IN THE COURT OF APPEAL

IN THE COURT OF APPEAL

Appeal No A3/2003/0372

ON APPEAL FROM

THE HIGH COURT OF JUSTICE

QUEEN’S BENCH DIVISION

COMMERCIAL COURT

BETWEEN

EQUITABLE LIFE ASSURANCE SOCIETY

Claimant

· and -

ERNST & YOUNG

Defendant

__________________________________

SUBMISSIONS OF ERNST & YOUNG

__________________________________

[References are given to the bundle/tab/page number. References to the judgment of Langley J are given by citing the relevant paragraph number in square brackets.]

A. INTRODUCTION.

The appeal.

1. The application made by Ernst & Young (“E&Y”) before Langley J was for an order striking out the sections B, C, D, E, F and G of the Amended Particulars of Claim [1/8] served by Equitable Life Assurance Society (“the Society”) on 15 August 2002, alternatively for an order granting summary judgment against the Society on the claims made in those sections. The application to strike out was made under CPR rule 3.4; the application for summary judgment was made under CPR rule 24.2.

2. In response to this application, the Society served draft Re-Amended Particulars of Claim (“RAPC”) [1/5] which purport to remedy certain defects in the pleading. The parties agreed that it was sensible for the application to be determined by reference to the RAPC. E&Y therefore consented to the re-amendments, but without prejudice to the application to strike out.

3. In the event, Langley J struck out the lost sale claims and the lost chance claims, and he laid down three parameters for any bonus declaration claim. The Society has attempted to re-plead its bonus claim at a reduced maximum value of £500 million. For reasons which need not concern this Court, E&Y oppose permission to re-amend, and this matter will be determined by Langley J on 4 April.

4. E&Y’s position on this appeal is, essentially, that Langley J was correct for the reasons he gave. His judgment is outstanding for its clarity of reasoning and its commercial good sense.

5. E&Y submit that the judgment on the lost sale claims should be upheld for the additional reason that the Society has no real prospect of establishing that its Directors would have resolved to sell the Society (whatever that may mean in the context of a mutual) before a final adverse ruling in the Hyman litigation. On this point, the Judge saw “considerable force” in E&Y’s submissions (judgment at [109]), and clearly felt that the case was borderline, but did not regard it as a sufficient basis of itself for striking out the lost sale claims.

6. E&Y further submit that the bonus declaration claim should be struck out in its entirety for two independent reasons. First, the Society has suffered no loss, because the payment of bonuses is not a loss at all and/or because the Society has in fact mitigated any loss. Second, the Society has no real prospect of establishing that E&Y’s insistence on a higher technical provision or disclosure of a contingent liability would have caused the Directors to declare lower reversionary bonuses or award lower rates of terminal bonus than they in fact did.

Dramatis personae, Chronology, Glossary and Reading List.

7. A glossary of relevant insurance, accounting terms and actuarial terms is appended as Annex A. An annotated reading list is appended as Annex B. A dramatis personae and a short form chronology are appended to this skeleton argument as Annexes C and D.

The Society’s changing case.

8. E&Y have faced a constantly changing case.

9. The first version is contained in the RAPC. This is an opaque and almost incomprehensible pleading. It ignores the fundamental distinction between reversionary and terminal bonuses. It treats the complaint about technical provisions and the complaint about non-disclosure of a contingent liability as alternatives (hence the Judge’s emphasis of the word “or” at [53] and [57]). It pleads no facts in support of the extraordinary decisions which it is alleged that the Directors would have made. It claims astronomic sums by way of damages without any proper explanation of how they have been arrived at. The Society has effectively admitted these deficiencies in its pleaded case because it has had to rely on its witness statements to explain the basis of the claim.

10. The second version of the claim was advanced at the hearing below. It differed materially from the pleaded claim in that: (a) virtually no reference was made in the Society’s written or oral submissions to the complaint about non-disclosure (see [34]); and (b) during argument (but not in its written submissions), the Society advanced for the first time the theory that there were “two black holes” in the Society’s finances. The Judge could not understand this theory (see [68]), and nor can E&Y.

11. The third version of the case is advanced in the Society’s Skeleton Argument for the appeal. This differs from the case advanced before Langley J because the Society now seeks to equate its complaint about non-disclosure with one of the two supposed black holes. This complaint has now assumed a new prominence.

12. There is a grave confusion at the core of the Society’s case. The Judge did not fail to understand what was being suggested. Rightly, he understood that the argument being put forward was misconceived. E&Y deal with the “two black holes” point in more detail below, but put the following points at the forefront of their argument:

(1) There were three GAR related costs that arose as a result of the House of Lords’ decision in Hyman announced on 20 July 2000:

(a) The cost of compensating GAR policyholders whose policies had matured before 20 July 2000 for having been presented with a choice between (i) exercising their GAO rights and receiving a reduced or no terminal bonus (“TB”) and (ii) not exercising their GAO and receiving a full TB. The cost of putting this right retrospectively (“the rectification scheme”) was estimated by the Society to be £200m.

(b) The cost of compensating non-GAR policyholders who had joined the Society’s With Profits fund before 20 July 2000 without having been informed that the non-GAR policyholders were collectively exposed to the potential cost of the GARs. This liability for mis-selling was also estimated to involve a potential cost of £200m.

(c) The “cost” of allocating the Society’s assets in the future in such a way as to provide that GAR policyholders received the same TB as non-GAR policyholders. It was estimated to involve a transfer of economic benefits of £1.3 billion at (then) present values. This was referred to at the time as “the cost of Hyman”. It is important to understand that the effect of the decision of the House of Lords was simply that the aggregate value of the GAR policyholders’ contractual entitlements increased, and the aggregate value of the non-GAR policyholders’ non-contractual entitlements decreased. Because this “cost of Hyman” involved a reallocation between members of assets which had not yet been contractually allocated to any member, the effect on the Society as a whole was neutral. All these points are explained very clearly by Mr Thomson in his Management Report in the Annual Report and Accounts for the year ended 31 December 2000 [8/244/1912].

(2) It is the Society’s case that the total present value of the Society’s GAR liabilities as at 31 December 1998 was £2.13 billion (see paragraph 45(a) of the RAPC, where it is alleged that a GAR provision calculated at a take up rate of 75% would have been £1.6 billion). At 31 December 1999, the total present value is alleged to have been £1.8 billion (see paragraph 45(b) of the RAPC, which on a 75% take up rate would reduce to £1.3 billion). By late 2000, the Society’s best estimate of the additional commercial “cost” of GAR liabilities was £1.3 billion (for unmatured GAR policies) and £0.2 billion for the rectification scheme. However, as Mr Thomson explained, the £1.3 billion merely involved “a reallocation of assets” within “a single pot of money”.

(3) It was in respect of those GAR liabilities that it is alleged that the GAR provisions should have been made at the level of £900m (1997), then £1.6 billion (1998), and then £1.3 billion (1999).

(4) The “cost of Hyman” reflected a liability of the Society to its GAR policyholders. That liability is the very same liability as that against which, it is alleged, the GAR provisions should have been made. The GAR provision figure and the cost of Hyman figure are arrived at by different routes, but they are not cumulative, not least because £1.3 billion (the 1999 GAR provision) plus £1.3 billion (cost of Hyman) exceeds £1.8 billion (total value of all GAR liabilities at end 1999).

(5) The Society has not previously relied upon the “rectification scheme” and “mis-selling” costs as having any part to play in this dispute.

(6) The “rectification scheme” and “mis-selling” costs are indeed additional and cumulative. It is vital to note, however, that the Society does not (and could not) claim to recover the £400m estimated aggregate cost from E&Y because E&Y are not responsible for the differential terminal bonus policy (DTBP) or mis-selling by the Society’s sales force. Instead, the Society’s case is that if the Directors had known of the possibility that the Society would have to face paying such costs, it would have changed its policies on mutuality and bonus distribution. This argument is unrealistic because as the judge pointed out (see paragraph 106 (iii)), this would have been to assume defeat in Hyman when victory was expected.

13. There are important questions of law which are independent of these factual matters and upon which E&Y rely as providing a complete answer to the Society’s case. However, so far as concerns issues of fact, the argument below and on appeal centres on what impact E&Y’s insistence on the making of the higher GAR provisions and a contingent liability note would have had on the minds of the Society’s Directors. E&Y submit that it is apparent from the contemporaneous documents that neither of these inclusions in the statutory accounts would have had the results contended for by the Society. The Directors would most certainly not have been alerted to the possibility of two £1.3 billion GAR liabilities, because no two such liabilities existed.

B.THE FACTS.

14. All the issues on the appeal have to be addressed in their factual context. There is no difficulty in ascertaining the relevant facts because they are fully documented in contemporaneous documents. As such, they are beyond serious argument (and are not understood to be disputed by the Society in any material respect).

15. Langley J summarised the key facts at [8] to [34] and also at various points in his description of the alleged loss at [35] to [72]. E&Y respectfully adopt the entirety of the Judge’s summary, and add the following to the chronology of events.

The Society’s constitution (Langley J at [8]).

