Scottish Court of Session Decisions

The reclaiming motion called before the First Division, comprising the Lord President (Rodger), Lord Kirkwood and Lord Caplan for a hearing on the summar roll.

At advising, on 1 May 1998—

LORD PRESIDENT (Rodger)—In 1989, the defenders and respondents, Dunedin Property Investment Company Limited (‘Dunedin’), were clients of the pursuers and reclaimers, the Bank of Scotland (‘the Bank’). The Bank had made a number of short-term loans to Dunedin and Dunedin decided that it would be preferable from their point of view to convert these into a long-term arrangement under which Dunedin would pay the Bank a fixed rate of interest. Dunedin therefore approached the Bank and negotiations followed. The subject of those negotiations was the possibility of Dunedin issuing, and the Bank subscribing for, debenture loan stock. After the first meeting the Bank produced a document (No 5/1 of Process) entitled ‘Outline Terms and Conditions’.

The second meeting took place on 6 June 1989 and the Bank's note of the meeting began by recording that it was held to discuss the Bank's recent offer to provide a £10/15 million Debenture Loan Stock. It went on to say that Mr Forest, Dunedin's Chief Investment Manager, advised that Dunedin had now more or less decided that they wished to proceed with the facility on the basis of a £10,000,000 (£10m) Debenture repayable at the end of ten years. Following the meeting the directors of Dunedin did indeed decide to proceed with the transaction and on 28 July they passed a resolution by which they created £10m debenture loan stock 1999 (‘the stock’). The Bank and Dunedin then entered into a Loan Stock Deed (‘the Deed’) dated 1 and 3 August 1989 under which the Bank agreed in Clause 3 to subscribe at par for the full amount of the stock on 1 August 1989 ‘on the terms and subject to the conditions’ set out in the Deed. Clause 5 provided that the Certificates for the stock were to have endorsed on them Conditions in the form set out in Schedule 1 to the Deed. It went on to provide that Dunedin: ‘shall comply with the terms of the Certificates for the Stock and the said Conditions endorsed on such Certificates and the Stock shall be held subject to and with the benefit of such Conditions all of which shall be deemed to have been incorporated in this Deed and shall be binding on [Dunedin] and the holders of the Stock and all persons claiming through or under them respectively.’

The Bank proceeded to subscribe for the stock and Dunedin granted them various securities for the sum involved. In the normal course, in terms of Condition 1, Dunedin were to redeem the stock at par on 30 June 1999 together with interest accrued up to and including that date. Condition 3 provided, however, that: ‘The Company shall be at liberty at any time on provision of six months prior written notice to the bank, to purchase the Stock, subject to the Bank being fully reimbursed for all costs, charges and expenses incurred by it in connection with the Stock.’ In terms of this Condition, on 17 October 1995 Dunedin gave the Bank notice that they intended to purchase the stock and on that basis the redemption date was to be 17 April 1996. In fact the loan stock was not redeemed until 7 March 1997, while the case was at avizandum before the Lord Ordinary. The dispute between the parties arises out of the interpretation and application of Condition 3. In order to understand that dispute it is necessary to appreciate the general nature of the arrangements which the Bank put in place at the time when they entered the Deed with Dunedin.

The rate of interest payable by Dunedin to the Bank under the Deed was fixed at 12.5 per cent per annum. The effect of the Deed was therefore that the Bank had agreed to lend Dunedin £10m for a period of ten years at a fixed rate of interest of 12.5 per cent. It was not the policy of the Bank, when entering into a fixed rate agreement for such a long period, to leave themselves exposed to the vagaries of interest rate movements and they accordingly set about hedging their position. This was done through the Bank's Treasury Division. In 1992 a separate company, Treasury plc, took over the responsibilities of the Treasury Division. Before the Lord Ordinary certain arguments were advanced on the basis of this change in the Bank's arrangements, but the Lord Ordinary decided those arguments in favour of the Bank and Dunedin did not challenge his decision in the reclaiming motion. It is therefore unnecessary to deal with them.

The Bank would obviously be concerned to see that their transaction with Dunedin was profitable to them. In theory the Bank might have secured their position by entering into a loan for an equivalent period at a fixed rate of interest lower than the rate of 12.5 per cent which Dunedin were to pay. In practice, however, in 1989 that was not possible. As Mr Cameron, the Deputy Chief Executive of Treasury Services plc, explained in cross-examination, at the relevant period a market in ten-year fixed rate loans did not exist and it was precisely for this reason that the swap market had grown up. Mr John McCormick, the Executive Director of the Derivative Audit Group, described the market for ten-year fixed rate deposits as ‘illiquid’ (Report No 16/1 of Process, p 3) and said in evidence that it was extremely difficult to operate it (Notes of Evidence, 18 December 1996, p 158). In that situation the Bank went into the market which did exist and which was liquid, the market for interest rate swaps. In effect they entered into two separate transactions.

The first was a transaction under which they borrowed £10m, the sum which they were paying Dunedin for the stock, on the London inter-bank market for short term loans. This short-term loan would require to be renewed periodically throughout the life of the Bank's loan to Dunedin. The Bank had to pay the prevailing Libor rate on their borrowing of the £10m under the inter-bank loan.

The second transaction was an interest rate swap in which the counter-party was an American bank, Security Pacific, which later became the Bank of America (‘Security Pacific’). The details of the arrangement are to be found in a letter from Security Pacific to the Bank, dated as at 1 August 1989, a confirmation from the Bank to Security Pacific, dated 7 August 1989 and a telex from the Bank to Security Pacific (Nos 5/4, 5/5 and 7/6 of Process respectively). The notional amount of the swap was £10m, the sum which the Bank was lending to Dunedin. The effective date was 2 August 1989 and the termination date was 30 June 1999, the day on which Dunedin were due to redeem the stock in terms of Condition 1 in Schedule 1 to the Deed. Under the swap agreement the Bank were liable to pay Security Pacific a fixed rate of interest of 11.03 per cent per annum on the notional amount, while Security Pacific were liable to pay the relevant Libor rate of interest, also on the notional amount. So long as Libor was lower than the fixed rate, the Bank would pay the difference to Security Pacific; if Libor rose above the fixed rate, Security Pacific would pay the difference to the Bank. In this way, in return for their liability to pay the fixed rate of 11.03 per cent, the Bank would receive a flow of funds which would allow them, at no additional cost, to pay the interest on their inter-bank loan even if the Libor rate rose above the fixed rate of interest. Therefore the effect of the inter-bank loan plus the swap transaction was that the Bank could be sure that, over the period of their loan to Dunedin, the Bank would never require to pay more than 11.03 per cent interest on £10m. They would thus make a profit on their loan to Dunedin since Dunedin were bound to pay the Bank 12.5 percent interest on their borrowing of £10m.

When Dunedin gave notice that they intended to redeem the stock in April 1996, the Bank took steps to terminate the arrangements which they had made in respect of the loan. In particular the Bank indicated that they would terminate their swap with Security Pacific. Although the matter was not spelled out in the contract conditions produced before the Lord Ordinary, it is not in dispute that, if they terminated the swap early, the Bank would become liable to pay a substantial breakage charge. The exact nature of that charge was not fully explained, but counsel proceeded on the basis that it was in the nature of a payment of damages for breach of the swap agreement by terminating it prematurely. We were told by senior counsel for the Bank that the payment amounted to £923,253.

The question at issue in the present proceedings is whether, as the Bank contend, the liability which the Bank incurred to make this payment on terminating the swap early is a cost, charge or expense incurred by them in connection with the stock and is therefore one which they are entitled to recover from Dunedin under Condition 3 of the Deed. The Lord Ordinary rejected the Bank's contentions and assoilzied Dunedin. The Bank have reclaimed against that interlocutor of the Lord Ordinary.

