In the case of Arnold v Britton the Supreme Court has again had occasion to consider the principles governing the interpretation of contracts. This is the fourth time in a decade that this subject has been considered at the highest level. The decision is important because it re-visits the question of how far the courts should allow themselves to be guided by commercial common sense in construing the language used by the parties in their agreement.
The basic approach taken by English law to the interpretation of contracts has not been in doubt for some time. That approach treats the written document as an objective record of the terms agreed by the parties. It relies on that foot soldier of the common law, the reasonable man. The court’s task is to ascertain the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract: Investors Compensation Scheme Limited v West Bromwich Building Society.
As the House of Lords made clear in the ICS case, the background, or ‘matrix of fact’ as it is sometimes referred to, includes absolutely anything which was reasonably available to the parties at the time and would have affected the way the reasonable man would have understood the language of the document, except for evidence of the negotiations between the parties and statements of subjective intent.
In Chartbrook v Persimmon the House of Lords reiterated that the process of interpretation seeks to establish 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 was no reason not to give effect to what they appear to have meant. Lord Hoffmann said at paragraph 1114G: “What is clear…is that 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.”
However, there are limits to this. The court can only get out its red pen if it concludes that the words used by the parties do not accurately reflect their true intentions. It is not the court’s job to start looking for mistakes and ambiguities in the language used by the parties in order to relieve one of them of the consequences of a bad bargain: see Attorney General of Belize v Belize Telecom Ltd at paragraph 16 per Lord Hoffmann.
The courts have long been prepared to have regard to the commerciality of competing interpretations in deciding how the reasonable man would have understood the words used by the parties. Indeed, Lord Diplock put it rather more forcefully in Antaios Compania Naviera SA v Salen Rederierna AB at paragraph 201: “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”.
Recourse to commercial (or business) common sense does, however, bring with it a risk of introducing uncertainty into the process of contractual interpretation. An interpretation which strikes one judge as sensible from a commercial perspective may be regarded by another as absurd. The Chartbrook case is a good example: an interpretation, which was regarded by the trial judge and two judges in the Court of Appeal as perfectly commercial, was eventually characterised as ‘arbitrary and irrational’ by the House of Lords.
Not surprisingly, therefore, some judges have sounded a note of caution. Neuberger LJ (as he then was) warned in Skanska Weatherfoil Ltd v Somerfield Stores Ltd: “Judges are not always the most commercially minded, let alone the most commercially experienced, of people, and should, I think, avoid arrogating to themselves overconfidently the role of arbiter of commercial reasonableness or likelihood”(paragraph 22).
The role of commercial common sense in interpreting contracts was, however, confirmed more recently by the Supreme Court in the case of Rainy Sky SA & Ors v Kookmin Bank. In that case Lord Clarke (with whom the rest of the court agreed) confirmed (at paragraph 21) that, if the language used by the parties admits of more than one construction, the court is entitled to prefer the construction which is consistent with business common sense and reject the other. He did stress, however, that “where the parties have used unambiguous language, the court must apply it” (paragraph 44).
The Scottish case of Aberdeen City Council v Stewart Milne Group Ltd involved a contract for the sale of land, which provided for additional consideration to be paid by the purchaser to the vendor on disposal. The contract appeared, on its face, not to have catered for the circumstances that had arisen (ie a disposal of land at an undervalue to an associated company of the defendant). From the contract as a whole, however, the court was able to establish that the parties must have intended that the additional consideration payable to the vendor would be calculated by reference to the open market value rather than the actual proceeds. In the Supreme Court Lord Hope DPSC regarded the fact that this interpretation made good commercial sense as ‘simply a makeweight’ (paragraph 22).
In similar vein, in BMA Special Opportunity Hub Fund & Ors v African Minerals Finance Ltd the Court of Appeal warned that commercial common sense was not ‘to be elevated to an overriding criterion of construction’, and that ‘the parties ‘should not be subjected to the individual judge’s own notions of what have been the sensible solution to the parties’ conundrum’ (paragraph 24).
Arnold v Britton concerns the interpretation of a service charge clause in chalet leases in a holiday park on the Gower Peninsula (the park).
Each lease contained a covenant by the landlord to provide services to the park and a covenant by the tenants to pay a service charge (clause 3(2)). There were, however, two main types of service charge provision across the leases. Seventy leases had been granted in the early 1970s, 66 of which included a service charge provision in which the initial service charge of £90 per annum was to be increased on a compound basis by 10% every three years (the earlier leases). This is roughly equivalent to a compound rate of 3% per annum.
