Long term contracts, changing circumstances and interpretation

In recent times there has been a wealth of analysis of the principles of interpretation of contract.  In addition to the Scottish Law Commission report (available at http://www.scotlawcom.gov.uk/law-reform-projects/contract-law-in-light-of-the-draft-common-frame-of-reference-dcf/), useful guidance was provided by the Supreme Court in the Scottish appeal, Multi-Link Leisure Developments Ltd v North Lanarkshire Council ([2010] UKSC 47).  A recent OH decision from Lord Glennie, Lloyds TSB Foundation for Scotland v Lloyds Banking Group plc ([2011] CSOH 105) has shed light on an interpretation issue which generally receives little attention from the courts, namely the way in which rules of interpretation are applied where performance of a long term contract has been affected by changed circumstances.   Should the interpretative rules be amended to take into account unanticipated changes having an impact on the way the contract operates?

The pursuer is a charitable foundation, set up at the time of floatation of the TSB group in 1986 in order to preserve the bank’s charitable status.  The contract at issue is a Deed of Covenant in terms of which payments were made by defender to pursuer.  It was entered into in 1997 and was to endure until terminated by the defenders by nine years’ notice in writing.  The dispute concerned the interpretation of the provision for payment in the Deed, and arose in the context of the defender’s acquisition of HBOS in 2009.  That acquisition gave rise to “negative goodwill.”  A change in accounting practices meant that negative goodwill became included in Audited Accounts as part of pre-tax profits or losses.  At the time this Deed was entered into, the defenders argued, no one could have contemplated that this would be the case.  The pursuers argued that the defender should be held to a literal meaning of the Deed despite the fact that this change, the inclusion within pre-tax profits of a figure for negative goodwill not subject to taxation, was not and could not have been anticipated at the time.  The defenders argued that this new approach should not affect the level of payments to the foundation from year to year. 

Lord Glennie tackled the difference between the parties on the appropriate starting position in the interpretative exercise.  The pursuers argued that the court should start with the words used in the Deed, whilst the defenders argued that one should look first to the relevant background knowledge available to the parties at the moment of formation of the contract.  In contrast to many other interpretation cases recently, Lord Glennie found that the words in question did indeed have a natural and ordinary meaning (para [68]).   He explained his approach as follows (para [67]):

“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 reconsideration.”

He concluded on this point (paras [72] and [73[]):

“…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.  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.”

This statement provides much-needed guidance.  The correct starting point is surely an important issue.  It seems unsatisfactory to state, as Lord President Hamilton did in the recent case of Luminar Lava Ignite Ltd v Mama Group plc that there is no starting position: it is a matter of choice (2010 SLT 147, para [38]). 

Speaking of the change in circumstances in particular Lord Glennie commented (at para [79]):

“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.”

The actual approach was explained in more detail (at para [80]):

“…it [the court] 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.”

The purpose of the Deed was, Lord Glennie held, to allow the foundation to participate in the Group’s trading profits (para [81]).  Relying on the approach in two other cases, Debenham Retail plc v Sun Alliance and London Assurance Co Ltd and Lian Hwee Choo Phebe v Maxz Universal Development Group Ptd Ltd, Lord Glennie with this specific purpose in mind, disregarded certain of the words in the definition of Pre-Tax Profit and Loss, explaining (at para [81]):

“This is not, to my mind, re-writing the contract so as to alter the bargain the parties have made.  It simply recognises that to find a construction consistent with the parties’ objectives may involve doing some slight violence to the wording of the contract or Deed…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.”

The pursuer’s claim failed and decree of absolvitor was granted. 

There is more in the case which is of interest, however.  As an alternative to the case on construction, the defender argued that there was scope in Scots law for the idea of “equitable adjustment.”  This is an attempt to resurrect an idea which, although long dormant, has a distinguished history, having been analysed by Lord Cooper (‘Frustration of Contract in Scots Law’, (1946) 28 Journal of Comparative Legislation, Pt III, 1’ not, it appears, cited to the court).  McBryde is in favour of its resurrection, exhorting the Scots lawyer to “…ignore dicta in English cases,” and “follow the approach of his predecessors” (‘Frustration of Contract’ (1980) J.R. 1 at 4).  The current author analysed it again recently in a comparative analysis of Scots and Louisiana law (‘The effect of unexpected circumstances in contracts in Scots and Louisiana Law’ in V. V. Palmer and E. C. Reid (eds), Mixed Jurisdictions Compared: Private Law in Louisiana and Scotland (2009) pp. 244-280).  Neither party in this case sought to argue that the contract was frustrated.  Rather, the defender submitted (para [85]):

“…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.”         

