Contractual interpretation and implied terms

In two decisions delivered during the past year, the Supreme Court has adopted a more literal approach to contractual interpretation and implied terms, moving away from a more interventionist approach.

The general principles for contractual interpretation are relatively well established as a matter of English law. As Lord Ho man set out in Chartbrook Ltd v Persimmon Homes [2009] AC 1101, ‘... the question is 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’.

However, the application of such principles can, in practice, be more diffcult. Problems can often arise in cases of perceived ambiguity, where a contract fails to deal with a particular matter or where the result appears uncommercial or unfair.

In such circumstances, to what extent can parties appeal to notions of fairness or commercial common sense and how great must the error or ambiguity be before the court will step in? Insofar as there has been any suggestion of a creeping increase in the importance being placed on commercial common sense and the surrounding circumstances, any such trend, whether perceived or real, appears to have been halted by two Supreme Court decisions delivered over the past year.

The more ‘commercial’ approach to contractual interpretation reached its high water mark in the case of Re Sigma Finance [2009] UKSC 2, in which the Supreme Court was concerned with construction of a clause determining the distribution of assets in a security trust deed. The majority considered that the Court of Appeal had attached too much weight to what was perceived to be the natural meaning of the words and too little weight to the context in which that sentence appeared and the scheme of the deed as a whole.

Arnold v Britton [2015] UKSC 36 concerned service charge provisions in residential leases. The lessees typically covenanted to pay ‘a proportionate part’ of the cost of providing the services, expressed to be £90 in the first year, rising by 10 per cent per year thereafter.

The issue for the court was essentially whether this meant: (i) a fixed service charge of £90 with a yearly increase of 10 per cent; or (ii) a fair proportion of the cost of providing the services, up to a maximum of £90 in the first year, that maximum figure rising by 10 per cent each year thereafter. If the former, it would mean that by 2072, the lessees would be paying over £550,000 per year in service charge.

he majority of the Supreme Court preferred the former, more literal construction. According to Lord Neuberger, ‘The reliance placed in some cases on commercial common sense and surrounding circumstances ... should not be invoked to undervalue the importance of the language of the provision which is to be construed.’ The Court accepted that the less clear the words, the more ready the court will be to depart from their natural meaning. However, that did not mean that the court should look for drafting errors to facilitate a departure from the natural meaning.

Further, it was stressed that commercial common sense should not be invoked retrospectively, just because, for example, the contractual arrangement had worked out badly for one of the parties. In this regard it should be noted that at the time the leases were drafted, an inflation rate of 10 per cent was not out of the ordinary and therefore the leases could not be said to have lacked commercial purpose at the time they were entered into. In any event, as Lord Neuberger noted, the purpose of contractual interpretation is to ascertain what the parties agreed and not what the court thought they should have agreed. It was not the court’s role when interpreting an agreement to relieve a party from the consequences of his imprudence or poor advice.

This does not of course change the position where there is actual ambiguity and in this regard, decisions such as Rainy Sky v Kookmin Bank [2011] UKSC 50 remain good law. Accordingly, where there are two possible constructions, the court was entitled to prefer the construction which was consistent with business common sense and to reject the other. The qualification that Arnold v Britton provides is that the court should not go looking for ambiguity.

A similar approach was adopted by the Supreme Court in the more recent case of Marks & Spencer v BNP Paribas [2015] UKSC 72, a case which concerned the issue of implied terms. The Supreme Court acknowledged that construing words the parties have used and implying terms into a contract are different processes and are governed by different rules. However, the two are closely connected in the sense that it is only after the express terms of a contract have been construed that the question of whether additional terms should be implied can be considered.

On the facts of the case, M&S, the tenant of commercial premises under four commercial leases, exercised a break clause. The leases provided for the payment of advance rent and M&S’s most recent payment comprised periods both before and after the break date. M&S sought to recover the proportion of advance rent for the period after the break date. There was no express term of the lease that allowed for an apportionment of advance rent in such circumstances. Instead, M&S argued that a term should be implied whereby the proportion of rent paid in advance of the break date that related to the period after the break date should be refunded. The Supreme Court confirmed that rent payable in advance is not apportioned unless the lease provides so expressly and that it was not ‘necessary’ to imply a term for repayment to make the leases work.

Of wider importance, the court clarified the principles that apply to implied terms. The following principles were reiterated:

• A term should not be implied into a detailed commercial contract merely because it appears fair.
• It must be necessary either to give business efficacy to the contract or because otherwise the contract would lack commercial or practical coherence. 
• It must be so obvious that it ‘goes without saying’. Lord Neuberger noted that while obviousness and necessity are alternatives, it will be a very rare case where only one of the two requirements are satisfied.
• It must be capable of clear expression. 
• It must not be contradicted by any express term of the contract.

In Belize Telecom, an earlier decision of the Privy Council, Lord Ho man had stated that ‘[t]here is only one question: is that what the instrument, read as a whole against the relevant background, would reasonably be understood to mean.’ Insofar as it had been suggested that this gave courts greater scope for implying terms or in any way watered down the necessity requirement, such suggestion was rejected by the Supreme Court.

This decision, when taken together Arnold v Britton, suggests a stricter and more literal approach to construing the scope of contracts.

A more literal approach to contractual interpretation should in principle be well received by corporates, as it should lead to greater certainty in how contracts will be construed. However, the corollary is that the courts are less likely to come to a party’s rescue where things have gone wrong and a party is appealing for what it considers to be common sense to prevail.

Nevertheless, the extent of a change in approach following these two decisions should not be overstated and there is no reason why there cannot continue to be a balance between achieving commercial certainty and the ability of the court to intervene where something has clearly and obviously gone wrong.