This is the full version of a shorter article that first appeared in Sharpe Focus 20 in October 2017.

In March this year, the Supreme Court handed down a judgment that has quickly become the final piece of a triumvirate of statements on the common law principles of contract interpretation.

Following on from Rainy Sky SA v Kookmin Bank [2011] UKSC 50 and Arnold v Britton [2015] UKSC 36 came Wood v Capita Insurance Services Ltd [2017] UKSC 24, ostensibly all saying the same thing in different ways.

This article revisits the trio of Supreme Court cases and the new status quo they have created.

Rainy Sky SA v Kookmin Bank [2011] UKSC 50

It all began with some boats. Six clients paid instalments in advance and the shipbuilder issued refund guarantee bonds. Before completing the boats the shipbuilder got into financial difficulty and then refused to refund the instalments paid by the six clients. Cue legal proceedings and a debate over the proper construction of the drafting in the bonds.

The specific text of the bonds was as follows:

“2. 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 (as the case may be) and the value of the buyer’s supplies delivered to the shipyard (if any) together with interest thereon at the rate of … (7%) per annum (or … (10%) per annum in the case of a total loss of the vessel) from the respective dates of payment by you of such instalments to the date of remittance by telegraphic transfer of such refund.

3. In consideration of your agreement to make the pre-delivery instalments under the contract and for other good and valuable consideration (the receipt and adequacy of which is hereby acknowledged), we hereby, as primary obligor, irrevocably and unconditionally undertake to pay to you, your successors and assigns, on your first written demand, all such sums due to you under the contract (or such sums which would have been due to you but for any irregularity, illegality, invalidity or unenforceability in whole or in part of the contract) provided that the total amount recoverable by you under this bond shall not exceed [US$26,640,000] … plus interest thereon at the rate of … (7%) per annum (or … (10%) per annum in the case of a total loss of the vessel) from the respective dates of payment by you of such instalments to the date of remittance by telegraphic transfer of such refund.”

The debate revolved around two possible meanings of “such sums” in the phrase “all such sums due to you under the contract” in paragraph 3. The buyers said it referred to the pre-delivery instalments in the first line of paragraph 3. The bank said it referred to the pre-delivery instalments in paragraph 2. The difference between these two interpretations was everything – owing to clause XII.3 of the contract (relating to insolvency events) the buyer’s interpretation would mean the pre-delivery instalments were repayable when the shipbuilder hit financial difficulty, whereas the bank’s interpretation would mean the instalments were not repayable in such circumstances.

Lord Clarke reviewed the case law and summarised, drawing on Lord Neuberger, that the “the ultimate aim of interpreting a provision in a contract, especially a commercial contract, is to determine what the parties meant by the language used, which involves ascertaining what a reasonable person would have understood the parties to have meant.” This reasonable person is, Lord Hoffman suggests, “one who has 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.”

Given that the two interpretations were both possible constructions, the answer hinged on the role of business common sense. Lord Clarke said “[i]t is not in my judgment necessary to conclude that, unless the most natural meaning of the words produces a result so extreme as to suggest that it was unintended, the court must give effect to that meaning.” Instead, “if there are two possible constructions, the court is entitled to prefer the construction which is consistent with business common sense and to reject the other.” Only “[w]here the parties have used unambiguous language, the court must apply it.”

Applying these principles to the case at hand, Lord Clarke held that there was “no very good reason” for the inclusion of paragraph 2 in the bonds other than to give context to paragraph 3. However, “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 the agreement.”

Lord Clarke agreed with Sir Simon Tuckey, the dissenting judge in the Court of Appeal judgment, when Sir Tuckey said:

“On the bank’s construction the bonds covered each of the situations in which the buyers were entitled to a return or refund of the advance payments which they had made under the contracts apart from the insolvency of the builder. No credible commercial reason has been advanced as to why the parties (or the buyers’ financiers) should have agreed to this. On the contrary, it makes no commercial sense. As the judge said, insolvency of the builder was the situation for which the security of an advance payment bond was most likely to be needed.”

Ultimately, Lord Clarke held that “the buyers’ construction is to be preferred because it is consistent with the commercial purpose of the bonds in a way in which the bank’s construction is not.”

