Scottish Court of Session Decisions

OUTER HOUSE, COURT OF SESSION [2011] CSOH 105
CA115/10	OPINION OF LORD GLENNIE in the cause LLOYDS TSB FOUNDATION FOR SCOTLAND Pursuers; against LLOYDS BANKING GROUP plc Defenders: _______________

Pursuers: Dean of Faculty, Richardson; Simpson & Marwick

Defenders: James McNeill QC, Barne; Maclay Murray & Spens LLP

17 June 2011

Introduction

[1] On 23 January and 4 February 1997, the defender, Lloyds Banking Group plc, entered into a Deed Covenant ("the Deed") with the pursuer, Lloyds TSB Foundation for Scotland, providing for payment to the pursuer of a certain amount each year from 1 January 1997 until, in effect, a date in the future to be specified by the defenders by not less than 9 years' notice in writing. I was told that such notice has recently been given in consequence of the dispute which has arisen in the present case. Upon the expiry of that notice some years hence, the Deed will have been in force for 20 years or more. In other circumstances it might have lasted for considerably longer. Whatever may turn out to be the precise duration of the Deed, it is clear that its terms were intended to regulate the payments to be made by the defender to the pursuer for a long time.

[2] The parties are in dispute about the proper interpretation of the provision for payment in the Deed. The dispute arises in the context of the defender's acquisition of HBOS in 2009 and the treatment in its accounts of the negative goodwill arising from that acquisition.

[3] In the Deed, the defender is referred to as "the Company" and the pursuer as "the Foundation". Clause 2(1) of the Deed provides as follows:

"2(1) The Company hereby covenants with the Foundation that on every Covenanted Payment Date during the period specified in Clause 3 the Company will subject to the provisions of this Clause pay to the Foundation whichever shall be the greater of:

(a)   an amount equal to one-third of 0.1946 per cent of the Pre-Tax Profits (after deducting Pre-Tax Losses) for the Accounting Reference Periods all or part of which fall within the Base Period but excluding in the case of any Accounting Reference Period part of which falls outside the Base Period that proportion of the Pre-Tax Profit or Pre-Tax Loss therefor which the duration of the said part bears to the duration of that Accounting Reference Period; and

(b)  the sum of £38,920.

TOGETHER with interest thereon for the relevant Interest Period contained at the Interbank Rate".

Clause 3 identifies the period referred to in Clause 2(1) as being the period commencing on 1 January 1997 and continuing until the happening of one of two events, the relevant one here being the expiry of a period fixed by the defender by giving not less than 9 years' notice in writing.

[4] There are a number of definitions relevant to the proper construction of Clause 2(1). These are set out in Clause 1. "Pre-Tax Profit" and "Pre-Tax Loss" are defined as meaning

"in relation to any Accounting Reference Period ... respectively the 'group profit before taxation' and the 'group loss before taxation' (as the case may be) shown in the Audited Accounts for such period adjusted to exclude therefrom any amounts attributable to minority interests and any profits or losses arising on the sale or termination of an operation, such adjustment to be determined by the Auditors on such basis as they shall consider reasonable, which determination shall be conclusive and binding on the parties thereto."

The expression "Audited Accounts" is defined as follows:

"'Audited Accounts', in relation to any Accounting Reference Period, means the audited consolidated accounts of the Company and its subsidiaries for that period."

An Accounting Reference Period means an accounting reference period of the Company. Finally, "Base Period", in relation to any Covenanted Payment Date, means

"the period of three years ending on 31 October in the year preceding the year in which such Covenanted Payment Date falls."

I am not concerned with the detail of the Covenant Payment Date.

[5] The "audited consolidated Accounts of the Company" for the Accounting Reference Period ending 31 December 2009, i.e. defender's Annual Report and Accounts for 2009 ("the Accounts"), were lodged in process. The figure shown for "Profit Before Tax" in the Consolidated Income Statement at p.127 of the Accounts is £1.042 billion (using billion in its current, short scale, American, sense of one thousand million, or 10⁹). For the purpose of the Deed, amounts attributable to minority interests are to be excluded from that figure. The profit before tax attributable to minority interests is agreed to be £135 million. On this basis, the pursuer contends that, for the purpose of Clause 2(1) of the Deed, the "Pre-Tax Profit" for the Accounting Reference Period ending 31 December 2009 is £907 million (£1.042 billion less £135 million). In the first Conclusion of the Summons, the pursuer seeks declarator to that effect. It is agreed that, on the pursuer's case, the sum due under Clause 2(1) for that Accounting Reference Period is £3,543,433. In its second Conclusion, the pursuer seeks decree for payment of that sum.

[6] The defender disputes the pursuer's construction of the clause. The figure in the Accounts for "Profit Before Tax" of £1.042 billion takes into account "negative goodwill" of £11.173 billion arising from the acquisition of HBOS in 2009. The defender argues that, on a proper construction of the Deed, that negative goodwill does not form part of "group profit before taxation", or "Pre-Tax Profit", for the purposes of the calculation to be made under Clause 2(1). It also advances a separate argument, in the event that it fails in its arguments as to the proper construction of the Deed. In those circumstances, it submits that the Deed should be "equitably adjusted" so as to exclude the negative goodwill from calculation of "Pre-Tax Profits" for the purpose of Clause 2(1), since otherwise performance of the payment obligations in the Deed would no longer bear any realistic resemblance to the performance originally envisaged thereunder.

[7] The dispute has arisen because of a combination of two separate factors. First, there have, over the years, been a number of significant changes in accounting practices, the most significant of which for present purposes is that negative goodwill is now required to be shown in the group income statement and, although not part of any profit distributable to shareholders, is treated for accountancy purposes as part of the pre-tax profit. The second factor is that, in 2009, the defender, then known as Lloyds TSB Group plc, acquired 100% of the ordinary share capital of HBOS plc. It is a matter of agreement between the parties, for the purpose of this action, that the fair value of the net assets thereby acquired by the defenders was significantly in excess of this sum, the difference between the fair value and the amount actually paid by the defender amounting to £11.173 billion. In accounting terminology, this is known as "negative goodwill". In accordance with accounting practices current at the time of the acquisition, and for the Accounting Reference Period in question in this action, therefore, that negative goodwill required to be stated as part of the defenders' pre-tax profit.

[8] The case came before the court for a proof before answer. It was agreed that the defender should lead at proof. In the event, there was no dispute about the basic facts. Joint bundles of productions were lodged, as were two Minutes of Admissions covering the documentation and certain other matters. The only evidence led was accountancy evidence, the defenders leading evidence from Mr Simmonds of Deloitte LLP and the pursuers leading evidence from Mr Merris of BDO LLP. Both experts gave their evidence under reference to Reports lodged in process.

Background

[9] The background to the entering into of the 1997 Deed was not seriously in dispute, though there was an issue as to the relevance of that background to the question of construction.

[10] The pursuer is one of four charitable foundations established at the time of the flotation of the TSB Group in 1986. They were established in order to preserve the charitable tradition of trustee savings banks.

[11] The flotation of the TSB Group and the establishment of the charitable foundations (referred to as "the foundations") were under discussion for a very considerable period before coming to fruition. Parties placed before the court selected documents (letters, papers, etc.) as a way of illustrating points that had been considered during the discussions.

[12] A letter from Sir John Read, the Chairman of the TSB Central Board, to Mr Monck, Under Secretary to the Treasury, dated 3 October 1983 set out the Board's proposed way of dealing with the foundations and how the endowment of the foundations would be explained in the prospectus. The prospectus would contain a section describing the purposes of the foundations, their constitutions and the way in which the endowment would be made. The steps to be taken included the endowment of the foundations with sufficient funds to enable them to subscribe for non-voting "A" ordinary shares which would not carry any entitlement to dividend. A deed of covenant would come into effect

"pursuant to which TSB Group plc will pay say 1% per annum of its pre-tax profits to the Charitable Foundations ..."

Sir John went on to ask Mr Monck to note that they did

"not propose to handle the income aspect of the charitable foundations by way of dividend on the ordinary shares, but rather through a deed of covenant which will require the TSB Group plc to pay say 1% of its annual pre-tax profits to the foundations. This is more tax effective."

He expressed the view that such a course would have some impact on the initial market value of TSB Group plc with a part of the Group's resources being devoted to charitable purposes, but considered that it would be acceptable to investors and would not prejudice the success of the issue.

[13] The overall scheme in terms of which the charitable foundations were to be endowed was set out in proposals recorded in a paper dated 11 October 1983 prepared for a meeting of the Central Board of the Trustee Savings Banks which took place on 20 October 1983. That paper, which was approved subject to one minor revisal, reflected an intention that the charitable foundations to be established should be provided with "a substantial and secure income ... by a combination of deeds of covenant and a special class of shares." A number of paragraphs from that paper were relied on and I should set them out. The Background is explained in paragraph 2:

"2.1 The concept of the charitable foundations had its origins in the efforts to resolve the problem of the future ownership of the Group, although solutions which would have vested the entire ownership of, or a controlling interest in, the Group in the foundations proved unacceptable to the Central Board and the Treasury because they failed satisfactorily to establish accountability and would not have provided the Group with full access to the capital markets.

2.2 Subsequently, the Treasury suggested that the foundations would form a useful part of the package to deal with the political problem of "produce". This was reflected in the proposals for future structure and status accepted by the Central Board and submitted to the Economic Secretary in July 1982.

As I understand it, the reference to "produce" was a reference to the fact that at one stage it was part of the proposals that depositors with the TSB, who were members of the Bank, might benefit from the flotation over and beyond their entitlement to interest on their deposits. This appears to have given rise to a "political problem" which, in presentational terms, might be counter-balanced by the endowment of charitable foundations. As was made clear in paragraph 3, by the time this paper was written, the "produce" package had been dropped. The Treasury did not oppose the establishment of the charitable foundations, but did not want there to be a provision in the Bill empowering the Central Board to endow them. The case for the charitable endowments was set out in paragraph 4, which noted inter alia that they would represent "a continuance of the TSB's original philanthropic purpose and ethos" and

"4.1(5) ... will provide a tax-efficient and operationally effective vehicle, not only for achieving the above purposes, but also for fulfilling the wider responsibilities which major commercial organisations are recognised as bearing."

