In the recent case of Arnold v Britton and others [2015] UKSC 36, the Supreme Court has restrained the recent approach of applying commercial common sense when interpreting contracts.

Development of business common sense approach

Commercial common sense as an aid to interpretation was propagated by Lord Hoffmann, first inInvestors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896 and then more recently in Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 1101. This approach was developed further by the Supreme Court in Rainy Sky S.A. & Ors v Kookmin Bank [2011] UKSC 50. InRainy Sky the Supreme Court held that, where language used in a contract has more than one potential meaning, it is generally appropriate to adopt the construction that is most consistent with business common sense. Since Rainy Sky parties routinely argue commercial common sense in support of their construction of disputed terms in contracts.

The recent decision in Arnold follows Lord Neuberger’s comments in Marley v Rawlings [2014] UKSC 2 last year. In Marley Lord Neuberger described Lord Hoffmann’s approach as “controversial” and highlighted academic commentary at the time which suggested that adopting Lord Hoffmann’s approach to contractual interpretation diminished the difference between interpretation and rectification of contracts. The difference is key because interpretation of contracts requires the court to determine the meaning and effect of a contract whereas rectification involves giving the contract a different meaning from that which it appears to have on its face and will result in the change of actual words used.

Rules of construction

In Arnold Lord Neuberger, giving the leading judgment, summarised that when interpreting a contract the court should identify the intention of the parties by reference to what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean. The court then set out the following aids to construction:

  1. The clause in dispute should be given its natural and ordinary meaning.
  2. Any other relevant provisions of the agreement should be taken into consideration. 
  3. The overall purpose of the clause in dispute and the agreement should be considered. 
  4. Facts and circumstances known or assumed by the parties at the time that the document was executed are admissible. 
  5. Commercial common sense can be applied. 
  6. The subjective evidence of any party’s intentions should be disregarded.

Commercial common sense - restricted

In the only dissenting judgment, Lord Carnwath recognised that there is often a tension between the principle that the parties’ common intention should be derived from the words they used and the need to avoid a nonsensical result.

Lord Carnwath emphasised that in Rainy Sky Lord Clarke had specifically rejected the previous proposition that unless the natural meaning of the words produces a result so extreme as to suggest that it is unintended, the court must give effect to that meaning. Lord Clarke’s view in Rainy Sky was that it was only if the words were unambiguous that the court had no choice in the matter.

Whilst the court accepted that commercial common sense was an aid to construction, Lord Neuberger (with whom the majority agreed) emphasised the following, to restrict the extent to which the court can rely on commercial common sense as an aid to depart from the actual language used in a contract:

  1. Commercial common sense and surrounding circumstances should not be invoked to undervalue the importance of the language of the provision which is to be construed.
  2. The clearer the natural meaning of the words in the contract the more difficult it is to depart from it.
  3. Commercial common sense is not to be invoked retrospectively. The mere fact that the natural meaning of a contract leads to a disastrous result for one party is not a reason for departing from the natural language.
  4. The purpose of interpretation is to identify what the parties have agreed not what they should have agreed. A court should be slow to depart from the natural meaning simply because it appears to be an imprudent term for one of the parties, even at the time that they entered into it. As Lord Hodge highlighted, there must nevertheless be a basis in the words used and the factual matrix for identifying a rival meaning.
  5. When interpreting a contract, only those facts or circumstances which existed at the time that the contract was made and which were known or reasonably available to both parties should be taken into account.  It was not right to take into account a fact or circumstance known only to one of the parties.
  6. When an event occurs which, judging from the language used, was plainly not intended or contemplated by the parties, the court will give effect to the intention of the parties, if it is clear what the parties would have intended in that situation.

Conclusion

The decision in Arnold emphasises the importance of the actual words used in a contract. 
The court highlighted that, unlike commercial common sense, the parties have control over the words they use in a contract and are focussed on the issue covered by a provision when agreeing the words of that provision.

Lord Neuberger’s approach reinforces the distinction between a claim for interpretation of a contract and rectification of a contract. However, Lord Carnwath (who gave the dissenting judgment) noted that this distinction was unnecessary and unhelpful. Lord Carnwath's view was that interpretation of contracts and correction of mistakes were aspects of the same task of interpreting a contract in its context, in order to get as close as possible to the meaning which the parties intended. Lord Carnwath also considered that implication of terms to give business efficacy to a contract was another permissible route for the court to achieve a commercially sensible result in cases of intractable language in a contract.

It is likely that Lord Neuberger’s approach may result in additional claims for rectification of a contract in the alternative to a claim for interpretation of a contract. A key practical effect of this is that when seeking rectification, parties are entitled to rely on evidence of the parties’ negotiations at the time the contract was entered into, which would not be the case in a claim for contractual interpretation.

More interestingly, Lord Neuberger’s approach may herald the start of a trend away from the increasingly commercial construction of contracts towards a more traditional ‘black letter’ analysis of contracts.

Please click here for a copy of the judgment.