Arnold v Britton [2015] UKSC 36

This author has a bone to pick with the Supreme Court on this one, but more on that later. This case concerned leases for chalets in a caravan park in south Wales. The contested clause in question was drafted slightly differently across the various leases but was broadly as follows:

“To pay to the lessors without any deductions in addition to the said rent as a proportionate part of the expenses and outgoings incurred by the lessors in the repair maintenance renewal and renewal of the facilities of the estate and the provision of services hereafter set out the yearly sum of £90 and VAT (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.”

The landlord contended that this provided for a service charge of £90 with 10% compound interest. The tenants contended that the clause required them to pay a fair proportion of the landlord’s costs of providing the services, and argued that the words “up to” should be read into the clause between “provision of the services hereafter set out” and “the yearly sum”.

The difference between the two positions was quite stark. Under the tenants’ interpretation, the service charge would forever be a fair proportion of the actual costs, with a maximum cap. Under the landlord’s interpretation, the service charge in 2072 would be a fixed cost of £1,025,004! There is a quote, attributed to Einstein but not verified, that says compound interest is “the most powerful force in the universe”.

Lord Neuberger reiterated the point from Rainy Sky, saying that the court must identify intentions by referring 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”. He set out his own framework for analysing meaning, stating that one must focus on “the meaning of the relevant words … in their documentary, factual and commercial context. That meaning has to be assessed in the light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provisions of the lease, (iii) the overall purpose of the clause and the lease, (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed, and (v) commercial common sense, but (vi) disregarding subjective evidence of any party’s intentions.”

Lord Neuberger gave his thoughts on the use of commercial common sense when interpreting a contract. It should not be used to undervalue the importance of the language of the provision, nor invoked retrospectively. “The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language.” At the time of the judgment in 2015 inflation was in the low single digits, but in 1974 when the leases were entered into inflation was averaging around 16%. In that context, 10% compound interest might seem a good bargain.

Perhaps slightly unforgivingly, Lord Neuberger said that “it is not the function of a court when interpreting an agreement to relieve a party from the consequences of his imprudence or poor advice”, even ignoring the benefit of hindsight. Given the average person’s lack of appreciation of the effects of compound interest, this may leave an inexperienced investor exposed. It is very similar to the recent ground rents scandal, where leasehold properties have been sold with a ground rent of £250 which doubles every 10 years. This may seem benign at first glance, but with a 125 lease the ground rent in years 120, 121, 122, 123, 124 and 125 will be £1,024,000 per year. The total sum payable over the 125 years is over £13m! This has effectively rendered the properties unsaleable and has trapped their owners in the spiralling ground rent situation. The sheer number of people who have recently bought new-build leasehold properties like this from Taylor Wimpey and other housebuilders suggests that both purchasers and legal advisers do not have an intuitive grasp of the consequences of this sort of maths. In the justices’ defence, they attempted to find something in the statute books that would assist the tenants, but none of the legislation offered any protections in the present case. Both Lord Neuberger and Lord Hodge suggested Parliament might consider extending the protections against unreasonable service charges. Until then, the courts can offer little help.

Which brings me to my bone. One argument that does not appear to have been offered in the case which may have saved the tenants is an analysis of the phrasing “ten pounds per hundred”, which has seemed curious to me since the judgment was delivered a couple of years ago. In my opinion it is absolutely not equivalent to 10%. There is only one full hundred in 150. There are three full hundreds in 378. There are 16 full hundreds in 1,609. If we apply “ten pounds per hundred” to these three examples we get £10, £30, and £160 respectively. If we apply 10% to the examples, we get £15, £37.80, and £160.90 respectively. Crucially, if we apply “ten pounds per hundred” to £90, we get £0. If the draftsman wanted to mean 10% she could have written 10%. The most likely explanation for using the unusual and unnecessarily cumbersome phrase “ten pounds per hundred” is that she did not mean 10%. The parties may well have agreed to the sum of £90 in full knowledge of the fact it would not trigger the “ten pounds per hundred” increase and therefore remain fixed at £90 for the lifetime of the leases. You may wonder why the draftsman did not just delete the offending words from the end of the clause, but you have to remember that this is in 1978, before widespread adoption of word processors. Deleting text was not as easy in those days and, with 91 chalets to draft leases for, the draftsman may just have chosen to leave the text in, assuming it would be redundant and harmless.

Ultimately, this argument was not run, the Supreme Court held that the landlord’s interpretation was correct, and this judgment was seen by some as a shift away from the purposive approach to contract interpretation employed in Rainy Sky and towards a more literal approach. This was to be denied by the Supreme Court two years later in Wood v Capita.