16. The Society was founded by a deed of settlement in 1762. By a resolution of 12 January 1893, the Society adopted and approved a Memorandum and Articles of Association pursuant to the Companies (Memorandum of Association) Act 1890. The substitution of the Memorandum and Articles of Association for the original Deed of Settlement was confirmed by the Court by an order made on 7 June 1893, and the Society thereupon became a company registered under the Companies Acts 1862 to 1890. It has no share capital.

17. From time to time, the Memorandum and Articles of Association have been amended. The version in the bundles [3/34] was adopted on 19 May 1995.

18. The relevant provisions of the Articles are contained in Article 46 (requirement for an Actuary), Article 64 (the preparation of a revenue account and balance sheet), Article 65 (the duty of the Directors to cause the Actuary to value the Society’s assets and liabilities, and their power to distribute surplus by way of bonus), and Article 68 (Auditors’ duties to be regulated in the manner provided in the Act, ie, the Companies Act 1985).

The Society’s business (Langley J at [9]).

19. A summary of the Society’s business and bonus philosophy is contained in the judgment of Lord Steyn in Equitable Life Assurance Society v Hyman [2002] 1 AC 408, 451-454. E&Y respectfully adopt this description.

20. Features of the Society’s business are pleaded at paragraph 34 of the RAPC [1/5]. The Society’s so-called “business model” is described by Mr Thomson at paragraph 14 of his Witness Statement [2/18/236]. It is accepted by E&Y that the pleading and the evidence on this point are arguably correct and must therefore be assumed to be correct for present purposes.

21. The main features of the Society’s business, so far as they are relevant at all, were: (i) the Society’s policy of full distribution of its investment income, thereby preventing the creation of an orphan estate; (ii) the Society’s low level of expenses (this is not mentioned in the RAPC, but is established beyond doubt by other documents to which reference will be made, eg, the Society’s press announcement on 20.07.00 [6/200/1471] stating that its expense base was the lowest in the industry); (iii) the flexibility of the Society’s policies; and (iv) the comparatively high percentage of with-profit GAR policies as a proportion of all with profit policies (at the time of the Hyman litigation, approximately 116,000 out of 416,000). This last feature was, however, mitigated by (a) the low take-up of the guarantee option, and (b) the inevitable reduction in the number of unmatured GAR policies year by year: see further below.

GARs (Langley J at [9]).

22. At the date of the Hyman litigation, there were about 416,000 with-profits policies held by approximately 380,000 policyholders. Within this overall figure, there were about 116,000 policies held by approximately 90,000 policyholders containing a guaranteed annuity rate (see paragraphs 13-14 of the judgment of Sir Richard Scott [5/158/1139]).

23. A brief description of GAR policies is contained in paragraphs 7 and 8 of the RAPC [1/9/62]. A detailed description of the terms of GAR policies can be found in the judgment of Lord Woolf MR at paragraphs 22-43, adopted by Lord Steyn at 454H. At this stage, the following additional points are made:

(1) By the date of the first impugned audit, GAR policies were a legacy of the past. They had been written between 1957 and July 1988 (see the judgment of Sir Richard Scott at [12] [5/158/1138]). It is not suggested, nor could it be, that E&Y bear any responsibility for the existence of GAR policies.

(2) The size of the portfolio would gradually reduce over a period of about 25 years (a GAR policy taken out in 1988 by someone aged 25 with a selected pension age of 60 would mature in 2023). Any cost to the Society occasioned by policyholders exercising a GAO would be spread over the same period. Provided that the DTBP was valid, there was no question of the Society suddenly being faced with a massive cost which had to be met in one year.

(3) The entire additional cost of policyholders exercising GAOs in 1998 was a mere £245,000 [4/100/840].

(4) The Society was aware from no later than December 1993 that GAR policies represented a potential cost to the Society if the guaranteed annuity rate were to exceed the current annuity rate. Hence the adoption of a differential terminal bonus rate on 22 December 1993 (as to this date, see RAPC para 14 [1/9/63]).

(5) As time went on, the GAR issue attracted increasing attention throughout the industry (see, eg, [4/84/703]) and within the Government Actuaries Department (see eg [4/77/685], [4/83/759], [4/88/777], [4/93/808], [4/98/825], [4/106/853]) and the FSA (see, [4/99/828], [4/100/832], [4/101/831], [4/104/846]).

(6) The GAR issue had a limited life span because no GAR policies had been written since 1988, and those which had been written before 1988 were maturing. The 11,000 GAR policies which matured in 1998 represented nearly 10% of all outstanding GAR policies.

(7) The Society believed that the cost of GARs was being “more than adequately covered by the terminal bonus cushion” and that “as the business to which annuity guarantees apply ages, the increasing terminal bonus cushion will make it increasingly unlikely that guarantees will actually bite”: see Answers 5.2 and 5.7 in the Society’s completed questionnaire to the GAD at [4/77/698, 699].

(8) As Langley J noted at [46], on 9 September 1998 the Appointed Actuary informed the Board that, if Equitable was not entitled to adopt the DTBP, the maximum potential cost to the Society was £1.5 billion. The same estimate was used by the Society in mitigating its alleged loss following the House of Lords decision (see further below).

Bonuses (Langley J at [11]).

24. The RAPC do not explain whether the alleged cuts would have been to reversionary bonuses or terminal bonuses. However, Exhibit CGT2 to Mr Thomson’s Second Witness Statement dated 12 January 2003 [2/20A/283K] asserts that cuts in policy values would have been achieved by reducing terminal bonuses.

25. The process by which the annual bonus decision was made, and the factors relevant to that decision, are apparent from the documentation relating to the declaration in February 1999. E&Y will refer to the following documents: (1) Initial paper on bonus declaration at 31.12 98 by Mr Headdon (the Appointed and Reporting Actuary) dated 19.11.98 [4/87]. (2) Minutes of Board meeting on 25.11.98, item 8 [4/89/786]. (3) Minutes of Board meeting on 16.12.98, item 8 [4/91/792]. (4) Mr Headdon’s paper on Valuation and Bonus Declaration as at 31.12.98 dated 22.01.99, paragraphs 4-7, 13-39 [4/103/838]. (5) Minutes of Board meeting on 27.01.99, items 3 and 7 [4/105/848]. (6) Agenda for meeting between the Society and E&Y on 01.02.99 [4/108/857]. (7) Note of meeting between the Society and E&Y on 15.02.99 [4/110/863]. (8) Agenda and paper for Special Audit Committee meeting on 24.02.99 [5/112/868]. (9) Mr Headdon’s final paper on Valuation and Bonus Declaration as at 31.12.98 dated 18.02.99, paragraphs 1-15, 22-23 [5/113/874]. (10) Mr Headdon’s paper dated 18.02.99 headed “GARs – Contingency Plan should ELAS lose the Court Case” [5/115/887]. (11) Managing Director’s Report dated 19.02.99 to the Board meeting on 24.02.99, para 1 [5/117/897]. (12) Agenda for Special Board meeting on 24.02.99 and para B7 of the attached statement of bonuses [5/120/911, 923-924]. (13) Minutes of Special Audit Committee meeting on 24.02.99 [5/121/937]. (14) Minutes of Board meeting on 24.02.99 [5/122/939]. (15) Minutes of Special Board meeting on 24.02.99 [5/123/942]. (16) E&Y audit report dated 24 March 1999 [5/138/1040]. (17) Standard form of annual statement to policyholders [9/259/2257].

26. The following specific points should be noted about terminal bonuses:

(1) The rate of terminal bonus was not fixed as such. It was simply the figure produced by the Board’s decisions as to (a) the level of earned income to be allocated to policyholders and (b) the level of reversionary bonuses.

(2) During the life of a policy, terminal bonus (the figure under the heading “Non-guaranteed final bonus in the annual statements”) represented an increasing percentage of the total policy value. It is apparent from the Society’s “Comparison of asset values and total policy values at 31/12/99” [8/254/1989] that the non-guaranteed element represented in excess of 20% of total policy values.

(3) Because terminal bonuses are not guaranteed, they were not provided for in the Society’s statutory accounts.

Overall financial position between 1993 and 2000.

27. In paragraph 65 of his Witness Statement [2/19/258], Mr Arnold set out a table summarising the financial position of the Society between 1996 and 2000. This table was expanded by Ms Canning to cover the period between 1993 and 2001 [2/20/283]. The expanded table demonstrates five indisputable facts:

(1) Before making the adjustments for which the Society contends, the Fund for Future Appropriations (FFA) increased from a figure of £1,963.6 million at 31.12.93 to £4,841.1 million at 21.12.99 (line 4).

(2) Even after the adjustments for which the Society contends, the FFA would have grown over the same period from £1,963.6 million to £3,741.1 million (line 5).

(3) Even after the adjustments, the Society could lawfully have distributed the amount of surplus which it in fact distributed. (The effect of Hyman is not that the Society distributed too much surplus, but that the surplus was distributed in accordance with an unlawful policy).

(4) The value of the Society’s assets (line 13) increased from £13,577.8 million at 31.12.93 to £34,474.7 million at 31.12.99.

