05-12-2011

Guidance on how courts will interpret contract terms in dispute

The Supreme Court has given guidance on when a court will apply a ‘commercial common sense’ test to interpret contract terms in a contractual dispute.

A dispute arose about two paragraphs in a contract between the buyer of a ship and a bank, under which the bank was obliged to pay a sum of money to the buyer if certain events stopped the seller from performing the contract. The seller of the ship became insolvent, and the buyer argued that this was one of the events that triggered the obligation of the bank to pay. However, the interaction between the two paragraphs was not clear. The bank argued that, on its interpretation of the two paragraphs, it did not have to pay.

The High Court ruled that the bank’s interpretation of the contract would lead to a surprising and uncommercial result. On that basis, it found in favour of the buyer.

The Court of Appeal disagreed with this reasoning. It said that the contract had to be interpreted literally, unless that would lead to such an extreme result that the court could infer that it was not what the parties had intended. On that basis it ruled in favour of the bank.

The Supreme Court (formerly the House of Lords) said that the Court of Appeal was wrong. The court’s job in contract disputes was to determine what the parties meant by the words used. It should therefore look at the words the parties had used in the contract and establish what a reasonable person, with the background information available to the parties to the contract at the time, would have understood them to have meant. If they were ambiguous, a ‘commercial common sense’ test could be applied.

The steps required were therefore:

  • Where contract terms are clear and unambiguous, the parties must have meant them. The terms will therefore apply, even if they go against commercial common sense and are improbable.
  • If there were two possible interpretations (as there usually will be in a contract dispute), the court was entitled to choose the one that was consistent with commercial common sense.
  • It is not necessary to find that an interpretation would produce an absurd or irrational result before bringing issues of commercial common sense into play.

In this case, the Supreme Court said that there were alternative interpretations of the contract terms. It therefore applied a commercial common sense test. It found that the insolvency that occurred was actually the most likely event that a buyer would have wanted to trigger the bank’s obligation to make a payment. It made no commercial sense for the buyer to have agreed to exclude it. For that reason, the Supreme Court ruled in the buyer’s favour.

Recommendation

As well as making sure their contracts are clear and unambiguous, the parties should also check that each contract term is commercially sensible or risk the court deciding those terms mean something different if there is a dispute. If a contract terms is unusual, increasing the risk, the reason the parties are agreeing to it should be made clear in the contract, and supporting records made and retained.