Lloyds TSB Foundation for Scotland v Lloyds Banking Group Plc (Scotland)

The Supreme Court construed a covenant in a 1997 Deed which obliged Lloyds Banking Group to pay the Foundation a share of the group’s "group profit before taxation" shown in the audited accounts. The court held that the phrase must be read in its legal and accounting context at the time the Deed was made and therefore refers to realised profits or losses before taxation, not to an unrealised negative goodwill entry recognised under later IFRS rules as a "gain on acquisition". The change effected by Regulation 1606/2002 and IFRS 3 (recognition of negative goodwill in consolidated income statements from 1 January 2005) was unforeseeable and would not, had it been foreseen, have been accepted as part of the computation of distributable or taxable profit under the Deed.

Accordingly the unrealised "gain on acquisition" included in the group consolidated accounts for 2009 was excluded when ascertaining the relevant group profit before taxation for the covenant. The Foundation therefore received only the contractual minimum payment for that year. The court also considered, but did not decide as necessary, arguments about a Scots-law doctrine of equitable adjustment and expressed doubt about a general power to adjust contracts in the way proposed.

Background and parties: The dispute concerned a covenant in a Deed executed in 1997 between Lloyds Banking Group (then Lloyds TSB Group plc) and Lloyds TSB Foundation for Scotland (the Foundation). The Deed replaced earlier Deeds dating from 1986 (amended 1993) and provided for payments to the Foundation equal to one-third of 0.1946 per cent of the group's pre-tax profits or a guaranteed minimum sum of

Facts and procedural posture: The dispute focused on the audited consolidated accounts for 2009, which included a consolidated entry described as "gain on acquisition" (negative goodwill) of over (over ) which converted an otherwise realised pre-tax loss into a pre-tax profit on the consolidated face of the accounts. The Foundation contended that the covenant tied to the line "profit before tax" should be applied mechanically to that consolidated figure; the bank contended that the unrealised negative goodwill should not be treated as realised profit for the purposes of the Deed.

Issues before the court: (i) whether the consolidated "gain on acquisition" (negative goodwill) recognised under IFRS 3 and Regulation 1606/2002 should be included in the group pre-tax profit for calculation of the covenant; (ii) whether the Deed required a literal reading tied to the single labelled line in audited consolidated accounts or a contextual construction informed by the accounting and statutory framework applicable when the Deed was executed; and (iii) as a cross-issue, whether a doctrine of equitable adjustment in Scots law should permit the court to alter the Deed to exclude the item.

Reasoning and decision: The court adopted a contextual and purposive approach to construction. It concluded that the Deed, conceived in an era when only realised profits could lawfully appear in profit and loss accounts under the Companies Act 1985 and associated GAAP/SSAP rules, referred to realised profit or loss before taxation. The recognition of negative goodwill in consolidated income statements from 2005 under IFRS 3 was an unforeseeable change and would not have been accepted by the parties as part of the computation of distributable or taxable profit. Applying that construction produced an outcome whereby the unrealised "gain on acquisition" was excluded and the Foundation received the minimum payment for 2009. The court did not need to decide finally the availability of a general equitable adjustment doctrine in Scots law and endorsed the view that there is no broad power to adjust contracts in the manner proposed where the contract is not frustrated.

Appeal allowed. The Supreme Court held that the phrase "group profit before taxation shown in the Audited Accounts" in the 1997 Deed must be read in the accounting and statutory context at the time the Deed was made and therefore refers to realised profits or losses before taxation. The consolidated unrealised "gain on acquisition" recognised under IFRS 3 in the 2009 accounts was excluded for the purposes of the covenant; accordingly the Foundation was entitled only to the minimum contractual payment for 2009. The court considered and rejected the need to invoke a general doctrine of equitable adjustment to reach that result.

The case came to the Supreme Court on appeal from the Inner House of the Court of Session: [2011] CSIH 87 (reversing the Lord Ordinary). The Lord Ordinary in the Outer House had granted decree of absolvitor: [2011] CSOH 105. The Supreme Court allowed the appeal and restored the Lord Ordinary's interlocutor.