Contractual Interpretation

9 December, 2011

Two recent cases have highlighted the need for clarity when negotiating and subsequently entering into commercial agreements to ensure that each party is clear as to what terms are actually agreed and the effect that those provisions will have on them.

While many of the traditional legal rules of interpretation continue to have a role in modern contractual interpretation, strict, literal meanings of words are becoming less important to the process. Considerations of business commonsense, commercial purpose, reasonableness and a holistic approach to the contract are now at the fore.

 

Rainy Sky SA and others v Kookmin Bank1

This case centred on a refund clause in a guarantee agreement between a bank and the purchasers of ships. The shipbuilder, having entered into separate agreements with individual purchasers who all paid instalments in advance, suffered financial difficulties. The purchasers claimed on the guarantee issued by the bank. Under the contract the purchasers were entitled to a refund of the instalments paid plus interest in the event of the shipbuilder’s insolvency. The bank argued that insolvency was not one of the events which would engage the guarantee as the words requiring the bank to pay the purchasers “all sums due to you under the contract” were not a specific reference to insolvency.

The Supreme Court applied a business commonsense approach and found that both interpretations presented were possible.  In these circumstances the court found that the bank’s interpretation would lead to what the judge called a “surprising and uncommercial result”. On the bank’s interpretation, the guarantees would cover every situation in which the purchasers could claim a refund, except the situation in which they were most likely to need it – the shipbuilder’s insolvency. The bank could not suggest any commercial reason for the purchasers to have agreed to this and the Court gave judgement in favour of the purchasers.

 

Daventry District Council v Daventry & District Housing Ltd2

This case concerned the transfer of council housing, council staff and their pensions to a registered social landlord. A deficit of £2.4 million in the employees’ pension fund would result.  Negotiation led to the agreement of various provisions about the pension deficit. The points failed to be documented correctly in the agreement and it appeared that the council had agreed to be responsible for the shortfall. The chief negotiator for the landlord realised the ambiguity as to the payment of the fund but briefed colleagues on the basis that the council would pay this.  The council however, believed that the landlord had agreed to make the payment. A further sub-clause was accepted by the Council and inserted into the agreement, not realising that it contradicted their agreement in principle. On learning what had happened the Council applied for rectification.

The Court of Appeal granted the rectification. The landlord’s chief negotiator’s conduct was considered important. If he had not known of the Council’s mistake they indicated that the rectification would not have been given. The Court found that it was never the intention of the landlord to pay the shortfall but on an objective view their words and actions led the Council to believe they had agreed to make the payment.  The commercial agreement outweighed the words of the sub-clause which were clear. It was not commercially feasible to suggest that by accepting the late amendment, the Council had agreed to give the Company a £2.4 million windfall for no commercial reason.

These cases show an increasing willingness by courts to give appropriate weight to commercial and business reasoning when interpreting contractual rights and obligations. Courts are willing to ignore the actual wording of contracts in order to ensure that the effect is in line with business commonsense. The Daventry case also serves as a warning about ‘sharp practice’ in negotiations. Even when it does not amount to dishonesty it may prevent that party from relying on the strict wording of the agreement.

 

1Link to judgment: Rainy Sky SA and others v Kookmin Bank [2011] UKSC 50

2Link to judgment: Daventry District Council v Daventry & District Housing Ltd [2011] EWCA Civ 153

 

 

Reviewed in 2015