28. Langley J correctly noted at [27] and [28] that both the LTBP and the FFA are shown in the statutory accounts as a liability of the Society to its members. He also correctly noted that any increase in the LTBP would have been matched by a corresponding reduction in the FFA. It follows that the Society’s case is not that the overall level of the Society’s liabilities was understated, but merely that a liability which was shown as part of the FFA should have been moved in the balance sheet and shown as part of the LTBP. It is for this reason that there was no black hole at all.

The differential terminal bonus policy (Langley J at [14] to [17]).

29. The differential terminal bonus policy (“DTBP”) is described in paragraphs 13 to 16 of the RAPC [1/5/20A], and in the various Hyman judgments: see Sir Richard Scott at [72] [5/158/1149]; Lord Woolf MR at [44]-[47]; and Lord Steyn at 451D and 454D.

30. The philosophy underlying the adoption of this policy was “to bring the value of benefits being undertaken by the policyholder on maturity up to a level that equates to the policyholder’s notional ‘asset share’ in the Society’s with-profits fund” (per Sir Richard Scott at [41] [5/158/1143]); “to ensure that the annuity benefit available to those who decided to take alternative benefits was no less than that available to those who chose the guaranteed annuity” (per Morritt LJ at [73]); and “to achieve fairness between GAR and non-GAR policyholders by equalising the financial result of different forms of policy” (per Lord Steyn at 454E). These are different ways of describing the same objective (see Lord Cooke at 461G).

31. It will be noted that there is no allegation that E&Y bear any responsibility for the adoption of the DTBP or for its continuance.

32. The DTBP undeniably had the effect of causing many GAR policyholders to elect not to take an annuity at the guaranteed rate. In his paper on Valuation and Bonus Declaration as at 31.12.98 dated 22.01.99 [4/103] Mr Headdon recorded that the GAR option had been exercised in only 97 out of 11,000 policies during 1998 (paragraph 13). He commented that “the extent of exercising of GARs is extremely low”, and that the commercial cost of meeting the additional benefits secured through the exercise of a GAR is correspondingly very low (paragraph 14).

33. Those very few GAR policyholders who did elect to take an annuity at the guaranteed rate imposed a cost on the Society equal to the difference between the amount required to fund an annuity at the guaranteed rate, and the actual amount of the policyholder’s guaranteed fund value at maturity. The DTBP enabled the Society to meet this cost out of terminal bonus which would have been allotted if the policyholder had elected not to take the guaranteed rate.

Cost v provision.

34. This point identifies the important distinction between a cost and a provision. The Directors appreciated that the exercise of a GAR option resulted in a cost to the Society. They determined to meet the cost by operating the DTBP.

35. In marked contrast, a technical provision in a set of accounts is not a cost at all. It involves no payment to anyone. Thus when it comes to considering the factual basis of the claim, it will be important to bear in mind that the commercial reality as it appeared to the Directors (and as recorded in contemporaneous documents) is that the DTBP not only depressed demand for guaranteed annuity rates, but provided a means by which to fund the cost of providing a guaranteed rate to those very few GAR policyholders who elected to take one. It is inherently improbable that a technical provision in the statutory accounts would have altered the Directors’ perception of the commercial realities in any way.

Policyholder discontent.

36. Policyholder disquiet about the Society’s approach to bonuses on GAR policies began to develop in the Autumn of 1998 (per the Society in its letter dated 23 April 2001 to the Financial Reporting Review Panel [8/245/1952]).

The Hyman litigation (Langley J at [18]).

37. The Hyman litigation was instituted by the issue of an Originating Summons dated 15 January 1999. In amended form, it sought the declarations set out by Lord Steyn at 454F. On 9 September 1999, Sir Richard Scott V-C granted the declarations. He concluded (judgment at [104] [5/158/1160]) that the Directors had not acted irrationally, and that they had not taken account of any irrelevant factor or omitted to take account of any relevant factor.

38. The hearing of the appeal began on 30 November 1999. Judgment was given on 21 January 2000. Lord Woolf and Waller LJ concluded that the DTBP was invalid. Morritt LJ dissented, being unable to see any ground on which the exercise by the Directors of their Article 65 discretion could be successfully challenged (judgment, paragraph 111). However Waller LJ endorsed the principle of ring-fencing (paragraph 135). He saw no reason why different bonuses could not be awarded to different types of policyholder. He acknowledged the possibility that with ring-fencing the GAR policyholders “will not in actual cash terms do very much better than they have done under the differential bonus scheme”.

39. The House of Lords dismissed the Society’s appeal. Lord Steyn concluded that Article 65 contains an implied term, necessary to give effect to the reasonable expectations of GAR policyholders, that the discretion is not to be exercised so as to deprive the relevant guarantees of any substantial value (page 459H). He rejected Waller LJ’s view about ring-fencing (page 460B). Lord Cooke reached the same result, but by a process of construction (460H and 462A). Lords Slynn, Hoffmann and Hobhouse agreed with both Lord Steyn and Lord Cooke.

The Society’s response to the decision.

40. Following the Hyman decision, the Society was able to, and did in fact, mitigate the cost of the decision and unwind the previous effect of the DTBP by a series of decisions:

(1) On 20 July 2000 (the day of the decision), the Board suspended terminal bonuses for all classes of policies from midnight on 19 July 2000 [6/199/1467].

(2) On 25 October 2000, the Board resolved to adopt revised terminal bonus rates for the period from 1 January 1994 to 19 July 2000 [7/219/1763].

(3) Mr Thomson’s Management Report dated 11 April 2001 in the Annual Report and Accounts for 2000 [8/244/1912] noted that the Hyman decision had effectively increased the value of GAR policies by £1.5 billion, and that to allow for these increased benefits, no bonuses would be allotted for the first seven months of 2000 (the relevant passage is quoted by Langley J at [65]).

(4) On 16 July 2001, the Society announced (i) that pension policies would be reduced by an amount equal to 16% of the policy value at 31 December 2000; and (ii) that there would be no growth on policies for the period from 1 January 2001 to 30 June 2001 [8/251/1973].

(5) On 1 December 2001, the Society issued a Circular to its members proposing a complex scheme of arrangement [9/258/2048]. The key features of the scheme were the removal of GAR rights, the waiver of GAR related claims of all Scheme Policyholders, and an increase in policy values if the Halifax £250 million were to be made available [9/258/2064]. The scheme was sanctioned by the Companies Court on 8 February 2002 [8/257/2002].

41. The key point about these steps is that they demonstrate that the Society was always in a position to counter an adverse final ruling in the Hyman litigation, unlikely as that appeared, by withholding bonuses (reversionary or non-guaranteed) and/or by cutting non-guaranteed policy values. When the disaster occurred, the “cost” (ie, the reallocation of assets was facilitated by withholding all bonuses for the first seven months of 2000 [8/244/1912].

C.THE ALLEGED TWO BLACK HOLES.

42. At the hearing below, the Society’s case relied heavily on an unpleaded assertion that there was not one black hole in the Society’s accounts, but two of them. The point is encapsulated in the following exchange [Day 4/131/11]:

“MR JUSTICE LANGLEY: Let us test it this way. Suppose that the provision against the differential bonus had been £1.6 [billion] and Ernst & Young had insisted on that against everyone’s better judgment; are you saying there should have been another £1.6 [billion] as well?

MR MILLIGAN: Yes.

MR JUSTICE LANGLEY: That is the point that I lose. I am afraid I simply do not follow that at the moment. I am sure it is my fault, but I do not, so I am warning you.”

The Judge remained unable to follow the point for the reasons he gave at [66] to [70].

43. The same point is now taken by the Society in paragraphs 2, 4, 13(b) and 16 to 41 of its Skeleton Argument on this appeal, albeit couched in somewhat more diffuse language. However, the Society now seeks to tie in the second alleged black hole with the omission of a note disclosing contingent liabilities. This is a new case which was not advanced below.

44. E&Y does not accept that there were any black holes in the Society’s finances or accounts. However, given that the application below necessarily proceeded on the assumption that the technical provision in the Society’s statutory account ought to have been higher, E&Y accepts for the purpose of this application (and appeal) that there was a black hole in the sense that the Society’s technical provisions (but not its overall liabilities) were understated. E&Y do not accept that there was a second black hole, and nor did the Judge.

45. To address this issue, it is necessary to identify the two alleged black holes and then to consider the relation between them.

The first alleged black hole: the technical provision.

46. It is common ground that the DTBP was effective in depressing demand for GARs to a point at which the cost was negligible (only £245,000 in 1998). It is also common ground that, to operate the DTBP, the Society had to continue paying terminal bonuses; if it did not, it would remove the financial incentive for GAR policyholders not to exercise their GAR option.

47. The only point of fact being made by the Society is that terminal bonuses had to be paid at a minimum level for the DTBP to be effective. This, with respect, is a statement of the obvious. By definition, a differential terminal bonus policy involves the payment of terminal bonuses. This must have been obvious to the Society’s Directors.