In her speech, junior counsel for Dunedin argued in effect that two aspects of the interpretation of Condition 3 were in dispute. The first was whether the terms ‘costs, charges or expenses’ or any of them were apt to cover the payment to be made by the Bank under the swap contract; the second was whether, even if the terms could cover that payment, such cost, charge or expense was one incurred by the Bank ‘in connection with the Stock’. Counsel submitted that the payment under the swap contract was a sum of damages which the Bank would require to pay for breach of their contract and such a sum of damages could not properly be described as a ‘cost’, ‘charge’ or ‘expense’ incurred by the Bank. In my view that is much too narrow an approach. Indeed it was not the approach which had been adopted by senior counsel for Dunedin when cross-examining one of the Bank's witnesses at the proof. In framing one of his questions counsel used the term ‘costs’ to describe the payments which would need to be made if the swap agreement were broken (Notes of Evidence, 18 December 1996, p 28D). In my view Mr Campbell's use of the term ‘costs’ in that passage simply reflected the reality that, whatever its precise nature, any payment to Security Pacific was a cost which the Bank had to bear if they terminated the swap contract prematurely. Not surprisingly therefore, although counsel adopted the submissions made by his junior, he himself started his submissions from the assumption that the court would accept that the swap payment would be a cost incurred by the Bank. Like the Lord Ordinary I find little difficulty in accepting that for the purposes of Condition 3 the cost of breaking the swap falls to be regarded as a cost, charge or expense incurred by the Bank. For the sake of convenience I shall refer to the payment as a ‘cost’.

With this first issue out of the way, as counsel rightly recognised, there remains only one issue in the case, viz whether the cost of breaking the swap contract was incurred by the Bank ‘in connection with the Stock’. It is this phrase which the court requires to interpret.

During the hearing before this court we were referred to a number of authorities on the approach which should be taken to the interpretation of a contract. In particular counsel analysed the five principles enunciated by Lord Hoffman in a speech in which both Lord Hope of Craighead and Lord Clyde concurred in Investors Compensation Scheme Ltd v West Bromwich Building Society at pp 114–115. For my part, however, in the present case I am content to follow Lord Steyn's general guidance that in interpreting a commercial document of this kind the court should apply the ‘commercially sensible construction’ of the condition in question: Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd at p 771A. I also find it helpful to start where Lord Mustill began when interpreting the reinsurance contracts in Charter Reinsurance Co Ltd v Pagan at p 384B–C: ‘I believe that most expressions do have a natural meaning, in the sense of their primary meaning in ordinary speech. Certainly, there are occasions where direct recourse to such a meaning is inappropriate. Thus, the word may come from a specialist vocabulary and have no significance in ordinary speech. Or it may have one meaning in common speech and another in a specialist vocabulary; and the content may show that the author of the document in which it appears intended it to be understood in the latter sense. Subject to this, however, the inquiry will start, and usually finish, by asking what is the ordinary meaning of the words used.’ I begin therefore, 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 connection with’ in Condition 3.

As counsel for Dunedin pointed out, the phrase must have been intended to narrow the range of costs, charges or expenses which the Bank could recover. The limitation is in the requirement that there be a connection between the cost, charge or expense and the loan stock. That is obviously correct so far as it goes. If there were no connection between a particular charge and the loan stock, then the Bank could not insist on reimbursement of the charge as a precondition of the company purchasing the stock. So, for instance, the words of qualification mean that the company could purchase the stock even if the Bank had not been reimbursed for some charge incurred by them in connection with one of the short-term loans which they had previously made to Dunedin.

But, even though the words serve to exclude certain more remote costs, charges or expenses incurred by the Bank, they also serve to include a range of such costs, charges or expenses. In particular the words are apt to bring within the scope of the condition costs, charges or expenses which are incurred outside the loan stock itself, but are connected with it. That again is something which seems to me to emerge from the ordinary understanding of the phrase ‘in connection with the loan stock’, but if authority is required for it then it can be found in the somewhat analogous approach taken by Russell LJ in Clarke Chapman-John Thomson Ltd v IRC at p 96.

The Lord Ordinary, on the other hand, held that the phrase ‘in connection with the Stock’ imposed a limitation to costs ‘directly connected with the stock’ and he instanced drafting costs in connection with the loan agreement, the costs of any necessary registration or any administrative costs that might be incurred. I can, however, find no justification in the wording of Condition 3 for inserting the adverb ‘directly’ to describe the manner in which the costs are to be connected with the Stock. Had the parties wished to delimit the range of costs in this way, they could have used the phrase used by the Lord Ordinary or something similar. In fact they used the phrase ‘in connection with the Stock’ and that phrase covers costs incurred by the Bank provided that they are incurred in connection with the loan stock. If costs can properly be described as having been incurred in connection with the loan stock, then they fall within the scope of Condition 3, irrespective of whether the connection is direct or indirect. I therefore consider that the Lord Ordinary interpreted the phrase too narrowly and that the words would be apt to cover a wider range of costs than the kind which he instanced.

Since the phrase ‘in connection with’ is an ordinary English phrase, rather than a technical legal phrase, there is probably little to be gained from scrutinising too closely the interpretations which have been placed on it in different contexts in other cases. We were referred, however, to three passages which have some bearing on the matter.

The first was from the opinion of McFarlane J in the Supreme Court of British Columbia in Re Nanaimo Community Hotel Ltd..The statute under consideration gave the court jurisdiction to hear and determine all questions that might arise ‘in connection with any assessment’ to tax made under the particular Act. McFarlane J said (at p 639): ‘One of the very generally accepted meanings of "connection" is "relation between things one of which is bound up with or involved with another"; or again "having to do with". The words include matters occurring prior to as well as subsequent to or consequent upon so long as they are related to the principal thing. The phrase "having to do with" perhaps gives as good a suggestion of the meaning as could be had.’

This passage was approved on appeal by the British Columbia Appeal Court and was referred to with approval by Somervell LJ in Johnson v Johnson at p 51.

The second authority to which we were referred was the opinion of Kitto J in the High Court of Australia in Berry v Federal Commissioner of Taxation. His Honour had to interpret ‘premium’ in a taxing statute where it was defined as ‘any consideration for or in connection with…any goodwill or licence attached to or connected with land a lease of which is granted, assigned or surrendered’. He stated (at p 659): ‘Now, while it is true that a payment cannot be described as a consideration "for" anything but that which is given in exchange for it, to speak of a consideration being "in connection with" an item of property parted with is to use language quite appropriate to the case of a payment received as consideration "for" something other than the property in question, so long as the receipt of the payment has a substantial relation, in a practical business sense, to that property.’ While the interpretation which Kitto J placed on the words was influenced by the particular phrase ‘for or in connection with’ which he was construing, it appears to me that in interpreting a commercial contract one can derive some guidance from his description of ‘in connection with’ as referring to something which has a substantial relation, in a practical business sense, to something else.

The other passage to which we were referred occurred in the judgment of Evans-Lombe J in Gomba Holdings UK Ltd v Minories Finance Ltd (No 4), at p 456 where, in interpreting the terms of a facility letter which referred to ‘expenses incurred in connection with this facility’, his Lordship described the words as ‘extremely wide’.

These passages confirm the view, which I should in any event tend to reach, that the phrase ‘in connection with’, while imposing a certain restriction on the costs which fall within the condition, none the less brings in costs over a wide area. For the rest, the passage from Berry in particular would suggest that a cost which had a substantial relation, in a practical business sense, with the loan stock would be a cost which the Bank incurred in connection with the loan stock.

In Gomba Evans-Lombe J considered that the potentially wide scope of the phrase ‘expenses incurred in connection with this facility’ might be limited so as to include only those expenses which were reasonably within the contemplation of the parties at the time the particular facility letter was entered into (at p 457d). Apparently because of this, counsel for the Bank were at pains to argue that the cost of breaking the swap would have been reasonably within the contemplation of the parties when the loan stock agreement was concluded. There is, however, no need to express any view on whether such a limitation would be appropriate or on whether the particular cost was foreseeable, since counsel for Dunedin made it clear that he was not arguing that the termination cost was excluded from the condition because it was not within the reasonable contemplation of the parties. His contention was, rather, that the termination cost was too distant from the stock for it properly to be regarded as a cost incurred ‘in connection with’ the stock.

Counsel pointed out that the cost arose under a completely separate contract between the Bank and a third party, Security Pacific. The Bank had not been obliged by the terms of their agreement with Dunedin to enter into that contract, but had chosen to do so for their own purposes. In particular the Bank had entered the swap arrangement because of their internal rule that they should not be exposed to the risks from interest rate movements in a transaction continuing for as long as ten years. The cost from breaking the swap had therefore been incurred under a purely voluntary relationship between the Bank and Security Pacific with which Dunedin had nothing to do and over which they had no control.

Attractively and skilfully presented though this argument was, it should in my view be rejected.

