The interpretation of contracts

January 16, 2015

In the second article in a five-part series, Stephen Brown and Sappho Dias, barristers at 4-5 Gray's Inn Square, consider how the Court will go about construing a contract.

The overall objective of the exercise

The most important, overriding principle is that the courts will seek to ascertain the objective intentions of the parties. They will ask themselves the question, "What would the words used in the contract mean to a reasonable person who has available to him all the relevant background known to the parties at the time?".

"the aim of the exercise is to ascertain the meaning of the relevant contractual language in the context of the document and against the background to the document. The object of the enquiry is not necessarily to probe the 'real' intention of the parties, but to ascertain what the language they used in the document would signify to a properly informed observer. [1]

There is an obvious reason for this. The contract is the parties' statement of their intention. It has to be interpreted for itself and that exercise cannot be influenced by subjective intention, evidence of negotiations including drafts, and conduct, all of which are capable of manipulation, or may not even be available to the courts by the time a dispute has arisen. We return to this "exclusionary principle" when we look at factual background.

It is not always necessary that ambiguity is required to run a construction argument. A party may run an argument that read in context, the express and clear words used in a contract mean something else, such as "12 January" meaning "13 January" or that the parties have given their own specific definition to a word, albeit not one expressly defined in the contract.

The meaning of words

Inevitably, the court will start with the words used in the written instrument but it does not approach them as a matter of dictionary definitions. When a court construes a contract, it will not change the words, it will state what they mean and may have to depart quite substantially from the words of the contract.

Hoffman LJ said in West Bromwich:

"The 'rule' that words should be given their "natural and ordinary meaning" reflects the common sense proposition that we do not easily accept that people have made linguistic mistakes, particularly in formal documents. On the other hand, if one would nevertheless conclude from the background that something must have gone wrong with the language, the law does not require judges to attribute to the parties an intention which they plainly could not have had."

He then refers to another case where it was said "if detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business common sense, it must be made to yield to business common sense" [2].

The crucial point is that, in the exercise of construing a contract, one should not get too hung up on the precise meaning of individual words or even whole sentences or clauses. For instance, in Mannai Investments Co. Ltd v Eagle Star Life Assurance Co. Ltd [3] the court interpreted "12 January" as "13 January".

Hoffmann LJ said in Chartbrook v Persimmon:

"When the language used in an instrument gives rise to difficulties of construction, the process of interpretation does not require one to formulate some alternative form of words which approximates as closely as possible to that of the parties. It is to decide what a reasonable person would have understood the parties to have meant by using the language which they did. The fact that the court might have to express that meaning in language quite different from that used by the parties… is no reason for not giving effect to what they appear to have meant."

This is a really important statement. It is borne out time and again in practice. The courts are interested in doing justice, not in enforcing literal interpretations of written instruments that cannot have been the real intention of the parties. A party who goes into court with a highly literal interpretation of a clause which finds no support in the context of the agreement or in commercial common sense, is going to struggle. There is no absolute right answer, it is all about persuasion. It is always important to look for meaning which comports with the facts and commercial common sense. An argument that has to work against these is unlikely to be persuasive.

Sometimes the meaning of particular words is a matter of definitions. It is of course possible for certain words to have a specific trade usage without being specifically defined in the contract. Evidence of this is permissible. The parties may define terms and they will usually do so expressly in the agreement. However, they may have their own private dictionary that they use for the transaction but do not write down. Evidence of this is admissible, which brings us on to what is meant by factual background.

Factual background

On its face factual background is very broad. Lord Hoffmann in West Bromwich described it as "absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man" subject to the caveat that the facts would have to have been reasonably available to the parties and to the exclusion of subjective intention and evidence of negotiations. Subsequently in BCCI v Ali [4], he clarified that he had not thought it necessary to emphasize that he meant "anything which a reasonable man would have regarded as relevant". He was merely saying that there was no conceptual limit.

In practice, what amounts to factual background will usually be relatively easy to identify. It is the factual background against which the contract was formed and therefore the context in which it has to be understood. Much will depend on the nature of the contract, but it could include: the nature of each party and its business; the practical feasibility of the competing constructions; and the regulatory framework in which a contract is to be performed. Good factual matrix might be that one construction was illegal at the time the contract was signed and there is a presumption that parties do not intend to agree something illegal.

The court is looking for context.

Admissible factual background becomes more difficult when it potentially crosses the line between objective facts and subjective intention, for instance, if it were to include evidence of pre-contractual negotiations. Parties have sought to rely on evidence taken from pre-contractual negotiations to show, for instance, a particular meaning attached to a word [5] or the commercial objective of a transaction [6]. However, as stated above, evidence of pre-contractual negotiations is inadmissible and there is a long line of consistent authority to that end (and Prenn v Simmonds [7] is often cited in this regard).

In Chartbrook v Persimmon, in the House of Lords, Persimmon challenged the rule as being illogical since it prevents the court from putting itself in the position of the parties and ascertaining their true intent. This proposition was examined very carefully. Lord Hoffmann said, in the course of his opinion that, "it would not be inconsistent with the English objective theory of contractual interpretation to admit evidence of previous communications between the parties as part of the background which may throw light upon what they meant by the language they used" [8]. He also acknowledged that, “A rule that prior negotiations are always inadmissible will prevent the court from giving effect to what a reasonable man in the position of the parties would have taken them to have meant” [9].

However, ultimately he concluded that there is no clearly established case for departing from the exclusionary rule. He said:

"This rule may well mean, as Lord Nicholls has argued, that parties are sometimes held bound by a contract in terms which, upon a full investigation of the course of negotiations a reasonable observer would not have taken them to have intended. But a system which sometimes allows this to happen may be justified in the more general interest of economy and predictability in obtaining advice and adjudicating disputes." [10]

Lord Hoffmann went on to say that, "There are two legitimate safety devices which will in most cases prevent the exclusionary rule from causing injustice. But they have to be specifically pleaded and clearly established. One is rectification [and we will discuss that in a later article in this series]. The other is estoppel by convention … If the parties have negotiated an agreement upon some common assumption, which may include an assumption that certain words will bear a certain meaning, they may be estopped from contending that the words should be given a different meaning" [11]. This does not offend against the exclusionary principle because it starts from the position that the words do not mean what the party seeking rectification or raising an estoppel contends. In other words, that party has to concede the adverse construction, since it cannot rely on pre-contractual negotiations in that regard, but then refer to those negotiations when seeking to set up the estoppel or prove the prior common accord or agreement not accurately set out in the written instrument.

When does the factual background come into play? Lord Stein, in R (Westminster City Council) v National Asylum Service [12] said, "The starting point is that language in all legal texts conveys meaning according to the circumstances in which it was used. It follows that the context must always be identified and considered before the process of construction or during it".

In our next article we consider how "business common sense" is deployed in the exercise of construction an agreement.

Stephen Brown and Sappho Dias are barristers at 4-5 Gray's Inn Square.

The first article in the series – Did I agree that?! – can be viewed here.

[1] Per Aikens J in Absalom v TCRU Ltd [2006] 2 Lloyd's Rep 129 at para 7.

[2] Antaios Compania Naviera S.A. v Salen Rederierna A.B [1985] AC 191, 201

[3] [1997] AC 749.

[4] [2002] 1 AC 251

[5] The Karen Oltmann [1976] 2 Lloyd’s Rep 708

[6] Tica City National Bank v Gunn (1918) 118 NE 607

[7] [1971] 1 WLR 1381

[8] Para 33E

[9] Para 33G