48. At paragraph 4 of its Skeleton Argument, the Society contends that the missing part of the technical provision reflected a liability in respect of guaranteed benefits and had to be included in the 1997 to 1999 accounts regardless of (a) the outcome of Hyman, (b) the existence of the DTBP, or (c) the inclusion in the accounts of a contingent liability note in respect of the consequences of losing Hyman.

49. E&Y dispute these allegations. For present purposes, however, if they are true they are irrelevant. They go to the question of liability, which is not before this Court.

50. The relevant point, which is a pure point of fact, is that the foundation of the Society’s case on causation is that, once GARs exceeded CARs, a minimum amount would have to be paid to GAR policyholders “regardless of whether or not the policyholder exercised his GAO”. This is true but the Society knew (irrespective of whether or not a provision was made) that it would have to pay this minimum amount to GAR policyholders. At most, the making of the higher Technical Provision might have told the Directors that the amount should be treated as a contractual obligation and not as non-contractual TB. Commercially, that was an irrelevance.

51. It not correct to suggest (as the Society does in the opening words of paragraph 4) that the Judge misunderstood this part of the Society’s case. He fully understood the Society’s complaint that there should have been a higher technical provision (see [29] to [32]) and that, for the purpose of the application, it had to be assumed that E&Y were in breach of duty (even though this is hotly disputed by E&Y) (see [33]). What he could not understand was the case advanced in oral argument that there were two black holes, not one.

52. The allegedly missing part of the technical provision is further addressed by the Society in paragraphs 28 to 36 of its Skeleton Argument. As to these paragraphs:

(1) Paragraphs 28 and 29 are agreed.

(2) The criticism of the Judge’s observation that the Directors were alive to the potential problem of GARs exceeding CARs is misplaced. The adoption of the DTBP was a clear recognition of the existence of the potential problem and was intended to provide a solution to it. The Board was informed by the Appointed Actuary on 9 September 1998 that, if the Society was not entitled to adopt the DTBP, the potential cost to the Society was £1.5 billion. The documents referred to above in relation to the setting of the 1999 bonus rates demonstrate the Board’s knowledge that terminal bonuses were being set at a level sufficiently high to solve the potential GAR problem. The serious consequences of losing the Hyman litigation were spelt out in Mr Headdon’s paper dated 18 February 1999 [5/115/887].

(3) Paragraph 31 is agreed. The understanding was correct because the DTBP did leave the Society with a relatively small cost resulting from the exercise of GAOs.

(4) Given the proposition in paragraph 31, the suggestion in paragraphs 32 to 35 that there was a missing part of the technical provision makes no commercial sense. Why provide for a cost which is never going to be incurred? However, this is a liability issue.

The second alleged black hole: the potential costs of losing Hyman.

53. Paragraph 37 of the Society’s Skeleton Argument identifies two potential costs to the Society of losing the Hyman litigation.

54. The first was the potential cost of unwinding the DTBP as it had applied in prior years. The second was the potential cost of mis-selling claims.

55. These costs are not claimed against E&Y, and nor could they be. E&Y bear no responsibility for the DTBP or the selling practices of the Society’s sales representatives.

56. The Society has not previously relied on these costs in formulating its claim against E&Y. They were not mentioned below. The second black hole identified below was an additional cost for GAR policyholders whose policies had not matured by 20 July 2000. Put this way, there is no additional cost for the reason given by the Judge at [66] – [70], namely that the first and second black holes arise in mutually inconsistent scenarios.

57. If it is now being said that a note disclosing such potential costs would have informed the Directors of something which they did not already know, the point is hopeless on the facts. The Society was aware of both potential costs because they were addressed in Mr Headdon’s paper dated 18.02.99 headed “GARs – Contingency Plan should ELAS lose the Court Case” [5/115/887, paras 7(iv) and (v), 10, 11, and 15(ii)].

58. In paragraph 39 of its Skeleton Argument, the Society makes five brief criticisms of the reasoning of Langley J at [66] to [70]. As to these:

(1) There is no inconsistency with the assumptions underlying E&Y’s applications because: (a) paragraph 61(a) of the RAPC speaks of “a transfer of economic benefits from the non-GAR policyholders to the GAR policyholders”; it makes no mention of an additional cost to the Society (no doubt because this point did not occur to the Society until later); (b) paragraphs 81 and 88 of the RAPC treat the disclosure of contingent liabilities as an alternative to additional technical provisions (as the Judge emphasised at [53] and [57]).

(2) E&Y’s argument was advanced for the first time in reply because the first suggestion of two black holes was made in the Society’s oral submissions.

(3) There is no evidence about two black holes for the simple reason that they did not exist.

(4) E&Y’s argument does not contradict the opinion evidence of Mr Thomson because Mr Thomson does not suggest that there were two cumulative black holes. The point he addresses at paragraph 6 of his 2nd Witness Statement is the curious similarity between the amount of the bonus claim (£1.6 billion) and the amount withheld by the Society following Hyman (£1.5 billion). This is a separate point.

(5) For the same reason, the Judge did not fail to understand the reasoning and effect of Mr Thomson’s evidence.

59. Paragraph 40 of the Society’s Skeleton Argument essentially repeats the point already made in paragraph 39(a). When the Judge said at [73(viii)] that: “If it [the DTBP] was valid it could be used to meet the provision in the sense that the provision would largely not be required”, he clearly meant that a provision for GAR liabilities would not translate into an actual cost. He was correct about this.

60. Paragraph 41 of the Society’s Skeleton Argument illustrates the changing nature of the Society’s case. At the hearing below, it was not suggested that a disclosure note would have added anything to a higher technical provision. The point made in paragraph 41 is flawed because it presupposes the existence of two black holes.

C.THE EVIDENCE.

61. The witness evidence consists of Witness Statements from Mr McNamara (E&Y audit partner) [2/15], Mr Plant (partner in Herbert Smith) [2/16], Mr Thomson (the Society’s chief executive since 1 March 2001 and its Appointed Actuary between 15 January and 28 March 2001) [2/18], Mr Arnold (actuarial expert) [2/19], and Ms Canning (partner in Barlow Lyde & Gilbert) [2/20].

62. There are also 7 bundles of contemporaneous documents. The documentation is far less voluminous than at first sight appears because many documents contain only one or two relevant passages. The more significant point is that the bundles contain much of the contemporaneous material which would be available at a trial. This enables the court to form a view about what facts the Society has a realistic prospect of proving at trial. No amount of cross-examination on behalf of the Society will displace the facts which are clearly established by the contemporaneous documents, in particular the Board minutes.

63. Mr Plant, whose factual and opinion evidence would be inadmissible at trial, suggests that “it is important to appreciate that the evidence which it is possible to put before the Court at this stage of the proceedings is limited in two significant respects” [2/16, para 3].

64. The first is that the Society is unable to obtain witness evidence from its former Directors. This limitation is self-imposed because the Society has chosen to sue its former Directors. The Society will continue to suffer this handicap, and it is one which the Court can properly take into account in assessing whether the Society has a realistic prospect of proving its case on the facts.

65. The Court can also take into account the factual averments in the Defences which have been served on behalf of the Directors, each of which is supported by a Statement of Truth signed by them.

66. Furthermore, “the hope that something may turn up during cross-examination of a witness does not suffice”, at least in relation to an allegation of dishonesty (per Lord Hobhouse in Three Rivers, supra, at [160]); in any other case, it is at best a factor of very limited weight. Furthermore, no amount of cross-examination can displace the facts which are so clearly recorded in the contemporaneous documents.

67. The court is also invited to note that the Witness Statement of Mr Thomson contains a good deal of opinion evidence as to what the Board (of which he was not then a member) might have done if E&Y had given different advice. This evidence is inadmissible. It is opinion evidence from a witness whose lack of independence disqualifies him from acting as an expert. Furthermore, the question of what the Directors would have decided to do if E&Y had given different advice is not a matter for expert evidence at all. It is a question of fact.

68. The simple truth is that the Society has been able to adduce virtually no relevant evidence from a witness of fact whose evidence would be admissible at trial. The significance of this is that, as Pill LJ observed in Green v Hancocks [2001] Lloyd’s Rep PN 212 at [74], a court will not necessarily assume facts in favour of a claimant merely because he is a respondent to an application under rule 24.2. This departure from previous practice reflects the overriding objectives of the CPR.

69. The second suggested limitation is that the Society does not presently have access to E&Y’s working papers. This is true, but irrelevant. E&Y’s internal working papers go to the issue of liability. They are not relevant to the issues which arise on this appeal.

D. THE LOST SALE CLAIMS.

The pleaded claim.

70. Langley J gave a clear and accurate summary of the lost sale claims at [38] to [58]. E&Y make the following additional points about the case as pleaded:

(1) The pleading conspicuously avoids characterising the case as a claim for diminution in the value of the Society’s assets. Yet this is precisely what it is. The allegation of lost sales performs no function other than to quantify the extent of the alleged diminution in value over time.

(2) The pleading also conspicuously avoids any identification of the causes of the diminution in value. When the Judge asked leading Counsel for the Society: “What has caused the loss of goodwill?”, the reply given was, in summary, (a) that it confuses things to ask that question, but (b) if the loss was caused by matters such as a fall in the stock market or in interest rates, that would be within the scope of E&Y’s duty [Day 4/32/13 – 4/35/14].