In order to fall within the condition, a cost must have been incurred in connection with the stock. As I have explained, counsel sought to paint the picture of the swap contract as something totally divorced from the loan stock agreement. There is another way of looking at the matter, however, and it is one which I find more compelling. The impetus for the loan stock agreement came from Dunedin who wished to obtain what they saw as the advantage of a fixed rate of interest on their borrowings over a ten-year period. It was they who approached the Bank and the Bank sought to meet the requirements of their customer. As the evidence showed, the policy of the Bank was that they would not enter into a commitment of this kind without taking steps to try to ensure that the transaction was profitable to the Bank. That is not only entirely understandable, but, equally importantly, it is what the position actually was. Whatever the Bank might or might not nave chosen to do if they had adopted different policies and arranged their affairs differently, the reality is that the Bank would not in fact have entered into the loan stock agreement without taking steps to protect their position. Therefore Dunedin could not in fact have enjoyed the benefit of the loan stock agreement with the Bank unless the Bank had taken the steps which they did, or similar steps, both of which would have resulted in the Bank incurring a liability in costs if they terminated the arrangement early. Indeed it is plain that the Bank entered into both the inter-bank loan and the swap transaction so that they would be in a position to enter the loan stock agreement with Dunedin. As counsel for Dunedin expressly accepted, the Bank would not have entered into their swap contract with Security Pacific, had it not been for their loan stock deal with Dunedin. To put the matter the other way round, without the swap agreement, there would have been no loan stock agreement and without the loan stock agreement the loan stock would not have been issued. That being so, in my view the swap contract itself had a ‘substantial relation in a practical business centre’ with the stock.

Even if the Bank could be said to have entered the swap contract in connection with the stock, counsel for Dunedin argued that any cost due to the termination of that contract had not been incurred by the Bank in connection with the stock. Counsel pointed out that the Bank were not obliged to terminate the swap contract with Security Pacific simply because Dunedin had chosen to redeem the loan stock prematurely. The Bank might have maintained the swap agreement and used the remainder of the swap in relation to some other transaction of suitable duration. Their decision to bring the swap contract to an end and to incur the penalty was therefore a voluntary step, independent of, and beyond the control of, Dunedin. Any cost incurred by the Bank as a result of this step was therefore not incurred in connection with the stock.

Again I consider that this approach is too narrow. In particular it ignores what seem to me to be the realities of the situation. The swap agreement was tailored to meet the particular need of the Bank to finance the loan stock agreement with Dunedin. This can be seen in the fact that both agreements were due to end on the same day. Had Dunedin allowed the loan stock agreement to run its course, they would have redeemed the stock on 30 June 1999 and on the same day the swap transaction between the Bank and Security Pacific would have come to an end, without the Bank incurring any additional cost, In fact, however, for their own purposes, Dunedin chose to invoke Condition 3 and to redeem the stock early, as they were entitled to do. It was this decision of Dunedin which in turn triggered the steps which the Bank took to terminate their swap contract with Security Pacific. By taking those steps the Bank incurred the liability to pay the termination cost. It may be the case that the Bank could have chosen not to terminate the swap, but their decision to do so cannot be described as in any way unreasonable: the Bank entered the swap contract in order to finance the purchase of the loan stock and they terminated it when Dunedin chose to redeem the loan stock and so removed the only purpose for which the Bank had entered the swap contract. In these circumstances it appears to me correct to say that the Bank incurred the termination cost as a result of Dunedin's decision to redeem the stock in terms of Condition 3 of the conditions ‘subject to [which] and with the benefit of [which]’ the Bank held the loan stock under Clause 5 of the Deed. That being so, the Bank incurred the termination cost in connection with the stock.

This does not appear to me to be an extravagant result at which to arrive when one recalls that Condition 3 deals expressly with early redemption of the loan stock. It seems not unreasonable to conclude that among the costs covered by that condition is the cost which the Bank incurred when they terminated the swap as a result of Dunedin's early redemption of the stock under the condition.

I have reached this view as to the construction of Condition 3 by asking what is the ordinary meaning of the words used by the parties and without considering the background of the matrix of facts, known to the parties, in which the loan stock agreement was set. It is, however, trite that in interpreting a provision in a contract the court may ‘enquire beyond the language and see what the circumstances were with reference to which the words were used, and the object, appearing from those circumstances, which the person using them had in view’: Prenn v Simmonds at p 1384 perLord Wilberforce, citing the speech of Lord Blackburn in Macdonald v Longbottom. See also Inglis v Buttery & Co at pp 102–103 and Bovis Construction (Scotland) Ltd v Whatlings Construction Ltd at p 357 per Lord President Hope. It would therefore be open to the court to consider the surrounding circumstances in which the words of Condition 3 were used; indeed we were urged to do so by counsel for the Bank.

As these authorities demonstrate, the rule which excludes evidence of prior communings as an aid to interpretation of a concluded contract is well-established and salutary. The rationale of the rule shows, however, that it has no application when the evidence of the parties' discussions is being considered, not in order to provide a gloss on the terms of the contract, but rather to establish the parties' knowledge of the circumstances with reference to which they used the words in the contract. For that reason I am satisfied that it was proper for the Lord Ordinary to take account of the evidence about what was said at the meeting on 8 June in order to establish the relevant circumstances in which the words of Condition 3 were used.

The first source of information about the discussions at the meeting is a note prepared by the Bank (No 5/2 of Process). It records that: ‘Mr Forrest sought an indication of the likely costs that would be incurred in the event of early repayment. It was explained to him that as we may wish to match the funds drawn under the Debenture Loan it was not really possible to provide this information as it would depend on the circumstances of the time of early repayment and whether the Bank could utilise the funds used to match the loan in some other way. He was assured we would use our best endeavours to minimise any cost and this was accepted.’

The Lord Ordinary, who heard evidence about what happened at the meeting, gives his conclusion on that evidence in these terms: ‘…the oral evidence and the terms of the notes of meetings indicate that it was explained to the defenders that the bank did intend to hedge the transaction; that if the transaction were brought to a premature conclusion there would be a cost; and that the bank would look to the defenders to pay that cost. It is clear that there was discussion of the cost to the bank of borrowing the funds required for the transaction. As I have noted, counsel for the defenders submitted that, according to the written notes, that was all that was discussed. In my view, however, the evidence went some way beyond that and showed that the discussion included, as Mr Masterton said, the discipline required by a fixed interest rate investment, the fact that there could be a cost on termination and the fact that no guarantee as to the amount of the cost could be given, although the bank would endeavour to minimise it. That evidence is uncontradicted and is supported by the terms of the relative minutes, and I, of course, accept it. On the other hand, however, the evidence does not establish that there was any discussion of interest rate swaps as a means of hedging, and, indeed, suggests the contrary, neither Mr Masterton nor Mr Elder being familiar with the technical details of such swaps. Further, there is no evidence that the practice of the inter-bank market whereby there would be no automatic right to terminate a term loan was explained or discussed.’

Although counsel for the Bank argued that the Lord Ordinary should have made certain additional findings in fact, neither the Bank nor Dunedin contested the findings contained in this passage. Therefore, except in so far as they record that the Bank would look to Dunedin to meet any costs on premature redemption, they indicate the circumstances in respect of which the words in Condition 3 were used and the court can look at them in interpreting those words.

The conclusion of the Lord Ordinary as to what was discussed at the meeting shows that both parties were aware that the Bank would borrow the funds which they required to subscribe for the loan stock. The parties were also aware that the Bank intended to hedge the transaction, but they were not aware that the hedge would take the form of a swap. It is also clear that the parties were aware that, if Dunedin redeemed the loan stock prematurely, there would be a cost of uncertain amount associated with the hedge.

In reaching his decision the Lord Ordinary attached particular weight to the facts that no mention was made of the use of a swap to provide the necessary hedge and that the inter-bank market practice whereby there would be no automatic right to terminate a term loan had not been explained. Because of that he did not think ‘that it has been shown that the parties must have had in contemplation, as one of the costs to be borne by the defenders on early termination, the non-negotiable cost of termination of an independent contract entered into by the pursuers for their own purposes, without reference to the defenders.’

Although it is true that interest rate swaps were not discussed, it is accepted that the parties were aware that the Bank would hedge the transaction. According to the evidence, only two forms of hedge would have been open, one by means of a long-term inter-bank fixed rate loan and the other involving a swap. The first was not available on the market at the time. Both of these forms of hedging would have involved an independent contract entered into by the Bank for their own purposes, without reference to Dunedin. For that reason I do not attach the same weight as the Lord Ordinary appears to have done to the fact that the particular form of hedging which was chosen was not one of which the parties had been specifically informed.

