This article first appeared in the February 2011 edition of The In-House Lawyer.

The Supreme Court has ruled that without prejudice material may be admissible as an aid to construing a settlement agreement. In doing so, it has created a new exception to the without prejudice principle in a judgment that will be of significant interest to practitioners involved in settlement negotiations.

The new "interpretation exemption" allows as admissible certain communications made between parties to without prejudice negotiations. It applies to communications of facts which:

  • are communicated between the parties in the course of without prejudice negotiations;
  • form part of the factual matrix or surrounding circumstances; and  
  • would, but for the without prejudice principle, be admissible as an aid to the construction of a settlement agreement which results from the negotiations.

This article will examine the potential impact of the Supreme Court's ruling in Oceanbulk.

The Facts

The dispute between the parties related to a series of shipping agreements. Having failed to pay the monthly instalment due in May 2008, Oceanbulk sought time for payment and the parties entered into settlement negotiations which were expressed to be "without prejudice". The negotiations were partly in writing but included two long meetings which were attended by the parties' representatives and their solicitors. The discussions resulted in a written settlement agreement (the Settlement Agreement).

There was no issue between the parties as to the existence of the Settlement Agreement. The dispute concerned the meaning of the word "co-operate" in the context of the Settlement Agreement. Oceanbulk's counterparty (TMT) argued that Oceanbulk made representations during negotiations that were relevant to the meaning of the word "co-operate" in the context of the Settlement Agreement. Oceanbulk argued that the alleged representations were made without prejudice and were therefore inadmissible as an aid to construction.

First Instance

At first instance, Mr Justice Andrew Smith held that, as the representations would have been admissible to determine the existence of a term or terms of the settlement, there was no cogent, public policy or other reason that they should not be admissible as to the meaning of those terms. Amongst other reasons, Smith J expressed the view that if the court was deprived of evidence of this type, it would be less well-equipped to discern the parties' intentions and less likely to construe the contract in accordance with those intentions.

Court of Appeal

On Oceanbulk's appeal, the Court of Appeal held, by a majority of two to one (Lord Justice Ward dissenting), that without prejudice material was not admissible as an aid to construing the Settlement Agreement.

Mr Justice Longmore gave the leading judgment. He rebutted the reasons given by Smith J and expressed the view that the policy of encouraging settlements in commercial disputes was not outweighed by the desirability of having all possible information available to the court.

In a spirited dissenting judgment, Ward LJ stated that "logic and justice" were good enough reasons to remove the without prejudice protection in this case. He said:

"If you can use the antecedent negotiations to prove the agreement, to rescind it, or to rectify it, why on earth can you not use the negotiations to establish the truth of what the concluded contract means? Not to do so would strike my mother as "barmy". Perhaps I should simply say it strikes me as illogical."

He further clarified that the exception should only apply in the limited circumstances in which the negotiating parties had achieved a compromise and thus "a new order" between them had replaced the old: "Where compromise has been reached, the purpose [of the without prejudice principle] has been served and the inhibitions fall away". This is an important point which was not addressed in the judgment handed down by the Supreme Court but is further commented on below.

Supreme Court

The Supreme Court unanimously overturned the Court of Appeal's decision. Lord Clarke, delivering the leading judgment, began by examining the development of the principle. He observed that the principle had broadened significantly in scope over the years and that the modern incarnation was applicable not just to statements which might strictly be termed admissions, but also to other statements made during negotiations, such as the statements made on the instant facts.

However, in a note of caution Lord Clarke also said that "because of the importance of the without prejudice principle, its boundaries should not be lightly eroded". The judgment outlines the existing exceptions and frames the central question as to whether there should be a further exception to the principle, allowing facts identified during without prejudice negotiations which lead to a settlement agreement to be admissible as evidence of how the settlement agreement should be construed. By finding in the affirmative the Supreme Court endorsed a new exception to the principle, which Lord Clarke termed the "interpretation exception".

In support of the ruling, Lord Clarke endorsed a contextual approach to the interpretation of contractual terms. He also highlighted the decision in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38 which confirmed that material which formed part of the factual matrix or surrounding circumstances of a contract should be available to the court as an aid to construction (whilst stipulating that evidence of pre-contractual negotiations should not).

Lord Clarke said he could see "no reason why the ordinary principles governing the interpretation of a settlement agreement should be any different regardless of whether the negotiations which led to it were without prejudice. The language should be construed in the same way and the question … should be the same, namely 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. That background knowledge may well include objective facts communicated by one party to the other in the course of the negotiations. As I see it, the process of interpretation should in principle be the same, whether the negotiations were without prejudice or not."

Lord Clarke did not accept that this finding offended the underlying public policy element. Instead, he considered that admitting objective facts communicated between the parties during settlement negotiations was more likely to engender settlement rather than the reverse because parties at the negotiating stage would be encouraged by the thought that a court would, if it later became necessary, have regard to the parties' true intentions at the time of formation.

 Comment

A number of commentators have already expressed concern that this decision represents a dangerous erosion of the without prejudice principle that could dissuade parties from engaging wholeheartedly in settlement negotiations. There is arguably a shift in emphasis from the judgment of the House of Lords' decision in Ofulue v Bossert [2009] UKHL 16 two years ago, when the sanctity of the principle was stressed.

However, it is possible that the practical effect of the ruling may be somewhat less significant than has been speculated. It is important to keep in mind that the application of the rule requires a specific set of circumstances, namely that communications of background information are made which are relevant to the construction of a settlement agreement which is subsequently formed but then becomes the subject of a dispute as to interpretation. It is difficult to imagine that the spectre of this chain of events will have an appreciable impact on the openness of parties to without prejudice negotiations.

It should be stressed that the interpretation exception will only apply where a settlement agreement has been reached. As such, the principle remains generous in its application under normal circumstances and it will continue to protect parties from statements made against their own interests in the event that negotiations break down and settlement cannot be reached.

It is perhaps interesting to note that this distinction was not addressed in any detail by the Supreme Court. It was, however, fundamental to the reasoning of a dissenting Ward LJ in the Court of Appeal who spoke of the formation of a "new order" between the parties once settlement is reached, whereby the pre-existing protection falls away. In fact, this interpretation of the effect of the without prejudice principle is reminiscent of its formulation in the older authorities, prior to more recent judicial extensions of its scope. The practical effect is that a party's statements against his or her own interest will only become admissible in court under this exception once the subject matter of the relevant proceedings has fundamentally changed. This distinction should certainly be a comfort to those who have expressed concern at the perceived erosion of the principle.

The decision underlines the importance of clear and unambiguous drafting of settlement agreements and comprehensive note-taking at meetings. In addition, Oceanbulk yet again demonstrates the courts' continued willingness to look behind the written words of a contract in order to establish and give effect to the true intentions of the parties. Indeed, this approach has become the hallmark of modern contract law.