On March 29 2017 the Supreme Court handed down its judgment in Wood v Capita Insurance Services Limited.(1) In that case the Supreme Court, when faced with two competing interpretations of a contractual indemnity, chose the interpretation that fitted best with the words that the parties had used, notwithstanding that it resulted in an apparently arbitrary distinction between what was and was not indemnified and was a bad bargain for one party. Five weeks after that judgment was handed down, Lord Sumption – a Justice of the Supreme Court – delivered a lecture on the topic of the interpretation of contracts at Keble College, Oxford, which set out his view of the recent history, and perhaps future, of English law.(2)
In the first part of his lecture, Sumption described the shift in English law in the late 20th century from a focus on the language used by the parties to using the "surrounding circumstances" and "commercial common sense" as tools to elucidate the meaning of contractual provisions.
The first of these was cemented by Lord Hoffman's famous judgment in Investors Compensation Scheme Limited v West Bromwich Building Society, in which he set out five principles governing the interpretation of contracts.(3) These included a concept of meaning as something distinct from the language used, namely what the document would convey to a reasonable person against the relevant background. This background, Hoffman explained:
"may not merely enable the reasonable man to choose between the possible meanings of words which are ambiguous but even (as occasionally happens in ordinary life) to conclude that the parties must, for whatever reason, have used the wrong words or syntax."
Building on this, Hoffman said that:
"if one would… conclude from the background that something must have gone wrong with the language, the law does not require judges to attribute to the parties an intention which they plainly could not have had."
In his lecture, Sumption paraphrased these principles as being that "the background may not only enable one to choose between possible meanings of the words, but to select impossible ones instead" and that "background may be used to show that the parties cannot as reasonable people have meant what they said, so that the court is entitled to substitute something else". This had led to the courts "treating the background circumstances as an alternative guide to the parties' intentions instead of a means of interpreting their language".
In Sumption's opinion, Hoffman's approach reached its zenith in Rainy Sky v Kookmin Bank,(4) which was a dispute about whether a guarantee given by the bank in connection with a shipbuilding contract covered certain advance instalments paid under that contract. The Supreme Court rejected the proposition (on which a majority of the Court of Appeal had relied) 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, the Supreme Court held that, where there are competing possible interpretations, the court may prefer the one which is most consistent with "business common sense". The Supreme Court held that, on the language used alone, the choice between the two competing constructions was finely balanced but the wider interpretation, to the effect that all the advance instalments were guaranteed, was preferable. However, had the narrow interpretation been the more natural meaning, this would nevertheless have been displaced because the wider interpretation was more consistent with the commercial purpose of the guarantee and the bank had advanced no credible commercial reasons for the narrow interpretation (which excluded certain instalments from the scope of the guarantee).
Having set out that history, Sumption explained his four objections to this wider and more flexible approach to the interpretation of contracts represented by ICS and Rainy Sky:
- The language of the parties' contract, read as a whole, is the only direct evidence of their intentions which is admissible. It follows that language should have primacy in the interpretation of contracts.
- It is difficult to make use of the surrounding circumstances to modify the use of language where the use of pre-contractual negotiations as evidence of the parties' intentions is excluded (which exclusionary rule follows from the objective nature of contract interpretation). It leaves judges in the position of having to speculate about why a party might have agreed a term that appears uncommercial or contrary to common sense when the one source of information that would provide the actual answer is unavailable.
- Judges are not necessarily well placed to determine what commercial common sense requires. Such notions of common sense will end up being shaped by fairness, which has nothing to do with commercial contracts.
- The broader and more flexible approach, by which the court can sidestep the language used by the parties apparently as part of the process of interpreting the contract, makes the doctrines of implied terms and rectification largely redundant.
Sumption suggested that the Supreme Court is now retreating from the wider and more flexible approach, first citing Arnold v Britton.(5) In Arnold, Lord Neuberger, giving the judgment of the majority of the court (and with whom Sumption agreed in that case), set out seven factors relevant to the interpretation of contracts. The first of these was that:
"the reliance placed in some cases on 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."
The judgment went on to express certain specific limitations on the use of commercial common sense.
Sumption conceded in his lecture that the Supreme Court's retreat is being sounded "in rather muffled tones", given that Arnold does not overrule or criticise ICS or Rainy Sky. However, he concluded his lecture by suggesting that Wood v Capita is "an indication of the new direction of travel", given that a unanimous Supreme Court upheld a "harsh" result based on a strict examination of the language of the contract.
While Sumption may be right that the Supreme Court's decision in Wood is indicative of a new direction, if it is, Lord Hodge's judgment (with which Sumption also agreed in that case) is even less willing to acknowledge that than the "muffled tones" of Arnold. The judgment in Wood went further than that, rejecting much of the recent history of English law on the interpretation of contracts that was set out by Sumption in his lecture. Hodge stated that "It is not appropriate in this case to reformulate the guidance given in Rainy Sky and Arnold; the legal profession has sufficient judicial statements of this nature". He went on to explain why he did not accept "the proposition that Arnold involved a recalibration of the approach summarised in Rainy Sky" or that ICS represented a break with the past.
Ultimately, Hodge is probably correct that the legal profession has enough statements of the principles of the interpretation of contracts to be getting on with. Whether Arnold and Wood represent a change in direction will ultimately be borne out in how those cases are applied by the lower courts. The acid test for that will be whether we now see an increase in outcomes on disputed points of interpretation that can be described as harsh but true to the language used.
This article was first published by the International Law Office, a premium online legal update service for major companies and law firms worldwide. Register for a free subscription.
For further information on this topic please contact Simon Hart or Daniel Hemming at RPC by telephone (+44 20 3060 6000) or email (firstname.lastname@example.org or email@example.com). The RPC website can be accessed at www.rpc.co.uk.
(1)  UKSC 24. For further details please see "Another bad bargain upheld: Wood v Sureterm Direct Ltd".
(2) "A Question of Taste: The Supreme Court and the Interpretation of Contracts" (May 8 2017), available at www.supremecourt.uk/docs/speech-170508.pdf.
(4)  1 WLR 2000. For further details please see "Common sense counts when construing commercial contracts".