The sky clears: common sense in interpreting contracts

The United Kingdom Supreme Court recently clarified the circumstances in which business common sense can be used when interpreting commercial contracts. The decision has implications for all those involved in drafting commercial contracts.

Rainy Sky SA and others v. Kookmin Bank¹

Six buyers, including Rainy Sky SA (the Buyers), signed materially identical shipbuilding contracts (the Contracts) with Jinse Shipbuilding Co Ltd (the Shipbuilder). Payment under the Contracts was by instalment. The Buyers were entitled to repayment of these instalments if the Shipbuilder became subject to defined insolvency events. The Contracts required the Shipbuilder to provide refund guarantees in a form acceptable to the Buyers’ financiers. In satisfaction of this requirement, Kookim Bank (the Bank) issued six materially identical “Advance Payment Bonds” (the Bonds).

After the Buyers had paid certain of the instalments, the Shipbuilder suffered financial difficulties and became subject to a debt workout procedure under Korean law. The Buyers demanded repayment of the instalments from the Shipbuilder. When the Shipbuilder refused to repay, the Buyers made a call on the Bank under the Bonds. The Bank refused to pay.

The Terms of the Bonds

The Bonds took the form of letter agreements and the paragraphs had no numbers. The second paragraph stated: “[p]ursuant to the terms of the Contract, you are entitled to, upon your rejection of the Vessel […], 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 […]”.

The third paragraph stated: “[i]n consideration of your agreement to make the pre-delivery instalments under the Contract […] we hereby […] irrevocably and unconditionally undertake to pay to you […] on your first written demand, such sums due to you under the Contract […]”.

Question for the Court

The question for the Supreme Court was whether the phrase “such sums” in the third paragraph meant repayment of the “pre-delivery instalments” referred to earlier in the sentence. Or whether, as the Bank argued, “such sums” was a reference to the sums payable in the limited circumstances specified in the second paragraph.

At first instance, Simon J had ruled for the Buyers. The Court of Appeal was split 2:1 in favour of the Bank. The casting decision had been that of Thorpe LJ, a family lawyer, who stated that he regretted having to provide the decisive opinion on “a field that [was] extremely foreign” to him.

Triumph of Common Sense

Lord Clarke gave the leading judgment of the Supreme Court, with which the other Justices all agreed. He held that the commercially reasonable interpretation was that the Bonds were available in the event of insolvency. In doing so, he reversed the decision of the Court of Appeal and reinstated that of Simon J.

The parties largely agreed on the principles of interpretation that applied. The issue between them was the role to be played by business common sense. The majority of the Court of Appeal had decided that:

“[u]nless the most natural meaning of the words produces a result that is so extreme as to suggest that it is unintended, the Court will have no alternative but to give effect to its terms.”

Lord Clarke thought this was wrong. In his view, the competing interpretations of the Bonds were much more finely balanced than held by the majority of the Court of Appeal. He held the Bonds were open to two interpretations. Indeed, the Bank had conceded this point (at least in the Court of Appeal).

From this basis, he explained the exercise of interpretation was a single unitary exercise. The court will consider the language used and what a reasonable person with all the background knowledge would have understood the parties to have meant. He went on: “if there are two possible constructions, the court is entitled to prefer the construction that is consistent with business common sense and to reject the other.”

He quoted Hoffman LJ (as he then was) in Co-operative Wholesale Society Ltd v. National Westminster Bank plc² on the limits of this principle. Hoffman LJ stated that this did not mean that: “one can rewrite the language which the parties have used to make it conform to business common sense. But language is a very flexible instrument and, if it is capable of more than one construction, one chooses that which seems most likely to give effect to the commercial purpose of the agreement.”

Lord Clarke agreed with Simon J, and the minority of the Court of Appeal, that insolvency of the Shipbuilder was the event in which the Buyers were most likely to need the security of the Bonds. In particular, the Bank had not advanced any credible commercial reason why the Bonds did not cover such an event. He was also clearly influenced by the fact that, on close analysis, the Bonds did not reflect all circumstances under the Contracts when the Bonds could be called.

Interestingly, Lord Clarke reached his decision despite recognising the Buyers had “advanced no very good reason” for the inclusion of the second paragraph in the Bonds. The best the Buyers could say was the second paragraph rehearsed some of the Buyers’ remedies under the Contracts.

Practical Implications

This decision provides useful clarification of the circumstances in which principles of business common sense can be looked to when interpreting commercial contracts. The fact the Court of Appeal decided the case the other way also shows the challenge of consistent decision-making when courts move away from a literal interpretation of instruments. The following points are worth noting:

• If parties are in dispute over the meaning of a contract, then the contract is almost certainly able to bear more than one meaning. The principle of business common sense is therefore likely to be frequently invoked.
• Those drafting contracts should be especially careful if the intended outcome may later be regarded as commercially implausible. If this is the case, then it will be necessary to spell out the intention unequivocally to avoid a common sense interpretation.
• In appropriate cases, the court can still override the natural meaning of the contractual language if they think this gives rise to an absurd outcome. Although this was not such a case, there may still be instances when the test applied by the Court of Appeal is the correct one.