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poundsIn the recent case of Lloyds TSB Foundation for Scotland v Lloyds Banking Group plc [2013] UKSC 3, the Supreme Court unanimously held in favour of Lloyds in finding that the amount they were contractually obliged to pay to the Foundation, a charitable organisation, was £38,920 instead of £3.5 million. The case concerns contractual interpretation and whether a principle of “equitable adjustment” exists in Scots law.

Factual background

Lloyds and the Foundation were parties to a Deed of Covenant agreed in 1997, which obliged Lloyds to pay the Foundation a precise percentage of its group’s annual profit every year.

A European Regulation was passed in 2002, which made it compulsory for Lloyds to include negative goodwill arising from a bargain purchase in its group’s profit and loss account. Accordingly, when Lloyds acquired HBOS in 2008, resulting in a gain on acquisition of over £11 billion, this significantly increased their profit figure.

The Foundation raised an action against Lloyds in the Court of Session in Scotland, claiming that this profit figure was the correct one to use in the calculation of the amount due to them, which would result in a payment of over £3.5 million. Lloyds argued that negative goodwill should be excluded from that calculation and that the Foundation’s entitlement was accordingly restricted to £38,920.

The main issue for the Court was therefore one of interpretation; specifically, how the Deed was to be construed in a novel legal and accounting context, which was not foreseen or foreseeable when the Deed was entered into.

Lloyds succeeded at first instance in the Court of Session before the Lord Ordinary (Lord Glennie), but his decision was overturned by the Inner House (Lord President Hamilton and Lords Carloway and Kingarth) and Lloyds appealed to the Supreme Court.

Arguments before the Supreme Court

The Foundation argued that the Deed should be given its ordinary meaning. It submitted that the phrases “group profit before taxation” and “shown in the audited accounts” in the Deed bound Lloyds to the figure in future accounts which corresponded to that description, even if the calculation for reaching group profit was fundamentally different by that point.

Lloyds submitted that, on a proper interpretation of the Deed, the gain on acquisition should be excluded from the amount payable to the Foundation. However, if they failed on the interpretation point, they argued that the Court should still find in their favour by equitably adjusting the Deed.

The Supreme Court’s decision

1. Interpretation of the Deed

The main judgment was delivered by Lord Mance, with whom Lords Reed and Carnwarth agreed.

He stressed the importance of placing the Deed in the legal and accounting context which existed at the date it was agreed. It was contrary to both law and accounting practice to include an unrealised gain like “gain on acquisition” in consolidated accounts in 1994. Only profits realised at the balance sheet date could lawfully be included, in accordance with the requirements of the Companies Act 1985 and accounting standards at that time.

As such, expert evidence before the Lord Ordinary was that the development in 2002 was unforeseen, unforeseeable and “unthinkable” at the date the Deed was executed. Accordingly, Lord Mance found that the change in accounting practice was completely outside the parties’ original contemplation in 1994.

The Foundation had argued for the wording of the Deed to be applied mechanically, with no consideration being given to legal and accounting changes, so that only the single line for group profit or loss should be referred to in the accounts. Lord Mance held that there was no principle of construction to support this argument.

Instead, the proper approach was to interpret the parties’ original intentions in a contextual and purposive manner, and then to evaluate how the wording of the Deed best operated in these unforeseen circumstances.

Lord Mance found that, when the Deed was agreed, the parties were only concerned with realised profits or losses before taxation. Accordingly, the wording of the Deed operated best, and naturally, by excluding the unrealised gain on acquisition. This approach gave effect to the original intentions of the parties in radically different legal and accounting circumstances, and did not involve re-writing the Deed, which was what the Inner House had concluded.

Therefore, the Inner House’s literal approach to interpretation was incorrect. They had failed to evaluate both what the parties had in mind, and the significance of the legal and accounting context, when the Deed was executed.

Although Lord Mance came to the same conclusion as the Lord Ordinary, he disagreed with his approach. The Lord Ordinary had disregarded the words “shown in the audited accounts”, but it was not necessary to do this to give effect to the real meaning of the Deed.

Interestingly, Lord Hope and Lord Clarke, who both delivered separate judgements, said that they were initially inclined to accept the Foundation’s argument that the Deed should be given its ordinary meaning. However, they were both persuaded by Lord Mance’s judgement and agreed that the correct approach was what the reasonable man would have taken the words of the Deed to mean, given what was known at the time the Deed was agreed, when it would have been unimaginable to include negative goodwill in accounts.

2. The doctrine of equitable adjustment

Lord Hope also addressed Lloyds’ alternative argument concerning equitable adjustment. This was not necessary as Lloyds had succeeded with their primary argument, but he felt the point was of general interest and so some comment should be made.

Lloyds argued that this doctrine should be available where performance of a contract did not resemble what was originally contemplated, due to supervening events for which neither party to the contract was responsible, and the substance of the contract was affected by these events.

Although Lord Hope stressed that it was important for the law to be adaptable, he held, with Lord Clarke agreeing, that Scots law did not allow a court equitably to adjust a contract on the basis that its performance, while not frustrated, was not originally contemplated by the parties.

Comment

This case makes for interesting reading, dealing with the unusual issue of how a contract should be interpreted in completely unforeseen and unforeseeable circumstances.

The Justices relied on the established principle of purposive interpretation, holding that it was necessary to examine the intentions of the parties at the time the contract was made, bearing in mind the legal and accounting rules at that time. Accordingly, external circumstances formed part of the interpretation exercise.

The Inner House had also taken account of these circumstances, but had held that the ordinary man would have known that these legal and accounting rules were bound to change, and simply because the result was radical one year did not mean that the change itself was radical. The Supreme Court disagreed with this conclusion, finding that this was a radical change that the ordinary man would not have foreseen. It was this evaluation of foreseeability, relying heavily on expert evidence, that made the difference.

The Supreme Court also held that, although the Lord Ordinary was wrong to disregard certain words of the contract, this “radical” approach may be acceptable in some contexts. Accordingly, it may be said that they disagreed with the Inner House’s conclusion that doing so would amount to re-writing the Deed. However, they did not provide examples of such circumstances, and it is difficult to imagine a change more unforeseen and unforeseeable than the “unthinkable” changes in this case.

Although Lord Hope’s comments on the existence (or lack thereof) of the remedy of equitable adjustment where a contract has not been frustrated were obiter, we now know that he agrees with the Lord Ordinary and the Inner House on this issue, as Lloyds argued for this at each stage of the case.