(3) Thus the claim seeks to place E&Y in the position of a warrantor of the value of the Society’s assets, no matter what external factors might have caused a diminution in value.

(4) The claim in respect of an alleged lost sale in September 1998 makes no allowance for the cost of the GAR problem. This is so even though the premise of the claim is: (a) that the statutory accounts would have included a provision of £900,000,000 for that very cost; and (b) that the Society would already have cut terminal bonuses for all its members by a decision taken in February 1998. So in this part of its claim, the Society is seeking to make E&Y fund a windfall gain of some £1.5 billion (being the cost of the Hyman decision).

(5) There is no allegation in pleading: (a) that E&Y knew or ought to have known that the Directors were contemplating a sale of the Society’s business; or (b) that E&Y knew or ought to have known that the Directors would have contemplated a sale of the Society’s business if E&Y had insisted on technical provisions or disclosure; or (c) that E&Y were instructed to advise in relation to any such sale; or (d) that E&Y knew or ought to have known that a failure to include a technical provision would cause the Society to suffer a loss of goodwill.

(6) The allegedly lost value includes savings that would have been made by cutting bonuses. To this extent, the lost sale claim replicates the bonus declaration claim.

71. It should also be noted that the lost sale claim will, if permitted to stand, materially enlarge the scope of the factual investigation at trial. As the Society agreed below, the lost sale claim will require investigation into at least the following matters:

(1) The attitude of some 15 Directors towards a sale of the Society. This will involve cross-examination of those Directors who give evidence.

(2) The various methods by which a sale might have been structured. This will require expert evidence.

(3) The general state of the market for life assurance companies in 1998 and 2000. This will require expert evidence.

(4) The likely assessment of interested parties about the degree of financial risk under the GAR policies.

(5) The terms of any offer, including whether an offer would have been subject to conditions, and if so, what conditions.

(6) The placing of any offer before members, including the difficult question of the various classes into which members would have needed to be divided for voting purposes to ensure fairness as between each of them.

(7) The attitude of the members to such offer as might have been made. It is unclear how the Society intends to prove this part of its case.

(8) The approval of a scheme of arrangement by the Companies Court, assessed against the possibility that some classes of members might have opposed the scheme.

(9) The overall timescale for effecting a sale (an issue which is critical to the lost sale claim at both September 1998 and September 2000). This will involve investigation of other demutualisations. Mr Arnold embarks on this enquiry at paragraphs 107-115 of his Witness Statement [2/19/271-273].

The claim lies beyond the scope of E&Y’s duty of care.

72. This was the first ground on which the Judge struck out the lost sale claim. He summarised the legal principles at [79] to [91] and applied them at [98] to 102].

73. In recent years, the courts have been much concerned to place fair and sensible limits on the liability of professional advisers.

74. A major development in this process has been the creation of a new control mechanism in the form of scope of duty. Quite simply, a loss which falls outside the scope of an adviser’s duty of care is irrecoverable.

75. This development flows from the decisions of the House of Lords in Caparo Industries Plc v Dickman [1990] 2 AC 605 and South Australia Asset Management Ltd v York Montague [1997] AC 191 (“SAAMCO”). Reference will be made to the following passages in the judgments: Caparo: Lord Bridge at 627D-F; Lord Oliver at 651F-652C; and Lord Jauncey at 660G-661E; SAAMCO: Lord Hoffmann at 210G-211B, 211G-212C, 213C-214F, and 222D-F.

76. The following points are made about the scope of duty concept:

(1) The relationship between scope of duty and causation is that a claim which fails on scope of duty is bound to fail on causation, but a claim which surmounts scope of duty may yet fail on causation: see Re Barings plc (No 1) [2002] BCLC 364, Evans-Lombe J, at [67]. It follows that scope of duty and causation are separate hurdles, each of which must be surmounted by the claimant. This is why causation is advanced by E&Y as a separate and independent ground for striking out the lost sale claim. The two concepts are, however, related because they both involve a value judgment as to “the extent of the loss for which the defendant ought fairly or reasonably or justly to be held liable” (per Lord Nicholls in Kuwait Airways Corpn v Iraqi Airways Co (Nos 4 and 5) [2002] 2 AC 883, 1091 at [70]).

(2) The utility of the scope of duty concept is that it automatically prevents recovery of losses which are not within the scope of duty. Thus in any case where part of the loss claimed was caused by factors for which the auditor is not responsible, the claimant is bound to formulate the scope of duty and to limit his claim to losses falling within it. This point has considerable importance in the present case. The Society quantifies the diminution in the value of its assets at £2,600,000,000. Yet the only pleaded element within this figure is the £1,600,000,000 of allegedly overpaid bonuses. It follows that, on the face of the pleading, at least £1,000,000,000 of the diminution in value has been caused by matters for which E&Y is not alleged to be responsible.

(3) It is also an inherent feature of the scope of duty concept that it obviates the need to investigate the cause of losses which are outside the scope of the defendant’s duty. Thus in all the cases conjoined in the SAAMCO appeal, it was unnecessary to consider how far the lender’s loss had been caused by a fall in market value of the mortgaged property, a fall in the value of other items of security, management failings by the borrower, or any other cause. The valuers could not be liable for more than the difference between the reported value and the accurate value. It follows that a party in the position of E&Y does not bear a legal, evidential or tactical onus to prove that loss was caused by factors for which E&Y are not responsible. On the contrary, it is for the Society to prove that its entire claimed loss was caused by E&Y’s alleged negligence, which it cannot do if any part of the loss was caused by factors for which E&Y are not responsible.

(4) The scope of duty concept has now been applied to most categories of professional advisers, including auditors (see Lord Millett’s review in Aneco Reinsurance Underwriting Ltd v Johnson & Higgins [2002] Lloyd’s Rep 157, 190 at [65]).

77. This leads to the question of how the scope of duty concept applies in claims against auditors. Before considering the two recent cases in which claims against auditors have been struck out on the ground that they fell beyond the scope of the auditors’ duty of care, it is convenient to consider how the concept fits in with three types of case where an auditor undoubtedly can be liable. These are: (i) claims in respect of specific transactions, (ii) claims in respect of failure to report internal fraud; and (iii) claims in respect of overpaid dividends.

78. Specific transaction cases are those where an auditor knows that audited accounts will be relied on for the purpose of a specific transaction. There are numerous examples of such claims: Al Saudi Banque v Clark Pixley [1990] Ch 313; Morgan Crucible & Co Plc v Hill Samuel & Co Ltd [1991] Ch 295, CA; Galoo Ltd v Bright Grahame Murray [1994] 1 WLR 1360, CA (the Hillsdown claim); ADT v BDO Binder Hamlyn [1996] BCC 808. What emerges from all these (and other cases) is that the relevant control mechanism for limiting liability is the auditor’s knowledge that the accounts will be relied on for the particular transaction. Given that this is the control mechanism where there is a specific transaction in contemplation, it would be surprising if it were not a similar control mechanism where there is a less immediate nexus between the accounts and a claimed loss. E&Y submit that the control mechanism lies in identifying the purpose for which the relevant duty is owed.

79. As to failure to report an internal fraud, there is no doubt that an auditor who negligently fails to detect the fraud of a director or employee can be liable for post audit frauds of a similar type. This is illustrated by the decision of the Court of Appeal in Sasea Finance Ltd v KPMG [2000] 1 All ER 676, CA. There is no difficulty in reconciling liability in this type of case with the requirement for knowledge on the part of an auditor and with the scope of duty principle. The possibility of internal fraud is a risk of which a competent auditor will be aware and it is a risk against which the company can reasonably rely on him for protection.

80. Claims in respect of overpaid dividends are in a somewhat special category. They are considered separately and later in the context of whether the payment of terminal bonuses was a loss to the Society.

81. These three types of cases (specific transactions, fraud and dividends) mark the boundary of the court’s imposition of liability on auditors. Upholding the Society’s lost sale claim would create a massive and almost uncontrollable extension of the scope of an auditor’s duty of care. There would be no logical stopping point short of holding that the scope of an auditor’s duty encompasses any loss resulting from any post audit management decision (or lack of decision) which can in any way be shown to have assumed the correctness of the audited accounts. Since almost every management decision having material financial consequences will be taken in a context of an assumption (however general) that the audited accounts are correct, an auditor’s liability would be open-ended. It would be extraordinary if a concept (scope of duty) which was adopted to limit the liability of professionals who are information providers rather than advisers could be turned round in this way so as to pave the way for a massive increase in their liability.

82. This leads to the two recent cases where claims against auditors have been struck out as being beyond the scope of duty. These are BCCI v Price Waterhouse (No. 3) [1999] BCC 351 (Laddie J), and Re Barings plc (No 1) [2002] BCLC 364 (Evans-Lombe J). Reference will be made to the followings parts of the judgments: BCCI: [28]–[36]; Barings [34]-[68].

