Contractual interpretation: when can you stray from the strict wording?

There were a number of 1974 leases, with variable wording. However, this article focuses on the following sample clause which provided that the lessee was:

"To pay to the Lessor without any deductions in addition to the said rent as a proportionate part of the expenses and outgoings incurred by the Lessor in the repair maintenance renewal and renewal of the facilities of the Estate and the provision of services hereinafter set out the yearly sum of Ninety Pounds and Value Added tax
(if any) for the first Year of the term hereby granted increasing thereafter by Ten Pounds per hundred for every subsequent year or part thereof." [emphasis supplied]

The lessor argued that the service charge provisions provided for a fixed annual charge of GBP 90 for the first year of the term, increasing each year by 10% on a compound basis. The current lessees primarily argued that this interpretation gave such an increasingly absurdly high annual service charge in the later years of each lease that it could not have been intended. They argued that, properly read, each service charge clause requires the lessee to pay a fair proportion of the lessor's costs of providing the services, subject to a maximum, and it was that maximum, or cap, that was GBP 90 in the first year, and which increased every year by 10% on a compound basis. In other words, the clause should be read as follows "…the provision of services hereinafter set out up to the yearly sum of Ninety Pounds…" The phrase "up to" being implied or read into the clause.

The following table illustrates the issue (the inflation figures were not in evidence but were taken from the Bank of England's published figures

A new approach to commercial common sense

The focus of the debate, and the importance of the decision, centres around the limits of the so-called "commercial common sense" (also referred to as "business common sense") approach to the interpretation of contacts. Over the past 45 years, the House of Lords and Supreme Court have discussed the correct approach to be adopted to the interpretation, or construction, of contracts in a number of cases starting with Prenn v Simmonds [1971] 1 WLR 1381 and culminating in Rainy Sky SA v Kookmin Bank [2011] UKSC 50 (see November 2011 Litigation Review).

When interpreting a written contract, the court has to identify the intention of the parties by reference to "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", to quote Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38 (see August/September 2009 Litigation Review).

It does so by focusing on the meaning of the relevant words, in their documentary, factual and commercial context. Lord Neuberger (providing the leading judgment in this case) held that that meaning has to be assessed in the light of: (i) the natural and ordinary meaning of the clause; (ii) any other relevant provisions of the contract; (iii) the overall purpose of the clause and the contract; (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed; and (v) commercial common sense; but (vi) disregarding subjective evidence of any party's intentions.

Lord Neuberger emphasised seven factors, which will no doubt form the basis of any subsequent analysis of the commercial common sense approach to contractual interpretation:

First, 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. Unlike commercial common sense and the surrounding circumstances, the parties have control over the language they use in a contract.

Second, when it comes to considering the centrally relevant words to be interpreted, it is accepted that the less clear they are, or, to put it another way, the worse the drafting, the more ready the court can properly be to depart from their natural meaning. However, that does not justify the court embarking on an exercise of searching for, let alone constructing, drafting infelicities in order to facilitate a departure from the natural meaning.

Third, commercial common sense is not to be invoked retrospectively. The fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language.

Fourth, while commercial common sense is a very important factor to be considered when interpreting a contract, a court should be very slow to reject the natural meaning of a provision as correct simply because it appears to be a very imprudent term for one of the parties to have agreed. The purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed.

Fifth, when interpreting a contractual provision, one can only take into account facts or circumstances which existed at the time that the contract was made, and which were known or reasonably available to both parties. Given that a contract is a bilateral arrangement involving both parties, it cannot be right, when interpreting a contractual provision, to take into account a fact or circumstance known only to one of the parties.

Sixth, in some cases, an event subsequently occurs which was plainly not intended or contemplated by the parties, judging from the language of their contract. In such a case, if it is clear what the parties would have intended, the court will give effect to that intention.

An example is Aberdeen City Council v Stewart Milne Group Ltd [2011] UKSC 56, where the court concluded that "any … approach" other than that which was adopted "would defeat the parties' clear objectives", but the conclusion was based on what the parties "had in mind when they entered into" the contract.

Seventh, and specific to leases, reference was made in argument to service charge clauses being construed "restrictively". Lord Neuberger was unconvinced by the notion that service charge clauses are to be subject to any special rule of interpretation.

Having examined the clauses (and their variations) in detail, Lord Neuberger was not persuaded that anything had gone wrong with the wording. He was also far from convinced, given when the leases were entered into, that the original lessee's agreement was commercially far-fetched (though he acknowledged that it had become so). He didn't even think that reading the words "up to" into the clauses made sense since that would render the cap was so high as to be ineffective. He therefore upheld the literal reading of the clause.

But what about the poor tenants?

Lord Carnwath, in the only dissenting judgment, was concerned about the plight of the tenants. He believed the clauses to be "wretchedly conceived" and regarded the consequences of the lessor's interpretation as so commercially improbable that only the clearest words would justify the court in adopting it. He held that the limited addition proposed by the lessees did not do such violence to the contractual language as to justify adopting the alternative reading which led to a result which he felt was commercial nonsense. In this respect, he noted that there appear to be two conflicting elements in the clause. Initially it appears to be aimed at ensuring tenants pay "a proportionate part of the expenses and outgoings incurred by the Lessor". However, it then abruptly changes tack, so that the tenants are obliged to pay an absolute amount which bears no apparent relationship to the costs incurred by the landlord in providing the services which the service charge covers. Further, the two halves of the clause do not appear to have any, or any adequate, conjunctive language, such that the proportionate and absolute elements just sit side by side, without being linked.

COMMENT

For many years, the English courts have moved away from the historic and very strict approach which supposedly used to characterise contractual interpretation. The courts have introduced the "factual matrix" and "commercial common sense" tests, as well as implied terms to cater for cases where a literal reading might otherwise produce extreme or absurd results.

However, "commercial common sense" has a risk of being in the eye of the beholder, and it has been difficult to set useful limits on how and when it might be applied. In this case, recent inflation rates have produced seemingly absurd results for the tenants. However, compounding service charges at 10% annually in 1974 – when some of the leases were first entered into – would equally have resulted in the landlord having to pay considerably more to provide the services than s/he could recover from the tenants who received those services. Viewed in this light, there was nothing inherently offensive to commercial common sense in the construction of the agreement adopted by the majority. Rather, chance meant that the bargain has turned out – so far – to be severely disadvantageous for one side, and highly beneficial for the other. The position could, of course, reverse itself, depending on future inflation rates. Equally, the bargain could have turned out, or could still turn out, to be roughly equal for both sides.

It is notable that Lord Neuberger seems to have concentrated on this element, rather than on the question of the lack of clarity of the clause – in particular, whether service charges were to be set as a "proportionate part" of the costs the landlord incurred, or by virtue of a fixed formula which did not necessarily bear any relation to the landlord's actual costs.

In this sense, it might be said that both he, and Lord Carnwath, found the answer from the part of the clause that they focused their analysis on, but did not necessarily say why one element of the clause should take precedence over another.

For businesses and lawyers, the test set out by Lord Neuberger is likely to help inform when one can stray from the literal words and adopt an interpretation that accords with commercial common sense.