Paragraph 5 went on to deal with the form of the endowment:

5.2 It is proposed that the foundations should draw their income under deeds of covenant from TSB Group plc. Since covenanted payments rank for tax purposes as a charge on income, they represent a more tax-efficient method of providing income than dividends: assuming that the Group has sufficient taxable profits to cover the payments, that relief is available at the full corporation tax rate and that tax rates remained unchanged, the same tax-free income can be provided with a 32% saving in cost.

5.3 It is proposed that the covenanted amounts should be expressed as a fixed percentage of the consolidated pre-tax profits of the Group. A covenant for an amount calculated by reference to dividends is unlikely to quality for tax relief, while to show the payments as made out of profits before tax will more effectively highlight the Group's support of charity in the Group accounts.

5.4 It is proposed that the sums covenanted to the four foundations should together equal one per cent of Group pre-tax profit. Using projected profits of £170m for 1983/84 for purposes of illustration, this would secure a combined annual income of £1.7m at a post-tax cost to the Group (on the assumptions set out in paragraph 5.2) of £0.81m.

5.5 For purposes of comparison, the twenty largest UK corporate donors in 1982 are shown in Appendix 1. Their UK donations, as a percentage of profit before tax, are mostly in the range 1/4%-1/2%, although one company in the list, and twenty or more other major donors, gave over 1% of pre-tax profits. Covenants of 1% of profits before tax and exceptional items would, on the TSB Group's 1981/82 results, have put it in 36^th place in that table.

...

5.9 It is proposed that the Foundations should be protected in these circumstances [viz. a change of control of the Group resulting in a reorganisation which would defeat the expectations of the foundations under the covenants] by the issue to them of "A" limited voting ordinary shares carrying no dividend rights, which would be convertible into ordinary shares in the event of a change of control or liquidation of the TSB Group plc or the cessation of the covenants. The conversion rights would be on a one-for-one basis initially and would be adjusted for any future scrip or rights issues to ordinary shareholders.

5.10 The number of shares to be issued to the Foundations should be such as would, initially at least, yield on conversion a dividend equal to the covenanted amount. Current market prices suggest that the TSB Group might expect to justify a fully taxed P/E ratio of 4.5. On that basis, and assuming a gross dividend yield in the region of 9%, the Foundations would need to be issued with around 5% of the total shares in issue. It is proposed that that figure be adopted."

It is clear from the above that, as at that time at least, the contemplation of those involved in considering the matter was that the payments to the foundations should come out of profits which were otherwise taxable. This is apparent from the references to this method being tax-efficient (as compared with an amount calculated by reference to dividends) and, further, from the illustrations given in paragraphs 5.2 and 5.4. The expression "pre-tax profit" is used in this context. Mr McNeill, for the defender, suggested that the default position (if things went wrong) of the shares being converted to ordinary shares and the foundations receiving payment by way of a dividend from those shares also showed that the intention was that the foundations would be paid out of distributable profits. To my mind this submission goes further than is warranted, since the dividend method of effecting payment is intended only as a substitute, and an approximate one at that, for the endowment method, which, on this hypothesis, will by then have failed - it is not a separate way of saying that the amount of the annual payment under the endowment, whilst it continues, will be directly related to distributable profits.

[14] It is apparent from a letter of 9 November 1983 from Sir John Read to Mr Monck that the Central Board gave its "full support" to the recommendations in what had by then become Section 7 of the paper (previously Section 8), a recommendation to proceed with the establishment of the foundations, each to be funded under deeds of covenant on the basis of a percentage of pre-tax profits, and each to be given "A" limited voting shares convertible into ordinary shares in the event of a change of control or cessation of the covenant.

[15] There is no record of the Central Board having given any further consideration to the issue of endowment. The Board did, however, have discussions with HM Treasury. TP Lankester of the Treasury wrote to Sir John Read on 25 January 1985 to set out the basis on which Ministers and the Central Board had agreed that the Board should carry forward the proposals to set up and endow the foundations. In paragraphs 7-11 he explained his understanding of the relationship between the "A" shares to be issued to the foundations and the covenanted payments:

"7. After the establishment of TSB Group plc, but before vesting, the TSB Central Board will as sole owner of that company cause the directors to make an issue of A shares to the foundations (to be paid for in the manner described in the previous paragraph). The "A" shares would carry no dividend rights except in the circumstances described in paragraph 11 below. These 'A' shares will be issued at the same time as a small number of ordinary shares are issued to the Central Board probably in the proportion of 1:19.

8. Immediately after vesting TSB Group plc will capitalise reserves so as to issue further 'A' shares to the foundations. The eventual ratio of 'A' shares to the ordinary shares issued to the public will be in proportion to the initial issue of 'A' shares and ordinary shares, assuming that the directors confirm the capitalisation decision. The terms of the capitalisation resolution will provide that the further 'A' issue will not take place until some weeks after the first meeting of TSB Group plc following the flotation. A further resolution of the directors would then be required to put the issue into effect; this will not be put until some weeks after that first meeting.

9. Also immediately after vesting, TSB Group plc would execute deeds of covenant endowing the foundations. However, these would be expressed to be conditional upon the adoption of a resolution approving them. The directors would consider this resolution at the same time as the further resolution necessary in order to achieve the capitalisation issue of 'A' shares.

10. I understand that TSB Group plc will endow the foundations by covenants which ensure that 1% of TSB Group pre-tax profits will be paid to the Foundations.

11. If TSB Group plc subsequently fails to renew the covenants or the control of TSB Group plc changes the 'A' shares will automatically become full ordinary shares entitled to dividend."

[16] The Trustee Savings Banks Act 1985 vested the Group's businesses in successor companies and thereby allowed the flotation of the TSB Group to proceed. As set out in a letter of 10 July 1986 from Sir John Read to Mr Stewart, the Economic Secretary to the Treasury, and in accordance with the proposals which had been discussed, TSB Group plc entered into Deeds of Covenant with the pursuer and the other charitable foundations established at the time of the flotation; and the foundations were issued with 'A' Limited Voting Ordinary shares in TSB Group plc equal to 5% of the equity of the company following the flotation. As had been envisaged, these shares did not confer any right on the holders to participate in any distribution of the profits of the defender by way of dividend; but they automatically converted into Ordinary shares on a one-for-one basis in the event that the covenants expired or were renewed on terms less favourable to the foundations.

[17] The terms of the 1986 Deed were substantially the same as those of the 1997 Deed which is the subject of this action. The definition of "pre-tax profit" and "pre-tax loss" was

"... respectively the 'group profit before taxation' and the 'group loss before taxation' (as the case may be) shown in the Audited Accounts for such period adjusted to exclude therefrom any amounts attributable to minority interests, such adjustment to be determined by the Auditors on such basis as they shall consider reasonable, which determination shall be conclusive and binding on the parties thereto."

The 1986 Deed excluded minority interests from the definition of "pre-tax profit" and "pre-tax loss" in the same way as they are excluded from that definition in the 1997 Deed. Accounting standards in the UK, both then and now, required consolidated group accounts to include the whole of the pre-tax profits of a subsidiary company, even though a Group's shareholding in that company was less than 100%. The entire pre-tax profit of any such subsidiary therefore appeared in the pre-tax profits of the Group. Mr McNeill referred to these as "putative" profits, in contrast to "actual" or "realised" profits. The exclusion of profits attributable to minority interests from the definition of pre-tax profit and pre-tax loss for the purpose of the 1986 Deed is consistent with an intention that the annual payment to the foundation should be a percentage only of "actual" or "realised" profits, to apply this terminology. It will be noted that at this stage the definition did not exclude "profits or losses arising on the sale or termination of an operation".

[18] The 1986 Deed was amended in 1991 and 1993. The 1991 amendment provided for a single annual payment date rather than the original quarterly payment dates provided for in the 1986 Deed. The amendment in 1993 altered the definition of "Pre-Tax Profit" and "Pre-Tax Loss" by introducing the exclusion of "any profits or losses arising on the sale or termination of an operation". It appears that that amendment was agreed in circumstances where it was contemplated that one-off, non-trading losses might arise on the sale of Hill Samuel Bank and TSB Property Services, whilst profits might arise from the sale of Swan National Leasing and Noble Lowndes. Accounting Standard FRS 3 (Financial Reporting Standard 3: "Reporting Financial Performance") had been issued by the Accounting Standards Board in October 1992. FRS 3 required profits or losses on a sale or termination to be included in the accounts within pre-tax profits, even though there were not included in the profit on which tax would be assessed. Previously, in terms of SSAP 6 (Statement of Standard Accountancy Practice 6: "Extraordinary items and prior year adjustments"), such amounts had been treated as extraordinary items and recorded after the calculation of profit before tax. The 1993 amendment, therefore, was made in order to ensure that the change in accounting practice did not affect the basis upon which the sums payable to the pursuer were calculated. That is consistent with an intention that there should be excluded from the sum in the accounts as a percentage of which the payment to the foundation was to be calculated, any sum which did not represent taxable profits.

[19] It is agreed between the parties that, in the years 1987 to 1993, the sums paid to the pursuer and others under the Deeds of Covenant were less than the dividends which would have been paid on the limited voting shares held by them following conversion (had conversion taken place). That differential was caused in part by the TSB Group plc making a loss of some £53m in 1991.

[20] In 1994 the TSB Group plc made a one-off payment to the charitable foundations, including the pursuer, in addition to the sums paid under the Deeds of Covenant. The background to that payment appears from two board minutes of TSB Group plc dated 25 February and 29 July 1993. It was made in part to redress the differential, identified in the last paragraph, between the sums paid to the foundations and the sums payable to shareholders by way of dividend. It may also have been made as a public relations exercise to improve the public image of TSB Group plc.

[21] The 1997 Deed was one of four Deeds entered into in similar terms in 1997 by the Defender and the charitable foundations. It was entered into as a result of a change in the accounting period following the merger of Lloyds Bank and the TSB Group to form Lloyds TSB Group plc. It represented a consolidation of the earlier Deeds. In particular, Clause 2(1) of the 1997 Deed is in the same terms as the original 1986 Deed as amended in 1993.

The acquisition of HBOS

[22] In January 2009, Lloyds TSB Group plc acquired 100% of the ordinary share capital of HBOS plc, and was re-named Lloyds Banking Group plc, the name by which it is sued in this action.

