Words which may have seemed clear in the meeting room when the contract was signed can seem impossibly obscure years later in a court room. Cases are won or lost on the resolution of these difficulties, and generations of commercial lawyers have devoted themselves to developing arguments as to how commercial contracts should be interpreted.

Tension

The courts’ decisions in these cases are often marked by a tension between: (i) the natural meaning of the words used; and (ii) a purposive meaning which makes commercial sense. This tension has been explored in a long line of authorities beginning with the House of Lords’ decision in Prenn v Simmonds [1971] 1 WLR 1381, [1971] 3 All ER 237 and culminating in the Supreme Court’s decision in Rainy Sky SA v Kookmin Bank [2011] UKSC 50, [2012] 1 All ER 1137. Those authorities have demonstrated an increasing willingness on the part of the courts to adopt a flexible approach to the task of interpretation, and a discernible leaning towards favouring commercial common sense over the strict literal meaning of the words used where the two do not coincide. As Lord Hoffmann observed in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38, [2009] 4 All ER 677 there is no “limit to the amount of red ink…or correction” that the court is allowed.

Continuing this line of authority, the decision of the Supreme Court in June 2015 in Arnold v Britton and others [2015] UKSC 36, [2015] All ER (D) 108 (Jun) reasserts the importance of giving effect to the words which the parties chose to use when reaching their agreement, and the caution that should be exercised before discarding the natural meaning of those words in favour of an interpretation which favours “commercial common sense”. Arnold may indicate that the tide has begun to turn again towards a more traditional approach to construction. It also contains a useful practical indication as to the evidence likely to be helpful on questions of interpretation.

Discarding the old intellectual baggage

In Prenn v Simmonds Lord Wilberforce stated that the time of interpreting contracts on purely “internal linguistic considerations” had “long passed”. Citing Lord Blackburn’s judgment in River Wear Commissioners v Adamson (1877) 2 App Cas 743, [1874-80] All ER Rep 1, he confirmed that the court should “inquire beyond the language” for the objectively ascertained intentions of the parties.

Lord Wilberforce’s speech was later relied on by Lord Hoffmann in Investors Compensation Scheme v West Bromwich [1997] UKHL 28, [1998] 1 All ER 98 in which he set out five seminal principles of contractual interpretation. Lord Hoffmann described Prenn as marking a “fundamental change” to contractual interpretation, although 12 years later in Chartbrook he stated that much of his statement of principle could be found in the earlier authorities.

Nevertheless, the increasing emphasis on commercially reasonable interpretations also cast its influence on other aspects of contract law, such as implied terms. Lord Hoffmann’s reasoning in Attorney General of Belize v Belize Telecom [2009] UKPC 10, [2009] 2 All ER 1127 drew heavily on Investors Compensation Scheme to support the conclusion that the question whether a term was to be implied into an agreement depended upon the interpretation of that agreement, understood in its relevant background. He considered that the traditional requirements for the implication of a term (necessity, the officious bystander, etc), were merely “alternative” expressions of the search for the objective intentions of the parties.

Business common sense

The difficulties involved in determining what is “business common sense” in any given case were neatly illustrated by Chartbrook. Both Briggs J at first instance and the majority of the Court of Appeal (Tuckey and Rimer LJJ) accepted without difficulty the interpretation ultimately rejected by the Supreme Court. Rimer LJ was particularly forthright, describing the interpretation ultimately adopted by the Supreme Court as one that “fundamentally distort[ed] the meaning” of the definition in question.

Despite these difficulties, the importance of business common sense was emphasised by the Supreme Court in Rainy Sky. Lord Clarke accepted that where there were competing interpretations of ambiguous words, the interpretation most consistent with business common sense should be adopted. Taken at its highest Rainy Sky goes further than Investors Compensation Scheme and allows parties to play business common sense as a trump card if any ambiguity or inconsistency can be found.

The flexibility allowed by Rainy Sky was illustrated in the Court of Appeal’s decision in April this year in MT Hojgaard a/s v EON [2015] EWCA Civ 407, [2015] All ER (D) 08 (May). A contract for the design and construction of wind turbines provided that the “design of the foundations shall ensure a lifetime of 20 years in every aspect”. Jackson LJ was conscious of the need not to be “led astray” by “ambiguities and inconsistencies” in the contract, and reached the conclusion that these words did not promise a 20-year warranty but instead only that the relevant design standard would be complied with and accordingly the foundations would have an expected design life of 20 years: something very different from a warranted life of 20 years. The court was persuaded that other references to “design life” in the contract and the fact that no allowance for a warranty had been “clearly flagged up” in the contract documents demonstrated that no warranty had been promised.

