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The Interpretation of Contracts When the Unforeseen Happens

Posted in Case Comments, Contracts
Geoff R. Hall

Purposive and contextual interpretation that achieves the original meaning

Disputes over the meaning of contracts most often arise in one of three circumstances. The first is when an event has occurred that the contracting parties did not foresee or provide for at the time of contracting. The second is when there was (subjectively) no meeting of the minds on a particular point, with the result that the parties have ended up with diverging expectations of their contractual rights and obligations. The third is when there has been sloppy or faulty drafting, such that the contractual language is ambiguous or unclear. The decision of the UK Supreme Court in Lloyds TSB Foundation for Scotland v. Lloyds Banking Group plc decidedly falls in the first category. A change in accounting rules that was unforeseen, unforeseeable and indeed unthinkable at the time of contracting led to an interpretive dispute. How, then, is a contract to be interpreted when the unforeseen happens?

The answer, according to the UK Supreme Court, is to consider the contractual language purposively and contextually to discern the meaning of the contract at the time it was made. The result does not break any new ground – rather it applies well established principles – but it is an interesting example of the way UK (and Canadian) courts approach contractual interpretation. (As a technical matter the case was decided under Scottish law, but the relevant principles are identical to the law of England and of common law Canadian provinces.)

Decision

In 1997, Lloyds Bank (“Lloyds“) and Lloyds TSB Foundation for Scotland (the “Foundation“) entered into an agreement requiring Lloyds to make an annual payment to the Foundation, which undertakes charitable activities. The payment was to be a certain percentage of Lloyds’ pre-tax profit or £38,920, whichever was greater.

In 2009, at the depth of the international financial crisis, Lloyds bought a troubled mortgage lender, HBOC plc, for half its book value. Under UK accounting principles at the time of the agreement in 1997, the acquisition would not have affected Lloyds’ consolidated income statement (its profit and loss statement) because the difference between the price Lloyds paid for HBOC and its book value was an unrealized profit. Only if Lloyds sold its interest and realized a profit would the gain be included on the profit and loss statement.

However, in 2005 the UK adopted European Union regulations that required publicly traded companies like Lloyds to include unrealized gains in their consolidated profit and loss statements. The uncontradicted expert evidence was that in 1997 such a change was not only unforeseen and unforeseeable but also “unthinkable”.

The “unthinkable” event had a potentially profound effect. Without inclusion of the unrealized gain on the acquisition of HBOS, Lloyds lost over £10 billion in 2009, which would result in the Foundation receiving the minimum payment of £38,920. However with inclusion of the unrealized gain, Lloyds’ loss of £10 billion became a profit of over £1 billion. As a result, the Foundation would be entitled to a payment of £3,543,333.

How, then, was the agreement between Lloyds and the Foundation to be interpreted in light of the occurrence of the “unthinkable” event?

The contract itself did not make clear what would happen if the accounting rules changed, for the simple reason that the parties “did not think of such a possibility because it was unthinkable”. Thus the case fell squarely in the first category of contractual disputes. There was no failure to achieve a meeting of the minds and there was no error in contract drafting. Something unforeseen and unforeseeable had happened through no fault of either of the contracting parties.

The Supreme Court therefore turned to two well-established principles of contractual interpretation: a contract must be read contextually and purposively, not mechanically and literally; and the meaning of a contract is fixed at the time of contract formation and cannot change subsequently.

The Foundation argued for a “mechanical” application of the contract language, contending that since Lloyds’ financial statements showed a profit of over £1 billion that was the end of the story. The Supreme Court rejected the mechanical approach, finding instead that “the proper approach is contextual and purposive”. Citing seminal cases like Prenn v. Simmonds, [1971] 1 WLR 1381 (HL) that mandate a contextual approach that gives significant weight to the factual matrix of a contract, the Supreme Court held that “the landscape, matrix and aim of the 1997 Deed as well as its predecessors could not be clearer. They 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.”

Moreover, what was important was the original intention of the parties at the time of contract formation: “the question is how [the contractual] language best operates in the fundamentally changed and entirely unforeseen circumstances in the light of the parties’ original intentions and purposes.” In this light, the contractual language “operates best, and quite naturally, by ignoring in the 2009 accounts the unrealised gain on acquisition and treating the loss which exists apart from that as the relevant figure”.

Thus it was an error for the lower court (whose judgment was reversed) to have “assumed, contrary to all the indications and regardless of the consequences, that the contract must operate on an entirely literal basis by reference to a single line in whatever accounts might in future be produced in circumstances and under legal and accounting conventions entirely different from those in and for which it was conceived.” The Foundation was therefore entitled only to the minimum payment of £38,920.

Significance

Lloyds TSB Foundation for Scotland v. Lloyds Banking Group plc does not alter the law but rather reaffirms longstanding principles. It has long been established that the meaning of a contract does not change over time (in contrast to statutory and constitutional interpretation, where meaning can change over time as social circumstances evolve). The shift to contextual interpretation based on the factual matrix occurred over 40 years ago and is now well entrenched in the jurisprudence (at least in the UK and Canada: Australia and some American jurisdictions follow a more textualist approach). But the case is a good illustration of the principles in play, and an interesting exposition of how a contract is interpreted when the unforeseeable occurs.

Case Information

Lloyds TSB Foundation for Scotland v. Lloyds Banking Group plc, [2013] UKSC 3

Date of Decision: January 23, 2013