House of Lords rules on limitation: contingent liability not actual damage

In its second judgment on limitation in just over two months, in Law Society v Sephton & Co (a firm) [2006] UKHL 22, the House of Lords has ruled on when the basic six-year limitation period will start to run against a claimant in a negligence action.

Where the defendant's negligence has caused the claimant to incur a contingent liability, without more, time will not begin to run for limitation purposes until the contingency occurs. In their Lordships' judgment a contingent liability, or the possibility of an obligation to pay money in the future, does not in itself amount to damage and therefore does not give rise to a cause of action in negligence.

In this case the Law Society sought to recover sums paid out of its Compensation Fund to clients whose funds had been stolen out of a solicitor's client account. The defendant accountants had prepared annual reports on the solicitor's accounts for submission to the Law Society but had failed to spot the misappropriations of client money. The House of Lords ruled that the Law Society did not suffer actual damage until the first claim on the Compensation Fund was received. Until that point, there was merely a contingent liability that the Law Society might have to pay money in future.

In their Lorsdships' judgment, however, the position is different in circumstances where the existence of a contingent liability diminishes the value of property owned by the claimant, or means that the claimant has received less than he should have done in a particular transaction. In such cases, the claimant will have suffered damage at that point. Whilst the case has brought some clarity to this area, the distinction seems somewhat arbitrary.

In March of this year their Lordships handed down judgment in Haward v Fawcetts (a firm) [2006] UKHL 9, establishing principles for extending the basic six-year limitation period where the claimant lacked knowledge of the relevant facts at the time the cause of action accrued (under section 14A of the Limitation Act 1980) - see post. 

Background

The Law Society sought to recover some £750,000 paid out of its Compensation Fund to clients of a dishonest solicitor. The solicitor had stolen monies held in his client account over a six-year period ending in March 1996.  During that period the defendant accountants had prepared annual reports on the solicitor's accounts for submission to the Law Society under the relevant statutory scheme for the supervision of the profession.

The Law Society alleged that in reliance on the negligent reports, it had refrained from making the investigation it would have made had the reports been properly prepared.  As a result, the solicitor was able to continue his misappropriations of client money, leading to payments out of the Compensation Fund when the fraud was ultimately discovered.

The defendant accountants accepted that the reports had been prepared negligently but argued that the claim was statute-barred under section 2 of the Limitation Act 1980, which requires an action in tort to be brought within six years from when the cause of action accrued.  It is well established that a cause of action in negligence arises when "actual damage" is suffered as a result of the negligence, so the question in this case (which was addressed as a preliminary issue) was whether the Law Society had suffered such damage before 16 May 1996, i.e. six years before the claim was issued. 

The defendant accountants argued that loss had been suffered when the solicitor first misappropriated client monies following submission of a negligent report, which was well over six years before the claim was issued. This, it was argued, gave the client a right to claim on the Fund and liability to such a claim, though contingent, amounted to actual damage.

The Law Society argued that no loss was suffered until (at the earliest) the first claim was made on the Compensation Fund in July 1996, and therefore the claim had been brought in time.

Lower court judgments

At first instance, the judge held that the cause of action had accrued at the time of the first misappropriation following a negligent report and therefore the claim was out of time.

The Court of Appeal, by a majority, reversed the judge's decision, finding that the cause of action did not accrue until the first payment was made out of the Compensation Fund.  However, Neuberger LJ delivered a strong dissenting judgement agreeing with the judge's conclusion that actionable loss had been suffered at the earlier date and therefore the claim was statute-barred.

House of Lords decision

The House of Lords unanimously dismissed the defendant's appeal. It ruled that the Law Society did not suffer loss, and therefore its cause of action did not accrue, until the first claim on the Compensation Fund was received.

Their Lordships considered in some detail the earlier authorities on the meaning of "actual damage" needed to found a cause of action in negligence. The classic formulation, as stated by the Court of Appeal in Forster v Outred & Co [1982] 1 WLR 86 and approved by the House of Lords in Nykredit Mortgage Bank plc v Edward Erdman Group Ltd (No 2) [1997] 1 WLR 1627, 1630, is "any detriment, liability or loss capable of assessment in money terms" including "liabilities which may arise on a contingency".

Lord Hoffman said this formulation gave rise to an ambiguity. In Forster, the claimant had signed a mortgage deed charging her farm to secure her son's borrowings. The son defaulted on the loan and, in an action against the solicitors who had advised her in connection with the transaction, it was held that the claimant suffered actual damage on entering into the mortgage. The thrust of the argument accepted in Forster was that although the liability under the mortgage was contingent, in that the son might pay off his debts and the claimant never be called upon to pay, it had the immediate effect of depressing the value of the claimant's farm. However, Lord Hoffman said, the reference to contingent liabilities in the quoted passage could give the impression that merely incurring a possible future liability counted as immediate damage.

The House of Lords rejected this broad interpretation, approving the judgment of the High Court of Australia in Wardley Australia Ltd v State of Western Australia (1992) 1975 CLR 514 and doubting the Court of Appeal judgment in Gordon v J B Wheatley (a firm) [2000] Lloyd's Rep PN 605. In Wardley, the claimant had been induced by the defendant's misrepresentation to enter into a guarantee. It was held that no loss had been suffered while the obligation under the guarantee remained contingent; damage occurred only later when the guarantee was called.

Their Lordships held that where, as a result of negligence, a claimant has incurred some liability which is wholly contingent, there is no loss and no cause of action unless and until the contingency is fulfilled. The situation is different if the value of some other property of the claimant is diminished as a result of the contingent liability (as in Forster), but in such cases it is the diminution in value and not the contingent liability which amounts to actual damage and gives rise to the cause of action.

In the present case, their Lordships held, the Law Society did not suffer actual damage at the time of the solicitor's misappropriations. At that point, there was merely a possibility that it would be obliged to pay money in future, pursuant to its public law duties to make discretionary payments from the Compensation Fund, if the solicitor's misappropriations were not made good and a claim was properly made on the Fund. Only once a claim had been received was the Law Society under any obligation to make payments, and actual damage was suffered only at that point.

Comment

The effect of their Lordships' judgment is that where a claimant incurs a purely personal contingent liability (for example, a personal guarantee) as a result of the defendant's negligence, no actual loss is suffered and time does not run against the claimant unless and until the contingency is fulfilled. In contrast, where the contingent liability is secured over the claimant's assets (such as a guarantee secured by a mortgage) immediate loss is suffered in the form of a diminution in the value of those assets and time starts to run at that point.

Whilst this has the benefit of clarity, and thus should assist in deciding where the starting line falls for the purposes of limitation in future negligence actions, the distinction does seem somewhat arbitrary.

In 2001, following a public consultation, the Law Commission recommended wholesale changes to the law of limitation which would render this distinction academic for the purposes of limitation. Under the proposals, there would be a basic limitation period of three years from when the claimant acquired knowledge of the facts relevant to the claim, subject to a long stop date of 10 years from the negligent act or omission. Although the government has accepted the recommendations in principle, there has been no further progress toward a draft bill.

For the time being, therefore, the distinction stands.