Contractual interpretation and commercial common sense
This article was originally published in the August edition of Legal News, the magazine of the Confederation of South Wales Law Societies.
The recent judgment in Arnold v Britton  UKSC 36 is of particular importance to property and housing litigators. The judgment of Morgan J, with whom the Supreme Court agreed, sets out in detail (and with clarity) those issues: of note in his judgment is, firstly, the fact that there are no special rules for interpreting service charges restrictively and that there is no requirement for there to be express wording to allow a service charge to make a profit.
However, the Supreme Court’s decision provides useful guidance to all those dealing with the interpretation of contracts in any field and, in particular, to what extent ‘commercial common sense’ is relevant.
The appeal related to holiday chalets in Oxwich Park in the Gower. In brief, the Supreme Court was asked to decide whether or not clauses relating to charges to be levied as part of leases were "service charges" as defined by Section 18 of the Landlord and Tenant Act 1985, and what the proper interpretation of those clauses were.
The provision relating to service charges was set at a fixed rate of £90 per annum; to be increased by 10% every year or, in some of the leases, every three years. That amount now stood at £3,000. The service charge for the final year of some versions of the leases would amount to £1,025,004. It was the fact that that amount was, on its face, commercially absurd which went to the heart of the dispute on interpretation.
Commercial Common Sense
In Rainy Sky S.A v Kookmin Bank  UKSC 50 the Supreme Court effectively agreed that where contractual words could bear multiple meanings then it was appropriate to adopt that which was the most consistent with a commercially sensible meaning.
Since then it has been argued, often with success, that the interpretation which made commercial sense was the correct interpretation. In effect, this meant that where commercially absurd results were seen, a court would be ready to find an alternative meaning. Often this meant that one party's bad deal was remedied.
The Majority’s Judgment
Lord Neuberger identified the diminishing difference between interpretation and rectification. The former ought to be limited to determining and giving effect to a contract; whereas the latter allows the court to impose a different meaning from that which, on the face of the contractual provision, the words have.
The starting point when interpreting a contract is to identify the intention of the parties with reference to what a reasonable person would have understood the language in the contract to mean. The majority accepted that commercial common sense was an aid to construction but emphasised the following principles:
The language used by the parties should not be undervalued in the face of commercial sense. What is key is that the parties had "control" over the wording used and must be presumed to have been focussed on the issue when agreeing that wording;
The less clear the wording, the more readily a court may depart from its ordinary meaning. Importantly, the reverse is also true;
Commercial common sense cannot be invoked retrospectively. The fact that the agreement is a bad bargain is not a reason to depart from the natural and ordinary meaning of the language used. It 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”;
A court should be slow to depart from the natural meaning of words simply because it appears to be bad bargain for one party. There needs to be a basis in the words used and the background factual scenario giving rise to the interpretation upon which a rival meaning may properly be based;
It is only those facts or circumstances which existed at the time that the contract was made and which were known or reasonably available to both parties that should be taken into account;
When an event occurs which, judging from the language used, was plainly not intended or contemplated by the parties, the court will give effect to the intention of the parties, if it is clear what the parties would have intended in that situation.
The Dissenting Judgment
Lord Carnwath recognised the tension which often arises between the requirement to interpret the words used by the parties, and the need to avoid a result which is commercially (and on any common sense view) nonsensical.
On the facts, he found that the commercial purpose of the relevant clause was to enable the recovery of the costs of maintaining the estate. As such the payments by each should be proportionate. The result of the strict interpretation of the words by the majority was clearly not proportionate and could not therefore be correct.
Lord Carnwath’s dissent would no doubt be answered by the majority with reference to Lord Neuberger’s third factor: the conclusion drawn is one based on the retrospective invocation of commercial common sense. It replaces the bilateral gamble on future inflation prices which the parties had entered into and replaces it with a wording which gives the parties a sensible and commercially desirable result today.
The judgment reinforces the importance of the words actually used by the parties: the court's role is to interpret and give effect to them. That is an important cautionary note to drafters and a useful interpretive tool to litigators. Commercial common sense, even in the face of paying over £1m in service charges, cannot trump the parties’ choice of words. As the judgment held the 'purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed….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.'
In practice, Lord Neuberger’s approach may give rise to an increase in claims for rectification of contracts in order to avoid the strict interpretative approach of the courts. Lord Neuberger's approach will likely also bring to an end the increasing reliance placed on commercial construction of contracts and the return to a more traditional, literal "black letter" approach.
Owain Rhys James