The decision in Arnold

Seen against the background of these authorities, the black letter lawyer will find the Supreme Court’s decision in Arnold a welcome reminder that contractual interpretation is not an exercise in judicial discretion. The Supreme Court did not of course demur from Rainy Sky, but the majority stressed that the words of the contract should not be undervalued by reliance on business common sense: a message reinforced by the tone and emphasis with which it was delivered.

Facts

Arnold concerned the interpretation of service charge provisions in the leases of chalets in a caravan park entered into between 1977 and 1991. The key provision varied slightly from lease to lease, but the following is representative: “To pay to the Lessor without any deductions in addition to the said rent as a proportionate part of the expenses and outgoings incurred by the Lessor in the repair maintenance and renewal of the facilities of the Estate and the provision of services hereinafter set out the yearly sum of Ninety Pounds and Value Added tax (if any) for the first year of the term hereby granted increasing thereafter by Ten Pounds per hundred for every subsequent year or part thereof.”

The appellant lessees argued that their obligation was to pay a “proportionate part” of the expenses incurred by the lessor, subject to a cap which was £90 in the first year, increasing every year by 10% on a compound basis. The respondent landlord argued that obligation was simply to pay a contribution of £90 in the first year, increasing by 10% on a compound basis in every subsequent year.

The consequences of the respondent’s interpretation were stark. Because of the compounding effect the service charge payable under the early leases would be hundreds of thousands of pounds per annum by 2072.

Decision

Despite these consequences the Supreme Court dismissed the appeal. Lord Neuberger, with whom Lord Sumption and Lord Hughes agreed, gave the leading judgment for the majority. Lord Hodge gave a concurring judgment. Lord Carnworth dissented.

“Generations of commercial lawyers have devoted themselves to developing arguments as to how commercial contracts should be interpreted”

Lord Neuberger identified seven factors relevant to the task of construction. The tone of the relevant paragraphs is striking: commercial common sense and the surrounding circumstances

“should not be invoked to undervalue the importance of the language of the provision which is to be construed”.

Unlike commercial common sense and the surrounding circumstances, “the parties have control over the language they use in a contract”. The court should not embark on an exercise of searching for “drafting infelicities” in order to facilitate a departure from natural meaning. A court should be “very slow” to reject the natural meaning of a provision as correct, simply because it appears to have been imprudent.

The majority did not find the provision under consideration to be ambiguous and were able to find commercial justifications for it. A fixed, as opposed to proportionate, service charge would give both parties certainty and avoid disputes. Further, set against the background of high inflation from 1974 to 1981, the 10% compound escalation represented a gamble on inflation, albeit an imprudent one.

Discussion

It would be wrong to suggest that Arnold signals a need to rethink the broad statement in Rainy Sky that, where words are ambiguous, business common sense should be preferred. Where there is genuine ambiguity, the Rainy Sky principle must be applied. But Arnold may make the courts more cautious than they have perhaps become in reaching the conclusion that a contract is ambiguous, and more resolute in holding a party to a commercial bargain which, with the benefit of hindsight, may seem to have been a disastrous misjudgement. Lord Neuberger acknowledged that the position in relation to some of the later leases in Arnold was particularly acute, since they were not entered into in a period of high inflation. With a degree of understatement, he commented that the relevant lessees’ decision to enter the leases was “rather extraordinary”, but he nonetheless held them to their bargain.

Practical guidance

For parties litigating difficult questions of contractual interpretation Arnold contains a useful indication that the factual matrix or “background” should be thoroughly explored for evidence that might support a rival interpretation. The court noted on a number of occasions how little evidence it had been presented with. One detects in Lord Carnworth’s comments as to the prevailing economic conditions and the usual calculation of service charges a frustration that more evidence was not available which might have made it possible to arrive at a different outcome.

Lord Hodge suggested that there was much to be said for the Scottish practice of setting out the surrounding circumstances relied upon and their effect on the interpretation. The Commercial Court Guide at C1.2(h) already requires that pleadings should set out each feature of the factual matrix that is said to be relevant. Even where parties are not strictly required to set out such facts the exercise of determining, at an early stage, what evidence is available is plainly an important one, particularly for a party who is looking to persuade a court to depart from the natural meaning of the words in a contract, in favour of an interpretation which accords with “commercial common sense”.

This article was first published in New Law Journal (www.newlawjournal.co.uk).

Contributor Benjamin Pilling QC