Accounting treatment of negative goodwill

[23] The following is taken from the agreed position of the parties reflected in the Joint Minute, as supplemented by the expert evidence of Mr Simmonds and, in some respects, Mr Merris. Although both experts were cross-examined, the evidence of accounting treatment of goodwill did not, on the whole, appear to be controversial. In any event, to the extent that the summary that follows goes beyond what was agreed, I find it established on the evidence.

[24] Goodwill, as a general accounting term, can be defined as "the difference between the cost of an acquired entity and the aggregate of the fair values of that entity's identifiable assets and liabilities": see para.2 of FRS 10 (Financial Reporting Standard 10: "Goodwill and Intangible Assets"), issued in December 1997. A similar definition appears in para.21 of SSAP 22 (Statement of Standard Accounting Practice 22: "Accounting for goodwill"), issued in December 1984 and revised in 1989.

[25] In accounting terms, therefore, when one entity acquires control of another, goodwill is the difference between, on the one hand, the price paid by the acquiring entity for the acquired entity as a going concern and, on the other, the aggregate of the acquired entity's identified separable net assets. In most acquisitions, the price paid for the acquired entity on a going concern basis is greater than the aggregate value of its identified separable net assets. In such circumstances, the difference between the price paid and the fair asset value is known as "positive goodwill". In practical terms, it represents the value which is expected to be generated by the future earnings of the acquired entity, reflecting factors such as customer loyalty and reputation.

[26] "Negative goodwill" arises when the price paid for the acquired entity is less than the aggregate fair value of its identified separable net assets. This may occur either because the acquired business is loss making, or because the acquirer has made a good bargain.

[27] In the financial statements of the parent entity (the parent company only accounts), the newly acquired asset is accounted for at cost (the consideration paid for the acquired business) - goodwill, whether positive or negative, does not have a place in the statutory accounts of the parent entity where it has acquired an interest in another company. However, in group consolidated accounts (or consolidated financial statements), which represent the group as one economic entity and combine the financial statements of the parent and its subsidiaries into a single set of financial statements, the fair value of the identified separable net assets of the acquired company, valued as at the time of acquisition, is shown, any goodwill being treated as "merely a residual balance in the allocation of purchase consideration".

[28] It is agreed in the Joint Minute that, at the time the parties entered into the 1997 Deed, generally accepted accounting practices, which the defender followed, did not require negative goodwill to be accounted for in its accounts as part of profit before tax.

[29] This is explained more fully by Mr Simmonds in his Report. In 1986, and from then until it was replaced by FRS 10 in December 1997, accounting for goodwill was dealt with by SSAP 22. For positive goodwill, SSAP 22 permitted companies to choose one of two treatments, viz.: immediate elimination on acquisition by deduction from shareholders' funds (shown in the consolidated balance sheet), described in SSAP 22 as the method normally chosen; or capitalisation as an asset followed by amortisation over its useful economic life. Immediate elimination, if chosen, would not result in any entry in the consolidated profit and loss account. If capitalisation and amortisation were chosen, the capitalised value would appear in the consolidated balance sheet while the amortisation would appear as an expense charged to the consolidated profit and loss account within ordinary activities - in other words, as the asset value was reduced, the amount of the reduction in that value would appear as a cost in calculating the profit or loss for the relevant period. If something occurred to cause a permanent diminution in the value of the capitalised goodwill, its carrying amount in the consolidated balance sheet would be written down immediately to its recoverable amount, and the reduction would appear as an expense in the consolidated profit and loss account.

[30] SSAP 22 required any amount arising as negative goodwill to be credited directly to reserves, thereby increasing shareholder funds in the consolidated balance sheet. It would not affect the consolidated profit and loss account either at the time of acquisition or subsequently. Mr Simmonds described this treatment of negative goodwill as the "mirror image" of SSAP 22's normally applied method, i.e. immediate elimination - in neither case does the goodwill, whether positive or negative, appear in the consolidated profit and loss account.

[31] As I have already pointed out, in December 1997 ASB withdrew SSAP 22 and replaced it with FRS 10. For the defender, the first year of application of FRS 10 was the year to 31 December 1998. FRS 10 continued to apply to the consolidated financial statements of UK listed companies until 2005, when it was superseded by European regulation (see below).

[32] FRS 10 removed the option (available under SSAP 22) of immediate elimination of goodwill. Instead, it required the capitalisation of all positive goodwill and its classification as an asset in the consolidated balance sheet; and, where it was regarded as having a limited useful economic life, consequent amortisation through the consolidated profit and loss account. Where the useful economic life was estimated to be more than 20 years, with the amortisation extending over a similar period, the carrying amount of goodwill was subjected to an annual impairment test to demonstrate that its carrying amount in the consolidated balance sheet was supported by the value from its intended use or disposal.

[33] As regards negative goodwill, FRS 10 changed the position in two ways: first, it was included in the consolidated balance sheet as a negative item adjacent to positive goodwill, thereby reducing the net asset value shown; and second, the amount recognised was economically related to the recognised net assets of the acquired entity (whether fixed assets such as buildings, plant and machinery, or stock or inventory) and released (or amortised) through the consolidated profit and loss account as those net assets were "realised", whether by amortisation or sale. In other words, as the assets of the acquired business are used in the activities of the business, an element of their cost would be charged to the profit and loss account. The amount of negative goodwill released through the consolidated profit and loss account would, in any given accounting period, be in proportion to the amount of recognised assets so realised in the same period. This linkage between the realisation of acquired net assets and the release of negative goodwill to the consolidated profit and loss account meant that the amount of negative goodwill released to the consolidated profit and loss account could be described as a realised profit, making the treatment of it consistent with the accounting principle in the Companies Act 1985 that only profits realised at the balance sheet date were to be included in the profit and loss account.

[34] This aspect of accounting practice changed with effect from 1 January 2005 as a result of European regulation. Regulation 1606/2002 was adopted on 19 July 2002 and published in the Official Journal of the European Communities on 11 September 2002. It came into force on 14 September 2002, the third day following publication in the Official Journal. Article 4 of the Regulation provided that from 1 January 2005, UK listed entities, among others, had to prepare their consolidated accounts in accordance with International Financial Reporting Standards ("IFRS"). For the purpose of the Regulation, the IFRS for UK listed entities, so far as concerns the treatment of goodwill, was IFRS 3, which was adopted by the International Accounting Standards Board ("IASB") in March 2004. In December 2002, prior to the adoption of IFRS 3, the IASB had issued an exposure draft ED 3. From 1 January 2005 the defender, as it was required to do, adopted IFRS 3.

[35] Under paragraphs 54 and 55 of IFRS 3 positive goodwill is recognised as an asset in the consolidated balance sheet but is not subject to amortisation. It is in effect regarded as having an indefinite useful economic life. It is, however, subject to annual impairment tests of its value, and if such tests reveal that its recoverable value is below its carrying value in the consolidated balance sheet, an impairment charge will arise in that year and will appear in the consolidated income statement.

[36] By contrast, paragraph 56(b) of IFRS 3 requires the immediate recognition of negative goodwill as a gain in the group consolidated income statement. This had already been proposed in a consultation document ED 3 (Exposure Draft 3) published by the IASB in December 2002, which invited comments on a number of issues relating to accountancy for business combinations. Mr Simmonds explained that the reason for this, as set out in the Basis for Conclusions in IFRS 3, is that negative goodwill relates to a bargain purchase, and is therefore treated as an immediate gain to be recognised immediately in the consolidated income statement notwithstanding that the gain is unrealised (since the related net assets of the acquired entity have not been realised through use or sale). Mr Merris put the same point somewhat differently. He said that at the date of acquisition the acquirer is immediately better off by the amount by which the fair value of what is acquired exceeds the consideration paid for it. In any event, it was not in dispute that this treatment of negative goodwill, resulting in an immediate credit (or gain) in the consolidated income statement for an "unrealised gain", would not be permissible under UK GAAP (Generally Accepted Accountancy Principles) or the principle in the Companies Act 1985 referred to above.

[37] It is agreed between the parties that negative goodwill, although required under IFRS 3 to be shown on consolidation of the Defender's accounts, (a) is not distributable to shareholders, (b) is not part of the defender's trading profits and (c) does not count towards the sum on which the Defender's liability to tax is calculated.

The defender's 2009 Accounts

[38] I have already noted that the defender's 2009 Accounts disclose, in the Consolidated Income Statement on p.127, a profit before tax of £1,042,000,000. That figure reflects, amongst other matters, the "gain on acquisition" of £11,173,000,000 arising as a result of the defender's acquisition of 100% of the ordinary share capital of HBOS plc.

[39] That figure of £11,173,000,000 represents the difference between the fair value of the net assets of HBOS at the date of purchase and the amount actually paid by the defender for those net assets and, in accounting terminology, is known as negative goodwill. On p.13 of the 2009 Accounts it is stated:

"On a statutory basis, the Group delivered a profit before tax of £1 billion for 2009. This result includes an £11.2 billion negative goodwill gain associated with the purchase of HBOS, given we acquired the business at half book value in anticipation of the likely losses resulting from their troubled portfolios."

[40] It is agreed that upon the hypothesis, which is disputed by the defender, that the "Pre-Tax Profit" for the Accounting Reference Period ended 31 December 2009, calculated in terms of the 1997 Deed, was £907 million (for the calculation, see para.[5] above), the outstanding balance owed by the Defender to the Pursuer would be £3,543,433. If the negative goodwill is excluded, however, the sum due to the pursuer in terms of clause 2(1) of the Deed would be the minimum sum of £38,920. The defender has paid that sum, and, on that basis, would have no further liability.

Accountancy evidence

[41] I have already taken account of substantial parts of the evidence of Mr Simmonds and, to a lesser extent, of Mr Merris. Both were well qualified to give expert evidence. Both were impressive witnesses whose evidence I am in general happy to accept.

[42] In Section 6 of his Report, Mr Simmonds, as I understood it, sought to place himself in the position of a well informed third party looking at the 1997 Deed at the time it was entered into and having regard both to the definitions of Pre-Tax Profit and Pre-Tax Loss and to norms of accountancy practice at that time; and, from that vantage point, to describe the anticipated "content" of the amount resulting from the terms of the Deed, a percentage of which would be payable to the foundation. He expressed the view that the formula was concerned with profit before taxation "from ordinary activities, before profit or loss on sale or termination of a business, less minority interests".