83. These decisions establish the requirement to plead and prove an auditor’s actual knowledge that the audit report will be relied on for a particular purpose. As noted above, there is no such allegation. The furthest the pleading goes is to allege in RAPC paragraphs 68B, 76A and 83A that E&Y knew or ought to have known that the “the Directors of the Society relied upon the figures contained in the statutory accounts .. when making decisions in relation to its business and in assessing its financial state and results, including its capital adequacy”. This does not suffice. It seeks to make E&Y liable for all business decisions, one of which happens to have been (so it is alleged) a decision whether to raise capital. The scope of duty concept requires that E&Y should have had specific knowledge that the Directors were considering a sale and were relying on the audited accounts for that specific purpose.

84. The point can be tested against the facts of SAAMCO. It would have been obvious to the negligent valuers that SAAMCO would rely on their valuation in deciding whether to enter into a loan transaction. The central point of the decision is that foreseeability is not sufficient to found liability against an information provider.

85. In fact, even forseeability is lacking in the present case. The foreseeable consequence of the Society’s accounts containing an inadequate technical provision was that the Society’s financial position might appear stronger than it actually was and that a purchaser might be misled into paying too much for its business.

86. Moreover, the proposed new paragraphs 68B, 76A and 83A do not allege a duty to protect the Society from a loss of goodwill. The foreseeable loss from failing to realise capital is that an upward movement in interest rates might make term borrowing more expensive. It is an impermissible leap to move from a duty of that kind to a duty to protect the Society from the consequences of a fall in equity values. Such a fall is an ordinary incident of being in existence as a life company.

87. As pleaded, the lost sale claim amounts to saying (i) that the Society became valueless as a result of the Hyman litigation, but (ii) that if E&Y had insisted on provisions or disclosures to reflect the decision which subsequently came to be made by the House of Lords, a purchaser could have been hoodwinked into paying £2,600,000,000 for a business which was in fact worthless. One’s immediate instinct is that there is something seriously wrong with such a claim. Indeed, there is.

88. Let it be assumed that there was in fact a diminution in the value of the Society’s business between February 1998 and early 2001. On this assumption, and leaving aside the impact of allegedly overpaid bonuses, any diminution in value must have been caused by factors for which E&Y is not responsible. As already demonstrated, this is not an assertion of fact, but an inescapable inference from the pleaded case.

89. This suffices to establish that the lost sale claim is simply an indirect way of claiming for allegedly overpaid bonuses. Since this loss is claimed directly, the Society does not have reasonable grounds for pursuing it under the guise of a lost sale claim. If the bonus declaration claim succeeds, the lost sale claim adds nothing. If overpaid bonuses cannot be recovered on a direct claim, they certainly cannot be recovered on an indirect claim.

90. There is no legal burden on E&Y to prove affirmatively the factors contributing to diminution in value for which E&Y are not responsible. But it is right to point out that such factors are easily identifiable. They include the following:

(1) First and most obviously, there is the Hyman decision itself. The decision was a disaster for the Society because it declared unlawful both the differential terminal bonus policy, and the only alternative, ring fencing.

(2) A direct consequence of the Hyman decision was to expose the Society to claims for mis-selling by non-GAR policyholders, and to claims for breach of contract by GAR policyholders who suffered loss in consequence of the DTBP.

(3) The market for purchasers of life companies probably deteriorated over the relevant period. Mr Thomson hints at this in paragraph 24 of his Witness Statement [2/18/239], as does Mr Arnold at paragraph 92 [2/19/267].

(4) Interest rates continued to decline. Base rate fell from 7.5% in September 1998 to 6% in January 2001. This aggravated the GAR problem and thereby reduced the value of the Society’s business.

(5) Equity values began to fall by no later than the beginning of 2000 (see the Society’s press announcement at [8/251/1973]).

91. As to the Society’s submissions:

(1) The formulation in paragraph 58 is too wide, because it is framed in terms of foreseeability. This offends the SAAMCO principle.

(2) The objection in paragraph 59 to formulating the kind of loss (which is apparently accepted as the appropriate test) by reference to its cause is misplaced. This is the approach taken in nearly all cases of purely economic loss. Thus the disputed kind of loss in SAAMCO was loss caused by a fall in market value. The very general test advocated by the Society (“decisions or omissions caused by errors in the accounts”) displaces the much tighter control mechanism which results from defining the kind of loss by reference to its cause.

(3) The Society poses the rhetorical question at paragraph 61: if a decision to cut bonuses is within the scope of the duty, why is a decision to sell also not within it? Assuming the correctness of the former proposition (although it is not accepted by E&Y), the answer is that E&Y’s duties included a duty review the Society’s level of technical provisions, but did not include a duty to advise the Society about raising capital, still less to protect the Society form the consequences of remaining in existence. This is the point which the Judge made at [101] to [102].

Alternatively, E&Y’s alleged breach did not cause the lost sales.

92. As already noted, causation is a separate and independent hurdle for the claimant. E&Y’s submission is that the pleaded case is bound to fail on causation.

93. The Society has to establish that E&Y’s alleged negligence in failing to insist on technical provisions or disclosure caused a diminution in the value of the Society’s goodwill. This proposition only has to be stated for the non sequitur within it to be apparent. If there is any causal nexus at all between E&Y’s alleged negligence and the alleged diminution in the value, there must be numerous intervening links in the chain.

94. The question ultimately is whether any negligence by E&Y in relation to technical provisions and disclosure was an effective cause of the diminution in value, or whether it merely created the opportunity for other causes to operate, or neither. This was the issue in Galoo in relation to the diminution in value claim. The case on causation was that (i) the auditors ought to have reported that the companies were insolvent; (ii) had they done so, the companies would have ceased to trade; (iii) as a result of continuing to trade, the net liabilities of the companies increased; (iv) accordingly the companies had suffered loss equal to the increase in their net liabilities. This claim was struck out because the breach of duty had merely created the opportunity for trading losses to be incurred. It did not cause those losses.

95. There is no difference in principle between a diminution in value represented by an increase in liabilities, and a diminution in value represented by a decrease in assets.

96. The present case cannot sensibly be distinguished from Galoo. In both cases: (i) auditors are alleged to have been negligent in the conduct of an audit; (ii) the alleged loss was proximately caused by post audit decisions of the Directors; and (iii) although the audit report may have featured somewhere in the chain of causation, it was too far back to be an effective cause of the claimed loss.

97. In fact, the case on causation in Galoo was materially stronger than the Society’s case on causation because the case satisfied the ‘but for’ test. If the auditors had reported that the companies were insolvent, they would no doubt have ceased to trade. Accordingly, but for the auditors’ negligence, the loss would not have occurred.

98. The Society seeks in paragraph 72 of its Skeleton Argument to distinguish Galoo on the ground that had not made trading decisions in ignorance of errors in the accounts. This is incorrect. The pleaded claim in Galoo was that if the Directors had known of the error in the accounts, they would have taken the decision to discontinue trading altogether.

99. Indeed, given that the Society declines to identify what caused the diminution in the value of its goodwill, it is impossible to see how the pleading can disclose a case on causation with a real prospect of success.

The flawed thesis.

100. The Judge also held at [104] to [108] that the lost sale claims are based on a thesis which is factually so flawed as to be fanciful. The commercial logic of his reasoning is compelling.

101. The Society’s response to this point comes down to the following points:

(1) The Judge started from the false premise that the loss suffered as a result of a lost sale consisted of lost bonus cut savings and loss of goodwill. This is challenged at paragraph 77 of the Society’s Skeleton Argument on the grounds that (a) the value included other assets and (b) the value of the goodwill was not included in the accounts. Both points are hopeless. The other assets are pointlessly included in the computation of loss as a credit and a debit. They realised their value. They add nothing to the claim. As to the goodwill not being valued in the accounts, this is true but does not assist the Society. If the goodwill had been valued in the accounts, the FFA would have been correspondingly higher.

(2) Paragraph 78 of the Society’s Skeleton Argument is incomprehensible.

(3) The suggestion in paragraphs 79 and 80 that the saving of £0.4 billion was to be made over 4 years contradicts the Society’s own pleaded case. It is expressly alleged in RAPC paragraphs 71(d) and 75 that the Society would have made savings of £0.4 billion before a sale in September 1998. Once more, the Society has shown that it does understand its pleaded case.

(4) The admission in paragraph 81 that the required cut in terminal bonus was 80% is very significant, for reasons which are self-evident. It is inexplicable how the extent of the cut can depend on the date of a subsequent sale.

(5) The evidence referred to in paragraph 82 is inadmissible and worthless. The documents speak for themselves.

(6) The point made in paragraph 83 again invoke the “two black holes argument” and is flawed for that reason.

No attempt to sell.

102. Before the Judge, E&Y submitted that the Society has no real prospect of establishing on the facts that a higher technical provision or a disclosure of continent liabilities would have caused the Directors to attempt to sell the Society’s business. The Judge saw “considerable force” in this submission. By this stage in the judgment, the point was academic. The Judge did not expressly reject the submission, but merely observed at [109] that it was not a sufficient ground for granting the orders sought by E&Y.

