Supreme Court rules on correct approach to contractual construction in unforeseeable and fundamentally changed circumstances

23/01/13

Lloyds TSB Foundation for Scotland v Lloyds Banking Group plc [2012] UKSC 3

The Supreme Court has allowed an appeal by Lloyds Banking Group plc in relation to the proper construction of a payment provision in a Deed of Covenant entered into in 1997. The case raised an interesting question as to the correct approach to contractual construction in the context of changed circumstances which were unforeseeable when the contract was entered into.

By the Deed, Lloyds covenanted to pay the Lloyds TSB Foundation for Scotland the greater of (a) a specified percentage of the "Pre-Tax Profits" of Lloyds and its subsidiaries or (b) a minimum specified sum. The term "Pre-Tax Profits" was defined in the Deed to mean "the ‘group profit before taxation' shown in the Audited Accounts" of Lloyds and its subsidiaries. In January 2009, Lloyds acquired HBOS plc, at a price which was lower than the fair value of its net assets. As required by the accounting standards applicable to Lloyds in 2009, the resulting negative goodwill of over £ 11 billion was recorded in Lloyds consolidated audited income statement as a "gain on acquisition". Having taken that gain on acquisition into account, the consolidated income statement recorded a figure for "profit before tax" of over £ 1 billion. The Foundation accordingly claimed (and the Inner House of the Court of Session held) that it was entitled to be paid the specified proportion of that sum.

However, at the time the Deed was entered into it would have been contrary to both the law and applicable standard accounting practice to include an unrealised item such as the "gain on acquisition" in the consolidated audited income statement. Rather, in accordance with the requirements of the Companies Act 1985, and UK GAAP, only profits realised at the balance sheet date could be included. Further, the evidence before the Outer House of the Court of Session had established that in 1997 it was not and could not have been anticipated (and indeed was "unthinkable") that the legal position would in the future change so as to require unrealised profits to be included in the consolidated audited income statement. Lloyds therefore contended that on a proper construction of the Deed, having regard to the background against which it was made, the "gain on acquisition" should not be taken into account when calculating the sum due to the Foundation.

The Supreme Court concluded that the proper approach as a matter of construction was to identify and use the figures in the consolidated audited income statement that showed the group profit before taxation in the sense intended by the Deed, namely realised profits, and hence to exclude the figure for the "gain on acquisition". In reaching this conclusion, Lord Mance (with whom Lords Reed and Carnwath agreed) identified the question as being how the language of the Deed best operated in the fundamentally changed and entirely unforeseen circumstances in the light of the parties original intentions and purposes. Lord Clarke (with whom Lord Hope agreed) suggested that the sensible approach was to promote the purposes and values expressed or implicit in the wording of the Deed and to reach an interpretation which applied the wording to the changed circumstances in the manner most consistent with them.

The Supreme Court also rejected an argument advanced in the alternative by Lloyds that as a matter of Scots law the court had the power equitably to adjust the performance to be expected under the Deed in the changed circumstances that had arisen.

The judgment is here.

The Supreme Court YouTube summary is here.