[43] In his Supplementary Report Mr Simmonds said that the IASB received about 130 letters in response to consultation document ED 3. His evidence was that, despite some support for it from the UK Accountancy Standards Board ("ASB") and some other, the majority of respondents opposed the proposal that negative goodwill arising on an acquisition should be recognised immediately in the consolidated income statement. In support of this he quoted from comments made by the Accounting Standards Committee of the Institute of Chartered Accountants of Scotland, from the European Financial Reporting Advisory Group ("EFRAG") and from many of the well-known accountancy firms. The IASB recognised that their proposal was not generally supported. They considered that negative goodwill was due only to one of three factors: (a) errors in recognising or measuring fair value; (b) a requirement in an accounting standard to measure identifiable net assets acquired at an amount that is not fair value; and (c) a bargain purchase. Mr Simmonds questioned whether the acquisition of HBOS could be said to fall into any of those categories. He elaborated on this in his oral evidence. The acquisition of HBOS was to a freely entered into market transaction at fair value. There was significant uncertainty as to whether the value ascribed to HBOS assets could be realised in the amounts stated in the HBOS balance sheet. So although the price paid by Lloyds TSB was significantly below the book value of the HBOS assets, there was an expectation of losses from those assets which justified that lower price. Accordingly this case might be said not to fall into any of the three categories of negative goodwill anticipated by the IASB.

[44] Mr Simmonds was asked to say what in his opinion would be the figure in the 2009 Accounts which was the equivalent of operating profit as used in the 1997 Accounts. He noted that the expression operating "profit" was not used in the 2009 Accounts. However, he thought that the equivalent to that would be "trading surplus" less "impairment", plus "share of results of joint ventures and associates" (a loss in 2009) less amounts "attributable to minority interests".

[45] Mr Merris gave evidence about the origin of the requirement to adopt IFRS in the UK, the introduction of the requirement that negative goodwill arising on an acquisition be immediately recognised in the group income statement, and the rationale behind IFRS 3 requiring negative goodwill to be released to the group income statement. This evidence was consistent with the summary given above.

[46] In his Supplementary Report, Mr Merris considered four additional questions. The first two related to changes in accounting standards from 1986 to date. He confirmed that there had been "many" such changes. He could not say exactly how many, but it was indicative of the extent of the changes that, in terms of international standards, since 1986 there had been 16 new issues of International Accounting Standards (IAS), 9 new issues of IFRSs, 19 International Financial Reporting Interpretations Committee (IFRIC) interpretations and 32 Standard Interpretations Committee (SIC) interpretations, whereas in terms of the UK there had been 2 new issues of SSAPs, 30 FRSs and 48 Urgent Issues Task Force (UITF) Abstracts. Since 1997 the figures for international standards were 8 IASs, 9 IFRSs, 19 IFRIC interpretations and 29 SIC interpretations and, within the UK, 21 FRSs and 33 UITF Abstracts. The rate of change had accelerated markedly over the period after 1997, but nonetheless there was frequent change before then.

[47] Mr Merris next considered whether it was possible to determine the 2009 Pre-Tax Profit (as defined in the Deed) by reference to the accounting standards in use in 1986 and 1997. He pointed out that it would not be lawful to prepare the 2009 accounts in accordance with the 1986 and 1997 accounting standards. But, further, he pointed out the difficulties of recreating the position in 2009 using 1986 and 1997 standards. This was so in particular because new business practices developed alongside new accounting standards. It would be necessary to do the equivalent of an accounting framework conversion process, which could take weeks if not months; and it would not be a precise exercise, since in many cases it would involve the exercise of judgment. Although his emphasis was different, I did not understand Mr Simmonds to differ significantly on this point. He thought that it could be done, though not with absolute precision, and it would be time consuming.

[48] In anticipation of an argument which I think was not, in the event, pursued by the defender, Mr Merris said that the figure on p.127 of the Accounts for "profit before tax" of £1.042 billion must represent the statutory "group profit before tax", since it appeared in the Consolidated Income Statement. Other references in the accounts (on pp.18, 22 and 149) were "non-GAAP" measures, which had to be reconciled with the statutory measure of £1.042 billion. The reconciliation was shown on pp.4 and 151 of the 2009 Accounts. These other figures were not relevant to the exercise which required to be carried out under the Deed. In his oral evidence, Mr Simmons explained that the term "financial statements" is a precise term. It refers to the audited financial statements in the back half of the company's annual report, starting at p.126. The word "accounts" was less precise. It could include the whole of the accounts or just the financial statements. He said that if he was asked to identify "group profit before tax" in the accounts, he would ask: what do you mean? I understand that in general terms. But it seemed to me that Mr Merris was correct in saying that if one was looking for a figure for group profit before tax in the Audited Accounts, one would look to the figure in the financial statement, since that is the part which has been audited. In so far as there was any difference between them on this point, I preferred the evidence of Mr Merris.

Construction of the 1997 Deed

Submissions

[49] In his note of argument, Mr McNeill QC, for the defender, initially defined the issue as being: whether, by defining "Pre-Tax Profits" by reference to "group profit before taxation ... shown in the Audited Accounts", the 1997 Deed should be construed as binding the parties to any changes in accounting practice, no matter how dramatic the change or how unexpected the consequence. In the course of his oral submissions he refined this submission. I understood him to submit, in the end, that it was a question of degree. If the purpose implicit in the 1997 Deed was that the pursuer should participate in the profit (or the realised gain) before tax, the change in accounting policies which led to the inclusion in the figure for pre-tax profit of an amount representing negative goodwill - which was not a realised gain, was not available for distribution to shareholders and was not included within the profit which formed the basis of the defender's liability to taxation - took matters outwith the objective intention of the parties as reflected in the wording used by the parties at the time when they entered into the 1997 Deed.

[50] The 1997 Deed was essentially a re-statement of the 1986 Deed, though taking account of the corporate changes relevant to the identity of the obligor and the amendments in 1992 and 1993. The circumstances surrounding the entering into of the 1986 Deed and the changes thereafter were relevant background circumstances casting light upon the intention of the parties in entering into the 1997 Deed on the terms therein set out. The documents leading up to the creation of the 1986 Deed showed that the parties anticipated that funding for the foundations would come out of taxable earnings. One of the purposes behind the way in which the covenant was formulated was to achieve tax efficiency. The change in 1993 showed that the parties thought that some amendment was necessary. It showed, in particular, a recognition by the foundation, consistent with the original intention in the 1986 Deed, that it should not, and could not, insist on an unrestricted interpretation of the (unamended) wording in the 1986 Deed; there was no evidence to suggest that the one-off payment made by the defender in 1994 to the charitable foundations was a price paid by the defender for the foundations not insisting on the strict application of the 1986 Deed and agreeing instead to the 1993 amendments. The changes brought about by the amendments in 1993 were for all time. The intention of the parties remained the same, namely that the payments made to the foundation in terms of the Deed were related to the actual profits made by the Group.

[51] Mr McNeill accepted that some changes in accounting practice were to be expected. This was made clear by the evidence of Mr Merris. However, the change in respect of the treatment of negative goodwill fell into "an almost unique category". As at the date the 1997 Deed was entered into, the incorporation of negative goodwill into the profit and loss account was unthinkable. When it was out at consultation the proposal to change the treatment of negative goodwill was opposed by a large majority of the accounting firms in the UK. It could not objectively have been the intention of the parties that the payment to the foundation should be increased as a result of such a change in accounting practice.

[52] Mr McNeill submitted that the result contended for by the pursuer was absurd. The parties were agreed that negative goodwill was neither distributable nor taxable, and did not form part of the trading profits of the company. It followed that a gain on acquisition in accounting terms was not a realised gain. It was only on disposal that it would give rise to a profit or loss, though he conceded that there might be circumstances in the future which caused a fresh view to be taken of the fair value of the assets acquired, and in those circumstances any reduction in the value of the assets would be reflected in the profit and loss account. Notwithstanding that, however, the pursuer maintained that its entitlement to a percentage of the Pre-Tax Profit should include this unrealised gain. The defender did not seek to exclude the pursuer from any profit of any kind engendered by the beneficial acquisition of HBOS. If there were an actual increase in profits arising from that acquisition, that increase would inure to the benefit of the pursuer. If in due course HBOS were to be sold by the defender during the life time of the covenant for a price less than the current fair value, that would not depress the amount to which the pursuer was entitled, since the Deed specifically excluded sales from the calculation from pre-tax profit. Nor, if HBOS were to be sold at a higher price, would that increase the amount to which the pursuer was entitled. On the pursuer's construction, it was entitled to participate in the unrealised profit on acquisition of HBOS, even though the 1997 Deed, as a result of the 1993 amendment, meant that it could not participate in actual profits generated by a sale of the business. And it could participate in an unrealised profit in which the shareholders themselves could not participate.

[53] For the pursuer, the Dean of Faculty submitted that the correct approach to the construction of the terms of the 1997 Deed was to consider the natural and ordinary meaning of the words used before going on to consider the background to its formation. The ordinary meaning of the words here was clear. There was no ambiguity; nor did they did not give rise to any commercial absurdity. It was not a case where "something must have gone wrong" with the wording. In those circumstances, the terms of the Deed should be given effect.

[54] Clause 2(1) provided the starting point for the calculation of the sum due by the defender to the pursuer. That starting point was the defender's "Pre-Tax Profit". That is a defined term. It means, in relation to any Accounting Reference Period, the Group profit before taxation "shown in the Audited Accounts for such period" adjusted in two respects: first to exclude amounts attributable to minority interests; and second to exclude any profits or losses arising on the sale or termination of an operation. The parties had selected figures contained in the Audited Accounts as the starting point for the calculation. No doubt this was to avoid the possibility of dispute. Both Audited Accounts and Auditors, were defined terms. There was no ambiguity. In addition, given the wording of the Deed, it was reasonable to draw two further inferences as to the intention of the parties. First, the specific exclusion of profits and losses arising from minority interests and the specified role of the Auditors in determining the extent of any adjustment required to the figures as a result, made it clear that the parties intended to establish a precise mechanism for determining the sum payable to the Pursuer. That figure was to be arrived at by a mechanical application of the relevant figures in the Audited Accounts. Second, the 1997 Deed was intended to regulate the parties' affairs for a considerable period of time. Clause 3(a) of the Deed made it clear that the defender required to give nine years notice in writing if it was to terminate the arrangement. Notwithstanding that, and notwithstanding that the parties must be taken to have known that accounting practices might change over time, the parties had chosen to use for each particular reference period the figures contained in the Audited Accounts produced by the accounting process applicable at the time of their preparation.