103. E&Y submit that the Society does not have a real prospect of establishing the hypothetical fact that the Directors would have attempted a sale of the Society’s business.

104. The formidable factual difficulties facing the Society will be apparent from the list of issues set out above on each of which the Society will have to prove its claim. This provides the general context in which the Society’s prospects of success have to be judged.

105. E&Y’s central submission in relation to a sale in September 1998 is that the Board would not have resolved to attempt a sale in 1998, or at any time before a final adverse ruling in the Hyman litigation.

106. E&Y’s central submission in relation to a sale in September 2000 is that there is no reason to suppose that any interested party would have completed a sale given that the Society announced on the very day of the Hyman judgment in the House of Lords (20 July 2000) that it was up for sale, but all interested parties withdrew before making a binding offer.

Sale in September 1998.

107. E&Y rely on the indisputable facts which are set out below. Before coming to these, it is right to note three aspects of the factual context in 1998 which make the lost sale claim inherently implausible.

108. The first is the concession by the Society that a sale could probably not have been effected during the pendency of the Hyman litigation: see RAPC, paragraphs 76(a) and 82(d)(i) [1/5/83A, 85A]. The reason for this concession is not disclosed, but, absent some other explanation, it must be taken to be that the Hyman litigation reflected a degree of uncertainty about the rights of GAR policyholders which would have been unacceptable to a purchaser. The Hyman litigation did not create the uncertainty, it merely reflected it. This makes it inherently improbable that a purchaser would have been found at any time after the GAR issue became prominent, which it certainly had by 1998.

109. The second aspect of the factual context is that the Hyman litigation did not suddenly fall out of the sky on 15 January 1999. The High Court became seized of jurisdiction because the Pensions Ombudsman relinquished his jurisdiction. The Pensions Ombudsman originally had jurisdiction because Mr Hyman submitted a complaint to him. Mr Hyman was not alone. It is apparent from an article published in the Daily Telegraph on 31 October 1998 [4/84/763] that other GAR policyholders had complained to the Society. This no doubt explains why the Society has selected September 1998 as the date of sale. The Society’s claim fortuitously reconstructs a sequence of events which concludes just before the storm broke. Yet it seems most improbable that the gathering storm clouds would not have been noticed by a purchaser carrying out due diligence in mid 1998.

110. Third, the Directors did not in fact attempt a sale, and as already noted, the primary case made against them by the Society is that they should have taken steps to preserve and enhance the value of the Society’s assets. This reflects a realistic appreciation by the Society that the Directors would have regarded a sale as a last resort (as they did when the House of Lords ruling went against them).

111. The Society’s case is that if E&Y had insisted on a disclosure or a technical provision of £900,000,000 in the accounts for the year ended 31 December 1997, the Directors would have decided to sell the Society’s business. E&Y submit that this allegation has no real prospect of success by reason of the following facts, all of which are indisputable:

(1) By 1998, the Society had been a mutual for 236 years. It was deeply committed to the principle of mutuality, both culturally and for business reasons. The evidence to this effect is overwhelming. E&Y will refer to: (1) the President’s Statement to Members in 1997 [4/67/661] and 1998 [5/139/1064]; (2) the Society’s press release on 20 July 2000 [6/200/1470]; (3) the reason for the Society’s rejection in March 1999 of the approach by Scottish Widows [5/122/941].

(2) The Directors were aware that the GAR policies represented a potential cost. A mere disclosure or the making of a provision in the accounts would not have told them anything which they did not already know.

(3) As already noted, a mere provision is not a cost at all. It would have represented a potential cost which the Directors did not believe would be incurred.

(4) The Directors must have believed that the DTBP was lawful, or they would not have adopted it. The DTBP both severely reduced demand for guaranteed annuity rates, and provided a method of funding the cost of providing a guaranteed rate to the few policyholders who elected to take one.

(5) The Society could lawfully have distributed the amount of surplus which it in fact distributed in 1997 and 1998 even if a provision had been made.

(6) A decision not to attempt a sale in the Spring of 1998 would not have ruled out an attempted sale at a later date should the need have arisen. The fact that the Society announced that it was up for sale on 20 July 2000 demonstrates that the Directors believed that a sale was achievable notwithstanding the disastrous outcome of the Hyman litigation.

112. E&Y’s case is further supported by events after September 1998. In particular:

(1) The Directors received advice from Counsel (believed to have been Brian Green QC and then Anthony Grabiner QC) that the Directors were entitled to award differential terminal bonuses on 17 September 1998 and 14 December 1998 (see paragraph 59(b) of the RAPC [1/5/75A]).

(2) The Directors believed that the Society could be protected from GAR liabilities by appropriate reinsurance [5/115/887].

(3) The Directors rejected an approach by Scottish Widows even after the Hyman litigation had commenced [5/122/941].

113. The inescapable conclusion is that nothing short of a final unappealable adverse ruling in the Hyman litigation would have caused the Directors to decide to sell the Society’s business.

Sale in September 2000.

114. On the very day of the House of Lords judgment in Hyman, the Society announced that it was up for sale [6/200/1470]; the terms of this press release were approved by the Board: 6/199/1468]. Schroder Salomon Smith Barney (“SSSB”) then prepared an information memorandum dated 25 August 2000 [7/203/1540]. Indicative proposals were tendered on 28 September from Prudential [7/211/1700], CGNU [7/212/1706], and Aegon [7/213/1722], and on 29 September from Eureko BV [7/214/1724]. It seems that each first round offeror caveated its proposal with specific concerns and stated that, as a result of further due diligence, it might withdraw (see SSSB’s presentation dated 25 October 2000 [8/220/1768]).

115. In the event, each of the interested parties did withdraw. The last of them withdrew on 7 December 2000 [see the Management Report for 2000 at 8/244/1912]. On 8 December the Society announced that it was closing to new business [8/223/1791].

116. Notwithstanding these facts, the Society now contends that a sale could have been effected after the House of Lords judgment. The pleader of this bizarre case might reasonably have felt the need to explain why a sale could have been effected by September 2000 when no sale materialised once the implications of the Hyman judgment became understood. What was not apparent before September 2000 which became apparent thereafter?

117. This aspect of the lost sale claim has no real prospect on the facts and should be struck out.

E.THE LOSS OF CHANCES OF SALES

118. As a variant of the lost sale claim, the Society also now seeks to claim in the alternative damages for loss of the chance of achieving a sale in September 1998 and September 2000 [RAPC, para 94A]. This claim should be struck out for the same reasons as those stated above and for the following additional reason, which was accepted by Langley J at [94].

119. The realisable value of an asset is a matter of historic fact to be determined on the evidence. It does not require the court to assess the value of the loss of a chance. The fallacy in the lost chance approach was recently exposed by the Court of Appeal in Skipton Building Society v Stott [2001] QB 261 at [11] (Evans LJ).

120. The reason is not difficult to see. The lost chance claim depends on a misuse of the word “chance”. Damages will only be awarded for loss of a chance where the claimant has been irrevocably deprived of an opportunity to do something. Examples include Chaplin v Hicks [1911] 2 KB 786, CA (loss of the chance to enter a newspaper competition to select actresses); Kitchen v Royal Air Force Association [1958] 2 All ER 241, CA (loss of the chance to pursue litigation through expiry of limitation period); Allied Maples Group v Simmons & Simmons [1995] 1 WLR 1602, CA (loss of the chance to negotiate a term in a commercial agreement).

121. In the present case, the Society has not lost the chance to sell the Society. There is no legal or other relevant impediment on the right of the Directors to solicit offers. All that has happened is that the Society has allegedly suffered a diminution in value such that no offeror will come forward. This is not the loss of a chance in any relevant sense.

F.THE BONUS DECLARATION CLAIM.

122. E&Y invited the Judge to strike out the bonus declaration claim in its entirely. In the event, the Judge concluded that it would not be right to do so, but he criticised the pleaded claim for being “fanciful in approach and amount”. He ruled that any re-pleaded claim would have come within the following three parameters. (1) There is no claim in respect of bonuses declared or awarded after 20 July 2000 (the date of the House of Lords decision in Hyman): [113] to [116]. (2) The Society’s claim must take account of steps actually taken which mitigated the alleged loss [118] to [121]. (3) The Directors would not have cut terminal bonuses by as much as 80% because that would have destroyed the efficacy of the DTBP [106(iii)].

123. E&Y have cross-appealed the Judge’s refusal to strike out or dismiss the bonus declaration claim in its entirety. There are two grounds of the cross-appeal. First, the Society has suffered no loss. Second, the Society has no real prospect of establishing that the Board would have taken a difference bonus decision in 1997, 1998 or 1999 if E&Y had insisted on higher technical provisions or (in 1998 and 1999) a disclosure note. It is convenient to address the cross- appeal first.

No loss.

124. E&Y submit that the Society has suffered no loss because: (a) the payment of bonuses to members is not a loss, but the discharge of a liability of the Society to its members and/or (b) the Society has mitigated its alleged loss.

Payment of bonuses not a loss.