The cost of breaking the swap was non-negotiable. At the meeting on 8 June the Bank representatives indicated that they would endeavour to minimise the cost relating to the hedge on premature redemption of the loan stock, but they gave no guarantee as to the amount of any cost. In those circumstances I do not see why the fact that the cost of breaking the swap was actually non-negotiable should mean that it is, for that reason, a cost which is incurred otherwise than in connection with the stock.

If the wording of Condition 3 is considered against the background facts which the Lord Ordinary found were known to both parties, those facts tend to reinforce the interpretation which I reached without referring to them. In particular they show that the parties were aware that the Bank would hedge the transaction—as they did. They show that there would be a cost relating to the hedge if the loan stock were redeemed prematurely—which there was. In these circumstances it appears to me that the ‘commercially sensible construction’ of the condition is that it covers the cost incurred by the Bank when they terminated the swap contract following the early redemption of the loan stock by Dunedin.

Counsel for the Bank asked the court to make certain additional findings based on the evidence led at the proof. In view of the conclusion which I have reached on the basis of the Lord Ordinary's findings I have not found it necessary to do so.

For these reasons I move your Lordships to allow the reclaiming motion and to recall the Lord Ordinary's interlocutor. At the hearing of the reclaiming motion we were told that there were certain matters in dispute between the parties due to the fact that the loan stock had not been redeemed until 1997 and in respect of the cost to the Bank of breaking the swap. It was hoped that these problems might be resolved. In the meantime I propose to your Lordships that we should put the case out By Order so that parties can address us on the appropriate way for us to dispose of the reclaiming motion.

LORD KIRKWOOD —Your Lordship in the chair has set out fully the facts of the case and the submissions of the parties.

The defenders (‘Dunedin’) had received a number of short-term loans from the pursuers (‘the Bank’) and in 1989 Dunedin decided that it would be in their interests to convert these short-term loans into a single long-term loan from the Bank at a fixed rate of interest. The parties entered into negotiations and discussed the possibility that Dunedin should issue, and the Bank should subscribe for, debenture loan stock. In the event the parties agreed that Dunedin would create £10m debenture loan stock, that on 1 August 1989 the Bank would subscribe for the full amount of that loan stock, that the loan stock and accrued interest would be repayable in full by Dunedin on 30 June 1999 and that throughout that period Dunedin would pay to the Bank a fixed rate of interest, namely, 12 1/2 per cent per annum. The parties entered into a Loan Stock Deed dated 1 and 3 August 1989 giving effect to this agreement. In the Deed it was stated that the Bank ‘shall subscribe at par for the full amount of the Stock on First day of August 1989 on the terms and subject to the conditions set out in these presents’.

Condition 3 was in the following terms: ‘3. The Company shall be at liberty at any time on provision of six months prior written notice to the Bank, to purchase the Stock, subject to the Bank being fully reimbursed for all costs, charges and expenses incurred by it in connection with the Stock.’

Accordingly, in terms of the Loan Stock Deed the Bank had agreed to lend Dunedin the sum of £10m for a period of just under ten years at the fixed rate of interest of 12 1/2 per cent, but Dunedin had the option of repaying the sum which they had borrowed at any time prior to 30 June 1999 provided that, in terms of Condition 3, they gave the Bank six months prior written notice of their intention to purchase the stock.

As I have said, in terms of the Loan Stock Deed the Bank were entitled to receive the fixed rate of interest of 12 1/2 per cent throughout the period of the loan. However, it was the policy of the Bank in the case of such a long-term loan not to expose themselves to the possibility that interest rates might move significantly against them and render the transaction with Dunedin unprofitable. In these circumstances they decided to hedge their position. In theory, there were two ways in which this could be done. The first was by a matching deposit whereby they would borrow the sum of £10m for the period of their loan to Dunedin and pay to the lender a lower rate of interest than they would be receiving from Dunedin, thereby ensuring a profit on their transaction with Dunedin over the whole period of the loan. However, evidence led at the proof established that in 1989 a matching transaction of that nature for such a period would not have been available. In the event, the Bank decided to adopt the alternative method of hedging and entered into an interest rate swap agreement. The Bank borrowed the sum of £10m which they were lending to Dunedin on the London inter-bank market for short term loans. They had to pay the prevailing Libor rate on the sum which they borrowed and the short-term loan would require to be renewed periodically. It was clear that if, during the period of the loan to Dunedin, the Libor rate rose above 12 1/2 per cent there was a risk, if no other step was taken by the Bank, that they would not make a profit on their transaction with Dunedin. Accordingly, the Bank entered into an interest rate swap agreement with Security Pacific National Bank, which later became the Bank of America. An interest rate swap transaction involves the exchange of fixed and floating interest payment obligations without the exchange of the underlying principal amount. The notional amount was £10m and in terms of the agreement between the Bank and Security Pacific the interest rate swap agreement was to run from 2 August 1989 until 30 June 1999, the date on which Dunedin were due to repay the loan stock in full. The Bank were to pay Security Pacific a fixed rate of interest of 11.03 per cent during the whole period on the notional principal amount and were to receive the appropriate Libor rate of interest on that same amount. The effect of the interest rate swap agreement was that the Bank would, prior to 30 June 1999, never require to pay interest to Security Pacific at a higher rate than 11.03 per cent on the notional sum of £10m. As the Bank were receiving interest at the rate of 12 1/2 per cent from Dunedin, it was clear that, by virtue of these two transactions, the Bank were bound to make a profit on its loan to Dunedin.

As I have said, in 1989 the Bank subscribed £10m for Dunedin's loan stock, borrowed £10m on the London inter-bank market and entered into the interest rate swap agreement with Security Pacific and thereafter the Bank received the agreed interest payments from Dunedin. However, on 17 October 1995 Dunedin gave the Bank six months written notice in terms of Condition 3 of the Loan Stock Deed that they intended to purchase the loan stock. The redemption date was to be 17 April 1996 (although redemption did not in fact take place until 1997). In these circumstances the Bank decided to repay the sum which they had borrowed in order to make the loan to Dunedin and to terminate the interest rate swap agreement with Security Pacific. The Bank now seek declarator that in the event of Dunedin proceeding to redeem the £10m debenture loan stock, it was a condition precedent of that redemption in terms of Condition 3 of the Loan Stock Deed ‘that the defenders reimburse the pursuers for all payments to be made by the pursuers to Security Pacific National Bank, London Branch, pursuant to an interest rate swap agreement between those parties…’. We were informed by senior counsel for the Bank that the payment which the Bank were obliged to make to Security Pacific resulting from the premature termination of the interest rate swap agreement amounted to £923,253. In the foregoing circumstances the dispute between the parties is whether Condition 3 entitled the Bank to recover from Dunedin the payment which the Bank have been obliged to make to Security Pacific in consequence of the early termination of the interest rate swap agreement.

Counsel for the Bank submitted that the Bank were entitled to be reimbursed for the breakage payment due to Security Pacific on the basis that the payment constituted a cost, charge or expense which had been incurred by the Bank ‘in connection with the Stock’. On the other hand, counsel for Dunedin submitted that the breakage payment was not a cost, charge or expense within the meaning of Condition 3 and, in any event, that it had not been incurred by the Bank ‘in connection with the Stock’.

The first question which arises is whether the breakage payment can properly be described as a cost, charge or expense incurred by the Bank. There was unchallenged evidence that if the Bank terminated the interest rate swap agreement prematurely then they would be under a legal obligation to make a breakage payment to Security Pacific. Once Dunedin had given notice that they were to exercise their option to purchase the stock early in terms of Condition 3 the Bank, not unnaturally, decided to terminate the interest rate swap agreement. Counsel for Dunedin submitted that the breakage payment for which the Bank were liable on premature termination of the interest rate swap agreement was a ‘loss’ incurred by the Bank in respect that they were in breach of their contract with Security Pacific and liable in damages therefor. In my opinion, however, this approach is misconceived. Once the Bank had terminated the interest rate swap agreement early and become liable for the breakage payment I have, like the Lord Ordinary, little difficulty in concluding that the breakage payment falls to be regarded as a cost or charge which has, in fact, been incurred by the Bank.

