updated on 17 December 2013
QuestionHow do the courts interpret contracts in the event of dispute?
Generally there is no requirement under English law for a contract to be in writing, but relying on an oral contract can lead to evidential problems at a later date if a dispute arises. Even if a contract is in writing, in the event of a dispute it is important that parties are able to predict - with reasonable certainty - how the contract will be interpreted. Any doubt about the meaning or effect of a contract may result in a greater likelihood of disputes arising and, in the event of a dispute, lead to increased litigation costs for both parties.
Historically, the courts favoured a literal approach to contractual interpretation, but this has been replaced by a purposive approach. The restrictions on the additional evidence that the courts can consider has also been relaxed over time.
Note that the courts have distinguished (see in particular the BMA Case below) between:
The landmark contractual interpretation case of the 20th century was Investors Compensation Scheme Ltd v West Bromwich Building Society (1998), in which Lord Hoffmann set out five principles to be used as guidelines when attempting to interpret parties' intentions. These principles show that the courts will have regard to what the parties agreed, rather than rigidly enforcing the literal meaning of the contract.
The five principles are set out below.
The starting point asks what would a reasonable person understand the contract to mean? If it is not possible to determine the meaning from the document alone, the court can consider the circumstances leading to the contract's formation and all admissible background knowledge that both parties would have had access to at the time of its creation. This allows the court to give effect to the parties' intentions, even in cases where the plain meaning is contrary to this.
The second principle allows the parties' intentions to be determined by the context of the disputed term. Where a word may be literally applied and understood in that way by the reasonable person, it is still possible for a party to provide evidence to show that the word (and its meaning) had a different meaning for the parties. The evidence must be that which would have been reasonably available to both parties and would influence the reasonable person's understanding of the contract, the so-called 'matrix of facts'.
The third principle sets the boundaries for the second. All previous negotiations between the parties are excluded, as well as the parties' declarations of subjective intent. The distinction between prior negotiations and the admissible 'matrix of facts' is a fine one, but was not explored by Hoffmann.
This principle requires the court to look beyond the words used in the contract. This illustrates the court's intention to take a purposive approach, as opposed to a strictly literal approach. Knowledge of the admissible background facts allows the court to determine that, while a reasonable person would interpret the contract and the parties' intentions one way, the parties used the wrong word(s) to convey their actual intentions.
Where the "natural and ordinary meaning" of a word would result in an absurdity or would create a situation inconsistent with the rest of the contract, the court can assign a different - more appropriate - meaning to that word.
The 21st century has seen an extension of this "common sense" approach being applied to the interpretation of contracts.
This case considered the correct approach to apply when the court is required to interpret a commercial contract in which the meaning of a contractual provision is ambiguous. Lord Clarke concluded that the appropriate construction of the ambiguous wording should be the one most consistent with 'business common sense'.
This extended the liberalised approach to the interpretation of ambiguous contractual terms. Those in favour of a more literal approach were concerned that this judgment would lead to uncertainty resulting from the inevitable divergence among judges as to what constituted "business common sense" in any given situation. Concerns were raised that ascertaining "business common sense" with the benefit of hindsight and without the context of the give and take of a commercial negotiation would be difficult or impossible, and would lead to unpredictable results.
The advice to apply "business common sense" to the interpretation of contracts was placed in context by a case this year, explained below.
The leading judgment in this Court of Appeal case was delivered by Lord Justice Aikens, who noted that the principles of interpreting commercial documents have undergone "considerable judicial exposition [in] the House of Lords and Supreme Court in recent years". It was emphasised that it is the "court's job to discern the intention of the parties, objectively speaking, from the words used in the commercial document, in the relevant context and against the factual background in which the document was created". It is only when there are two "possible constructions of the document [that] a court is entitled to prefer the construction which is more consistent with 'business common sense'".
This case set the judgment of Rainy Sky in context and makes it clear that commercial common sense should not be elevated to an overriding criterion of construction. In this respect, the principles set out by Hoffmann remain the first means of determining the true interpretation of the contract, and only in the event of remaining ambiguity can the court determine the true construction of the contract based on what is most consistent with "business common sense". In the BMA Case, it was held that the meaning of the relevant provisions was clear and that - notwithstanding that one of the parties could reasonably argue that the outcome of the language did not make business common sense - the court should not overwrite what had been agreed. The judgment emphasised that both of the commercial parties had been advised by leading law firms on the contract in question and its provisions.
When considering a contract, it is still good practice to look at the plain meaning of the contractual language and use the five principles set out in Investors Compensation Scheme Ltd v West Bromwich Building Society. Only in cases where there are two or more possible constructions should you seek to apply business common sense to aid interpretation. As always, the emphasis must be on clear and unambiguous drafting, and ensuring that the commercial parties fully understand the effect of that drafting.
Sheridan Steiger is a second-year trainee at Ince & Co LLP.