2015: A good year for contract law?

The Supreme Court has been active this year in relation to the law of contract,
with three key decisions on contractual construction, penalties, and implied terms.

Construction

Arnold v Britton [2015] UKSC 36 concerned service charge provisions within 99-year leases of chalets on an estate. The provisions typically required the tenant: 'To pay to the Lessor… a proportionate part of the expenses… incurred by the Lessor in the repair maintenance [etc] hereinafter set out the yearly sum of Ninety Pounds… for the first year… increasing thereafter by Ten Pounds per Hundred for every subsequent year…'

The landlord contended that the clause meant a service charge of a fixed sum of £90 was due for the first year, thereafter increasing at 10 per cent compounded annually, with the startling result that a lease granted in 1980 would have a service charge of £550,000 per annum by 2072.

The tenants contended the clause meant they
had to pay a fair proportion of the landlords' costs, subject to a cap of £90 for the first year, the cap increasing by 10 per cent compounded per annum.

Giving the leading judgment, Lord Neuberger concluded that the words used plainly bore the landlord's construction.

Seven points of general application in construing contracts were identified:

• Commercial common sense should not be invoked to diminish the importance of the contract's language;

• The less clear the actual wording, the more likely the court will be to depart from its natural meaning;

• Commercial common sense must be assessed at the date of contracting and not applied retrospectively, even if a bargain has worked out 'disastrously';

• The court should be 'very slow' to reject the natural meaning of language simply because
  a term appears imprudent: the 'purpose of interpretation is to identify what the parties have agreed, not what the court considers
  that they should have agreed';

• Surrounding background circumstances can only be considered if they existed at the time of the contract and were known or reasonably available to both parties;

• As regards unanticipated or unintended events, if it is clear what the parties would have intended, the court will give effect to that; and

• Service charges are in no special category for construction purposes.

Penalties

A significant decision was reached in Cavendish Square Holdings BV v Talal El Makdessi; ParkingEye Limited v Beavis [2015] UKSC 67. The two cases were radically different factually: Cavendish concerned
a commercial contract with significant price adjustment/compulsory sale clauses in the event of the seller of a business failing to abide by non-compete provisions; ParkingEye concerned an £85 parking charge levied by the manager of a car park on those who, in breach of a condition on signs in the car park, overstayed their welcome.

In a joint leading judgment, Lord Neuberger
and Lord Sumption held that the law of penalties should not be abolished - but nor should it be extended. The dichotomy between a 'penalty' and 'a genuine pre-estimate of loss' was determined to be false, flowing from a mis-application of Dunlop Pneumatic Tyre Co Ltd v New Garage and Motor Co Ltd [1915] AC 79. While a provision that constituted a genuine pre-estimate of loss would not be a penalty, the converse did not necessarily follow.

The real test was 'whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation'. So, the rule only regulates contractual remedies, not the primary obligations, and should not be extended to allow a party to escape a bad bargain.

Lord Mance put the matter slightly differently - but to the same effect - by asking whether the provision was 'extravagant, exorbitant, or unconscionable' by comparison with 'the legitimate business interest' the innocent party was seeking to protect.

While the innocent party ‘can have no proper interest in simply punishing the defaulter’, seeking to deter the counterparty from breaching its primary obligations can be acceptable. In a negotiated contract ‘between properly advised parties of comparable bargaining power, the strong initial presumption must be that the parties themselves are the best judges of what is legitimate in a provision dealing with the consequences of breach’.

The relevant obligations in Cavendish were seen by the majority as primary obligations but, in any event, were not considered out of proportion to Cavendish’s legitimate interest in ensuring the non-compete obligations were met. The provisions were therefore upheld. In ParkingEye, the charge was a secondary obligation, so the rule was engaged in principle. However, the court held that both ParkingEye (as manager) and the owners had legitimate interests in charging overstaying motorists and the £85 charge was proportionate to those interests; for similar reasons, the charge did not fall foul of the Unfair Terms in Consumer Contracts Regulations 1999.

There was no indication of how high a charge would have to be to constitute a penalty. While the legal test itself is clear, predicting its outcome in cases is likely to be challenging.

Implied terms

Marks and Spencer plc v BNP Paribas Trust Company (Jersey) Limited and another [2015] UKSC 72 concerned a typical break clause in a commercial lease. For the break to be effective, the tenant needed to give a notice and ensure that there were no arrears as at 24 January (that being the date the lease would end in the event of an effective break). Rent was payable quarterly in advance: the tenant therefore had to, and did, pay the December quarter in full, and then brought proceedings to recover the 'overpayment' referable to 25 January to 24 March. The tenant argued there was an implied term that the landlord would refund
the 'overpayment'.

Lords Neuberger and Sumption gave the joint leading judgment and summarised the law of implied terms. There are two types of contractual implied term: the first (with which the case and summary below is concerned) is a term implied
'in the light of express terms, commercial common sense, and the facts known to both parties at the time the contract was made', and the second concerns terms implied by law into certain classes of relationship.

The law in this area (in particular Lord Simon's five-fold test in BP Refinery (Westernport) Pty Ltd
v Shire of Hastings (1977) 180 CLR 266 (PC)) represents 'a clear, consistent, and principled approach'. However, some further guidance was given. A term would only be implied if it satisfied the test of business necessity, or was so obvious a term that it went without saying. For the necessity requirement, the test is not 'absolute necessity':
the test is whether, without the term, 'the contract would lack commercial or practical coherence'.

It is not necessary to satisfy 'necessity' and 'obviousness' (Lord Simon's second and third requirements), but 'it would be a rare case where only one of those two requirements would be satisfied'. Lord Simon's three other requirements, however, did have to be satisfied in every case:
the term must be reasonable or equitable, be capable of clear expression, and not contradict
any express term.

The implication of a term is not critically dependent on proof of the actual intentions of the parties; rather, one is concerned with reasonable people in the parties' position at the time of contracting. A term 'should not be implied into a detailed commercial contract merely because it appears fair or merely because one considers that the parties would have agreed it if it had been suggested to them' - those are necessary 'but not sufficient' grounds for implication.

Lord Hoffman's view in Attorney General of Belize v Belize Telecom Ltd [2009] UKPC 10 - that the process of 'implying' a term was simply part of the exercise of 'construction' - was disapproved.
The majority took the view that Lord Hoffman's comments in Belize Telecom 'should henceforth be treated as a characteristically inspired discussion rather than authoritative guidance on the law of implied terms'.

Applying these principles, the court concluded there were no grounds to imply a term requiring repayment into the lease. (As an aside, and putting to rest a long-running debate, it was also decided that rent payable in advance is not apportionable under the general law or by statute.)

It therefore appears the direction of travel, led
by Lords Neuberger and Sumption, is towards freedom of contract and faithfully upholding the actual bargains reached by the parties, particularly in relation to commercial and professionally drawn contracts.

So, 'commercial common sense' is not a panacea to be used to bend the clear meaning of the parties' bargain (see Arnold); the law of penalties has been clarified, enabling commercial parties (in particular) somewhat greater freedom for movement (Cavendish); and there has been a return to orthodoxy in relation to implied terms (Marks and Spencer). SJ

Richard Hayes is a barrister practising from Lamb Chambers