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N2-11: Contractual interpretation

General test

General test

- Identify objective intention of parties by reference to known background

 

"[10] The court’s task is to ascertain the objective meaning of the language which the parties have chosen to express their agreement. It has long been accepted that this is not a literalist exercise focused solely on a parsing of the wording of the particular clause but that the court must consider the contract as a whole and, depending on the nature, formality and quality of drafting of the contract, give more or less weight to elements of the wider context in reaching its view as to that objective meaning. In Prenn v Simmonds [1971] 1 WLR 1381 (1383H-1385D) and in Reardon Smith Line Ltd v Yngvar Hansen-Tangen [1976] 1 WLR 989 (997), Lord Wilberforce affirmed the potential relevance to the task of interpreting the parties’ contract of the factual background known to the parties at or before the date of the contract, excluding evidence of the prior negotiations. When in his celebrated judgment in Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896 Lord Hoffmann (pp 912-913) reformulated the principles of contractual interpretation, some saw his second principle, which allowed consideration of the whole relevant factual background available to the parties at the time of the contract, as signalling a break with the past. But Lord Bingham in an extra-judicial writing, A new thing under the sun? The interpretation of contracts and the ICS decision Edin LR Vol 12, 374-390, persuasively demonstrated that the idea of the court putting itself in the shoes of the contracting parties had a long pedigree."

"[15] When interpreting a written contract, the court is concerned to identify the intention of the parties by reference to "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", to quote Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38, [2009] 1 AC 1101, para 14. And it does so by focussing on the meaning of the relevant words, in this case clause 3(2) of each of the 25 leases, in their documentary, factual and commercial context..." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Identify objective intention of parties by reference to known background

- Assess ordinary meaning, other provisions, purpose and commercial common sense

 

"[15] ... That meaning has to be assessed in the light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provisions of the lease, (iii) the overall purpose of the clause and the lease, (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed, and (v) commercial common sense, but (vi) disregarding subjective evidence of any party's intentions. In this connection, see Prenn at pp 1384-1386 and Reardon Smith Line Ltd v Yngvar Hansen-Tangen (trading as HE Hansen-Tangen) [1976] 1 WLR 989, 995-997 per Lord Wilberforce, Bank of Credit and Commerce International SA (in liquidation) v Ali [2002] 1 AC 251, para 8, per Lord Bingham, and the survey of more recent authorities in Rainy Sky, per Lord Clarke at paras 21-30." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Assess ordinary meaning, other provisions, purpose and commercial common sense

- Iterative exercise

 

"[77] This unitary exercise involves an iterative process by which each of the rival meanings is checked against the provisions of the contract and its commercial consequences are investigated (Re Sigma Finance Corp ([2009] UKSC 2) [2010] 1 All ER 571, para 12 per Lord Mance). But there must be a basis in the words used and the factual matrix for identifying a rival meaning. The role of the construct, the reasonable person, is to ascertain objectively, and with the benefit of the relevant background knowledge, the meaning of the words which the parties used. The construct is not there to re-write the parties' agreement because it was unwise to gamble on future economic circumstances in a long term contract or because subsequent events have shown that the natural meaning of the words has produced a bad bargain for one side. The question for the court is not whether a reasonable and properly informed tenant would enter into such an undertaking. That would involve the possibility of re-writing the parties' bargain in the name of commercial good sense. In my view, Mr Morshead's formulation (para 67 above), on which his case depends, asks the court to re-write the parties' leases on this illegitimate basis." (Arnold v. Britton [2015] UKSC 36, Lord Hodge)

- Iterative exercise

- Does not matter whether detailed analysis commences with factual background or relevant language

 

"[12]This unitary exercise involves an iterative process by which each suggested interpretation is checked against the provisions of the contract and its commercial consequences are investigated: Arnold para 77 citing In re Sigma Finance Corpn [2010] 1 All ER 571, para 10 per Lord Mance. To my mind once one has read the language in dispute and the relevant parts of the contract that provide its context, it does not matter whether the more detailed analysis commences with the factual background and the implications of rival constructions or a close examination of the relevant language in the contract, so long as the court balances the indications given by each." (Wood v. Capita Insurance Services Limited [2017] UKSC 24)