[55] In a rhetorical flourish to press home this point, the Dean of Faculty made the following particular observations. First, if the parties had not wished to determine the matter by reference to the Group pre-tax profit in the consolidated Accounts, they would not have said "Group profit before taxation" shown in the consolidated Accounts of the Group. Second, if the parties had not wished to determine the matter by reference to the Group pre-tax profit shown in the consolidated accounts, they would not have said so. Third, if the parties had wanted to determine the matter by reference to "trading profits" or "operating profits", they would have said so. Fourth, if the parties had wanted to exclude profits arising on acquisition of a business, as well as on the sale or termination of a business, they would have said so, especially when there had just been such an acquisition at the time that this amendment was made in 1993. Fifth, it the parties had wished the matter to be calculated in accordance with accounting practices in 1997, (a) they could have said so, and (b) they would not have specified that the pre-tax profit should be that shown in the consolidated Audited Accounts for each year, since the Accounts for each year would have to be prepared and audited in accordance with the standards in force at the time. And sixth, if the parties had wished payment to be calculated on distributable profits, they would have said so; and they would not have used as a reference point the consolidated Accounts for the Group, which would never have shown a profit available for distribution.

[56] Accordingly, the Dean of Faculty submitted that the terms of the 1997 Deed were clear and unambiguous. It was with those terms that the inquiry should begin and end. There was nothing to suggest any need to go further. The construction put forward by the Defender raised a number of questions, mainly by reference to the subjective intention of the parties, but there was no reason to go into that.

[57] Insofar as it was necessary to look at the circumstances surrounding the entering into of the 1986 and 1997 Deeds, the Dean of Faculty emphasised, first, that the endowment of the foundation was not a unilateral gratuitous alienation by the Bank. He pointed out that, by 1983, the four trustee savings banks, which were grouped under the umbrella of a Council and a Chairman, wished to pursue commercial activities. The Board of TSB was anxious to secure flotation. This required parliamentary approval. Accordingly, the issue of "produce" had to be addressed. The Deed was the product of lengthy negotiation. In reality, the Central Board had to agree to the establishment and endowment of the foundations as a condition of the government proceeding with the Bill. Secondly, he submitted that the parties did not intend to tie the sums to be paid to the pursuer and the other foundations to distributable profits. The Central Board wished the foundations to be provided income by way of covenanted payments expressed as a fixed percentage of the consolidated pre-tax profit of the Group rather than by way of dividend for a number of reasons: first, because covenanted payments represented a more tax efficient method for the Group to provide the income to the foundations; second, because it was considered that a covenant calculated by reference to dividends was unlikely to qualify for tax relief; and, third, because showing the payments to be made out of profit before tax would more effectively highlight the Group's support of charity in its accounts. Those reasons were all unrelated to an intention to link the sums to be paid to the foundations to distributable profits. Nor was there any indirect link to distributable profits by reason of the endowment of the foundations with limited voting ordinary shares, to be converted automatically in certain circumstances into ordinary shares. This was set up simply for the purpose of protecting the foundations in the event that there was a change in control of the bank or an attempt to defeat the expectations of the foundations arising under the covenant.

Discussion

[58] In the course of submissions, I was addressed in some detail as to the correct approach to the construction of a contract, it being agreed that those principles applied equally to the construction of the agreement reached between the parties in the 1997 Deed. I make no complaint of this, since the issues of construction in this case are somewhat unusual. As the Dean of Faculty pointed out, although the principles have been set out in detail and at length in a large number of recent cases, including Investors Compensation Scheme v West Bromwich Building Society [1998] 1 WLR 896 at 912-3 and, in Scotland, Bank of Scotland v Dunedin Property Investment Co Ltd (No.1) 1998 SC 657, Emcor Drake & Scull v Edinburgh Royal Joint Venture 2005 SLT 1233 at paras.[13] and [14], Credential Bath Street Ltd v Venture Investment Placement Ltd (unreported, 31 December 2007, [2007] CSOH 208) at paras.[14]-[28] and Luminar Lava Ignite Ltd v Mama Group plc 2010 SLT 147 at paras.[38]-[45], any judicial summary of the relevant principles will inevitably tend to concentrate on the aspects most directly relevant to the issues before the court in that case.

[59] In the present case, the Dean of Faculty submitted that the correct approach was to consider the natural and ordinary meaning of the words used before going on to consider the relevant background. In support of this approach he relied in particular on a passage in Bank of Scotland v Dunedin Property Investment Co Ltd (No.1) at p.661, in which the Lord President (Rodger), under reference to the speech of Lord Mustill in Charter Reinsurance Ltd v Fagan [1997] AC 313, began, "not by enquiring into the state of knowledge of the parties to the contract, but by asking myself what is the ordinary meaning of the words [in the particular clause of the contract]"; and see also the Opinion of the Inner House in Fobo-Nairn Ltd v Murrayfield Properties Ltd (unreported, 15 December 2009, [2009] CSIH 94). This approach was consistent with the fifth principle enunciated by Lord Hoffman in Investors Compensation Scheme v West Bromwich Building Society at p.913D-F. If the ordinary meaning of the words is clear, that will be the end of the exercise (Charter Reinsurance Ltd v Fagan at p.438B-C, Fobo-Nairn Ltd v Murrayfield Properties Ltd at para.[12]), unless an examination of the factual background and surrounding circumstances at the time the contract was made suggest that "something must have gone wrong" with the language: Investors Compensation Scheme at p.913D-E, Credential Bath Street Ltd v Venture Investment Placement Ltd at para.[36], Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101, per Lord Hoffman at para.14.

[60] There was in fact little dispute between the parties as to the general principles applicable to the question of construction. It was not disputed that, as the Dean of Faculty submitted, in many cases the enquiry would start and finish with the words used. But even in such cases, it would often be necessary to look a bit wider. The court should ask what a reasonable person, having all the background knowledge which would have been available to the parties, would have understood them to be using the language in the contract to mean: Chartbrook Ltd v Persimmon Homes Ltd at para.14, Emcor Drake & Scull v Edinburgh Royal Joint Venture 2005 at para.[13] and Luminar Lava Ignite Ltd v Mama Group plc at para.[45]. That will, of course, require a consideration of the words used by the parties, but the meaning of the document is not necessarily the same thing as the meaning of its words: Investors Compensation Scheme at p.913C. The meaning of the document is what the parties, using the words they have used against the relevant background, would reasonably have understood them to mean. That background consists of all the relevant facts surrounding the transaction which are known to the parties or which they could reasonably be expected to be known to them: Bank of Credit and Commerce International SA v Ali [2002] 1AC 251, Howgate Shopping Centre v Catercraft Services Ltd 2004 SLT 231, at para.[36], Emcor Drake & Scull v Edinburgh Royal Joint Venture at para.[13] and Luminar Lava Ignite Ltd v Mama Group plc at para.[45]. The background

"... may not merely enable the reasonable man to choose between the possible meanings of words which are ambiguous but even (as occasionally happens in ordinary life) to conclude that the parties must, for whatever reason, have used the wrong words or syntax":

see Investors Compensation Scheme at p.913C-D.

[61] The background information may cast light on the commercial purpose of the agreement, and by so doing may assist the court in deciding whether the meaning put forward by one or other party is a commercially sensible construction. The court will always strive for a commercially sensible construction (Mannai Investment v Eagle Star Life Assurance Co. [1997] AC 749, per Lord Steyn at p.771A) and will prefer a commercially sensible construction over one that is not: L Schuler AG v Wickman Machine Tool Sales Ltd [1974] AC 235, per Lord Reid at p.251E. But it is not for the court to impose its own view of what is commercially sensible or reasonable. That is to be judged from the point of view of the person experienced in the relevant aspect of commerce: Glasgow City Council v Caststop Ltd 2002 SLT 47 at para.[34]. Indeed, as Lord Reed warned in Credential Bath Street Ltd v Venture Investment Placement Ltd at para.[24], the court must beware of excessive confidence that its view of what might be commercially reasonable necessarily coincides with the views of those actually involved in commercial contracts. Where there are simply differences of view, and assertions by each side that its own interpretation makes commercial sense, "there is room for error" if the court is too bold in its own view of what makes commercial sense: per Lord Mustill in Torvald Klaveness A/S v Arni Maritime Corp (The Gregos) [1994] 1 WLR 1465, 1473.

[62] It seems to me in this context that the clearer the manner in which the parties have expressed themselves in the contract, the greater must be the burden on the person seeking to show that the parties have not properly expressed their meaning. It may be that the background information shows that a nuanced interpretation is justified. But if a party is seeking to persuade the court to go further, and hold that, whatever was said in the contract and however clearly it was said, the parties could not have intended a particular result; so that as a matter of construction - and I should emphasise that I am not here concerned either with implication of terms or rectification - the court should read the contract in a way which departs from the clear meaning of the words and expressions which the parties have used, he will have to show clearly that "something has gone wrong with the language". Nothing short of that will do: see Credential Bath Street Ltd v Venture Investment Placement Ltd at para.[36]. "Unless the most natural meaning of the words" - including a meaning of the words based on an understanding of the relevant background and context - "produces a result which is so extreme as to suggest that it was unintended the Court has no alternative but to give effect to its terms. To do otherwise would be to risk imposing obligations on one or other party which they were never willing to assume and in circumstances which amount to no more than guesswork": Kookmin Bank v Rainy Sky SA [2010] Con LR 19 per Patten LJ at para.[42].

[63] I should add this further point. Parties were agreed that the terms of the Deed had to be construed in accordance with the meaning and understanding current at the time the Deed was made. Mr McNeill referred to a number of authorities on this point in his Note of Argument, namely: Stair, Institutions, IV, 42,21; Glasgow Magistrates v Farie (1888) 15R (HL) 94, 95; Earl of Lonsdale v AG [1982] 1 WLR 887, 889; Dano v Earl Cadogan [2003] 2 P&CR 10; Debenhams Retail Plc v Sun Alliance and London Assurance Co Ltd [2006] 1 P&CR 8; Excelsior Group Productions Ltd v Yorkshire Television Ltd (Flaux J, unreported, [2009] EWHC 1751 (Comm)). In oral argument he added a reference to Lian Hwee Choo Phebe v Maxz Universal Development Group Pte Ltd [2009] SGCA 4 at paras.11-15. The basic proposition is trite and, to my mind, flows naturally from the proposition that a contract must be construed in light of all the background circumstances which are known to, or could reasonably be known by, the parties at the time they entered into the contract. However, some contracts are made in circumstances where it is known at the time the contract is made that there are likely in the future to be legislative or other changes during the lifetime of the contract which may affect its performance. In this context I should refer in more detail to two of the cases cited.

