Daniel Hemming November 15 2011 Common sense counts when construing commercial contracts RPC | Litigation - United Kingdom Daniel Hemming Litigation FactsRelevant terms of bondsBusiness common senseCorrect construction CommentIn Rainy Sky SA v Kookmin Bank ( UKSC 50) the Supreme Court provided useful guidance on the role of business common sense in construing a clause in a commercial contract, particularly in circumstances where there are competing plausible constructions, neither of which is clearly preferable on the language used alone.Facts On May 11 2007 the first to sixth appellants entered into separate contracts with Jinse Shipbuilding Co Ltd under which it agreed to build and sell a vessel to each of them. The price of each vessel was $33.3 million, payable in five equal instalments of $6.66 million, with the final instalment payable on delivery. It was a condition precedent to payment of the first instalment that the shipbuilder deliver a refund guarantee to each buyer in a form acceptable to the buyers' financiers. On August 22 2007 the respondent bank issued an advance payment bond to each of the buyers. The seventh appellant was the assignee of the benefit of the bonds.The buyers had each paid the first instalment (and one buyer had also paid the second) when, in late January 2009, the shipbuilder became insolvent. The buyers notified the shipbuilder that this triggered an obligation under Article XII.3 of the contracts (which dealt with the insolvency of the shipbuilder) to repay the instalments received. The shipbuilder refused and the dispute was submitted for arbitration. The buyers demanded repayment of the instalments paid from the bank under the bonds. The bank refused on the grounds that: it was not obliged to pay until the dispute between the buyers and the shipbuilder was resolved; and in any event, the bonds did not cover refunds in the event of insolvency under Article XII.3 of the contracts. Both arguments were rejected in the High Court and summary judgment was given for the appellants. The bank appealed on the second ground only; the Court of Appeal allowed this appeal by a majority of two to one. The appellants appealed to the Supreme Court. The only question for determination was whether, on a true construction of the bonds, the buyers were entitled to payment under the bonds of refunds to which they were entitled under Article XII.3 of the contracts.Relevant terms of bonds The bonds took the form of a letter from the bank to the buyers. Among other things, it provided as follows:" Pursuant to the terms of the Contract, you are entitled, upon your rejection of the Vessel in accordance with the terms of the Contract, your 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 you prior to such termination or a Total Loss of the Vessel…  In consideration of your agreement to make the pre-delivery instalments under the Contract and for other good and valuable consideration… we hereby, as primary obligor, irrevocably and unconditionally undertake to pay you, your successors and assigns, on your first written demand, all such sums due to you under the Contract." (Emphasis added.)The question of construction was simply whether the phrase "all such sums" in the final line of Paragraph 3 referred to the pre-delivery instalments in the first line of that paragraph or to the sums to which Paragraph 2 referred.If it referred to the pre-delivery instalments in Paragraph 3, the bank would be obliged to repay them irrespective of how they became due under the contracts, including in the event of the shipbuilder's insolvency. However, if the phrase referred to the sums in Paragraph 2, the obligation arose only in the narrower circumstances of termination of the contract or the total loss of the vessel, and not in the event of the shipbuilder's insolvency.Business common sense The parties accepted that both constructions were plausible. Therefore, the key issue became the extent to which it was permissible to rely on considerations of business common sense in choosing between the two plausible constructions. The appellants argued that it flew in the face of business common sense to suppose that the buyers would have accepted bonds that did not protect against the shipbuilder's insolvency, which was the most likely trigger of default. Therefore, their construction should be preferred.The majority of the Court of Appeal considered that on the natural meaning of the words used, and without considering the issue of business common sense, the bank's construction was preferable. The court then refused to rely on business common sense to displace this construction. It stated that:"Unless the most 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 would be to risk 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."The Supreme Court unanimously rejected this proposition, restating the correct approach to construction and the role of business common sense as follows: The exercise of construing a contract is unitary. The court considers the language used to ascertain what a reasonable person would have understood the parties to have meant. The relevant reasonable person is one who has all the background knowledge which would reasonably have been available to the parties at the time of the contract. Where the parties have used unambiguous language, the court must apply it even if the effect of this language is at odds with business common sense. However, if there are competing plausible constructions, the court can prefer the construction which is consistent with business common sense even if, focusing only on the language used, this is the less natural meaning. Correct construction The Supreme Court agreed with the parties that both constructions of the bonds were plausible. The problem with the buyers' construction was that it was difficult to discern a purpose for Paragraph 2 if the words "all such sums" in Paragraph 3 referred back the first line of that paragraph. The strength of the construction was that it was more straightforward, reducing the bank's promise to that of repaying the pre-delivery instalments as they became due under the contracts, whereas the scope of Paragraph 2, and therefore the circumstances in which liability would be triggered under the bonds on the bank's construction, were far less clear.Following a careful analysis of the bonds and some of the relevant terms of the contracts, the Supreme Court concluded that, looking at the agreements as a whole and focusing only on the natural meaning of the words used, the buyers' construction was to be preferred. However, had the bank's construction been preferable on the language (as the Court of Appeal had found), it would have been appropriate to displace this given the commercially surprising result - namely, that it would not cover the insolvency of the shipbuilder, which was the situation for which the security of an advance payment bond was most likely to be needed. If such a result had been intended, the bonds should have made this clear. The appeal was therefore allowed.Comment Given that the Supreme Court preferred the buyers' construction on the language used alone, the comments on business common sense were unnecessary for the decision reached. However, the court was clearly anxious to correct what it considered to be an inaccurate statement of the principles of contractual construction by a majority of the Court of Appeal, and to restate the effect of previous authorities on the point. Considerations of business common are a significant tool to use when determining what a reasonable person would have understood the parties to have meant by a contractual clause and, as such, form part of the normal principles of construction.For further information on this topic please contact Daniel Hemming at RPC by telephone (+44 20 3060 6000), fax (+44 20 3060 7000) or email ([email protected]).