"[61] It happened that the approach the FTT took was to examine the circumstances it considered relevant to commercial context before it then considered the contract terms. As Mr Tolley KC pointed out, that was a perfectly legitimate approach and one that was envisaged by Lord Hodge, in Wood v Capita [2017] UKSC 24 where he had explained that it mattered not whether the analysis started with terms and then looked at circumstances or vice versa." (Exchequer Solutions Ltd v. HMRC [2024] UKUT 25 (TCC), Flaux J and Judge Raghavan)

- Does not matter whether detailed analysis commences with factual background or relevant language

Primacy of words used

Primacy of words used

- Meaning is most obviously gleaned from words used

 

"[17] First, the reliance placed in some cases on commercial common sense and surrounding circumstances (eg in Chartbrook, paras 16-26) should not be invoked to undervalue the importance of the language of the provision which is to be construed. The exercise of interpreting a provision involves identifying what the parties meant through the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision. Unlike commercial common sense and the surrounding circumstances, the parties have control over the language they use in a contract. And, again save perhaps in a very unusual case, the parties must have been specifically focussing on the issue covered by the provision when agreeing the wording of that provision." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Meaning is most obviously gleaned from words used

- Poor drafting may justify departing from ordinary meaning more readily

 

"[18] Secondly, when it comes to considering the centrally relevant words to be interpreted, I accept that the less clear they are, or, to put it another way, the worse their drafting, the more ready the court can properly be to depart from their natural meaning. That is simply the obverse of the sensible proposition that the clearer the natural meaning the more difficult it is to justify departing from it..." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Poor drafting may justify departing from ordinary meaning more readily

- Even professionally drafted contracts may lack clarity

 

"[13] Textualism and contextualism are not conflicting paradigms in a battle for exclusive occupation of the field of contractual interpretation. Rather, the lawyer and the judge, when interpreting any contract, can use them as tools to ascertain the objective meaning of the language which the parties have chosen to express their agreement. The extent to which each tool will assist the court in its task will vary according to the circumstances of the particular agreement or agreements. Some agreements may be successfully interpreted principally by textual analysis, for example because of their sophistication and complexity and because they have been negotiated and prepared with the assistance of skilled professionals. The correct interpretation of other contracts may be achieved by a greater emphasis on the factual matrix, for example because of their informality, brevity or the absence of skilled professional assistance. But negotiators of complex formal contracts may often not achieve a logical and coherent text because of, for example, the conflicting aims of the parties, failures of communication, differing drafting practices, or deadlines which require the parties to compromise in order to reach agreement. There may often therefore be provisions in a detailed professionally drawn contract which lack clarity and the lawyer or judge in interpreting such provisions may be particularly helped by considering the factual matrix and the purpose of similar provisions in contracts of the same type. The iterative process, of which Lord Mance spoke in Sigma Finance Corpn (above), assists the lawyer or judge to ascertain the objective meaning of disputed provisions." (Wood v. Capita Insurance Services Limited [2017] UKSC 24)

- Even professionally drafted contracts may lack clarity

- Not to search for infelicities

 

"[18] ... However, that does not justify the court embarking on an exercise of searching for, let alone constructing, drafting infelicities in order to facilitate a departure from the natural meaning. If there is a specific error in the drafting, it may often have no relevance to the issue of interpretation which the court has to resolve." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Not to search for infelicities

- Alive to the possibility that a provision may be a negotiated compromise due to inability to agree more precise terms

 

"[11]...Similarly, the court must not lose sight of the possibility that a provision may be a negotiated compromise or that the negotiators were not able to agree more precise terms." (Wood v. Capita Insurance Services Limited [2017] UKSC 24)

- Alive to the possibility that a provision may be a negotiated compromise due to inability to agree more precise terms