That being so, the second question which arises, and which is, in my view, attended with considerable difficulty, is whether the breakage payment was incurred by the Bank ‘in connection with the Stock’. It was submitted on behalf of Dunedin that the breakage payment had clearly not been incurred ‘in connection with the Stock’. The interest rate swap transaction was not one which the Bank had been obliged to enter into in terms of the Loan Stock Deed. It was a quite separate transaction, and one which the Bank had decided to enter into in their own interests in order to protect their position in pursuance of their policy not to be exposed, in the case of a long-term loan, to the possibility that interest rates might move against them and render the loan unprofitable. That was a matter for the Bank and it was not connected to the issue of the loan stock.

If our task had been to construe Condition 3 in vacua, without reference to any of the surrounding circumstances established by the evidence, then it would, in my view, have been difficult to draw the conclusion that the cost of breaking the interest rate swap agreement was a cost, charge or expense incurred by the Bank ‘in connection with the Stock’. So, if Condition 3 had to be construed in isolation, I would have been inclined to agree with the Lord Ordinary that the condition would not have entitled the Bank to recover the cost of breaking the swap transaction. However, as Lord Wilberforce observed in Reardon Smith Line Ltd v Yngvar Hansen-Tangen at p 995H: ‘No contracts are made in a vacuum; there is always a setting in which they have to be placed. The nature of what is legitimate to have regard to is usually described as "the surrounding circumstances" but the phrase is imprecise: it can be illustrated but hardly defined. In a commercial contract it is certainly right that the court should know the commercial purpose of the contract and this in turn presupposes knowledge of the genesis of the transaction, the background, the context, the market in which the parties are operating.’

In Bank of Scotland v Stewart Lord President Inglis observed: ‘In a question of this kind, arising upon the construction of a contract, the Court are quite entitled to avail themselves of any light they may derive from such evidence as will place them in the same state of knowledge as was possessed by the parties at the time that the contract was entered into.’

In Scottish Power plc v Britoil (Exploration) LtdStaughton LJ observed as follows: ‘It has been established law for the greater part of this century that contracts are not construed in a vacuum. The court is entitled to know the surrounding circumstances which prevailed when the contract was made.’

Further, in Investors Compensation Scheme Ltd v West Bromwich Building Society Lord Hoffmann (at p 114) summarised the principles by which contractual documents are nowadays construed and he observed inter alia as follows: ‘Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract…The meaning which a document (or any other utterance) would convey to a reasonable man is not the same thing as the meaning of its words. The meaning of words is a matter of dictionaries and grammars; the meaning of the document is what the parties using those words against the relevant background would reasonably have been understood to mean.’

So it is legitimate to look at the surrounding circumstances in order to ascertain what was the intention of the parties ‘expressed in the words used as they were with regard to the particular circumstances and facts with regard to which they were used’ (Inglis v Buttery & Co per Lord Blackburn at p 103).

The question then arises as to the nature of the surrounding circumstances which the court is entitled to take into account. It is clear, on the authorities, that evidence of prior negotiations and evidence of the subjective intention of either of the parties will not be admissible. However, the court can have regard to ‘facts which both parties would have had in mind and known that the other had in mind at the time when the contract was made’ (Scottish Power plc v Britoil (Exploration) per Staughton LJ). The limits to be placed on the evidence of surrounding circumstances which will be admissible in any particular case may be difficult to define and in the present case it seems to me that certain of the evidence led by the Bank at the proof went rather beyond what was properly admissible as evidence of the surrounding circumstances.

Before I turn to the evidence of the surrounding circumstances I wish to deal with two other issues which were raised in the course of the hearing.

In the first place the Lord Ordinary expressed the opinion that, in the absence of surrounding circumstances, Condition 3 was limited to costs directly connected with the loan stock, such as drafting costs in connection with the loan agreement, the costs of any necessary registration or any administrative costs that might be incurred. I do not, however, agree that the Bank would only be entitled to recover costs, charges or expenses which were directly connected with the stock. Condition 3 uses the words ‘in connection with’ the loan stock and I can see no justification, when that condition is being construed, for inserting by implication the word ‘directly’. If it is established that the sum claimed by the Bank was a cost, charge or expense incurred by the Bank ‘in connection with the Stock’ it does not, in my view, matter whether that connection was direct or indirect.

In the second place, with regard to the construction to be placed on the words ‘in connection with’ used in Condition 3, we were referred to three cases, namely, Re Nanaimo Community Hotel Ltd, Berry v Federal Commissioner of Taxation and Gomba Holdings UK Ltd v Minories Finance Ltd (No 4). The interpretation to be placed on the phrase in question must, of course, depend on the context in which it is used and references to the interpretations placed on such a phrase in previous cases will be of only limited assistance. However, I note that in Gomba Holdings UK Ltd it was stated by Evans Lombe J (at p 456) that it was ‘true that the words "expenses incurred in connection with this facility" are extremely wide’. Further, in Berry Kitto J observed (at p 659) as follows: ‘Now, while it is true that a payment cannot be described as a consideration "for" anything but that which is given in exchange for it, to speak of a consideration being "in connection with" an item of property parted with is to use language quite appropriate to the case of a payment received as consideration "for" something other than the property in question, so long as the receipt of the payment has a substantial relation, in a practical business sense, to that property.’

For my part I am prepared to accept that the words ‘in connection with’ are capable of a wide construction and in a case of this nature I would be prepared to accept that it would be sufficient if it was demonstrated that there was a substantial relationship in a practical business sense.

Turning now to the evidence of the surrounding circumstances, there was unchallenged evidence that the Bank borrowed the money which was used to subscribe for Dunedin's loan stock and entered into the interest rate swap agreement. It was accepted by counsel for Dunedin that Dunedin were aware (1) that the Bank had borrowed the money which it was to lend to Dunedin and that they were going to hedge the transaction and (2) that if the hedging transaction was brought to a premature conclusion there would be a cost to the Bank, and no guarantee as to the amount of the cost could be given. The evidence established that in 1989 it would not have been practicable for the Bank to hedge by means of a matching deposit. It was also accepted that the Bank would not have subscribed for Dunedin's loan stock if they had not entered into the interest rate swap agreement. Dunedin elected not to lead any evidence to explain their own position or to contradict the evidence led by the Bank. However, it was submitted on behalf of Dunedin that in the circumstances the payment which the Bank had to make as a result of terminating the interest rate swap agreement early was not a payment incurred ‘in connection with’ the loan stock. The interest rate swap agreement was an independent contract which was not referred to in the Loan Stock Deed and was entered into by the Bank for their own purposes in order to ensure that they made a profit by subscribing for the loan stock. The interest rate swap agreement had nothing to do with the terms of the Loan Stock Deed or the loan stock which was issued. While Dunedin knew that the Bank were going to hedge the transaction, Dunedin had been unaware that the Bank were going to enter into an interest rate swap agreement and they did not know that there would be no provision in any hedging transaction for early termination. In any event, it had been the Bank's decision to break the interest rate swap agreement and they had been under no obligation to do so. Counsel sought to rely on what they described as the ‘tolerably clear’ meaning of the words used in Condition 3, which made no reference to hedging or breakage costs, and submitted that in the circumstances of this case that meaning could not be altered by the evidence which had been led relating to the surrounding circumstances. In particular, Dunedin's knowledge of what the Bank were going to do was not relevant to the issue of what agreement had been reached by the parties. As the Bank had entered into the interest rate swap agreement for their own protection it was not unreasonable that they should pay the cost of its early termination.

The Lord Ordinary concluded that it had not been shown that the parties must have had in contemplation, as one of the costs to be borne by Dunedin on early termination, the non-negotiable cost of termination of an independent contract entered into by the Bank for their own purposes without reference to Dunedin. In his opinion the evidence did not go far enough to show that the cost was so intimately involved in the character, aim or object of the transaction that it must be held to form part of the consensus at which the parties arrived. He therefore concluded that the terms of Condition 3 did not entitle the Bank to claim the cost of termination of the interest rate swap agreement.

