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

A contract must be interpreted objectively and in its legal, factual and commercial context. Where unforeseen changes have altered the meaning or consequences of an accounting expression, the court should apply the contractual language in the manner most consistent with the parties’ original purposes.

A covenant calculated by reference to group profit before taxation did not encompass an unrealised gain which later accounting rules required to be recognised. The expression meant realised profit or loss before taxation, as understood when the deed was executed. The audited accounts remained the contractual source, but the relevant figure could be derived from more than one entry.

A 1997 deed required Lloyds Banking Group plc to make an annual payment to a charitable foundation calculated by reference to group profit before taxation shown in its audited accounts, subject to a minimum payment. Its 2009 consolidated accounts recognised an unrealised gain exceeding £11 billion following the acquisition of HBOS. That entry converted an underlying loss exceeding £10 billion into a reported pre-tax profit exceeding £1 billion.

The Lord Ordinary granted decree of absolvitor: [2011] CSOH 105. The Inner House reversed that decision: [2011] CSIH 87. The central issue was whether the covenant included the unrealised gain, which accounting rules introduced after the deed required to be recognised in consolidated accounts.

1. Appeal allowed unanimously. Lord Mance, with whom Lord Reed and Lord Carnwath agreed, held that the unrealised gain on acquisition fell outside the calculation required by the deed. Lord Hope and Lord Clarke reached the same conclusion. The Inner House’s interlocutor was recalled and the Lord Ordinary’s decree of absolvitor restored.
2. The proper approach to construction was contextual and purposive. Contractual words must be read within the landscape of the instrument as a whole and against the circumstances and purposes known when the contract was made. Where unforeseeable changes create a fundamentally different legal and accounting context, the language should operate in the manner most consistent with the parties’ original intentions.
3. When the deed and its predecessors were executed, company law and accounting practice permitted only realised profits to be included in a profit and loss account. The covenant was intended to operate by reference to realised profits or losses before the taxation falling on group companies. An unrealised gain on acquisition, which could not be taxed, distributed as a dividend or included in such accounts when the deed was executed, did not answer that contractual description.
4. The expression “shown in the Audited Accounts” remained effective. It did not compel the selection of a single bottom-line entry regardless of later changes in accounting rules. The relevant profit or loss could be identified from several entries in the consolidated income statement. The unrealised gain was therefore excluded, leaving a loss for the relevant period and restricting the Foundation’s entitlement to the minimum £38,920.
5. Lord Hope, with Lord Reed, Lord Carnwath and Lord Clarke agreeing, considered the alternative argument concerning equitable adjustment. Although unnecessary to the disposition, they concluded that Scots law does not empower a court to adjust a contract merely because supervening events have made performance materially different from what was contemplated, where performance remains possible and the contract is not frustrated. Such a power would undermine pacta sunt servanda. Existing equitable remedies associated with frustration, destruction of essential subject matter and unjustified enrichment did not justify rewriting an otherwise enforceable obligation.

1. United Kingdom Supreme Court: Allowed the appeal unanimously, recalled the Inner House’s interlocutor and restored the Lord Ordinary’s decree of absolvitor: [2013] UKSC 3.
2. Inner House of the Court of Session: Reversed the Lord Ordinary on contractual construction and rejected the Bank’s cross-appeal concerning equitable adjustment: [2011] CSIH 87.
3. Outer House of the Court of Session: The Lord Ordinary granted decree of absolvitor on the construction issue and concluded that the proposed doctrine of equitable adjustment was unavailable: [2011] CSOH 105.