Commercial common sense

Commercial common sense​

- Not to be invoked retrospectively

 

"[19] The third point I should mention is that commercial common sense is not to be invoked retrospectively. The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language. Commercial common sense is only relevant to the extent of how matters would or could have been perceived by the parties, or by reasonable people in the position of the parties, as at the date that the contract was made. Judicial observations such as those of Lord Reid in Wickman Machine Tools Sales Ltd v L Schuler AG [1974] AC 235, 251 and Lord Diplock in Antaios Cia Naviera SA v Salen Rederierna AB (The Antaios) [1985] AC 191, 201, quoted by Lord Carnwath at para 110, have to be read and applied bearing that important point in mind." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Not to be invoked retrospectively

- Slow to reject clear meaning simply because it appear imprudent

 

"[20] Fourthly, while commercial common sense is a very important factor to take into account when interpreting a contract, a court should be very slow to reject the natural meaning of a provision as correct simply because it appears to be a very imprudent term for one of the parties to have agreed, even ignoring the benefit of wisdom of hindsight. The purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed. Experience shows that it is by no means unknown for people to enter into arrangements which are ill-advised, even ignoring the benefit of wisdom of hindsight, and it is not the function of a court when interpreting an agreement to relieve a party from the consequences of his imprudence or poor advice. Accordingly, when interpreting a contract a judge should avoid re-writing it in an attempt to assist an unwise party or to penalise an astute party." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Slow to reject clear meaning simply because it appear imprudent

- Use to choose between possible constructions

 

"[11] ... Interpretation is, as Lord Clarke stated in Rainy Sky (para 21), a unitary exercise; where there are rival meanings, the court can give weight to the implications of rival constructions by reaching a view as to which construction is more consistent with business common sense. But, in striking a balance between the indications given by the language and the implications of the competing constructions the court must consider the quality of drafting of the clause (Rainy Sky para 26, citing Mance LJ in Gan Insurance Co Ltd v Tai Ping Insurance Co Ltd (No 2) [2001] 2 All ER (Comm) 299 paras 13 and 16); and it must also be alive to the possibility that one side may have agreed to something which with hindsight did not serve his interest: Arnold (paras 20 and 77)..." (Wood v. Capita Insurance Services Limited [2017] UKSC 24)

"[76] This conclusion is not a matter of reaching a clear view on the natural meaning of the words and then seeing if there are circumstances which displace that meaning. I accept Lord Clarke's formulation of the unitary process of construction, in Rainy Sky SA v Kookmin Bank [2011] 1 WLR 2900, para 21:
"[T]he 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."" (Arnold v. Britton [2015] UKSC 36, Lord Hodge)

- Use to choose between possible constructions

- Clause not interpreted as obligation that both parties knew could not in practice be complied with

 

"[74] There was no error of law in this orthodox application of the Arnold v Britton principles. In ascertaining what the parties had agreed when they referred to “work” being provided, the FTT had to give that term a meaning which reflected the particular relevant circumstances, namely that, in respect of the gap periods, both parties knew ESL was not expected nor in any position to provide work. The FTT was not ignoring the use of the term “work”; it was saying that, given the relevant circumstances, the parties’ agreement can only have referred to ESL using its best efforts to put itself in a position where its likelihood of being able to act as employer was increased. There was no error of approach in the FTT construing the language in this way and the conclusion was, in the light of the findings the FTT made, plainly one the FTT was entitled to reach. ESL is not able to point to any findings which explain why the FTT would have been duty bound to find otherwise." (Exchequer Solutions Ltd v. HMRC [2024] UKUT 25 (TCC), Flaux J and Judge Raghavan)

- Clause not interpreted as obligation that both parties knew could not in practice be complied with

Facts known to the parties

Facts known to the parties​

- Only facts known or reasonably available to both parties at time of contracting

 

