Supreme Court confirms that both commercial common sense and the natural meaning of the words matter in contractual interpretation
26 April 2017
In Wood v Capita Insurance Services Ltd  UKSC 24, the Supreme Court again examined the principles of contractual interpretation. In Arnold v Britton the Supreme Court had cautioned against commercial common sense overriding the natural meaning of a provision. In Rainy Sky SA v Kookmin Bank, it had explained that, if there were two possible constructions, the court was entitled to prefer the construction consistent with business common sense. Now the court has confirmed that textualism (Arnold v Britton) and contextualism (Rainy Sky), should not be regarded as "conflicting paradigms" in a battle for primacy in contractual interpretation. Rather, they are tools for ascertaining the objective meaning of the language chosen by the parties to express their agreement: the extent to which the court will rely on each tool will vary depend on the circumstances.
An opaque indemnity
The case concerned the interpretation of an indemnity clause in a sale and purchase agreement for an insurance broker. The purchaser was indemnified for loss suffered as a result of claims or complaints for mis-selling registered with the financial services regulator. However, the purchaser had suffered loss as a result of a remediation scheme imposed by the regulator following its self-reporting of mis-selling (rather than through claims or complaints of customers). That remediation scheme had lead to the purchaser paying approximately GBP 1.35 million in customer compensation. Was this loss covered by the "admittedly opaque" language of the indemnity?
The Supreme Court held that the loss fell outside the indemnity clause. The text of the clause was key: the circumstances triggering the indemnity were principally found in a careful examination of the language used, and did not extend to loss covered by self-reporting mis-selling. Both on the face of the clause, and following a detailed parsing, the court favoured the seller's narrow construction.
The purchaser's suggested wider reading of the indemnity clause was rejected: it would mean that a part of the clause would be rendered otiose, and failed to identify the persons against whom mis-selling claims or complaints needed to be made (a necessary trigger for the indemnity to operate).
However, the court noted it was still necessary to place the clause in its contractual context and to consider the wider factual matrix. The parties to the contract were commercially sophisticated. In addition to the contractual indemnity covering loss from mis-selling, the seller had also given detailed warranties as to regulatory compliance. These warranties may have enabled the purchaser to recover for its loss: but for the expired two-year contractual limitation period on warranty claims. The court held it was not contrary to business common sense for the parties to agree wide-ranging but time limited warranties, with the protection of a further indemnity unrestricted as to time, but triggered in more limited circumstances. The court would not improve the bargain for the purchaser.
A unitary exercise
Contractual interpretation is a unitary exercise: it does not matter whether the process commences with the factual background, or a close examination of the relevant language, provided that the court balances the indications given by each method through an iterative process.
Where there are rival meanings, the court can give weight to the construction which is more consistent with business common sense. But, in striking a balance between the indications given by the language and the implications of the competing constructions, the court must:
- consider the quality of drafting of the clause;
- be alive to the possibility that one side may have agreed to something which with hindsight did not serve his interest; and
- not lose sight of the possibility that a provision may be a negotiated compromise or that the negotiators were not able to agree more precise terms.
The type of agreement, and sophistication of parties, may also impact the analysis preferred by the court. For example, sophisticated and complex agreements, negotiated and prepared by skilled professionals, may be more successfully interpreted textually. However, it was accepted that even negotiators of complex formal contracts may not always achieve a logical and coherent text.
The challenge ahead
The court was quick to reject the submission that Arnold involved any "rowing back" from Rainy Sky guidance: it is clear that all is not lost when it comes to considering business common sense. While the pure words of the contract remain important, they do not trump common sense considerations post-Arnold. This can be a relief in the context of complex commercial contracts, where a drafting ambiguity can threaten to undermine the wider commercial structure.
The challenge for those drafting contracts is that, when subject to close scrutiny by the courts, different judges, applying the correct principles, can reach different opposing conclusions on the meaning of provisions. There is not a simple solution to this, and this latest update from the Supreme Court means that some of the certainty that Arnold v Britton afforded has vanished.
It is clear that the pendulum has swung back away from Arnold: the court was quick to reject the submission that Arnold involved any "rowing back" from Rainy Sky guidance. This can be a relief in the context of complex commercial contracts, where a drafting ambiguity can threaten to undermine the wider commercial structure. Importantly, for detailed professionally drawn contracts, the Supreme Court has reiterated the utility of the iterative process (described in Sigma Finance) when interpreting ambiguous provisions. This involves checking each suggested interpretation against the provisions of the contract and its commercial consequences. In such contracts, Lord Hodge comments, the lawyer may be particularly helped by considering the factual matrix and purpose of similar provisions in contracts of the same type.
This case summary is part of the Allen & Overy Litigation and Dispute Resolution Review, a monthly publication. For more information please contact Amy Edwards at firstname.lastname@example.org.
Please see Compact Contract, a blog where experts from Allen & Overy analyse the latest contract law themes and developments, and what they mean for your business.