In the first place it is, in my opinion, of significance that Condition 3 only came into operation in the event of Dunedin deciding to exercise their option to purchase the loan stock early. While Dunedin were given the right to terminate the loan transaction early, the exercise of that right was subject to an obligation on their part to reimburse the Bank for ‘all costs, charges and expenses incurred by it in connection with the Stock’. So it would, in my view, be reasonable to interpret the reference in Condition 3 to ‘costs, charges and expenses’ as including costs, charges and expenses which were incurred by the Bank in consequence of the early purchase of the loan stock. It is clear, on the evidence, and it was accepted by Dunedin, that but for the loan stock transaction with Dunedin the Bank would not have entered into the interest rate swap agreement. The interest rate swap agreement was due to terminate on 30 June 1999 which was also the date of termination of the loan stock transaction. It was also accepted on behalf of Dunedin that if the Bank had not entered into the interest rate swap agreement then Dunedin would not have received the loan of £10m. As Mr McCormick said in evidence (at p 164) the loan stock transaction and the interest rate swap agreement were ‘separate but linked transactions’, and senior counsel for Dunedin expressly accepted that there was a causal link between the loan stock transaction and the interest rate swap agreement. Further, it was admitted that Dunedin were aware that the Bank were going to hedge the transaction. While it is true that Dunedin had not been informed specifically that the hedging was to take the form of an interest rate swap agreement, they knew that a hedging transaction of some form was to be entered into by the Bank and that if it was terminated early there would be a cost, the amount of which was uncertain, and that that was a cost which would be incurred by the Bank to the other party to the swap transaction. There was evidence that whatever means of hedging had been adopted by the Bank there would be a breakage cost if the hedging transaction was terminated prematurely, and that the amount of the breakage cost would be about the same whichever method was adopted. In these circumstances I do not consider that the fact that Dunedin were not given details of the interest rate swap agreement is fatal to the Bank's claim. In light of the information which was provided to Dunedin, it was clear to them that if they exercised their option to terminate the loan stock transaction early, the consequence would be that a cost would be incurred by the Bank. If the loan stock transaction had run its full term, the Bank would not, of course, have been entitled to recover from Dunedin the cost of putting the interest rate swap agreement in place. However, once Dunedin had elected to exercise their option to terminate the loan transaction early, it cannot, in my view, be said to be unreasonable that Dunedin should be required to reimburse the Bank for a cost which effectively was incurred by the Bank as a consequence of Dunedin's exercise of their option. In my opinion the evidence has established that there was a substantial relationship in a practical business sense between the loan stock and the breakage cost which was incurred on early termination of the interest rate swap agreement. In the particular circumstances of this case I have reached the conclusion that having regard to the wording of Condition 3, read in light of the surrounding circumstances established by the evidence, the cost of breaking the interest rate swap agreement with Security Pacific was, in fact, a cost which was incurred by the Bank ‘in connection with the Stock’ and that the Bank are entitled to be reimbursed by Dunedin therefor.

For the foregoing reasons I agree that the reclaiming motion should be allowed, that the interlocutor of the Lord Ordinary should be recalled and that the case should be put out By Order so that the parties can have the opportunity of addressing us in relation to the final disposal of the reclaiming motion.

LORD CAPLAN —This litigation arises out of a debenture stock scheme entered into between the parties on 1 and 3 August 1989. The pursuers are a well known bank and the defenders, who carry on an established business as property developers, were their customers. In the summer of 1989 the defenders were financed by a number of short term loans. They wanted to improve their financial arrangements by consolidating their borrowing into a single long term loan at a fixed rate of interest. This had obvious advantages for them particularly during a period of fluctuating interest rates. With a long term fixed interest loan they could predict their borrowing costs over an extended period. This in turn helped them to estimate and secure the profitability of their property developments. The financing by the Bank was to be achieved by the creation of debenture loan stock. Once this had been issued the Bank would provide the finance facilities by subscribing and paying for the stock. At the conclusion of the arrangement the defenders would buy back the stock.

About June 1989 the pursuers offered to subscribe for £10 or £15 million secured debenture loan stock. In preparation for the consequential transaction the pursuers sent to the defenders a document called ‘Outline Terms and Conditions’. This was meant to serve as the outline of the proposed agreement although when the parties eventually entered into a formal loan stock agreement the terms had been quite substantially adjusted. In any event, following upon the submission of the original outline terms, the representatives of the parties had two meetings at which the terms of the proposed loan were discussed. I shall later revert to what was said at these meetings and indeed there would appear to be little divergence between the parties as to what passed. In any event it was agreed that the debenture loan would be for £10 million, would be for a fixed period of ten years, and would be at a fixed rate of interest of 12.5 per cent per annum. The terms of the parties' agreement were incorporated into a Loan Stock Deed executed by the parties and dated 1 and 3 August 1989.

The Loan Stock Deed contained a number of terms and conditions. During the pre-contract discussions the defenders had queried what would happen should they want to terminate the ten year loan prematurely. Condition 3 of Schedule 1 of the Loan Stock Deed provides for this contingency. It sets out that the defenders have a right on giving six months notice to purchase the Stock but ‘subject to the (pursuers) being fully reimbursed for all costs, charges and expenses incurred by it in connection with the Stock’. Parties are in dispute as to the meaning to be ascribed to the word ‘costs’ in the foregoing phrase.

Just as a property developer may want to protect himself against significant interest fluctuations by securing long term finance at a fixed interest rate, so a prudent bank, making a long term loan at a fixed rate of interest, would want to guard against interest fluctuations which could create a significant loss for it. Thus banks will cover a long term loan by the process known perhaps rather loosely as ‘matching’ or ‘hedging’. Certainly the evidence shows that it was the policy and practice of the pursuers to hedge their lending if they were lending long term. For example, if after lending on a long term basis the cost of borrowing in the market were to rise, the bank could find that it was paying more for the money it had loaned than it was receiving in fixed interest from the borrower.

One conventional method of matching or hedging is for the bank itself to borrow the whole amount of the sum it has loaned, to do that for a corresponding term, and at a rate of fixed interest rather lower than its customer has to pay. Such an arrangement would secure a fixed profit for the bank over the period of the loan and the only risk would be that the customer would default. However in practice such hedging loans are difficult to obtain and in recent times more sophisticated methods of matching loans have developed.

One of these methods is known as a Swap Contract and it is that type of contract that the pursuers entered into in this case. Under a Swap no money passes in respect of the principal loan. The bank borrows the funds it needs to finance its loan on the six month London Inter-Bank floating interest rate market (Libor). What the counterparty who enters into the Swap then does is in effect to underwrite a fixed interest rate that will give the lending bank a profit. The bank will make up that agreed interest rate to the counterparty should the interest rate remain below it. If the bank has to borrow at a higher rate than it is receiving from its customer then the counterparty will cover the interest loss. The technical details of the Swap machinery are quite complicated but what it achieves I think is clear. There are effectively two counterparties. One (the Bank of Scotland) wants to pay a fixed rate of interest to cover its borrowing and to receive a floating rate of interest. The other counterparty (in this case Security Pacific National Bank—now Bank of America) wants to pay a floating rate of interest and receive a fixed rate.

In any event the pursuers decided to match the borrowing which they required to fulfil the Dunedin loan by way of a Swap arrangement. The other counterparty was the Security Pacific National Bank. The arrangement was effected by way of an exchange of correspondence between these parties dated 1 and 7 August 1989. The Bank had undertaken to see that the counterparty got an interest return of 11.03 per cent per annum but that itself would have to pay no more than that rate. This would have ensured the Bank a tidy and regular profit so long as the loan to the defenders continued. The Bank would procure the sums loaned to the defenders by borrowing on the short term Inter-Bank market. They are protected against interest rate fluctuations above 11.03 per cent per annum by the Swap arrangement.

At the time they entered into the Loan Stock Deed the pursuers effectively had divided their business into two separate divisions. One, the banking division, dealt with the negotiation of banking transactions and what could broadly be called the Banking side of the business. The other division was known as Treasury and that division administered and controlled the detail of the money management side of the Bank business. For administrative reasons the pursuers eventually transferred their Treasury business (including the Swap agreement) to a separate company, Bank of Scotland Treasury Services plc, but, by a series of complicated arrangements, the pursuers remain liable for the obligations under the Swap Arrangement and the defenders are now taking no point about that particular matter.

On 17 October 1995 the defenders gave to the pursuers notice pursuant to Condition 3 that they wished to purchase the debenture stock. This, if done, of course would have had the effect of terminating the fixed term loan on 17 April 1996 when the notice would have expired. The obvious reason why Dunedin wanted to terminate the loan was that interest rates had dropped considerably so that they could have expected to borrow money for less than they were then paying the bank. On the other hand, correspondingly, the low interest rates were profitable for the Bank of America since the pursuers required to pay them the difference between the low interest rate and the 11.03 per cent the pursuers were effectively paying them to maintain the hedge.

