Interpretation of contracts and business common sense
15 December 2011
It has also clarified the circumstances in which “business common sense” should be applied when interpreting commercial contracts.
Lord Clarke said “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 case provides useful guidance on the approach to contractual interpretation as set out by Lord Hoffmann in Investors Compensation Scheme Ltd v West Bromwich Building Society  1 WLR 896 and follows a line of recent decisions such as Chartbrook Ltd v Persimmon Homes Ltd  UK HL 38 and Re Sigma Finance Corp  UKSC 2, where the House of Lords and Supreme Court respectively have favoured a purposive rather than literal approach to contractual construction.
The decision has been welcomed by both the shipping industry and commercial counterparties as it demonstrates a sensible acknowledgement of commercial considerations by the courts.
Rainy Sky and five other parties (the Buyers) entered into materially identical shipbuilding contracts (the Contracts) with a Korean manufacturer (the Shipbuilder). Payment under the Contracts was by pre delivery instalments (the Instalments) conditional on the Shipbuilder delivering refund guarantees in a manner acceptable to the Buyers’ financiers. Kookmin Bank (the Bank) provided these guarantees in the form of advanced payment bonds (the Bonds). The Bonds were designed to provide a right of recourse, the extent of which was at issue here, in respect of the Instalments if the Buyers became entitled to repayment of them pursuant to the terms of the Contracts.
The Shipbuilder suffered financial difficulties and entered into an insolvency procedure under Korean law. The Buyers duly demanded repayment of the instalments from the Shipbuilder, but when the Shipbuilder refused to repay, the Buyers made a call on the Bank under the Bonds. The Bank also refused to pay.
Dispute over the scope of the Bonds
The Buyers argued that the Bonds guaranteed repayment on the Shipbuilder’s insolvency, whereas the Bank contended that the scope of the Bonds was much narrower and only contingent upon cancellation, termination and rescission. Insolvency was covered specifically in the Contracts, but not specifically in the Bonds.
The disagreement focused on the construction of two paragraphs of the Bonds. A long and poorly drafted clause required the Bank to pay “such sums” but it was unclear whether “such” referred back to:
- “Instalments” mentioned earlier in the same sentence (being sums due under the Contract and including the refund of advance payments on the Shipbuilder’s insolvency); or
- the sums mentioned in the previous sub clause (ie payable on various guarantee trigger events but not insolvency).
The Supreme Court decision
Lord Clarke reinstated Simon J’s decision at first instance and sided with the minority judgment of Sir Simon Tuckey in the Court of Appeal. The Supreme Court held that the commercially reasonable interpretation was that the Bonds were available in the event of insolvency.
Lord Clarke stated that:
- the court must consider the language used and ascertain what a reasonable person (that is, someone who has all the background knowledge that would reasonably have been available to the parties at the time of the contract) would have understood that party to have meant. In doing so the court must have regard to all the relevant surrounding circumstances;
- language used by the parties to a commercial contract “would often have more than one potential meaning”. If there are two possible constructions as was the case with the Bonds, it was appropriate for the court to have regard to considerations of commercial common sense;
- if the language of a contract is unambiguous then the court must apply the wording. However, Lord Clarke specifically rejected Patten LJ’s approach that “unless the most natural meaning of the words produces a result which is so extreme as to suggest that it was unintended, the court has no alternative but to give effect to its terms”. Instead he endorsed the dissenting judgment of Sir Simon Tuckey, who argued that the Buyers’ construction should be preferred because “it is consistent with the commercial purpose of the bonds”;
- the Banks’ construction of the Bonds had a “surprising and uncommercial result” that the Buyers would not be able to call upon the Bonds in the event of insolvency.
Comment: The decision provides useful guidance on one of the rules of interpretation of contracts and circumstances in which business common sense can be considered when reviewing commercial contracts. Of particular interest to commercial practitioners:
- The decision has wide application extending beyond the interpretation of refund guarantees and advance payment bonds to the construction of commercial agreements generally. If the court is asked to interpret ambiguous contractual provisions it can and will consider the particular commercial purpose of a provision. If, however, the wording is unambiguous, the court must still apply it. No doubt parties will debate the ambiguity of contractual terms, but further to the Court of Appeal’s decision in Gesner Investments Ltd v Bombadier Inc  EWCA Civ 1118 (November Litigation Review) any assertions of ambiguity will require a convincing alternative explanation.
- As ever, clear drafting is essential to avoid accusations of ambiguity. If there is a risk that the intended outcome may later be regarded as commercially implausible, then it will be necessary to set out the intention unequivocally to avoid a “business common sense interpretation” to the contrary.
- It continues a trend that commercial purpose should prevail over niceties of language. It is not necessary to conclude that a particular interpretation would produce an absurd or irrational result before having regard to the commercial purpose of the agreement.
- It was clearly significant in this particular case that the Bank did not address any commercial reasons why insolvency might have been excluded. There may be cases where the line is finer than in this case and where the scope for argument and expert evidence will remain.
This case summary is part of the Allen & Overy Litigation Review, a monthly update on interesting new cases and legislation in commercial dispute resolution. For more information please contact Sarah Garvey firstname.lastname@example.org, or tel +44 (0)20 3088 3710.