Wood v Capita Insurance Services Ltd [2017] UKSC 24

This case involved the sale and purchase of an insurance brokerage company. Following the sale, the company referred itself to the FSA for mis-selling products in the period prior to completion. The company agreed with the FSA to compensate the customers who had been affected. The buyer claimed against the seller under the following indemnity clause:

“The Sellers undertake to pay to the Buyer an amount equal to the amount which would be required to indemnify the Buyer and each member of the Buyer’s Group against all actions, proceedings, losses, claims, damages, costs, charges, expenses and liabilities suffered or incurred, and all fines, compensation or remedial action or payments imposed on or required to be made by the Company following and arising out of claims or complaints registered with the FSA, the Financial Services Ombudsman or any other Authority against the Company, the Sellers or any Relevant Person and which relate to the period prior to the Completion Date pertaining to any mis-selling or suspected mis-selling of any insurance or insurance related product or service.”

The two competing interpretations revolved around whether “claims or complaints registered with the FSA” included the company’s self-referral.

Lord Hodge took time to explain why Arnold did not involve a recalibration of the principles in Rainy Sky:

“The court’s task is to ascertain the objective meaning of the language which the parties have chosen to express their agreement. It has long been accepted that this is not a literalist exercise focused solely on a parsing of the wording of the particular clause but that the court must consider the contract as a whole and, depending on the nature, formality and quality of drafting of the contract, give more or less weight to elements of the wider context in reaching its view as to that objective meaning.”

Lord Hodge confirmed Lord Clarke’s assertion in Rainy Sky that interpretation is a unitary exercise, and “where there are rival meanings, the court can give weight to the implications of rival constructions by reaching a view as to which construction is more consistent with business common sense.” The quality of the drafting should also be considered. Lord Hodge also confirmed the balancing considerations put forward by Lord Neugberger in Arnold regarding the “possibility that one side may have agreed to something which with hindsight did not serve his interest” and “the possibility that a provision may be a negotiated compromise or that the negotiators were not able to agree more precise terms”. Ultimately, “[t]his unitary exercise involves an iterative process by which each suggested interpretation is checked against the provisions of the contract and its commercial consequences are investigated”.

The common law approach to contract interpretation is often said to be like a pendulum, but Lord Hodge elegantly rejected this, saying:

“Textualism and contextualism are not conflicting paradigms in a battle for exclusive occupation of the field of contractual interpretation. Rather, the lawyer and the judge, when interpreting any contract, can use them as tools to ascertain the objective meaning of the language which the parties have chosen to express their agreement. The extent to which each tool will assist the court in its task will vary according to the circumstances of the particular agreement or agreements.”

So, it depends, on a case by case basis. For legal advisers looking for a steer on when one approach might be more appropriate than the other, Lord Hodge had this, somewhat useful, guidance:

“Some agreements may be successfully interpreted principally by textual analysis, for example because of their sophistication and complexity and because they have been negotiated and prepared with the assistance of skilled professionals. The correct interpretation of other contracts may be achieved by a greater emphasis on the factual matrix, for example because of their informality, brevity or the absence of skilled professional assistance. But negotiators of complex formal contracts may often not achieve a logical and coherent text because of, for example, the conflicting aims of the parties, failures of communication, differing drafting practices, or deadlines which require the parties to compromise in order to reach agreement. There may often therefore be provisions in a detailed professionally drawn contract which lack clarity and the lawyer or judge in interpreting such provisions may be particularly helped by considering the factual matrix and the purpose of similar provisions in contracts of the same type.”

Turning to the indemnity clause, Lord Hodge said that, on its own, it may appear anomalous, but in the context of the rest of the agreement, it made more sense. One of the other clauses in the agreement “probably covered the circumstances which eventuated”, but they expired after two years. Thus, there was a remedy for the buyer for this particular outcome, but they had run out of time to rely on it. With that in mind, the restrictive nature of the indemnity clause was not contrary to business common sense. The court held that the indemnity clause was not triggered.

Comment

As Lord Hodge said in Wood, “[t]he recent history of the common law of contractual interpretation is one of continuity rather than change.” These judgments provide clear guidance on long-standing principles. Although at a glance these three cases may appear to be affording different weights to these principles, this is in fact justified by the particular facts of each case, and the overall approach is consistent across them all.