I shall be referring in some detail to the discussion between the parties' respective representatives referable to the debenture contract. However, one thing that seems reasonably clear is that, whatever the pursuers had said about matching or hedging, they did not mention specifically that they were contemplating entering into a Swap Agreement. Indeed they do not seem to have informed the defenders when they did decide to enter into such an agreement. Nor did they inform the defenders that a Swap Agreement (and their own agreement in particular) had no provision for the bank terminating the agreement prematurely. However this would not matter. The witness Mr Cameron gave uncontradicted evidence that it was perfectly normal market practice for long term hedging arrangements to have no break provision. If a fixed term Swap were broken, a counterparty would expect to recover the anticipated economic loss resulting from not being allowing to recover the whole value of the Swap. I do not find this situation surprising. The party accepting the risk of floating interest rates is perhaps taking the riskier position in the transaction and no doubt his policy is determined on the expectation that the Swap will run for its pre-determined period. It so happens that with interest rates falling the Swap agreement was profitable to the counterparty so that the loss of prospective profit was considerable. We were told by senior counsel for the Bank that the sum required by the Bank of America to release the pursuers from the swap was £923,253. The pursuers have claimed to be reimbursed for such break costs as they may finally have to pay to terminate the Swap at this juncture. The defenders have refused to pay the costs of breaking the Swap on the basis that they are not obliged to do so in terms of Clause 3 of the Loan Stock Deed. The Lord Ordinary held that their position is justified and it is this decision which is now reclaimed against.

The defenders argue that any costs recoverable under Clause 3 must be connected directly with the ‘Stock’. In terms of the interpretation clause of the Loan Stock Deed that word is defined as meaning ‘the said £10,000,000 Debenture Loan Stock 1999 of the Company or, as the case may be, the principal amount thereof for the time being issued and outstanding’. It was further contended that the Swap Agreement was entered into by the Bank with a third party, the transaction was one for the bank's own interest and the defenders have no responsibility for the consequences of the Swap. It certainly was not connected with the Loan Stock. There could be no reference to material that emerged in negotiation in interpreting Clause 3 but even were this permissible there was nothing in the pre-contract discussions to alert the defenders that the pursuers were contemplating a Swap arrangement such as they eventually decided they would enter into. In particular the defenders had no reason to suspect that the pursuers were about to enter into a contract where they were committed to pay unrestricted breakage charges in the event that the loan to the defenders was prematurely terminated.

I agree that the drafting of Clause 3 is somewhat maladroit. It could readily have been given a meaning that was clear beyond peradventure. Indeed if I had to construe it entirely on its own terms and without reference to any background circumstances I may well have had difficulty in giving the clause the construction the pursuers urge upon me. However I consider that there was a background to this agreement which was very pertinent.

It is perhaps fortunate that recent authority has given important guidance on the interpretation of commercial contracts (of which this is plainly one). The emphasis of these authorities is placed on the desirability of arriving at a common sense practical construction likely to reflect what the parties must be taken to have meant. Formal language is less important than an attempt to extract from the language what parties must in all the circumstances have intended. I am certainly not suggesting that plain words should be ignored but equally it is not useful or sensible to struggle with contorted semantic exercises if it is perfectly obvious what reasonable and informed business people must have meant if they were hoping to achieve a workable and intelligent result.

In Prenn v Simmonds, in a passage since much quoted, Lord Wilberforce said: ‘In order for the agreement of July 6, 1960, to be understood it must be placed in context. The time has long passed when agreements, even those under seal, were isolated form the matrix of facts in which they were set and interpreted purely on linguistic considerations.’

Certainly Lord Wilberforce proceeds to explain how the substance of negotiations must be excluded from questions of construction. However I do not think his Lordship meant this to be applied too rigidly. As he states (p 1385): ‘It may be said that previous documents may be looked at to explain the aims of the parties. In a limited sense this is true: the commercial, or business object, of the transaction, objectively ascertained, may be a surrounding fact.’

More recent enlightenment is given in Investors Compensation Scheme Ltd v West Bromwich Building Society. At p 1257 Lord Hoffmann observed: ‘I do not think that the fundamental change which has overtaken this branch of the law, particularly as a result of the speeches of Lord Wilberforce in Prenn v Simmondsand Reardon Smith Line Ltd v Yngvar Hansen-Tangen, is always sufficiently appreciated. The result has been, subject to one important exception, to assimilate the way in which documents are interpreted by judges to the common sense principles by which any serious utterance would be interpreted in ordinary life. Almost all the old intellectual baggage of legal interpretation has been discarded. The principles may be summarised as follows: (1) Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract; (2) The background was famously referred to by Lord Wilberforce as the "matrix of fact", but this phrase is, if anything, an understated description of what the background may include. Subject to the requirement that it should have been reasonably available to the parties and to the exception to be mentioned next, it includes absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man.’

Lord Hoffmann then proceeds to exclude from the admissible background the previous negotiations of the parties and their declarations of subjective intent.

Another case that was referred to in connection with contractual interpretation was Mannia Investment Co Ltd v Eagle Star Life Assurance Co Ltd. At p 372 Lord Steyn observed: ‘In determining the meaning of the language of a commercial contract, and of unilateral contractual notices, the law generally favours a commercially sensible construction. The reason for this approach is that commercial construction is more likely to give effect to the intention of the parties. Words are therefore interpreted in the way in which a reasonable commercial person would construe them.’

In the same case Lord Hoffmann gives a very expansive and detailed analysis of the topic I am considering. However some of his obiter observations have attracted comment in other recent cases and I do not think that I need to become entrapped in such issues for I have all the guidance I need from Lord Hoffmann and others in the passages I have already quoted.

I think it would be useful at this point to discuss the background facts that were before the parties when they had their pre-contract discussions. The evidence shows that there were two meetings and that one of these was held on 8 June 1989. Those attending for the defenders were Mr M A Forrest, Mr A S Patience, and Mr M M Shepherd. Mr Forrest was an actuary and was the Chief Investment Manager of the Life Association of Scotland. His employers are well established in the financial world and they in fact were partners in the defenders' Company. Mr Shepherd and Mr Patience were accountants. None of these persons gave evidence at the Proof. For the pursuers Mr G G Masterton, Mr J S Henderson, and Mr D W Elder attended the meeting. Mr Masterton was a General Manager of the Bank and attended the meeting in that capacity. Mr Elder was also a banker and Mr Masterton's assistant. Mr Henderson was the Assistant General Manager. Mr Masterton and Mr Elder gave evidence at the Proof. A note was taken of the meeting. It records that: ‘Mr Forrest sought an indication of the likely costs that would be incurred in the event of early repayment. It was explained to him that as we may wish to match the funds drawn under the Debenture Loan it was not really possible to provide this information as it would depend on the circumstances of the time of early repayment and whether the Bank would be able to utilise the funds used to match the loan in some other way. He was assured we would use our best endeavours to minimise any cost and this was accepted.’

The Outline Terms and Conditions (No 5/1 of Process) are of limited applicability because they record negotiation positions that were later superseded. It is, however, worth noting that there is a condition entitled ‘Early Repayment’. This provides as follows: ‘The Debenture Loan may be repaid in full on giving six months notice but subject to the Bank being compensated and fully reimbursed for any costs, losses and expenses incurred by it in respect of funds borrowed by it for the purpose of making and maintaining the Debenture Loan. We will, of course, use our best endeavours to minimise such losses/costs.’

What the two documents which I have quoted do show is that the costs which during negotiations were at the forefront of the parties' concerns in connection with early repayment were not, for example, administrative costs relating to the Loan Stock, but rather costs relating to the pursuers' own funding and matching arrangements.

In relation to the evidence led by the pursuers at the Proof it also has to be observed that the Lord Ordinary does not appear to have any difficulty in accepting the veracity of this, as far as it went. This is perhaps not surprising because the defenders led no evidence in reply. If they had wanted to contradict the construction put on the pre-contract meetings by the pursuers' witnesses, or the evidence about the degree of technical understanding that could have been expected from those attending the meetings on behalf of the defenders, they could have led evidence to explain their own position.

