The UK Supreme Court has recently overturned a much-criticised and controversial ruling of the Court of Appeal by finding an ambiguously worded advance payment bond effective in the case of insolvency. In doing so, it clarified the proper role and application of considerations of business common sense when interpreting commercial contracts. Where a clause is capable of two or more possible interpretations, Rainy Sky SA v Kookmin Bank held that the court should prefer the one which is most consistent with common business sense. Furthermore, only where the parties have used wholly unambiguous language should a commercially improbable result be upheld.
In May 2007, Jinse Shipbuilding Co Ltd, a company incorporated in South Korea, contracted to build a ship each for Rainy Sky SA and five other buyers under separate shipbuilding contracts. Jinse was to be paid for each vessel in five equal instalments of US$6,600,000. Under clause X.(8) of each of the contracts, it was a condition precedent of each buyer's payment of the first instalment that Jinse would deliver a refund guarantee relating to the instalments to each buyer. Accordingly, Kookmin Bank issued six materially identical advance payment bonds in favour of the buyers.
In August 2007, the buyers each paid the first instalment. In September, Rainy Sky paid a second instalment. In 2008, Jinse experienced financial difficulties and in late January 2009 it became subject to a debt workout procedure under Korean law. Under clause XII.(3) of the shipbuilding contracts, the buyers had a right to require Jinse to refund the full amount of all sums paid by them if Jinse became subject to certain insolvency proceedings. Accordingly, in January 2009, the buyers sought to exercise this right. Jinse refused on the basis that the right had not been triggered. This dispute was submitted to arbitration.
The buyers then sought to claim the refund from Kookmin under the terms of the advance payment bonds. Kookmin refused to pay on the basis that it was not obliged to do so until the dispute between the buyers and Jinse had been resolved. This argument was rejected at first instance. However, Kookmin also argued that it was not liable to pay on strict construction of the terms of the bonds.
The two key clauses in the advance payment bond were as follows:
Clause 2: "...[the buyer] is entitled, upon [the buyer's] rejection of the Vessel in accordance with the terms of the Contract or [the buyer's] termination, cancellation or rescission of the Contract or upon a Total Loss of the Vessel, to repayment of the pre-delivery instalments of the Contract Price paid by [the buyer] prior to such termination or a Total Loss of the Vessel..."
Clause 3: "In consideration of [the buyer's] agreement to make the pre-delivery instalments under the Contract...,...as primary obligor...[Kookmin Bank] undertakes to pay to [the buyer] all such sums due to [the buyer] under the Contract." [our emphasis]
The issue was whether the sums which Kookmin had undertaken to pay in Clause 3 included instalments which the buyers had paid but sought to recover through Jinse's insolvency proceedings pursuant to clause XII.(3).
The buyers argued that "such" in "all such sums" was a reference to all "pre-delivery instalments", as referenced at the start of Clause 3, and consequently that they were entitled to a refund from Kookmin in any of the circumstances which entitled them to a refund under the shipbuilding contracts, including the exercise of the right under clause XII.(3).
Kookmin argued that "such" was a reference back to Clause 2 and consequently the buyers were only entitled to the refund under the bond in the circumstances expressly referred to in Clause 2, namely upon termination, cancellation or rescission of the contract, or on rejection or a total loss of the vessel.
First instance and Court of Appeal
At first instance, the judge favoured the buyers' interpretation, but the Court of Appeal overturned this decision by a majority. Patten LJ, in the majority judgment, noted that if the buyers' interpretation was accepted, Clause 2 of the terms of the bond became superfluous. He held that Kookmin's interpretation was the natural one and was consistent with the terms of Jinse's obligation to provide a bond under clause X.(8).
Although this would seem to produce the uncommercial result that the buyers had a bond which failed to protect them against Jinse's insolvency, Patten LJ stated that "unless the natural meaning of the words produces a result which is so extreme as to suggest that it was unintended, the Court has no alternative but to give effect to its terms. To do otherwise risks imposing obligations on one or other party which they were never willing to assume and in circumstances which amount to no more than guesswork on the part of the Court." Both parties, he contended, were well-advised, commercial organisations who could have drafted the bonds differently if they had been intended to cover all the circumstances in which repayment arose in the underlying contracts.
By a unanimous decision, the Supreme Court rejected Patten LJ's reasoning and found in favour of the buyers. Lord Clarke, with whom the four other Lords agreed, found that the competing arguments between the two interpretations were more finely balanced than Patten LJ suggested. Both interpretations were arguable because both had weaknesses in their construction. Kookmin's interpretation, he stated, was not, as Patten LJ had found, consistent with the terms envisaged under the contract; clause X.(8) did not dictate the final form of the bonds which, at the time of the contract, was "yet to be agreed" and was to be in a form acceptable to the buyers' financiers (as part of an annex that was never created). Focusing only on the language of the terms of the bond, Lord Clarke preferred the buyers' construction.
In any event, however, the crucial principle identified by Lord Clarke was that where there are two possible constructions of a clause, the court is entitled to prefer the construction which is consistent with business common sense, and to reject the other. It was necessary for courts, he suggested, to attribute meanings to clauses which accord with commercial business sense. Only where a commercially improbable result flows from unambiguous language should it be upheld. He also affirmed previous case law which is clear that if the language is capable of more than one construction, it is not necessary to conclude that a particular construction would produce an absurd or irrational result before having regard to the commercial purpose of an agreement. In this case, he determined, Clause 3 of the terms of the bonds was capable of more than one interpretation, but Kookmin's interpretation flouted business common sense. Jinse's insolvency was the situation for which the security of an advance payment bond was most likely to be needed and there was no credible commercial reason for it to have been excluded from the scope of the bonds. Accordingly, he decided in favour of the buyers.
The different rationales of the Court of Appeal and the Supreme Court are revealing. The latter has a far stronger view of the ability of a court to impose its view of what represented commercial sense on the interpretation of the contract. It is also consistent with a single interpretative approach which places commerciality at the centre of the courts' construction armoury rather than relegating it to a second stage of analysis, to be taken after a textual analysis of the contract. The judgment is clear that this approach will be followed where the "more natural meaning" of a clause produces a commercially absurd or irrational result, where there is some ambiguity, or where a choice is to be made between two equally balanced textual conclusions.
This is, in large part, a confirmation of what was understood to be the law, although even this bolstering of the principle will bring with it challenges in its practical application. As always the solution lies in clear drafting.