Revisiting the approach to contractual interpretation

The environment in the financial markets over the last few years has ?inevitably led to greater scrutiny of the legal documents underpinning commercial transactions. Parties have been ?incentivised to review contracts for any ?commercially beneficial ambiguities. The English court has taken this opportunity to clarify ?the principles to be applied when construing ?a contract to correct an obvious defect ?in drafting.

The decision of the House of Lords in Chartbrook Ltd v Persimmon Homes Ltd and others [2009] UKHL 38 reflected a sophisticated and commercially sensitive approach to construction where the general structure of the bargain was considered. Lord Hoffmann set out the test to be applied in deciding whether it is possible to construe a contract to correct an obvious error: (1) it should be clear that something has gone wrong with the language; and (2) it should be clear what a reasonable person would have understood the parties to have meant.

Other than in the clearest case, the English court has tended to revise the terms of the contract by reference to business common sense in order to produce a more reasonable result. However, in doing so, the English court has to be careful not to impose its own view of what the commercially sensible bargain for the parties to have reached would have been.

In ING Bank NV v Ros Roca S.A. [2011] EWCA Civ 353, there was a dispute with regard to how to interpret a reference in a contractual formula to a company's EBITDA 2006 to calculate an additional fee for financial services provided by ING Bank NV to Ros Roca S.A. on a transaction that did not take place until the end of 2007. At first ?instance, the judge held that it should be interpreted as a reference to EBITDA without linking it to a specific year on the basis that a different approach would be a 'commercial nonsense' when it was clear that the reference to 2006 had been included by oversight. In his view, any other interpretation would have resulted in an outcome that was commercially unreasonable.

Failure to anticipate outcomes

The first instance finding in ING Bank on construction was, however, overturned on appeal. Carnwath LJ considered the first limb of the test set out in Lord Hoffmann's judgment in Chartbrook and concluded that it was not clear that something had gone wrong with the language and, even if there had been an error, it was not clear what a reasonable person would have understood the parties to have meant. Carnwath LJ considered that the fact that the parties had overlooked the possibility that the transaction would not be concluded promptly (as expected) was insufficient to engage Lord Hoffmann's two-stage test. In his view, the mistake was not in the language used but in failing to anticipate what its consequences might be. This was not in itself a reason for rewriting the agreed formula as the judge had done.

Rix LJ considered that it was impossible to ignore the reference to EBITDA 2006 or to turn it into a reference to a different EBITDA: the fact that Ros Roca S.A. did not seek to renegotiate this term when the transaction was delayed was an error of commercial ?intuition, not an error of language in the expression of an agreement.

The contract would have operated perfectly well if the transaction had completed on the timetable originally envisaged. Rix LJ noted that, in contrast, the error in Chartbrook had 'always existed'.

Rix LJ continued that '[c]onstruction cannot be pushed beyond its proper limits in pursuit of remedying what is perceived to be a flaw in the working of the contract'¦ in that it does not provide for all eventualities'¦ [T]here is a danger, frequently warned against in such cases, of the courts seeking to remake contracts for the parties on the basis of what the courts consider would have been reasonable, or more sensible, for the contract to have said. Judges should not see in Chartbrook an open sesame for reconstructing the parties' contract, but an opportunity to remedy by construction a clear error of language which could not have been intended.'

The Court of Appeal was therefore emphasising the need to ensure that the English court does not substitute its own view of what would have been a commercially reasonable bargain simply because the contract does not provide for all eventualities

This '“ in contrast to a clear error '“ was not something that should be remedied through construction. The Court of Appeal did, ?however, preserve the judge's order through the application of equitable doctrines ?(essentially holding that it was unjust to ?permit ING Bank NV to renege on the shared assumption that EBITDA 2006 was not to ?be used).

Business common sense

In Rainy Sky S.A. and others v Kookmin Bank [2011] UKSC 50, the Supreme Court considered the role to be played by business common sense in determining what the parties meant by the words used in a shipbuilder's refund guarantee and restated the principles to be applied when construing commercial contracts.

The court held that it was necessary to consider the language used while having regard to all of the relevant surrounding circumstances, reflecting the fact that words derive their meaning by their use in a particular context. Lord Clarke stated that the key was to ascertain what a reasonable person '“ a person who has all the background knowledge that would reasonably have been available to the parties at the time the contract was concluded '“ would have understood the parties to have meant.

The Supreme Court disagreed with the view of Patten LJ in the Court of Appeal that the court must give effect to the wording unless the natural meaning of the words produces such an extreme result that it could not have been intended. Patten LJ had considered that '[t]o do otherwise would be to risk imposing obligations on one or the 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'.

Instead, while acknowledging that the English court must apply unambiguous language where it is used (unless those words have been used mistakenly), Lord Clarke noted that the language used in a contract will often have more than one potential meaning. Therefore, 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'. The Supreme Court allowed the appeal and restored the order of the judge.

This judgment reflects again the commercially sensitive approach of the ?English court to construction. The construction being contending for by ?Kookmin Bank would have had the uncommercial result that Rainy Sky and others would not have been able to call on the bonds on an insolvency of the shipbuilder, which was an event that would be most likely to require the security to be ?available.