At the proof Mr Masterton said that there was discussion in the pre-contract meetings of the fact that early termination of the Debenture Scheme would involve cost. The fact that the Bank would be hedging or matching their position was made quite clear to the defenders' representatives. The discussions between the parties must be viewed against the background that Mr Masterton was a banker and his function was to negotiate the terms of the Debenture. He had an overall understanding of matching and he was familiar with the fact that it was the policy of the Bank to cover its funding by matching. However, he was not so familiar with the technical details of matching procedures. These were the responsibility of the Treasury division of the Bank. The witness Mr J A Cameron was a Deputy Chief Executive in the Treasury branch of the Bank. He explained that the matching operations carried on by the Bank were no different to normal banking practice. The witness explained why it had been practical for the Bank to cover its position by a Swap Agreement, particularly because long term hedging loans were difficult to obtain. The witness John McCormick was experienced in derivative managing structures. He had not personally attended the pre-contract meeting but he was aware of the likely state of knowledge of experienced financial managers. He explained how property companies themselves apply a form of hedging by seeking fixed term loans at fixed interest to match their rental income. He said that he would have expected Dunedin to be aware of the general prepayment policy within banks and investment institutions relating to loans and deposits now and in the past. They would have to keep a dose eye on borrowing and lending rates in case they wanted to prepay or cancel their own borrowing arrangements and the cost of doing so would be important to them. He explained that it was well known within the finance industry that breakage costs arise and that they cover the costs on the breakage, amendment, and cancellation of a transaction. He would expect actuaries to have a knowledge of derivatives.

It has to be acknowledged that Mr Masterton had a limited knowledge of the detailed operation of Swap transactions. Moreover I think it is unlikely that there was specific reference to Swaps at the pre-contract meetings. The discussions centred round matching and hedging. However the pursuers' evidence is that from the borrowers' point of view there is no practical difference between matching and Swaps. They are alternative technical means of achieving the same end. This makes sense. Whichever method of matching is employed, the critical factor is the interest margins and the breakage of a Swap is likely to involve compensation for the same amount of lost interest as would hedging or other forms of effective matching. There was no evidence to contradict the pursuers' evidence that in the market the premature termination of a long term matching arrangement always involves breakage costs representing the economic effect of bringing the matching to a premature conclusion. Suggestions were made to the pursuers' witnesses by the defenders that they could have covered their position by means that were less onerous than the Swap Agreement which they entered into, but none of this was accepted or supported.

The defenders argued that the court could not derive any help in construction from the pre-contract discussions. These were of the nature of negotiations and were superseded by the final Loan Stock Agreement. An attempt was made to gain support for this from the analyses of Lord Wilberforce and Lord Hoffman which I have already referred to. However I do not think that their Lordships were trying to exclude from the construction process communications which themselves bear on the factual matrix against which the parties were contracting. What, of course, cannot be prayed in aid are pre-contract communications which reflect the parties' aspirations and intentions at the time when they were made. In Bovis Construction (Scotland) v Whatlings Construction before the First Division it was made clear that the correspondence preceding the contract could be looked at to determine the circumstances in which a provision in the contract was intended to apply. This is consistent with long established Scottish authority. Thus in Mackenzie v Liddell it was held that telegrams preceding the contract could be looked at as proof of surrounding circumstances although not as proof of the parties' meaning itself.

The defenders argued that the reference in Clause 3 to the costs ‘incurred by it in connection with the Stock’ should be taken into account and can only mean that the kind of costs contemplated were those directly arising from rearranging the Stock upon repayment, such as registration costs, administration costs and matters of that kind. We were referred to a number of authorities and in particular Berry v Federal Commissioner of Taxation, Clarke Chapman-John Thomson v IRC and Gomba Holdings UK v Minories Finance Ltd (No 4). These cases are rather dependent on their own facts and the most useful general rule may be that in Gomba to the effect that the words ‘fees and expenses incurred in connection with’ should be restricted in application to ‘within parameters which the court may come to the view were reasonably within the contemplation of the parties at the time the particular document was entered into’.

Construing Clause 3 against the whole background circumstances I think it would not have made much sense if the parties had merely been attempting to provide for the relatively minor expenses that may have resulted from administering the repurchase of the loan stock. During discussions there does not appear to have been any mention of the administrative costs. What were at the forefront of the parties' discussion were the costs of bringing the loan agreement to an end. It was obvious to the defenders that if the pursuers matched their loan, early termination of the Debenture Scheme was going to involve cost. The defenders' representatives were not inexperienced laymen but professionals in the financial sector who knew the rudiments of financial transactions. The pursuers themselves were not charging for any loss of profit on the early termination of the loan. It was clear that if they matched the fixed term loan there were going to be expenses on early termination. Not only had the defenders been told that there was likely to be matching but from their knowledge of banking practice they might have expected this. Moreover they must have known that the very circumstances likely to prompt them to seek early termination of the loan were the very circumstances likely to add to the cost of breaking any agreement with a matching counterparty. They had been told that the cost of breaking the loan would depend on circumstances. They had been given an indication that the Bank would perhaps try to employ the loaned funds elsewhere but this was not a warranty. I do not see that it makes any difference to the overall situation that the Bank decided to utilise the Swap Agreement process to match their borrowing since it was certainly not shown that this exposed the defenders to more risk than any other kind of matching. When the defenders received the final contract deed there was no reference to any breakage costs other than the possible reference in Clause 3. It seems unlikely that the defenders thought that the pursuers had just forgotten about these costs which would inevitably arise if circumstances were such as would tempt the defenders to terminate early. The words ‘in connection with’ could mean ‘directly deriving from the loan stock itself’ or ‘extraneous to the loan stock but related to the loan stock scheme’. Clause 3 is part of Schedule 1 and this in turn derives from Clause 5 of the main deed. The conditions of the Schedule have all to appear on the Stock Certificates. Thus these conditions, including Clause 3, all relate to the Stock. They are all ‘connected with’ the Stock. That is to say they are all connected with the arrangements for the creation and management of the Stock. The defenders can repurchase the Stock but they must pay costs which the pursuers will incur as a result. The words ‘in connection with the Stock’ are restrictive in a sense and would exclude claims that may have nothing to do with the termination of the Stock Agreement. The hedging arrangements were an intrinsic part of the pursuers' offer to provide a long term loan and the defenders not only knew this but appreciated that it was going to involve the pursuers in unpredictable costs if there was early termination of the loan. It would not make business sense for the pursuers to permit termination of the loan without making some arrangement to cover the cost to them that this would generate. It is curious that the defenders should have thought that they could break a long term arrangement at their will without material penalty. It has to be noted that Clause 3 merely provides the defenders with an option. If at any particular time they consider that the breakage costs are too high they are under no obligation to proceed with the termination.

The Lord Ordinary obviouszly found that the construction of Clause 3 was a difficult matter and I can sympathise with that view. At the end of the day what seems to have weighed most with him was the fact that the intricacies of Swap agreements were not explained to the defenders and that they were not warned that the breakage costs of Swap agreements were not negotiable. However the defenders had every reason to anticipate that the pursuers would enter into a contract with a third party to match their loan. This would be inevitable were they to want to match. The particular means and conditions of matching do not seem to have been discussed at all and the defenders made no issue of this at the time. At pp 173–175 of the Notes of Evidence Mr McCormick asserts that it is well understood in the market place that if interest rates rise and the borrower decides to take his money away the Bank will need to refund the money at a higher interest rate than they will then receive and will have to charge for that. None of the pursuers' witnesses suggest that the principle upon which the Bank's consequential expense arises would be affected by the fact that the Swap machinery was used rather than the hedge machinery. Mr Masterton explained that it was not the convention to have a breakage clause in a matched deposit agreement and that the fact that breakage would involve cost was spelled out in discussions. He said that the Inter-Bank market does not allow minimisation of cost if hedging is interrupted and that there is a non-negotiable consequential cost at all times (pp 28,32). Since the matching process was not explained to the defenders (and they apparently did not require nor seek explanation of this) it is difficult to see why a particular form of matching should affect their liability for costs unless it imposed a greater than normal burden. I must repeat that there was no evidence from the defenders to the effect that they were only anticipating costs relating to matching by way of a hedging loan and that the choice of Swap Agreements placed them under an unexpected burden.

I thus differ from the Lord Ordinary in that I have concluded that the phrase ‘costs, charges and expenses incurred by it in connection with the Stock’ was intended by the parties to include costs incurred by the pursuers by way of breakage charges arising from the early cancellation of their hedging arrangements.

I may say that I would have no difficulty in accepting the additions proposed by the pursuers to the findings in fact but agree with your Lordship in the chair that the proposed additions are not necessary.

On the whole matter I agree with your Lordships that the reclaiming motion should be allowed. This means that the case should appear By Order so that further procedure can be determined.