"[21] The fifth point concerns the facts known to the parties. When interpreting a contractual provision, one can only take into account facts or circumstances which existed at the time that the contract was made, and which were known or reasonably available to both parties. Given that a contract is a bilateral, or synallagmatic, arrangement involving both parties, it cannot be right, when interpreting a contractual provision, to take into account a fact or circumstance known only to one of the parties." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Only facts known or reasonably available to both parties at time of contracting

Unforeseen events

Unforeseen events​ ​

- Court will strive to give effect to what parties would have intended if it is clear

 

"[22] Sixthly, in some cases, an event subsequently occurs which was plainly not intended or contemplated by the parties, judging from the language of their contract. In such a case, if it is clear what the parties would have intended, the court will give effect to that intention. An example of such a case is Aberdeen City Council v Stewart Milne Group Ltd [2011] UKSC 56, 2012 SCLR 114, where the court concluded that "any … approach" other than that which was adopted "would defeat the parties' clear objectives", but the conclusion was based on what the parties "had in mind when they entered into" the contract (see paras 17 and 22)." (Arnold v. Britton [2015] UKSC 36, Lord Neuberger)

- Court will strive to give effect to what parties would have intended if it is clear

Contra proferentem 

Contra proferentem ​

- Ambiguity construed against party who proferred that drafting

 

“Because of the extravagant result which the former view involves, I think that the latter construction is the one which the court ought to adopt. We are presented with two alternative readings of this document and the reading which one should adopt is to be determined, among other things, by a consideration of the fact that the defendants put forward the document. They have put forward a clause which is by no means free from obscurity and have contended that, on the view for which they argued, it has a remarkably, if not an extravagantly, wide scope, and I think that the rule contra proferentem should be applied and that the result is that the present claim is not one which obliges the first plaintiffs to give to the defendants a release and an indemnity.” (John Lee & Son (Grantham) Ltd v. Railway Executive [1949] 2 All ER 581 at 584)

- Ambiguity construed against party who proferred that drafting

Contractual powers/discretions to be exercised in good faith

Contractual powers/discretions to be exercised in good faith​

- Well established principle in absence of very clear language to the contrary

 

"[18] Contractual terms in which one party to the contract is given the power to exercise a discretion, or to form an opinion as to relevant facts, are extremely common. It is not for the courts to re-write the parties' bargain for them, still less to substitute themselves for the contractually agreed decision-maker. Nevertheless, the party who is charged with making decisions which affect the rights of both parties to the contract has a clear conflict of interest. That conflict is heightened where there is a significant imbalance of power between the contracting parties as there often will be in an employment contract. The courts have therefore sought to ensure that such contractual powers are not abused. They have done so by implying a term as to the manner in which such powers may be exercised, a term which may vary according to the terms of the contract and the context in which the decision-making power is given.

...

[31] But whatever term may be implied will depend upon the terms and the context of the particular contract involved. I would add to that Mocatta J's observation in The Vainqueur José, that "it would be a mistake to expect [of a lay body] the same expert, professional and almost microscopic investigation of the problems, both factual and legal, that is demanded of a suit in a court of law" (577). Nor would "some slight misdirection" matter, at least if it were clear that, had the legal position been properly appreciated, the decision would have been the same. It may very well be that the same high standards of decision-making ought not to be expected of most contractual decision-makers as are expected of the modern state." (Braganza v. BP Shipping Limited [2015] UKSC 17)

