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Last week, on 27 and 28 of November, the Supreme Court heard the appeal from the Inner House of the Court of Session in the case of Lloyds TSB Foundation for Scotland v Lloyds Banking Group plc [2012] SC 259. This case concerns both contractual interpretation and whether Scots Law recognises the concept of ‘equitable adjustment’.

Background

Lloyds TSB Foundation for Scotland (the “Foundation”) and Lloyds Banking Group plc were parties to a deed of covenant, which obliged Lloyds to pay the Foundation a precise percentage of its group’s annual profit.

After the Deed was agreed, a European Regulation was passed, making it compulsory to include negative goodwill in company accounts. Accordingly, when Lloyds acquired HBOS, the resulting amount of negative goodwill significantly increased their profit figure.

The Foundation raised an action against Lloyds, claiming that this negative goodwill should be included in the amount due to them, which would result in a payment of over £3.5 million. Lloyds argued that negative goodwill should be excluded and that the Foundation’s entitlement was accordingly restricted to £38,920.

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

Contractual interpretation

Outer House decision

The Lord Ordinary considered the background to the Deed, including its purposes and values, and held that the parties did not intend to include negative goodwill in the amount payable to the Foundation.

He then proceeded to interpret the Deed consistently with that background. In doing so he disregarded the words ‘shown in the Audited Accounts’ in the definition of Pre-Tax Profit and Loss in the Deed, resulting in negative goodwill being excluded from the calculation.

Inner House decision

The Court found that the Lord Ordinary had erred in his interpretation of the Deed. It was necessary to ascertain what a reasonable person, with all the background knowledge reasonably available to the parties at the time of entering into the Deed, would have understood it to mean.

Looking first at the background to the contract, it held that although that reasonable person would not have known that a European Regulation would require negative goodwill to be incorporated into the accounts, he would have known that it was possible for accounting rules to change. Further, although he would not know that the figure for negative goodwill would have been so large after the acquisition of HBOS, the size of that particular figure could not affect his interpretation.

Next, the reasonable person would consider the formulation of the agreement. As the parties had agreed that a precise percentage of the profit figure would be payable, he would expect to find that profit figure in the accounts without adjustment being required.

In contrast, the Lord Ordinary had been persuaded that the parties did not intend the calculation to be affected in a dramatic way by accounting practice changes. This was wrong, as the fact that the amount of negative goodwill was dramatically high one year did not mean that the accounting rule itself was dramatic. Further, he was mistaken in finding that, after considering the background to the Deed, the parties did not intend for negative goodwill to be included, as it was not the actual intention of the parties which was material, but rather that of the aforementioned reasonable person.

Further, even taking into account the background considered by the Lord Ordinary, the Inner House concluded that the parties must have meant for the figure in the accounts to be used in the calculation. Disregarding the words ‘shown in the Audited Accounts’ was contrary to the clear and unambiguous wording of the provision. It was not valid for the Lord Ordinary to create ambiguity by removing those words and then construing the rest of the provision against the purposes and values of the Deed.

Equitable adjustment

Lloyds’ alternative argument was that the Court should, by applying the concept of ‘equitable adjustment’, exclude negative goodwill from the calculation.

This was rejected in both the Outer House and the Inner House.

The Inner House held that there was no general doctrine of equitable adjustment in Scots law which would allow them to alter the contractual obligation Lloyds owed to the Foundation. Although the equitable adjustment of contracts is permitted in some European jurisdictions, the Inner House held that developing the concept to assist Lloyds would be beyond the scope of their judicial power.

Appeal in the Supreme Court

As in the lower courts, the issues for the Supreme Court to consider are, firstly, the correct construction of the Deed, and, secondly, whether the Court could equitably adjust the Deed.

The appeal was heard by Lords Hope, Mance, Clarke, Reed and Carnwath and the decision is awaited.