of the loans (subject to a contractual cap on liability) on the basis that the repayment effected by the Refinance was collateral to the loss caused by the defendant’s breach of duty. Mr Hunt was also a claimant in the action, but the judge found that the defendant did not owe a duty of care to Mr Hunt and this finding was not appealed.

The defendant appealed and a majority of the Court of Appeal upheld the first instance decision. It held that although the Refinance may have resulted from the defendant’s breach of duty, it did not arise in the ordinary course of business, largely because Mr Hunt would not have funded the Refinance for any other company. If Mr Hunt had given the funds directly to the claimant this would have amounted to an act of benevolence and to hold differently because the payment was made through EMSL would be a triumph of form over substance. It dismissed the defendant's submission that to look behind the source of the funds would be to pierce the corporate veil, finding instead that it was "merely to disregard technicalities".

A strong dissenting judgment was delivered by Lord Justice Davis, who argued that the form of the transactions could not be ignored or regarded as a mere technicality.

Decision

The Supreme Court unanimously allowed the defendant's appeal. In a rather scathing opening paragraph, Lord Sumption, delivering the lead judgment, referred to the fact that the distinct legal personalities of companies had been a fundamental feature of English commercial law for a century and a half but that this had "never stopped businessman from treating their companies as indistinguishable from themselves." He commented that Mr Hunt was not the first businessman to make this mistake and "doubtless he will not be the last."

Collateral loss

Lord Sumption held that the Refinance could not be regarded as collateral. The fact that Mr Hunt was the source of the funds for the Refinance was no more relevant than if the funds had been borrowed from a bank or obtained from some other unconnected third party. In view of the fact that the defendant did not owe any relevant duty to Mr Hunt, there was nothing special about the fact that Mr Hunt provided the funds.

Lord Sumption acknowledged that, had Mr Hunt lent money directly to the claimant to strengthen its financial position following EMSL's default, the payment would have been collateral. It would have had no effect on the damages recoverable from the defendant as the payment would not have discharged EMSL's debt. However, in circumstances where the Refinance discharged the very debt representing the claimant's loss, the Refinance could not be regarded as collateral. Mr Hunt's loan to EMSL was a distinct transaction between himself and EMSL which was made for valuable consideration and could not be regarded as an indirect repayment to the claimant, even though the payment ultimately reached it.

Both Lord Mance and Lord Neuberger (delivering concurring judgments) referred to the principle laid down by Lord Reid in Parry v Cleaver [1970] AC 1 that the question whether such a transaction should be ignored depends on its "intrinsic nature" rather than on the identity of the source of the payment. Lord Mance said there was "all the difference" between a benevolent act which benefits a claimant collaterally in an amount equivalent to a loss which it has incurred and satisfaction of the claimant's loss by repayment of the loan which represents that loss.

Similarly, Lord Neuberger commented that the Refinance was not a gift and that, had the Refinance been funded by someone other than Mr Hunt, the repayment of the loan by EMSL would plainly not have been collateral. Whilst the funds could have been made available to the claimant in a way that would not have resulted in the claimant's loss being avoided, that could not justify the conclusion that the actual transaction must be treated as if it had that effect. The fact that a transaction could have been differently arranged does not mean that it must have the same consequences (in law and in commercial reality) as if it had been differently arranged.

Alternative grounds

The court also considered two alternative grounds upon which the claimant submitted that the decision in the Court of Appeal should be upheld:

  1. The claimant was entitled to recover on the principle of transferred loss.
  2. The defendant had been unjustly enriched by Mr Hunt's provision of funds to effect the Refinance and Mr Hunt should be subrogated to the claimant's claims against the defendant to prevent the unjust enrichment.

The court rejected both of these grounds.

The court confirmed that the principle of transferred loss is a limited exception to the general rule that a claimant can recover only loss which it has itself suffered. The principle should only apply in circumstances where a transaction is intended to benefit a third party and there is a breach of duty or contract that causes the third party to suffer loss.

The court referred to both the "narrow" application of the principle (where the third party suffers loss as the intended transferee of property affected by the breach) and the "broader" application (where the contracting party has an interest in ensuring the third party receives the benefit it was intended to have). However, Lord Sumption emphasised that, whether in its broader or narrower form, it is an essential feature of the principle that the recognition of a right in the contracting party to recover the third party's loss should be necessary to give effect to the object of the transaction and to avoid a "legal black hole", in which the only party entitled to recover would be different from the only party that could be treated as suffering loss.

The court held that neither the broad nor the narrow version of the principle was of any assistance to the claimant. It was clear the claimant did not contract with the defendant for the benefit of Mr Hunt. Mr Hunt's loss was attributable to his funding the Refinance which had nothing to do with the defendant and did not arise out of its breach of duty.

The court also unanimously rejected Mr Hunt's argument that he should be entitled to rely on the principle of equitable subrogation to prevent the unjust enrichment of the defendant. The focus of all three judgments was on the question of whether any enrichment was unjust and, if so, whether subrogation was the appropriate way of addressing that.

Lord Sumption noted that the cases on the use of equitable subrogation to prevent or reverse unjust enrichment were all cases of defective transactions. In such cases the enrichment was unjust because the claimant paid money on the basis of an expectation which failed. The purpose of equitable subrogation was "to replicate some element of the transaction which was expected but failed".

Here, however, the Refinance was not a defective transaction, as Mr Hunt achieved the whole of the benefit which he was expecting to achieve (namely repayment to the claimant by EMSL and a right to recover his loan from EMSL). The fact that the Refinance had the indirect consequence of extinguishing the claimant's loss did not render the transaction defective.

Comment

It was evident that the majority in the Court of Appeal was motivated by a desire to achieve what it considered to be a "just" result in providing Mr Hunt with compensation for his loss in circumstances where it had been found that he was owed no duty of care. In doing so, it was prepared to overlook what it described as "mere technicalities" and (arguably) wrongly pierced the corporate veil.

The Supreme Court decision clarifies that considerations of "justice" are the basis upon which the law has arrived at the legal principles relating to avoided loss and not, as Lord Sumption put, "licence for discarding those principles, and deciding each case on what may be regarded as its broader commercial merits."

As a result, the Supreme Court was not prepared to disregard the distinct legal personalities of the claimant and Mr Hunt, nor was it prepared to ignore the nature of the transactions involved and, essentially, equate Mr Hunt's and the claimant's loss.

The decision suggests that the Supreme Court will adopt a strict approach to the application of the legal principles involved, regardless of whether this may result in a windfall to the defendant.

The decision reinforces the need for caution in taking steps which might have the unintended consequence of reducing the claimant's loss (while of course bearing in mind that a claimant's damages might equally be reduced where it fails to take appropriate steps to mitigate its loss).