Lloyds TSB Foundation for Scotland v Lloyds Banking Group Plc (Scotland) [2013] UKSC 3

The Supreme Court held that an unrealised £11bn "gain on acquisition" arising from Lloyds' rescue of HBOS, newly required by IFRS 3, fell outside the "group profit before taxation" in a 1997 charitable covenant. Appeal allowed; the Foundation received only the £38,920 minimum.

Facts

On the 1986 flotation of TSB Group plc, four deeds were executed under which four charitable foundations were to receive payments totalling around 1% of the group’s pre-tax profits. Covenanted payments were used because they were a charge on income and a more tax-efficient method of providing income than dividends.

The deed relevant to the respondent, Lloyds TSB Foundation for Scotland (“the Foundation”), was amended in 1993 and replaced by a new Deed in February 1997 with the appellant, now Lloyds Banking Group plc (“Lloyds Bank”). Clause 2 obliged Lloyds Bank to pay the greater of one-third of 0.1946% of “Pre-Tax Profits (after deducting Pre-Tax Losses)” or £38,920. Clause 1 defined those terms by reference to the “group profit before taxation” and “group loss before taxation” “shown in the Audited Accounts”, adjusted to exclude minority interests and “any profits or losses arising on the sale or termination of an operation”. That last exclusion had been added in 1993 to counteract the effect of Financial Reporting Standard 3, which had moved such exceptional items into “ordinary activities”.

When the deeds were made, two principles governed accounts under the Companies Act 1985 (implementing the Fourth Council Directive 78/660/EEC): the profit and loss account concerned ordinary activities before taxation, and only profits realised at the balance sheet date could be included. Negative goodwill on a bargain purchase was credited to reserves, not the profit and loss account. EU Regulation 1606/2002 changed this: from accounting periods beginning on or after 1 January 2005, listed companies had to prepare consolidated accounts under IFRS, and paragraph 34 of IFRS 3 required negative goodwill on a bargain purchase to be recognised immediately in the consolidated income statement, although unrealised.

Following Lloyds Bank’s rescue of HBOS, its 2009 consolidated income statement showed a “gain on acquisition” of over £11 billion, converting a loss of over £10 billion into a “profit before tax” of just over £1 billion. That gain was unrealised, non-distributable, non-taxable, and did not appear in Lloyds Bank’s own individual accounts, where the acquisition was recorded at cost. The Foundation claimed £3,543,333; Lloyds Bank said only the £38,920 minimum was payable. The Lord Ordinary granted decree of absolvitor (holding the words “shown in the Audited Accounts” could be disregarded); the Inner House reversed.

Issues

Lord Mance framed the question at the outset:

The issue on this appeal is how a covenant should be construed and understood as applying in a novel legal and accounting context, which was not foreseen or foreseeable – or was, according to uncontradicted expert evidence, “unthinkable” – when the covenant was entered into.

Specifically: (1) whether the unrealised “gain on acquisition” formed part of the “group profit before taxation … shown in the Audited Accounts” under clause 1 of the 1997 Deed; and (2) if the Foundation succeeded on construction, whether Scots law recognised a doctrine of “equitable adjustment” permitting the court to adjust a contract not frustrated but whose performance no longer resembled what was contemplated.

Arguments

For the Foundation, the Dean of Faculty argued for a straightforward, mechanical application of clauses 1 and 2: the accounts contained a line “profit before tax: 1,042[,000,000]”, which should be taken without further enquiry. The parties must have anticipated changes in accounting standards over the life of the covenant, and the 1993 amendment showed that where they wished to exclude an item, they said so expressly. He submitted that any unfairness was answered by the fact that if the unrealised gains did not materialise, that would tell against the Foundation in later years; and that Lloyds Bank’s construction would cause problems in later accounting periods.

For Lloyds Bank, it was argued that the gain on acquisition should be left out of account, the deeds having been aimed at realised, distributable, taxable profits. Mr Barne argued in the alternative for equitable adjustment, confined to cases where supervening, unforeseen and unforeseeable events for which neither party was responsible affected the substance of the contract; he expressly disclaimed frustration and any general power to adjust contracts.

Judgment

The Supreme Court allowed the appeal unanimously, recalled the Inner House’s interlocutor and restored the Lord Ordinary’s decree of absolvitor, though for different reasons.

Lord Mance (with whom Lord Reed and Lord Carnwath agreed)

Lord Mance rejected the Foundation’s mechanical approach:

The description mechanical is appropriate, but the value of machinery depends upon its being correctly directed towards the right end. In this respect, the proper approach is contextual and purposive.

He relied on Prenn v Simmonds [1971] 1 WLR 1381 and Lord Mustill’s observation in Charter Reinsurance Co Ltd v Fagan [1997] AC 313 that words “must be set in the landscape of the instrument as whole”. Placed in their legal and accounting landscape, the deeds “were, when made, and could only have been, concerned with and aimed at realised profits or losses before the taxation which would fall on group companies”. The Lord Ordinary had found on unchallenged expert evidence that the change could not have been anticipated without “magical powers of foresight” and that, if foreseen, the parties would have adopted a different formula.

