Contract interpretation: commercial intent takes centre stage

Throughout the commercial world, on a daily basis, contracts, drawn up to regulate the commercial activities of parties to a business enterprise, are subjected to close scrutiny for the purpose of ascertaining legal rights and obligations. As Richard Smellie explains, where the language is clear, the rights and obligations will be clear, but language is often susceptible to more than one possible meaning, particularly when arguments arise or the unexpected occurs. The commercial world of international construction contracts is no exception. These contracts are often complex, and ascertaining the true nature of the parties’ agreement on a particular point can be challenging.

The starting point is, of course, the words on the page, but where there is conflict or ambiguity - as there often is when a dispute arises - they must be interpreted. It is at this point that the law of the contract steps in, with rules on how the contact is to be interpreted.

In English law, for many years now, there has been a steady move away from the application of individual, strict rules of interpretation, particularly for commercial contracts, with the primary touchstones being that the relevant provision in the contract must be interpreted in the context of the document as a whole, and that what the parties meant by the language used involves ascertaining what a reasonable person would have understood the parties to have meant.

To that end, the “reasonable person” is a person with the background knowledge that would have reasonably been available to the parties at the time they entered into the contract. However this definition excludes the subjective knowledge and intentions of the parties, and importantly excludes the detail of contract negotiations.

Recently, English law took a further, important step along the road of contract interpretation, in the decision of the Supreme Court in Rainy Sky S.A. and Others v Kookmin Bank. In short, the Supreme Court (which since October 2009 has been the highest court in the United Kingdom, taking over the judicial functions of the House of Lords) confirmed the particular importance of giving weight to “business common sense” in ascertaining what the parties meant by the language they used, when ambiguity arises.

The Rainy Sky decision concerned the insolvency of a shipbuilder, and whether the purchasers of vessels not completed at the time of the shipbuilder’s insolvency could claim back monies paid to the shipbuilder against refund guarantees issued by the Kookmin Bank. The underlying shipbuilding contract provided that insolvency triggered the repayment of any advance instalments paid to the Buyers. However, although the guarantees recorded that the advance payments were repayable on certain conditions, they did not specify insolvency as one such ground.

This left a problem for the parties with the wording of the guarantees being open to two possible interpretations. The bank contended for a literal interpretation, which, whilst making the guarantees available for many types of default by the shipbuilder, meant that the guarantees were not available as security in the event of the shipbuilder’s insolvency.

The bank succeeded on its interpretation before the Court of Appeal. In particular the Court of Appeal said as follows:

“Unless the most natural meaning of the words produces a result which is so extreme as to suggest that it was unintended, the court has no alternative but to give effect to its terms. To do otherwise would be to risk imposing obligations on one or other party which they were never willing to assume and in circumstances which amount to no more than guesswork on the part of the court.”

The Supreme Court, however, disagreed. In so doing, it placed considerable importance on the fact that the literal interpretation contended for by the Bank meant that the security was not available on the shipbuilder’s insolvency, saying that it “defies commercial common sense to think that this, among all other such obligations, was the only one which the parties intended should not be secured.”

Consequently, whilst the Supreme Court reaffirmed that where the language in the contract is unambiguous, then the court must apply it. The Supreme Court went on to say that where there is ambiguity, generally the interpretation that is consistent with business common sense should be taken to be the interpretation intended by the parties.

The Supreme Court put it as follows:

“The language used by the parties will often have more than one potential meaning. I would accept the submission made on behalf of the appellants that the exercise of construction is essentially one unitary exercise in which the court must consider the language used and ascertain what a reasonable person, that is a person 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, would have understood the parties to have meant. In doing so, the court must have regard to all the relevant surrounding circumstances. 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.”

And

“where a term of a contract is open to more than one interpretation it is generally appropriate to adopt the interpretation which is most consistent with business common sense.”

This decision, arguably, reflects an emphasis on the perceived commercial realities that many Dispute Adjudication Boards and arbitrators have been quietly giving precedence to for many years. It does, however, place business common sense at the heart of contract interpretation when ambiguity arises, and so has important ramifications for all commercial contracts, not least construction contracts.

The language of complex construction contracts, including the layering of obligations through appendices, is often capable of more than one meaning. It remains the case that the aim of interpreting the relevant term is to determine what the parties meant by the language used, which involves ascertaining what a reasonable person with the background knowledge reasonably available to the parties at the time of the contract, would have understood the words used to mean.

But English law now calls for more weight to be given to “business/commercial common sense” and the commercial purpose of that which is being considered, and does not require a particular interpretation to give rise to an absurd or irrational result before having regard to that commercial purpose.

Conclusions

Parties - and their advisors - must therefore give much more consideration to the possible commercial purpose and business common sense of a provision when disagreements arise and the provision is open to more than one interpretation. This means that they must also place less emphasis on a literal interpretation that might not sit with business common sense.

Further, in the drafting of commercial contracts, the parties - and their advisors - must now give greater thought to the inclusion of provisions that expressly confirm the commercial purpose of the agreement, and in particular the commercial purpose of any provision which might be said to be contrary to business common sense.

The facts in Rainy Sky provide a simple example: if it had been intended that the guarantees should not secure the insolvency of the shipbuilder, the recitals should have confirmed this to be the commercial intention of the parties, and included some explanation as to the reason for this unusual allocation of risk.

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