"[91] Counsel for the claimants relied on the now well established principle that in the absence of very clear language to the contrary, a contractual discretion must be exercised in good faith for the purpose for which it was conferred, and must not be exercised arbitrarily, capriciously or unreasonably (in the sense of irrationally): see e.g. Abu Dhabi National Tanker Co v Product Star Shipping Ltd, (The 'Product Star')(No 2) [1993] 1 Lloyd's Rep 397, 404; Paragon Finance Plc v Nash [2002] 1 WLR 685, paras 39-41; Socimer International Bank Ltd v Standard Bank London Ltd [2008] 1 Lloyd's Rep 558, 575–577; British Telecommunications Plc v Telefónica O2 UK Ltd [2014] UKSC 42, para 37. That principle applies to discretions in relation to remuneration like any other contractual discretion. The leading authorities in which the principle has been applied to payments of discretionary bonuses are Clark v Nomura International plc [2000] IRLR 766, Horkulak v Cantor Fitzgerald International [2004] EWCA Civ 1287, [2005] ICR 402, and Keen v Commerzbank AG [2006] EWCA Civ 1636, [2007] ICR 623. As expressed by Burton J in Nomura at para 40:
"My conclusion is that the right test is one of irrationality or perversity (of which caprice or capriciousness would be a good example) ie that no reasonable employer would have exercised his discretion in this way."
[92] This principle is buttressed in the employment context by the overarching obligation implied by law as an incident of the employment contract that an employer will not without reasonable and proper cause conduct itself in a manner calculated or likely to destroy or seriously damage the relationship of confidence and trust between employer and employee: see Malik v Bank of Credit and Commerce International SA [1998] AC 20. The essence of this obligation is one of fair dealing: see Johnson v Unisys Ltd [2001] UKHL 13; [2003] 1 AC 518, para 24, per Lord Steyn. As explained by Lord Nicholls (with whom Lords Hoffmann, Rodger and Brown agreed) in Eastwood v Magnox Electric plc [2004] UKHL 35; [2005] 1 AC 503, para 11, it means "in short, that an employer must treat his employees fairly in the conduct of his business" and that "in his treatment of his employees, an employer must act responsibly and in good faith". It allows "a balance to be struck between an employer's interest in managing his business as he sees fit and the employee's interest in not being unfairly and improperly exploited": see Lord Steyn in Malik at 46D." (Brogden v. Investec Bank Plc [2014] EWHC 2785 (Comm), Leggatt J)

- Well established principle in absence of very clear language to the contrary

- Applies where one party given responsibility for making judgment

 

"[100] Both on the authorities and as a matter of principle, it seems to me that where a contract gives responsibility to one party for making an assessment or exercising a judgement on a matter which materially affects the other party's interests and about which there is ample scope for reasonable differences of view, the decision is properly regarded as a discretion which is subject to the implied constraints that it must be taken in good faith, for proper purposes and not in an arbitrary, capricious or irrational manner. Those limits apply in circumstances where the decision is final and binding on the other party in the sense that a court will not substitute its own judgment for that of the party who makes the decision. There is therefore also a discretion in the second sense distinguished earlier. The concern, as Rix LJ observed in Socimer at para 66, is that the decision-maker's power should not be abused. The implication is justified as a matter of construction to give effect to the presumed intention of the parties. In the employment context it is further reinforced by the obligations of good faith and fair dealing which, as discussed above, are a necessary incident of the employment relationship.
[101] As I have construed the bonus clause in the claimants' contracts of employment, the clause conferred on Investec a discretion in the relevant sense to determine the EVA generated by the equity derivative business – a determination which involved numerous and substantial exercises of judgement and which fixed the amount of bonus that the claimants were entitled to receive. I conclude that the assessment of EVA was subject to implied requirements of good faith and rationality, as contended for by the claimants as their alternative case." (Brogden v. Investec Bank Plc [2014] EWHC 2785 (Comm), Leggatt J)

- Applies where one party given responsibility for making judgment

Mistakes

Mistakes

- Can only correct clear mistakes through interpretation if it is clear what the correction ought to be

 

"[78] Nor is this a case in which the courts can identify and remedy a mistake by construction. Even if, contrary to my view, one concluded that there was a clear mistake in the parties' use of language, it is not clear what correction ought to be made. The court must be satisfied as to both the mistake and the nature of the correction: Pink Floyd Music Ltd v EMI Records Ltd [2010] EWCA Civ 1429, para 21 per Lord Neuberger MR. This is not an unusual case, such as KPMG (above) in which a mistake was obvious on the face of the contract and the precise nature of the correction had no effect on the outcome." (Arnold v. Britton [2015] UKSC 36, Lord Hodge)

- Can only correct clear mistakes through interpretation if it is clear what the correction ought to be
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