Since no one suggested frustration, the question was how the language best operated in fundamentally changed and unforeseen circumstances, having regard to the parties’ original intentions: Bank of Credit and Commerce International SA v Ali [2001] UKHL 8, [2002] 1 AC 251, Bromarin AB v IMD Investments Ltd [1999] STC 301 and Debenhams Retail plc v Sun Alliance and London Assurance Co Ltd [2005] EWCA Civ 868, [2006] 1 P & C R 123. He held:

No principle of construction insists that the words “group profit [or loss] before taxation … shown in the Audited Accounts” can only be satisfied by reference to a single line entry in accounts, however great and unforeseen the changes in law and accounting practice which have in the meantime occurred and whatever the consequences.

He noted that between 1986 and 1991 the prescribed formats may have required an exercise in subtraction to identify the figure, which would still be “shown in the Audited Accounts”. The correct approach was:

The proper approach as a matter of construction is to identify and use the figures in the consolidated income statement which show the group profit or loss before taxation in the sense intended by the Deed.

He rejected the Foundation’s argument that the 1993 amendment showed that all accounting changes must be accepted absent express exclusion: those items were realised and could lawfully appear in a profit and loss account. He also identified “striking irrationality” in the Foundation’s case: because of the £38,920 floor, the Foundation could retain the benefit of an unrealised gain without suffering the corresponding later detriment; and because clause 3 excluded profits or losses on the sale or termination of an operation, a later actual sale of HBOS at a profit would not benefit the Foundation, nor would a loss be brought into account. The Inner House had erred in treating the contract as operating on an entirely literal basis by reference to a single line, and in thinking Lloyds Bank’s construction involved “re-writing” the Deed. The Foundation’s suggested future-period difficulties were dismissed as unsupported by the expert evidence.

Lord Hope (with whom Lord Reed and Lord Carnwath agreed)

Lord Hope had initially been inclined towards the Foundation’s reading, but was persuaded that the words must be read as a reasonable person would have taken them in 1997, when the introduction of negative goodwill into the profit and loss account was unthinkable; the Foundation’s reading “would be to give them a meaning which no reasonable person would have dreamed of at that time”.

Although it was unnecessary to decide the point, Lord Hope addressed equitable adjustment because it had been fully argued. He accepted that Scots law provides equitable readjustment in cases such as frustration (Cantiere San Rocco SA v Clyde Shipbuilding and Engineering Co 1923 SC (HL) 105) and abatement of rent on partial destruction (Muir v McIntyre (1887) 14 R 470; Sharp v Thomson 1930 SC 1092), and cited Wilkie v Bethune (1848) 11 D 132. But he held there was no general doctrine allowing adjustment where a contract is “nearly frustrated but not quite”. Modern purposive construction, as in Rainy Sky SA v Kookmin Bank [2011] UKSC 50, [2011] 1 WLR 2900, made resort to equity unnecessary; nor could enrichment be unjustified if it flowed from the covenant’s true meaning. He also noted the acquisition was a voluntary act taken after IFRS 3 had been issued. He concluded that to recognise such a doctrine “would be to undermine the principle enshrined in the maxim pacta sunt servanda which lies at the root of the whole of the law of contract”.

Lord Clarke

Lord Clarke began: “I have found this to be a very difficult case.” Initially attracted to the Foundation’s case, he was persuaded by Lord Mance’s reasoning, emphasising the finding that unrealised profits being treated as group profit before taxation was unthinkable in 1997, and endorsing the approach in Debenhams of applying the wording to changed circumstances in the manner most consistent with the purposes and values expressed or implicit in it. He agreed entirely with Lord Hope on equitable adjustment.

Implications

The decision is a leading illustration of contextual and purposive construction where supervening legal or regulatory change alters the meaning that literal wording would produce. It shows that a formula tied to a defined accounting figure is not necessarily bound to whatever single line later appears under that label; the court will ask what the parties meant by the concept when they used it, in the legal and accounting landscape then existing.

The reasoning is fact-sensitive. It rested on unchallenged expert evidence and findings that the change was unforeseen and unforeseeable, that the deeds were directed at realised, distributable and taxable profits, and that the Foundation’s reading produced incongruous results given the guaranteed minimum and the clause 3 exclusion. It does not license departure from clear wording merely because a party finds the outcome commercially unattractive, nor did the Court treat the contract as frustrated or rewritten.

For practitioners, the case is important to those drafting long-term formulae referable to published accounts, tax or regulatory measures: express provision for changes in accounting standards, or for realised versus unrealised items, avoids this litigation. It is also of significance in Scots law: although strictly obiter, the reasoning of Lord Hope, agreed with by Lord Reed, Lord Carnwath and Lord Clarke, rejects a free-standing doctrine of equitable adjustment for contracts short of frustration, while leaving intact established equitable remedies in frustration, unjustified enrichment and lease abatement cases.

Verdict: Appeal allowed. The Supreme Court held that the unrealised “gain on acquisition” of over £11 billion recognised under IFRS 3 in the 2009 consolidated accounts fell outside the “group profit before taxation” for the purposes of the 1997 Deed, so that the group had made a loss and only the minimum payment of £38,920 was due. The Inner House’s interlocutor was recalled and the Lord Ordinary’s interlocutor granting decree of absolvitor was restored, albeit for different reasons. It was unnecessary to decide the equitable adjustment issue, but Lord Hope (with Lord Reed, Lord Carnwath and Lord Clarke agreeing) would have held that no doctrine permitting equitable adjustment of an unfrustrated contract forms part of Scots law.

Source: Lloyds TSB Foundation for Scotland v Lloyds Banking Group Plc (Scotland) [2013] UKSC 3