The remaining four leases, and a further 21 leases which were entered into between 1977 and 1991 (the leases) ultimately had a different service charge provision at clause 3.2 (the clause). The language of the clause differs in small respects between the leases, but the Supreme Court gave the following as a typical example: "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 renewal 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” (paragraph 7).
The current owner of the park and landlord under the leases argued that this clause represented a fixed annual service charge of £90 in the first year, increasing at a compound rate of 10% in each succeeding year. The appellants, the current tenants under 24 of the 25 leases, contended that this construction resulted in such an absurdly high annual service charge in the later years of the leases that it must be wrong. In real terms, it would equate to an annual service charge of over £550,000 by 2072. The total amount payable under each lease from December 2013 to the end of the term in 2071 would be £11,238,016 (compared to £53,386 under the earlier leases).
The appellants argued that the clause required them to pay a fair proportion of the respondent's costs of providing the services, subject to a maximum, which is £90 in the first year of the term, and increases every year by 10% on a compound basis. In effect, the appellants argued that the words "up to" should be read into the clause, between the words "hereinafter set out" and "the yearly sum of ninety pounds". That interpretation had found favour with the first instance judge (HHJ Jarman QC), but was rejected on appeal by Morgan J and again by the Court of Appeal.
A majority of the Supreme Court (Lords Neuberger, Sumption, Hodge and Hughes) dismissed the tenants’ appeal, with Lord Carnwath the sole voice of dissent.However, Lord Neuberger had “considerable sympathy” for Lord Carnwath’s “powerful” reasons (paragraph 62), and Lord Hodge described the outcome as “highly unsatisfactory” for the appellants (paragraph 66). Why then did the majority adopt a literal rather than liberal approach to construction?
When considering the correct approach to the construction of contracts, Lord Neuberger emphasised seven factors, summarised below (paragraphs 17 - 23):
In essence, the appeal failed because the majority considered that the natural meaning of the words used in the clause was clear, “at least until one considers the commercial consequences” (paragraph 24): the first half of the clause provides that the lessee is to pay an annual service charge, and the second half of the clause identifies how that service charge is to be calculated. In Lord Neuberger’s view, were it not for the “plainly unattractive, indeed alarming” consequences of the compound annual increases, coupled with the subsequent history of inflation in the UK, “that would be the end of it” (paragraph 30).
Lord Neuberger was also unpersuaded by the commercial argument that no lessee would have agreed a service charge provision with that effect, at least in the 1970s and much of the 1980s. At a time when annual inflation had been running at a higher rate for a number of years, a lessee could have taken the view that a fixed rate of increase of 10% per annum on a fixed initial service charge was attractive or at least acceptable. The appellants therefore fell foul of Lord Neuberger’s view that “the mere fact that a contractual arrangement… has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language” (paragraph 19).
Lord Carnwath in his dissenting judgment saw more of a Rainy Sky over the Gower Peninsula. His detailed dissenting judgment is perhaps best encapsulated by what he viewed as “the essential question: what in the view of a reasonable observer did clause 3(2) mean?” (paragraph 158). He regarded the consequences of the respondent’s interpretation as “so commercially improbable that only the clearest words would justify the court in adopting it”. He agreed with HH Judge Jarman QC that the appellants’ construction did “not do such violence to the contractual language as to justify a result which is commercial nonsense”.
This decision does not represent a radical departure from what was said in Rainy Sky about commercial common sense. Both decisions underline the primacy of the words used by the parties. If those words are unambiguous, the court must give effect to them, no matter how uncommercial the result. The majority took the view that the words used in the service charge clause were unambiguous; Lord Carnwath, on the other hand, considered that something clearly had gone wrong with the words and that the court was therefore entitled to re-write them so as to achieve a sensible result.
This decision is, however, less enthusiastic in its embrace of commercial common sense than Rainy Sky was. Lord Neuberger’s observations about the limits on the role that commercial common sense should be allowed to play in the process of interpretation are consistent with the reservations he had expressed previously (as Neuberger LJ) in the Skanska case.
Furthermore, the approach of the majority may also be characterised as more conservative with regard to the amount of ‘violence’ that may be done to the words used by the parties in order to bring them into line with their intentions. Contrary to what Lord Hoffmann said in Chartbrook, it would seem that there are indeed limits to the amount of red ink that the court is allowed.
This article was published in Commercial Litigation Journal in September 2015.