Disputes about what commercial contracts mean consume time and money that could be spent running a business, so the less scope there is for arguing that the express wording of the contract should be departed from the better.

The common denominator of the three landmark Supreme Court decisions of 2015 is respect for the language of the contract. In the first, the court refused to put a gloss on the words actually used in the contract. In the second, the court refused to imply a term into a contract where the language was clear. In the third, the language used was enforced, with the court refusing to strike down the disputed clause as an unenforceable penalty.

Lord Neuberger gave leading judgments in all three cases:

  1. Arnold v Brittan on contract interpretation, which restates the rules for interpreting written contracts
  2. M&S v BNP Paribas, which restates the law on implying terms into contracts
  3. Cavendish v Makdessi; Beavis v ParkingEye, in which the rule against contractual penalties was updated

1. Contract interpretation: start with what the contract actually says  

In Arnold v Brittan (Supreme Court, 10 June 2015) the court was asked to construe a service charge provision in leases of holiday chalets entered into between 1978 and 1981. The leases were not subject to any statutory protection against excessive service charges. The first part of the relevant clause required that the tenants pay a proportionate charge to the landlords for providing services, and the second part quantified the charged as a fixed annual sum, with compound increases of 10% per annum.

It was accepted that a literal interpretation of the second part of the service charge clause would result in a charge for 2015 per tenant of £2,500, increasing by 2072 to £550,000. Lord Neuberger acknowledged that this could mean that the landlord would recover more than its expenditure. The tenants argued the charge was absurdly high and could not have been intended; the second part of the clause should be construed as a cap on their contribution, rather than quantifying it. They also argued for an implied term that the landlord could not recover more by way of service charge than would be recoverable under service charge provisions in other leases in the chalet park (which provided for increases only every 3 years rather than every year).

The Supreme Court held that the court could not step in and save the tenants from a bad bargain. Commercial common sense was not relevant where the meaning of language was clear, as in this case. They also declined to treat the construction of service charge provisions differently from any other contract.

Lord Neuberger reviewed and approved the reasoning of the House of Lords in Investors Compensation Scheme v West Bromwich, 1997: the process of interpretation is the "task of ascertaining the meaning a contractual document would convey to a reasonable person" and involves

  • starting with what the contract actually says
  • assessing the parties' intentions objectively; and
  • reading the contract with commercial common sense, and not in a pedantic or literal way

He stressed, though, that the importance of 1) should not be diminished by applying commercial common sense to the meaning; 3) is only relevant if the meaning of the contract is ambiguous. Moreover, commercial common sense is not to be looked atretrospectively, it should be assessed at the date the contract was made. That was important in this case where the lease had been drawn up in the late 1970s and early 1980s, at a time when inflation was running at over 10% per annum.

2. Implied terms: the old test remains, but you must construe express terms first

In December 2015, in a decision which comments on how the process of implying contract terms should be approached, the Supreme Court, in M&S plc v BNP Paribas Securities Trust Company, (M&S) held that commentators may have misunderstood a 2009 Privy Council decision on implied terms, (Attorney General of Belize v Belize Telecom).

Lord Neuberger suggests in M&S that some have taken Lord Hoffman's remark inBelize:

"there is only one question: is that what the instrument, read as a whole against the relevant background, would reasonably be understood to mean?"

to permit a term to be implied into a contract if it is merely reasonable to do so. Belizehad not diluted the requirements for implication of terms, he said: reasonableness alone is not sufficient.

The fact of M&S

M&S, the tenant of commercial premises leased from BNP, the defendant, asked the court to imply a term in the lease to the effect that advance rental payments it had made under the lease, relating to a period after it had ended, should be refunded. There was no express provision in the lease dealing with refunds.

The decision

The Supreme Court dismissed M&S' appeal, restating the "cardinal rule" (also stressed in Arnold v Brittan above) that no term will be implied into a contract that contradicts an express term. Until the express terms have been construed, it is therefore not possible to decide whether a further term should be implied. Construing express terms and deciding whether terms should be implied are two different exercises, Lord Neuberger said.

Lord Neuberger cited with approval Sir Thomas Bingham's remarks in Philips Electronique Grand Public SA v British Sky Broadcasting Ltd 1995: it is because the implication of a term is "so potentially intrusive…[as the parties have made no such express provision] that the law imposes strict constraints on the exercise of this extraordinary power"; and Lord Simon's in BP Refinery (Westernport) Pty Ltd. v Shire of Hastings, PC, 1977: for a term to be implied, "the following conditions (which may overlap) must be satisfied: 1) it must be reasonable and equitable; 2) it must be necessary to give business efficacy to the contract so that no term will be implied if the contract is effective without it; 3) it must be so obvious that "it goes without saying"; 4) it must be capable of clear expression; 5) it must not contradict any express term".

Lord Neuberger declined to reformulate the existing principles for implying terms, but did comment on them, in a passage which is likely to become essential reading for contracts lawyers:

  • Notional reasonable people not the parties to the contract. The implication of a term is not dependent on proof of the actual intention of the parties when negotiating the contract. What matters is the intention of notional reasonable people in the position of the parties at the time they were contracting.
  • The fairness of a term, or the fact that the parties would agree to it, is necessary but insufficient. A term should not be implied into a detailed commercial contract merely because it appears fair or because one considers that the parties would have agreed it if it had been suggested. Those are necessary, but not sufficient, grounds for including a term.
  • The requirement of BP Refinery that implied terms must be reasonable and equitable adds nothing. If a term satisfies the other requirements, it is hard to think that it would not be reasonable and equitable.
  • The business efficacy and officious bystander tests are not cumulative. Only one of these tests needs to be satisfied; in practice, however,  if one is satisfied, the other probably will be.
  • It is important correctly to formulate the question to be asked by the officious bystander.
  • Necessity for business efficacy involves a value judgment. The test is not one of "absolute necessity"”. A more helpful way of putting the business efficacy requirement may be that a term can only be implied if, without the term, the contract would lack commercial or practical coherence.

3.  The rule against contractual penalties: "the strong presumption must be that the parties themselves are the best judge of what is legitimate in a provision dealing with the consequences of breach"

In the conjoined appeals in Cavendish v Makdessi; Beavis v Parking Eye (Makdessi), in November 2015, the Supreme Court was invited to abolish the rule relating to contractual penalty clauses: a common law rule, with equitable origins, under which the courts can relieve a party from contractual provisions for penal payments on breach of contract.

The Supreme Court declined to abolish the rule, acknowledging that it still has a part to play in cases where sums to be paid on breach of contractual provisions are "unconscionable" or "extravagant". Instead they set out a new test: where the clause in question is a "primary obligation" the rule against penalties will not be engaged. Where, however, it is truly a secondary obligation, arising only on breach of contract, the rule will be engaged and the test as to whether the provision constitutes a penalty is whether it "imposes a detriment on a contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of a primary obligation". Our detailed analysis of Makdessi can be found here, and commentary on the ramifications for contract drafters here.

So Makdessi is another decision in which the Supreme Court avoided reshaping the agreement reached by the parties. As in Arnold v Brittan, there was no ambiguity in the wording of the contract. Mr Makdessi was clearly prohibited from competing with the interests of the group of companies in which he had sold a large portion of his shares (so that he was no longer the majority shareholder). The issue was not whether he was in breach, but whether, given the breach, two clauses which 1) disentitled him to payments otherwise due to him and 2) forfeited his remaining shares, were enforceable, or void as penalty clauses. A majority in the Supreme Court held that both were properly construed as primary obligations (price adjustment clause) and so the rule against penalties, as restated, was not engaged at all