In support of this argument, the defender cited an old chestnut of a case, Wilkie v Bethune (1848) 11 D. 132.  In that case an agricultural labourer was entitled by contract to be paid partly in money and partly in potatoes.  The 1846 potato crop failed and there was a dramatic price rise.  The defender sought to rely on McBryde’s suggested approach which was to treat this case as an example of adjusting a contract to achieve a fair and equitable approach.  Placing this idea in the context of the ius commune, the defender cited Grotius, De Jure Belli ac Pacis, II.xvi.25.2 and Pufendorf,  De Jure Naturae et Gentium III.vi.6.  Finally, the defender cited Pole Properties Ltd v Feinberg (1982) 43 P&CR 121 and a decision of the US District court of Pennsylvania, Aluminium Company of America v Essex Group Inc 499 F Supp 53 (1980). 

Despite the citation of these distinguished authorities, Lord Glennie rather bluntly concluded (para [89]):

“I am not persuaded that there is a such a doctrine in Scots law.”            

Even if it existed, he did not see it as a doctrine specific to Scots law (para [90]).  Wilkie v Bethune was characterised as an unhelpful authority (para [90]):

“Each of the judges seems to have decided the case on different grounds.  Lord Mackenzie…decided the case on equitable grounds by refusing interdict for payment by 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.”

Lord Glennie suggested that, if the doctrine was part of Scots law, it must also be part of English law (para [90]).  This conclusion is surely questionable.  Although, as he pointed out, the law of frustration in both system tends to be discussed by reference to the case of Davis Contractors Limited v Fareham UDC ([1956] AC 696), there are differences in the way each system approaches this whole area.  The law of unjustified enrichment regulates the positions of the parties after frustration.  English law applies a statute which has no application in Scotland, the Law Reform (Frustrated Contracts) Act 1943, and Scots law the common law principles of unjustified enrichment.  With such a different underpinning structure, and a completely different historical development, it seems likely that further differences may exist.       

Finally, he questioned the existence of a concept of equitable adjustment: there appears to be no history of its application in contracts where a steep rise in the cost of performance has occurred (para [91]).  This point can be discussed by analogy with cases involving extraordinary inflation.  Whilst English authority confirms that “ordinary” inflation does not provide grounds for frustration (British Movietone News Ltd v London and District Cinemas[1952] AC 166; Wates Ltd v Greater London Council (1983) 25 BLR 1 (CA)), modern writers are at least open to the possibility that extraordinary inflation could frustrate a contract (G. H. L. Treitel, Frustration and Force Majeure (2004), para 6-045).  Perhaps we should keep an open mind on whether an extraordinarily large hike in the cost of performance of a long term contract could amount to frustration.  Comparative material on this point is interesting.  In Germany, where currency devalued after the Second World War, the German courts were called upon to consider this point regularly (see the discussion in E. Hondius and H. C. Grigoleit, Unexpected Circumstances in European Contract Law (2011) p. 218 et seq).  The lack of discussion of the effect of extraordinary inflation may be explicable because, in the U.K., we have so far been lucky enough not to suffer from drastic currency devaluation. 

For all these reasons the argument on equitable adjustment failed.  This is perhaps not surprising given the lack of authority and the age of the authorities which are available.  It is disappointing, however, that reference appears not to have been made to more of the Scottish academic commentary.  The legal teams appear to venture no further than McBryde’s book.  Whilst this blogger would certainly not question the central role of this book, other academic analysis exists, including an article by Professor McBryde written in 1980.  The relevant section in the Stair Memorial Encyclopaedia (volume 15, Obligations, para 880) also contains support for equitable adjustment.  Lord Cooper’s article would have been particularly useful to the court, setting out the differing history in Scotland and England, and perhaps leading to a recognition that the law may differ in the two countries. 

Lord Glennie’s rejection of the concept is unlikely to be the end of the story.  Equitable adjustment appears in the DCFR III. -1:110(2): “ If, however, performance of a contractual obligation or of an obligation…becomes so onerous that it would be manifestly unjust to hold the debtor to the obligation, a court may: (a) vary the obligation in order to make it reasonable and equitable in the new circumstances: or (b) terminate the contract at a date and on terms to be determined by the court.”  Given that the Scottish Law Commission is currently subjecting Scots law to a “health check” by reference to the DCFR, they may indeed consider this area once more. 

This case presented a useful opportunity for reconsideration of the rules of interpretation and the idea of equitable adjustment.  Lord Glennie provides succinct and practically useful analysis.  The defender’s legal team should be thanked for running an argument based on equitable adjustment, allowing the rest of us to consider it once more.