[64] In Debenhams Retail plc v Sun Alliance and London Assurance Co Ltd, retail premises were leased to the respondent retailers for a term of 99 years on terms which included payment of rent made up of two elements, namely (i) a fixed annual amount and (ii) additional rent calculated as a proportion of "turnover", turnover bring defined as "the gross amount of the total sales including services from trade". It was common ground that the lease was to be construed as at the date it was entered into (which was treated as having been in 1965). Among the taxes levied in 1965 was purchase tax, which was levied on wholesalers of goods - so far as retailers were concerned, the tax element was simply an identified part of the price they paid for the goods. VAT did not then exist, nor would the prospect of it being introduced have formed any part of the thinking of either party - at best it was "no more than a gleam in the eyes of some economists and the Treasury". As at the date of the lease, the respondents' trading accounts would have simply have shown the cost of goods purchased from the wholesaler (which would have included within it an amount attributable to the purchase tax levied on the wholesaler, though this would not have been identified as such) and the value of goods sold. When VAT was introduced, it operated as a tax on the retailers' turnover. At no point would it enter into the respondents' accounts as trading receipts or expenses. Explanatory Note SSAP5, issued in April 1974 after the introduction of VAT, required that a retailer's accounts should not include the VAT element in the figures for income and expenditure. Accordingly, whereas the amount of purchase tax paid by the wholesaler, and passed on to the retailer in the prices charged for the goods, would indirectly have been included within turnover for the purpose of calculating the additional rent, VAT was not included, whether directly or indirectly. On a literal interpretation of the lease, therefore, the additional rent was less than it had previously been before the change, since the turnover had been, but was no longer, increased by the amount passed on by the wholesaler on account of purchase tax. The Court of Appeal, reversing the judge below, rejected this construction. It held that the calculation of "turnover" for the purpose of the lease should include the VAT levied and paid by the respondent retailers. The words "gross amount of total sales" did not have a single plain and unambiguous meaning. They were to be construed in their commercial context. Purchase tax would have had a significant effect of what was actually paid by way of rent. It was an inbuilt cost to the retailer. It affected ultimate prices, just like VAT. There was no reason why the parties should have regarded a substitute for purchase tax which also affected ultimate prices as excluded by the words "the gross amount of the total sales including services from trade". As a commercial matter, purchase tax and VAT were both included within the price charged; it was just that one was levied further down the chain of supply than the other. Jacob LJ, with whom the other members of the court agreed, placed particular emphasis on the commercial context. He took the view that what would have mattered to the businessmen negotiating the lease was money. Form would be a secondary consideration. In the real world, leaving aside form, "purchase tax affected ultimate prices, just like VAT". So he could not see "why the parties should have regarded a substitute for purchase tax which also affected ultimate prices as excluded by the definition of turnover". Nor did he think it relevant what appeared in the company accounts - that was "essentially machinery and convention ... a secondary consideration to the actual money involved". He accepted that when a trader is asked about his turnover he would generally give the ex-VAT figure; but "all depends on context" and the context here was different. Mance LJ agreed, but added some words of his own because the case required "an interesting exercise of contractual interpretation in changed factual circumstances". At p.130 he said this:

"To speak even of objective intention in such circumstances involves some artificiality. Even if we were judicial archaeologists, we would find in the wording of the lease negotiated in 1965 no actual or buried intention regarding VAT .... But no-one suggests that the lease cannot or should not apply in the changed circumstances. We have to promote the purposes and values which are expressed or implicit in its wording, and to reach an interpretation which applies the lease wording to the changed circumstances in the manner most consistent with them."

He then analysed the facts in the same way as Jacob LJ had done and concluded that it would be wrong to treat the differences between the incidence and operation of purchase tax and VAT as relevant under the terms of the lease.

[65] Lian Hwee Choo Phebe v Maxz Universal Development Group Pte Ltd, a decision of the Singapore Court of Appeal, concerned the proper construction of the articles of association of the defenders. The issue arose because of changes to the Companies Act which abolished two requirements, namely par value and authorised share capital; and the question before the court was whether and, if so, how the repeal of the requirements of authorised share capital affected the interpretation of Article 32 of the company's articles, which provided that the company might by ordinary resolution "increase the share capital by such sum, to be divided into shares of such amount, as the resolution shall prescribe". The question was whether a resolution passed at the EGM of the company contravened Article 32 because it did not specify the number of new shares which the board was authorised to issue, the argument for the appellants being that, construed as at the date of the incorporation of the company, and read in the light of the Companies Act at the time, the Article related only to "authorised" share capital. The case is of interest here, not for the decision, which upheld the validity of the resolution, but for the discussion about the interpretation of the company's Articles in light of subsequent legislative changes. The court noted, at para.11, that the articles were a contract between the company and its members and that a key canon of interpretation was that in interpreting the contract the court would have regard to the legal, regulatory and factual matrix forming the background in which the document was drafted. The court accepted the general rule that a contract must be interpreted as at the date it was made, but recognised the potential for a "somewhat dynamic approach to interpretation", exemplified in the decision of Branson J in Re GIGA Investments Pty Ltd (1995) ACSR 472 in holding that the requirement in a company's articles that there be a "meeting" of directors was satisfied when one of the directors was "present" only by telephone. The court referred to a passage from Lewison, The Interpretation of Contracts (4^th Edition, 2007), in which the author says (at p.185):

"There is a presumption that a contract must be interpreted as at the date when it was made; that words must be given the meaning which they bore at that date .... However, in the case of a contract intended to endure for a long time, the presumption may be rebutted."

The court also referred to another passage (at p.130-1), in which Lewison states:

"Where statute law changes, the court must decide how to apply the words of the contract to the changed circumstances ..."

There was then a reference to the remarks of Mance LJ in Debenhams Retail plc v Sun Alliance and London Assurance Co Ltd to which I have referred. The court concluded (at para.14):

"Put simply, in deciding how the words of a contract should apply in the context of a subsequent change in legislation, the court has to first carefully dissect the purposes and the values embedded within the relevant provisions of the contract. The interpretation reached must be one which is in consonance with the purposes and values of those provisions."

That approach is, clearly, consistent with the approach of the Court of Appeal in Debenhams Retail plc v Sun Alliance and London Assurance Co Ltd. I would only question whether that approach is, as suggested by Lewison, an exception to the general rule or, as the Court of Appeal appears to have thought, an application of it, by recognising that at the time the contract was entered into parties would have been aware that form, structures, practices and legislation might well change over the lifetime of the contract but would have intended that those changes were not to affect the essence of what they had agreed.

[66] There is, therefore, judicial approval for an approach to construction which asks, in changed legislative circumstances, what are the purposes and values expressed or implicit in the provisions of the contract under consideration, or, to put it more colloquially, which tries to identify what the clause is driving at, and then applies that understanding of the clause to the changed circumstances. I shall return to this point later.

[67] Although, as I have said, there was no real difference between the parties as to the applicable principles, there was a difference between them as to where to begin. While the Dean of Faculty submitted that, in this case, the court should start with the words used by the parties in the Deed, Mr McNeill's preferred point of departure was to ascertain the relevant background knowledge. As was acknowledged in Luminar Lava Ignite Ltd v Mama Group plc at para.[38], there is no one starting point that is right in every case, nor is there always one that is right in any particular case. It is essentially "a matter of choice". In the present case, I am persuaded that the words of the contract should be considered first. That seems to me to be the best course where, as here, the argument is not so much about the language used as about the application of the clause to the circumstances that have arisen. There is no argument here about syntax or grammar, or ambiguity in the meaning of the words used, no suggestion that the wrong words or expressions have crept in by mistake. Nor is any case advanced that an appreciation of the background would assist the court in understanding the sense in which words and expressions are used in the Deed. In those circumstances it seems to me that I should first consider the natural and ordinary meaning of the words used, bearing in mind (a) that there is always some context, however meagre, to take into account (Kirin-Amgen Inc v Transkaryotic Therapies Inc (No.2) [2005] RPC 9 per Lord Hoffman at para.[64]) and (b) that, in a contract of this sort, the words or expressions used may not have been used in a natural and ordinary way (Investors Compensation Scheme at p.914E). On the basis of the words used, I should form, in the first instance at least, a provisional view as to what the parties must be taken to have intended. Where, as here, background or contextual information is to hand and is relied on by the parties, that provisional view must be assessed, or re-assessed, in light of that information, to see whether it makes sense, whether it requires some re-consideration. This, I think, is consistent with the approach adopted by Lord Reed in Credential Bath Street Ltd v Venture Investment Placement Ltd.

[68] In my opinion, the words and expressions used in clause 2(1) of the Deed, when understood in the light of the definitions set out in clause 1, do have an ordinary and natural meaning which is clear and straightforward. I need not concern myself with the date for payment (the "covenanted Payment Date"). There is no dispute about that. I am concerned only with the amount that is to be paid to the pursuer. That amount is stipulated to be the greater of £38,929 and

"an amount equal to one-third of 0.1946 per cent of the Pre-Tax Profits (after deducting Pre-Tax Losses) for the Accounting Reference Periods all or part of which fall within the Base Period but excluding in the case of any Accounting reference period part of which falls outside the Base Period that proportion of the Pre-Tax Profit or Pre-Tax Loss therefore which the duration of the said part bears to the duration of that Accounting Reference Period",

together with interest as laid down in the clause. Nothing turns on the relevant Accounting Reference Period. This is agreed to be the Accounting Reference Period ending on 31 December 2009. It is not necessary to worry about the exclusion of part of the Pre-Tax Profits or Losses falling outside the Base Period. That does not affect the basic construction of the clause. Nor am I concerned with the precise fractions and percentages. The amount payable is simply a percentage of the Pre-Tax Profits (after deducting Pre-Tax Losses) for the Accounting Reference Period ending on 31 December 2009. Those terms, "Pre-Tax Profit" and "Pre-Tax Loss", are themselves defined. They mean, respectively, the "group profit before taxation" and the "group loss before taxation" shown in the Audited Accounts for relevant period, subject to certain adjustments which I shall come back to consider. The expression "Audited Accounts" is also defined. It means "the audited consolidated accounts of the Company and its subsidiaries" for the relevant period. So the definition of the amount payable can be further simplified: it is simply a percentage of the group profit before taxation (after deducting group loss before taxation) shown in the audited consolidated accounts of the Company and its subsidiaries for year ending on 31 December 2009.

