Getting the “red ink” out

3 July, 2009

There are some interesting parallels between construction contracts and IT contracts. Both types of contract often involve large expenditures in a project whose final outcome and parameters are not always clear. Both involve an interplay between how the project proceeds on an ongoing basis, and how the final delivery can be assessed and accepted. The resulting contracts are often highly complex, and negotiated against tight deadlines. And there are real dangers of the responsibility for important provisions falling between the “legal” and “commercial” representatives for a party.

A dispute involving the housebuilder Persimmon Homes shows the problems that can arise where a contractual clause in a complex contract turns out, once a dispute arises, to be far less clear than the parties may have assumed when the agreement was signed. Persimmon bought a development site in Wandsworth from a company called Chartbrook Limited. The agreement included provision for an additional payment to Chartbrook were Persimmon to achieve a higher price than anticipated for the residential units it built on the site. This “Additional Residential Payment” (ARP) was defined as:

23.4% of the price achieved for each Residential Unit in excess of the Minimum Guaranteed Residential Unit Value [MGRUV] less the Costs and Incentives.

Now, what does this clause mean in practice? Chartbrook and Persimmon soon came to blows over this, with starkly differing interpretations. Chartbrook argued that a literal interpretation of the clause meant that it should receive a total ARP of £4,482,862 – almost doubling the original price paid by Persimmon for the land. Persimmon argued that, taking the commercial purpose of the clause into account, the ARP should come to £897,051 – a healthy top-up to reflect the prices achieved for the flats, but now the near-100% uplift sought by Chartbrook.

The usual position in English law is that the literal interpretation of the contract should be followed, and this is the position followed by the High Court and Court of Appeal in the earlier stages of the case. However, when the case reached the House of Lords (whose judgment was issued this week), Lord Hoffman took a very different view.

Lord Hoffman argued that “something must have gone wrong with the language” in the ARP clause, and argued (on the basis of previous cases) that:

In such a case, the law did not require a court to attribute to the parties an intention which a reasonable person would not have understood them to have had.

“To interpret the definition of ARP in accordance with ordinary rules of syntax makes no commercial sense”, Hoffman continued. It was therefore open the court to apply “red ink” to the contract, rejigging the wording so that it accomplished what the court took to have been the parties’ mutual intention. He continued:

There is not, so to speak, a limit to the amount of red ink or verbal rearrangement or correction which the court is allowed. All that is required is that it should be clear that something has gone wrong with the language and that it should be clear what a reasonable person would have understood the parties to have meant.

There are a number of lessons for those involved in negotiating complex commercial agreements, not least IT contracts, to take from this:

  1. Those drafting clauses of this nature would probably be advised to make sure the agreement makes some reference to the commercial purpose for the clause. It is now clear that the courts will take this into account and, where the actual wording of the contract is wildly at odds with the stated purpose, may allow the commercial purpose to override the literal wording.
  2. One point not mentioned by the court, but which is apparent from the wording of the ARP clause: this looks like an attempt to turn a mathematical formula into legal text. In the process, “something has gone wrong”, as Lord Hoffman put it. There is a reason why mathematicians abandoned prose centuries ago in favour of formulas, and lawyers would do well to learn from them. Where a mathematical formula needs to be applied, why not just put that in the contract rather than attempting a translation into legal prose?
  3. I have no idea of the circumstances in which the ARP clause was worded, but my mental picture is of a hard-fought negotiation, possibly going well into the night, in which words were added into and out of the clause, but no-one had the time or presence of mind to try to put a few numbers through the clause to see if it worked. Those circumstances are almost unavoidable – but lawyers in particular would do well to try to keep a cool head when involved in such negotiations. While Persimmon may have won this case, the possibility that they might lose this dispute – at a cost of over £3.5m in additional ARP – may well have caused their lawyers a few sleepless nights, not to mention a claim on their PI insurance.
  4. Finally, does this case (as some have suggested) strike a blow against certainty of contract? This case does provide another weapon for commercial litigators to employ when faced with a clause whose literal interpretation is deeply unhelpful for their client. However, Lord Hoffman’s judgment makes it clear that the court will only depart from the literal interpretation where the literal wording “appear[s] arbitrary and irrational”, not where it merely represents a “bad bargain” for one party.