How Far The Duty to Defend May Extend

ARROWHEAD CAPITAL FIN. LTD. (in Liquidation) v. KPMG LLP (Court of Appeal [2012] EWHC 1801)

This case takes a look at duty of care issues under English law and, particularly, how far such a duty can extend. The case also examines limitations issues and when “damage” occurs for the purpose of time bar.


An English company, Dragon Futures Ltd (Dragon), sought to trade in branded mobile telephones in the grey market, which is a market outside the distribution channels authorised by the brand owners. The trades would constitute of Dragon buying consignments of mobile phones and then selling them onto other traders for a profit and recover the VAT (Value Added Tax ) element Dragon paid on the purchase prices. To be profitable, Dragon had to recover the VAT from the UK tax authorities (Her Majesty’s Revenue & Customs (HMRC).This type of trade, however, was highly risky because of the difficulty in recovering the VAT element. HMRC sought to combat fraud in the wholesale market in mobile telephones. There were schemes, known as carousel frauds or missing trade intra-community frauds, designed to obtain substantial repayment of sums which had never been paid as output tax, and, as such, HMRC considered that any transaction for which the VAT element was sought to be recovered, which was not genuine because it was part of a fraud, would not be capable of VAT recovery. HMRC prepared advices to traders on how to avoid being caught up in such frauds and the checks HMRC would expect a trader to make to ensure the integrity of the supply chain. If a transaction was not genuine, a trader could still recover the VAT element if he could show HMRC that he had the proper checks in place and that he made the appropriate checks.

In light of the above, it was therefore central for Dragon to demonstrate to potential investors that it had proper checks in place so that it could recover the VAT element of its trades. Dragon engaged KPMG’s services to establish rigorous operating procedures. To bolster its potential offering, Dragon referred to KPMG’s independent due diligence exercise in its business plan, which it distributed to potential investors. As such, Dragon secured a loan facility with Arrowhead. Although Dragon referred to KPMG in its business plan, Arrowhead never actually met with the relevant personnel at KPMG.

Unfortunately, the systems put in place by Dragon were not enough and HMRC rejected all Dragon’s claims for VAT returns, resulting in Dragon having to cease trading and defaulting on its loan repayments. Arrowhead sought to claim against KPMG for negligence.

The Issues

The main issue was whether KPMG did owe a duty of care to an investor, which was an entity it did not deal with directly. The court referred to an earlier case, Customs & Excise Commissioners v Barclays Bank Plc [2007] 1 AC 181, which set out a test to establish whether a duty of care exists or not. The test is as follows:

(a) Has there been an assumption of responsibility?;

(b) Has the threefold test of foreseeability,proximity and “fairness, justice and reasonableness” been satisfied?;

(c) Would the alleged duty be incremental to previous cases?

In the circumstances, the court found that, based on the facts, KPMG did not assume responsibility voluntarily. This was because KPMG set out its services in an engagement letter addressed to Dragon only and which contained specific limitations to the extent of the responsibility which KPMG was prepared to accept. Further, although KPMG knew of Arrowhead’s existence, there had been no contact between KPMG and Arrowhead.

The court further held that, although Arrowhead could potentially satisfy the foreseeability and proximity requirements in the threefold test, it would be unjust and unfair to impose such a duty on KPMG. This finding was based on the same reasons as stated above. The parties agreed that there was no need to opine on the third arm of the above test. As a result of these findings, the court held that KPMG did not owe a duty to its client’s investors.

The other issue was whether Arrowhead’s claim was time barred and, particularly, when Arrowhead did sustain damage. Section 2 of the Limitation Act 1980 stipulates that “an action founded on tort shall not be brought after the expiration of six years from the date on which the cause of action accrued”. An action in negligence accrues when the victim sustains damage.

Damage in context of claims for purely financial loss means actual damage, or measurable, relevant loss. To establish when actual damage was suffered, the court set out the following principles:

(a) there must be actual damage, the mere possibility of damage is not enough;

(b) the mere fact that a lender enters into a transaction by making a loan, which it would not have done otherwise, does not necessarily amount to damage;

(c) the comparison between the value of the loan and the value of the rights which the lender acquires will indicate whether the loan constitutes damage;

(d) a certain degree of factual certainty is necessary when making the above comparison.

On the facts, the court thought that Arrowhead sustained damage when it made the loans to Dragon, which happened more than six years before the claim was issued. As such, Arrowhead’s claim against KPMG was in any event time barred.

Impact: The case above illustrates how important it is for professionals to have a well-drafted engagement letter prior to taking on work. Particular focus should be also applied on the limitation of liability aspects of the engagement letter.