[69] By these definitions, the parties have removed any potential for uncertainty. Had the expressions "Pre-Tax Profit" and "Pre-Tax Loss" been left undefined, a question might have arisen as to whose pre-tax profit or loss was relevant. That has been resolved. It is the group profit and loss. How is that to be ascertained? It is the group profit and loss shown in the Audited Accounts for the relevant period. What Audited Accounts? The audited consolidated accounts of the Company and its subsidiaries. Except for the possible ambiguity about what is included in the word "accounts", which does not matter here for reasons which I have attempted to explain in para.[48] above, these definitions leave no room for argument.

[70] The Pre-Tax Profits after deduction of Pre-Tax Losses as ascertained require to be adjusted to exclude two things: (i) any amounts attributable to minority interests; and (ii) any profits or losses arising on the sale or termination of an operation. The amounts attributable to minority interests are readily identifiable. They are agreed at £135 million. Nor will the profits and losses arising on the sale or termination of a business give rise to any problems. But if there was any issue about either of these deductions, the definition goes on to provide how they will be resolved. The necessary adjustments, if any, are to be determined by the Auditors "on such basis as they shall consider reasonable", and their determination is "conclusive and binding on the parties."

[71] I agree with the submission made for the pursuer that the provision that the extent of the adjustment to be made should be determined by the Auditors, and that their determination should be conclusive and binding on the parties, demonstrates an intention to establish, in respect of these adjustments, a mechanism for determining the amount due which was independent of the parties. But the point only goes so far. It applies only to the adjustments to be made on account of minority interests and profits and losses arising on the dale or termination of an operation. It does not provide a mechanism for identifying the headline figure in the accounts, i.e. the pre-tax profit or loss. But that may be simply because there is no potential for dispute there. In my opinion, the figure for the group profit before taxation in those Audited Accounts is the figure of £1.042 billion shown on p.127 as "profit before tax". I do not think that it was seriously suggested that the figures on pp.18, 22 and 149 should be used instead, but if it was so suggested I so not accept it. I find on the evidence that the group profit before taxation for the relevant year was £1.042 billion.

[72] Accordingly, I conclude that on the natural meaning of the words and expressions used in the Deed, the parties have settled upon a formula which plainly points, in the present circumstances, to the result for which the pursuer contends.

[73] But this is not the end of the matter. That construction must be cross-checked against the evidence the court has before it as to the circumstances in which the agreement in the Deed was made.

[74] In his Note of Argument, Mr McNeill submitted that no-one at the time the covenants were entered into would have contemplated the possibility that items such as negative goodwill, or profits on a sale or termination of an operation, or any merely putative (or unrealised) gain, might be included in the Audited Accounts as part of the pre-tax profits or losses, and accordingly be reflected in the level of payments to the foundations from year to year. He argued that the evidence disclosed an intention to establish (i) that the sums to be made over to the foundations were to come from ordinary activities (less minority interests), and (ii) that the calculation of those sums was not to be affected by technical accounting treatments. The first was, he submitted, evidenced by the expectation that the payments would be deductible for tax purposes; and the second by the exclusion of minority interests from pre-tax profits.

[75] In the course of his oral argument, Mr McNeill departed somewhat from the second plank of his argument, namely that the calculation of the payment to be made to the foundations in each year was not to be affected at all by "technical accounting treatments". In light of the evidence given by Mr Merris, he accepted that there had been many changes in accounting standards since 1986 (when the initial Deed was entered into) and since 1997, the date of the Deed in question in this action, albeit that changes were less frequent in the early days than they have become more recently. He accepted, therefore, that the parties to the Deed, at the time it was entered into (whether one takes 1986 or 1997) would have been aware that accounting standards and practices were not fixed but might well change over the course of time. Nor, as I understood it, did he challenge Mr Merris' evidence that it would not now be possible, or (if possible) certainly not easy, on the basis of the 2009 audited accounts for the Group, to determine the Group profit before taxation applying the accounting standards and practices in force in 1986 or 1997. Accounting standards are developed in line with new business practices, and there might be a large number of transactions in the year 2009 which would not specifically be covered by the accountancy guidance that applied in 1986 or 1997. Accordingly he did not insist on his argument that the parties did not intend the calculation of the payments to be affected in any way by changes in accountancy practice. But he maintained, nonetheless, that they did not intend that calculation to be affected "in a dramatic way" by such changes. As at 1997, the generally accepted accountancy practice would not have regarded negative goodwill as something to be accounted for as part of the profits before tax.

[76] I am persuaded that this argument is correct. It is, in my view, permissible to look at the various exchanges leading up to the de-mutualisation of the TSB and the setting up of the Deed in 1986. They are not properly to be regarded as negotiations, and, thus, for reasons explained in the cases, suspect as a means of ascertaining objectively the aims of the parties. Rather they form the background to the transaction and show the thinking behind setting up the foundations and securing their funding. They show, in broad terms, an intention to fund the foundations by taking a percentage of the pre-tax profits of the group (then the TSB Group plc). The emphasis throughout the documents is on this being a tax-efficient method of providing income to the foundations. In light of this, it is clear, in my opinion, that in lighting upon "pre-tax profit" (or "group profit before taxation") as the basis of the calculation in the 1986 Deed of what was to go to the foundation, the framers of the Deed and the parties to it intended that the percentage payable to the foundation ought to be a percentage of profits susceptible to taxation, or "realised" or "actual profits" to use two of the expressions used in argument. I do not think it necessary to fix on a particular expression. They may not be precisely the same or lead to precisely the same result. That does not matter. What matters can be expressed better in the negative. They did not intend that the foundation should receive a percentage of profits which included a figure for negative equity which was neither realised, subject to tax nor capable of distribution.

[77] It is not surprising that the parties should attempt in the definitions in the Deed to ensure that there could not be any dispute about what that pre-tax profit was. Hence the specific reference to the Audited Accounts. This tells you where to find the pre-tax profits for any particular period. It is that figure which is then to be used as the basis for the calculation of the sums to be paid to the foundations. But this agreed stipulation of where and how to identify the pre-tax profit in the Audited Accounts was chosen on the basis that the figure thus identified would be a figure for real or actual profit. No-one in 1986, or 1997 for that matter, conceived of the possibility that it might not. It is therefore no answer to the problem that has arisen in the present case to say that the parties have made clear and detailed provision for identifying the figure to be taken as the base for calculating the payment to be made to foundation. That is the problem, not the solution.

[78] The change in accounting practices brought about by IFRS 3, requiring the immediate recognition of negative goodwill in the Group income statement, meant that the headline figure in the Audited Accounts would not necessarily equate to realised gain or taxable or distributable profit, whichever concept one takes as best identifying the intention of the parties to the Deed. But it took a one-off event like the take-over of HBOS at a cost which was considerably less than its asset value to highlight this difficulty. I heard no evidence of the frequency with which, since IFRS 3 came into force in the UK, negative goodwill has appeared in group income statements. My understanding is that it had not appeared in the defender's group income statements before the acquisition of HBOS in 2009. But whatever the position, the fact is that the combination of these two factors has resulted in the group pre-tax profit shown in the Audited Accounts being increased by an amount of in excess of £11 billion which (a) is not realised profit, (b) does not form part of the group's taxable profit, (c) is not available for distribution to shareholders and (d) would not have been shown in the group pre-tax profit at the time the Deed and the amended Deed were entered into in 1986 and 1997 respectively, or at any time before 2005. The pursuer's argument seeks to hold the defender to a literal meaning of the 1997 Deed despite the fact that this change, the inclusion within pre-tax profits of a figure for negative equity which is not subject to taxation, was not and could not have been anticipated at the time.

[79] Before the articulation of the "modern" rules of construction in recent times, the problem with which the court is faced in this case might have been addressed by the defenders seeking to imply a term that they should not be bound to pay a sum calculated by reference to an amount which was neither realised, taxable nor capable of distribution, on the basis that reasonable men, faced with the suggested term which ex hypothesi was not expressed in the Deed, would without hesitation say: "yes, of course, that is so obvious that it goes without saying": c.f. Shirlaw v Southern Foundries (1926) Ltd., [1939] 2 K.B. 206, at p. 227, per MacKinnon LJ. This form of implication - by necessary implication from the express terms of the contract read in the light of the subject matter and the purpose of the clause - is often known as "constructional implication". It has featured in countless decisions, often at first instance. One example, to which I refer to illustrate the relationship of constructional implication to other methods of implication, is the case of Mosvolds Rederi A/S v Food Corporation of India (Damodar General TJ Park and King Theras) [1986] 2 Lloyd's Rep 68. To my mind it has much in common with one aspect of the modern approach to construction. This is not, of course, a case where something must have gone wrong with the language. In light of what was known and foreseeable at the time, the method of expressing what the parties intended cannot be criticised. But they did not deal with a situation which has subsequently emerged and which they could not have foreseen. Had they had magical powers of foresight, I have no doubt that the parties would have come up with a different formula to express their basic intention. The parties not having had such foresight (for which they cannot be blamed), and therefore having expressed themselves in a manner which, in the changed circumstances, gives rise to unintended consequences, is the court powerless to intervene? I think not.

[80] In my opinion the court should follow the approach laid down in Debenhams Retail plc v Sun Alliance and London Assurance Co Ltd and Lian Hwee Choo Phebe v Maxz Universal Development Group Pte Ltd. Consistent with that line of authority it should ask what are the "purposes and values" expressed or implicit in the wording of the Deed, as understood in the context of the facts and matters in existence at the time it was entered into, and, having identified those purposes and values, attempt to reach an interpretation which applies the wording of the Deed to the changed circumstances in the manner most consistent with them.