125. As the Judge noted at [28], the FFA is shown as a liability in the accounts of a mutual company such as the Society and it can only be allocated in future as bonus or, if derived from earlier generations of policyholders, be retained as an inherited estate. There can be no dispute about this because the Judge has adopted the description of the FFA given by the Society itself (Arnold, para 52 at 2/19/253).

126. The treatment of the FFA as a liability in the accounts accurately reflects the fact that, matching this liability, there are assets which will one day be distributed to the Society’s members.

127. Therefore the Society’s claim necessarily involves the assertion that if the £1.6 billion of cash distributed to retiring members in the period 1998 to March 2001 had not been distributed, it would now be included on the assets side of the Society’s balance sheet, and the FFA on the liabilities side would be £1.6 billion larger.

128. This £1.6 billion would ultimately be distributed to the Society’s members. It could not have been used for any other purpose. The Society itself would never have received the benefit of the £1.6 billion.

129. On the Society’s case, all that has happened is that the £1.6 billion was distributed to a different generation of policyholders and at a different time.

130. Furthermore, in the ordinary way, the discharge of a liability is not a loss. This must clearly be the position in the case of the payment of a debt. A claim against an auditor alleging that the Claimant would not have paid a particular debt when it did but for the auditor’s alleged negligence would not disclose a loss – or at least, not a loss in the amount paid in discharge of the debt.

131. It is true that the payment of terminal bonus did not discharge specific contractual debts, but it did reduce pound for pound the liability represented by the FFA. By paying the terminal bonuses which it did, the Society obtained an equal and opposite benefit through the corresponding discharge of its liabilities.

132. The cases in which companies have recovered from their auditors the amount of dividends paid to shareholders are distinguishable:

(1) All of them are concerned with the recovery of dividends paid out of capital. This puts them in a special category. The statutory prohibition on the payment of dividends out of capital (Companies Act 1985, s263(1)) is for the protection of a company’s creditors. No such considerations arise where an excess dividend is paid out of profits or, as in this case, out of available surplus.

(2) Where dividends are properly paid out of profits available for the purpose, the payment does not in any sense discharge a pre-existing liability. Nor does the payment reduce the company’s profits; it merely distributes them.

(3) The cases where payments have been made in reliance on an auditor’s negligent report to third parties who were contractually entitled to those payments (for example a profit related bonus) are distinguishable because the payment is not voluntary but contractual. If the payment cannot be recovered on the basis that it was made under a mistake of fact, then it does reduce the company’s profits (and therefore causes loss).

133. It is not suggested (and nor could it be) that the bonuses paid in 1997, 1998 and 1999 were unlawful or that they exceeded the surplus available for distribution. Accordingly, if an auditor can ever be liable for a life assurance company’s distributions to its members, this is not such a case.

Mitigation in fact.

134. If the payment of bonuses was a loss to the Society, then the Society mitigated that loss by the steps it took on and after 20 July 2000 summarised at paragraph [40] above. The withholding of bonuses for the first seven months of 2000 was expressly intended to cover the “cost” of losing Hyman. The Judge accepted that the Society’s claim must take account of its actual mitigation.

135. The Society seeks to overcome this difficulty by the two points made at paragraph 92 of its Skeleton Argument. The first is the “double black hole” point. For the reasons given above, there were no “black holes”.

136. The second seeks to look through the Society to the identity of those who were overpaid and those who funded the £1.5 billion. The difficulty which the Society faces is that its rejection of the “no loss” point requires it to invoke the separate legal personality of the Society. If this is the correct approach for the “no loss” point, it must also be the correct approach for the mitigation point. What has to be considered is the Society’s net financial position. In ascertaining the Society’s net financial position, the £1.5 billion must clearly be brought into account.

No reduction in bonuses.

137. E&Y made submissions below to the effect that the Directors would not have decided to cut bonuses even if E&Y had insisted on a higher technical provision or a disclosure note. The foundation of this submission is, in summary, (a) that the Directors would have been most anxious not to declare bonuses at an uncompetitive level, (b) that there was no need to cut bonuses in response to potential GAR liabilities unless and until the Society was subjected to a final adverse ruling in Hyman, and (c) that a higher technical provision or a disclosure note would not have told the Directors anything which they did not already know.

138. The Judge described these submissions as “powerful” but was not persuaded that they justified dismissal of the claim (see [125]). E&Y submit that they do justify dismissal of the claim because the factual basis of the submissions is incontrovertible, and the Society has no real prospect of dislodging the facts established by the contemporaneous documents.

139. The position at February 1998 (the date of the first impugned bonus declaration claim) was as follows:

(1) The Directors had been aware of the potential GAR problem since late 1993. They had successfully solved the problem by adopting the DTBP in December 1993 and thereafter at each annual bonus declaration.

(2) There had been no challenge to the DTBP, either from members or within the Society’s management.

(3) Throughout the periods when GARs exceeded CARs, the Directors believed that equality between policyholders electing for a guaranteed rate and policyholders electing for benefits in fund form could only be achieved in paying a smaller terminal bonus to the former (see Lord Woolf’s summary of the Society’s argument at [3]). Thus, in the belief of the Directors, the achievement of equality required the continued application of the DTBP.

(4) The Society was aware of the risk inherent in a policy of full distribution (as distinct from the quite separate risk that the DTBP would be declared invalid) . The evidence shows that the Directors were aware of this risk and considered that a policy of full distribution was in the best interests of the Society’s members (see, e.g. the Tritton/Nash correspondence at [4/56/597] and [4/59/600]).

140. By February 1999, the following additional events had occurred:

(1) On 29 July 1998, the Society reported to the GAD that the cost of GARs was being “more than adequately covered by the terminal bonus cushion” and that “as the business to which annuity guarantees apply ages, the increasing terminal bonus cushion will make it increasingly unlikely that guarantees will actually bite”: see Answers 5.2 and 5.7 in the Society’s completed questionnaire to the GAD at [4/77/698,699].

(2) In the Autumn of 1999, certain GAR policyholders complained about the DTBP. The Society then obtained advice from Counsel (believed to have been Brian Green QC and then Anthony Grabiner QC) that the Directors were entitled to award differential terminal bonuses. This advice was apparently given on 17 September 1998 and 14 December 1998 (see paragraph 59(b) of the RAPC [1/9/88]).

(3) On 9 September 1998, the Appointed Actuary informed the Board that the potential cost if the DTBP were invalid was £1.5 billion.

(4) The process of considering the appropriate level of bonuses to declare and award in February 1999 involved very detailed consideration of the whole GAR issue, including different approaches to reserving and contingency plans for the eventuality of an unsuccessful outcome to the Hyman litigation: see the documents summarised at paragraph 25 above.

(5) The Board was aware by February 1999 that GAOs had been exercised in only 99 out of some 11,000 policies during 1998.

(6) The Society strongly opposed suggestions by the GAD in late 1998 that the regulatory return should contain higher reserves for GAR policies. The basis of opposition was that the Society considered its existing approach to be sufficiently prudent, and that if reserving were required “at the onerous end of the spectrum”, the Society would have to take steps “which would threaten the continued independence of the office”; and further, that giving way to pressure to adopt an excessively prudent and over-cautious reserve would have consequences for the office which were “potentially extremely serious” (see paragraphs 26 and 27 of Mr Headdon’s letter to Mr Hewitson dated 24 November 1998 [4/88/782]).

(7) In the event, the dispute was resolved by the Society taking out reinsurance (see paragraph 1(c) of the Managing Director’s Report dated 19 February 1999 [5/117/897] and items 3 and 4 of the minutes of the Board’s meeting on 24 February 1999 [5/122]), and by including a net reserve of £800,000,000 in its regulatory return. This compromise did not cause the Directors to reduce bonuses. It simply removed an obstacle to them declaring and allotting bonuses at the level which, in their commercial judgment, was appropriate.

(8) Throughout, the focus of the Directors was on the statutory solvency margin and the excess over the required minimum margin shown by the regulatory returns. This was because the regulatory returns required more prudent reserves than were required in the statutory accounts (in the form of provisions), with the result that it was the regulatory returns which determined the Society’s room for manoeuvre in relation to bonuses.

(9) Having squared its position with the GAD and the FSA, the choice which faced the Society was (on the case being advanced by the Society that provision had to be made for potential GAR liabilities notwithstanding the effect of the DTBP): (i) to defend the DTBP, in which case the Society’s highly successful business model would remain in place pending the outcome of the litigation; or (ii) to embark on a fundamental change of direction with potentially very serious consequences, even though the Society believed that the DTBP would be declared valid.

141. By February 2000, the following additional events had occurred:

(1) On 9 September 1999, the Society achieved complete victory in the Hyman litigation before Sir Richard V-C.

(2) On 21 January 2000, the Court of Appeal over-ruled the judgment below, but from a commercial perspective there was no impact on the Society because Waller LJ had sanctioned ring-fencing and Morritt LJ had agreed with Sir Richard Scott V-C. When the judgments in the Court of Appeal were handed down, the Society sought permission to continue operating the DTBP.

142. In these circumstances, the Directors would have regarded a technical provision as a book entry in respect of a cost which was unlikely ever to be incurred. They would have regarded the p