[81] I have already attempted to identify the purposes and values expressed or implicit in the wording of the Deed. Its purpose, put short, was the foundation to participate in the Group's trading profits. Applying the approach in Debenhams Retail plc v Sun Alliance and London Assurance Co Ltd and Lian Hwee Choo Phebe v Maxz Universal Development Group Pte Ltd, I consider that the court should, in a case where it is necessary to do so in order to achieve those purposes and values, disregard the words "shown in the Audited Accounts" in the definition of Pre-Tax Profit and Loss in the Deed. This is not, to my mind, re-writing the contract so as to alter the bargain the parties have made. It simply recognises the fact that to find a construction consistent with the parties' objectives may involve doing some slight violence to the wording of the contract or Deed: see e.g. Aberdeen City Council v Stewart Milne Group Ltd [2010] CSIH 81 at para.[12]. This may be necessary not only where something must have gone wrong in the drafting but also where, because of changed circumstances, the drafting gives a result which neither party could have intended. If those words are disregarded, Pre-Tax Profit and Pre-Tax Loss are defined as

"respectively the 'group profit before taxation' and 'group loss before taxation' (as the case may be) for such period adjusted to exclude ..."

On this definition the expression "group profit before taxation" is ambiguous. In construing it in accordance with the parties' objectives, it is not necessary to identify any particular wording to express what is or is not included. It is sufficient to say that it does not include the figure for negative equity resulting from the HBOS acquisition.

[82] On this basis I am satisfied that the pursuer's claim must fail. I shall therefore grant decree of absolvitor.

Equitable adjustment

[83] As an alternative to his case on construction, Mr McNeill submitted that there was scope in Scots Law for the application of the principle of "equitable adjustment". This was disputed by the Dean of Faculty who submitted that there was no such principle in the law of Scotland. This raises an important issue of principle.

[84] In light of my decision that the pursuer's claim must fail, it is strictly unnecessary for me to decide this point. But in deference to the careful arguments presented to me, and in case this matter should go further, I should set out briefly my opinion on the issue.

[85] It is necessary to set out Mr McNeill's submissions as set out in his Note of Argument and as elaborated in oral submissions in some detail. He submitted that a radical change of circumstances may lead to a court finding a contract frustrated and neither party bound to its obligations. Neither party here contended that the contract contained in the Deed was frustrated. Further, he recognised that a contract will not normally be frustrated because of a fall or rise in market prices, or shortage of supplies or other commercial difficulties in performance, however extreme. However he submitted that, in circumstances not amounting to frustration, where performance of a provision in an ongoing contract would, as a result of unforeseen circumstances, no longer bear any realistic resemblance to the performance originally contemplated, and would produce a manifestly inequitable result, the courts would intervene. He submitted that on occasion, and in unusual circumstances, the courts have been astute to recognise that some form of equitable adjustment of the contractual provisions should be ordered for the purpose of avoiding a windfall and quite unanticipated gain to one or other party.

[86] Mr McNeill referred to McBryde, The Law of Contract in Scotland (3^rd Ed. at para.21-21) and its citation of Wilkie v Bethune (1848) 11 D 132 as an example of this. In that case an agricultural labourer was entitled by his contract to be paid partly in money and partly in potatoes. The 1846 potato crop failed and there was a dramatic price rise. Mr McNeill submitted that, whilst there were indications in the opinions of Lords Mackenzie and Jeffrey that the contract, not being a proper mercantile contract, could be treated specially, McBryde sees it as fitting with the modern approach to frustration and to the object of achieving a just and reasonable result. He contrasted that with the treatment of Wilkie in Gloag, Contract, 2^nd Ed. at p.339 n2. Mr McNeill submitted that that approach, which finds the Courts prepared to intervene where there has been a material change in circumstances short of impossibility, and a consequent change in the obligation, is consistent with certain of the views of the Institutional Writers regarding a material change of circumstances affecting the enforceability of a promise. In this connection he referred to Hugo Grotius, De Jure Belli ac Pacis (1631) (Tuck/Barbeyrac Edition 2005) II.xvi.25.2:

"'Tis also a very usual Inquiry, whether Promises are to be understood with this tacit Condition, If things continue in the same Posture, they are now in; that is what is not to be granted, unless it plainly appears, that that present Posture of Things was included in that one only reason we are talking of; and we frequently read in Histories of Ambassadors, who understand that there was a great Turn in Affairs, as would render the whole Matter and Reason of their Embassy void, have returned Home without opening their Commission at all."

He also referred to Samuel von Pufendorf, De Jure Naturae et Gentium (1688) (Scott Edition 1934) III.vi.6:

"... if a promise was based upon the presumption of some fact, which was not as stated, or if I made my promise on the supposition of some fact or quality and would not have bound myself had I not supposed it to be there, the promise will naturally have no force; provided the very nature of the business and the circumstances clearly show that I based and conditioned my consent entirely upon that fact or quality."

[87] In support of his argument, Mr McNeill referred to two other authorities. First, in Pole Properties Ltd v Feinberg (1982) 43 P&CR 121, the Court of Appeal, having found that the situation surrounding the obligation under a lease to contribute to heating costs had altered so radically that the terms could no longer be applied, determined that a fair and reasonable approach should be adopted. The leading judgement was given by Lord Denning MR, who indicated that the task of the court in such circumstances was to ask itself: what were the circumstances in which the contract was made? Did it apply to the new situation which had developed? And, if events had occurred for which the contract had made no provision and which were outside the reasonable contemplation of the parties or anyone sitting in their shoes at the time the contract was made, how should the court intervene? Secondly, in Aluminium Company of America v Essex Group Inc 499 F Supp. 53 (1980), the US District Court of Pennsylvania determined upon the re-formation of a long term service contract where the seller's non-labour production costs had risen greatly beyond the foreseeable limits of risk under the non-labour component of an objective pricing formula tied to a wholesale price index for commodities. Teitlebaum J (at p.91-2) suggested that the maxim that courts would not make a contract for the parties bore less weight when applied to dispute resolution than to questions of contract formation. In resolving a dispute, the court may have information from hindsight far superior to that which the parties had when they made their contract. The parties, with their business knowledge, might be able to negotiate a better working arrangement than the court could impose, but if they did not do so they might be better served by an informed judicial decision based on known circumstances than "by a decision wrenched from words of the contract which were not chosen with a pre-vision of today's circumstances".

[88] Mr McNeill submitted that in disputes relating to a price mechanism, the court will intervene where, although that mechanism has not become inoperable, it has to be treated as having failed the parties because, if applied literally, performance would, as a result of changed and unforeseen circumstances, no longer bear any realistic resemblance to the performance originally contemplated, and would produce a manifestly inequitable result. The unforeseen change of circumstances here - relating to the imposition of IFRS 3 and the extraordinary difference between the result, for the 1997 Deed, of applying pre-2004 accounting standards compared with applying IFRS 3 - would produce a manifestly inequitable result. The intended function of the mechanism for making payment to the charitable foundations was to allow those foundations to participate in the Group's trading profits; it was not intended to give the foundations something which would not have been available to ordinary shareholders. In addition, the circumstances in which the defender acquired HBOS, giving rise to the problem of negative goodwill in the accounts, were exceptional and wholly unforeseen as at the time the Deed was entered into. In those circumstances, he submitted, the court should intervene by altering the provisions of the 1997 Deed so as to exclude from the calculation of "Pre-Tax Profits" the negative goodwill brought about by the combination of the acquisition of HBOS and the application of IFRS 3.

[89] Despite Mr McNeill's interesting submissions, I am not persuaded that there is such a doctrine in Scots law. I will set out my reasons briefly.

[90] First, I find it difficult to accept the argument that, if the doctrine exists, it is a doctrine peculiar to Scots law. Mr McNeill cited Wilkie v Bethune. But in my opinion that provides no support for his argument. Each of the judges seems to have decided the case on different grounds. Lords McKenzie, as I understand his decision, in effect decided the case on equitable grounds by refusing interdict for payment in potatoes. Lord Jeffrey emphasised that it was not a mercantile contract and that he was not laying down any principle of mercantile law. He construed the contract as a contract to provide a certain amount of aliment, and, while it happened to mention potatoes, the provision of potatoes was not an essential part of the obligation. Only Lord Fullerton dealt with the case on the basis of frustration, but he was in the minority. McBryde discusses the case in a chapter on frustration and does not suggest any doctrine of equitable adjustment falling short of frustration. Mr McNeill also cited decisions from England and the United States. If the doctrine is sound, there is no reason to think it is not also sound in England and Wales and, no doubt, elsewhere. It must be tested by reference to the general principles of law there too. Yet I was shown no case law, text book, treatise or article suggesting in terms the existence of such a doctrine in those other systems.

[91] Second, the formulation of the circumstances in which the doctrine is said to apply is the classic formulation used in the context of frustration. Where performance of a provision in a contract would, as a result of unforeseen circumstances, no longer bear any realistic resemblance to the performance originally contemplated, and would produce a manifestly inequitable result, the courts will intervene. The doctrine of frustration is well established. It operates whenever the law recognizes that without default of either party a contractual obligation has become incapable of being performed because the circumstances in which performance is called for would render it a thing radically different from that which was undertaken by the contract: Davis Contractors Limited v Fareham UDC [1956] AC 696, per Lord Radcliffe at p.729, citing Aeneas' somewhat ungallant response to Dido's offer of conjugal bliss (Aeneid Book 4, line 339). The difference in the formulation advanced by Mr McNeill appears to be that the doctrine of frustration will not usually apply when the change of circumstances amounts simply to an unforeseen rise, even a very steep rise, in the cost of performance. But if a doctrine of equitable adjustment exists and can apply in such circumstances, it is surprising, to say the least, that it has not been mentioned, let alone applied, in the many cases where parties have unavailingly advanced a frustration argument in such circumstances.

[92] The citations from Grotius and Pufendorf do not appear to me to assist Mr McNeill's argument. They propose that a party will be relieved of his promise where there has been a radical change of circumstances or where the promise has been given under a mistake of fact. Both such cases are dealt with now by the common law of frustration and mistake (unilateral and/or mutual). They add nothing to the argument that there should be an additional doctrine of equitable adjustment where a contract is nearly frustrated but not quite.

[93] For those brief reasons I would have held that the argument based on equitable adjustment must fail. However, standing my decision on the main argument, the point is academic.

Disposal

[94] For the reasons given, I shall assoilzie the defenders from the conclusions of the summons.