The In-House Lawyer

Parties faced with an ambiguous contractual term, or indeed parties faced with what seems to be an unambiguous term not to their liking, often seek to rely on evidence of the factual background to support their favoured interpretation. In doing so, reliance is placed on the decision of the House of Lords in Investors Compensation Scheme Ltd v West Bromwich Building Society [1998]. Here, Lord Hoffman reiterated that interpretation was an objective exercise seeking to determine what a reasonable person, having all the background knowledge available to the parties, would have understood the contract to mean.

Evidence of ‘background knowledge’ is permissible whether or not the contractual wording is ambiguous, and whether or not the interpretation of the contract is an ‘available’ meaning of the words or syntax used. While evidence of ‘background knowledge’ is on occasion of assistance in contractual interpretation, that presented is all too often plainly subjective in nature and more aptly described as after-the-event wishful thinking of what a party would like a clause to mean to succeed. In Investors, Lord Hoffman noted that these were the only points that could be thought in the least controversial, and that – despite the fears of many commentators – his decision in had not greatly increased the quantity of background material that courts or arbitrators are invited to consider. That may well be true, although the rule remains capable of abuse by litigants faced with clear drafting and inevitable defeat.

One category of documents cannot, however, be relied upon as an aid to the interpretation of a contract. That is evidence of pre-contractual negotiations. This ‘exclusionary rule’ has a long pedigree. In recent times, it was affirmed by the House of Lords in Prenn v Simmonds [1971], and has now been restated in Chartbrook Ltd v Persimmon Homes Ltd[2009].

Disputes

Chartbrook concerned a development contract between the owner of land and a property developer. The contract contained what at first sight might appear to be a straight-forward pricing formula, but on analysis was capable of several meanings. The difference in value between the competing interpretations of the owner and property developer was almost £3.6m. This was not therefore a case where interpretation was straight-forward, a fact demonstrated by the divergence of views between judges as the case progressed from first instance to the House of Lords. The owner succeeded at first instance and by a majority in the Court of Appeal. The property developer won the final battle in the House of Lords. The property developer’s interpretation had required several words to be written into the agreement. This had been fatal to its arguments in the lower courts, as both had held that to do so would ‘fundamentally distort’ the meaning of the clause, and would constitute an impermissible ‘re-writing’ of the agreement that the parties had reached.

Interpretation of the clause

In overturning the decision of the Court of Appeal, the House of Lords felt able to stand back and, without worrying about the ‘alternate form of words’ that would accurately express the contractual meaning, and how much this would differ from the words actually used, put themselves in the shoes of the reasonable person, to ask what they would have ‘understood the parties to have meant by using the language they did’.

For the House of Lords, the ‘striking feature of the case’ was that the interpretation of the owner led to what the Law Lords regarded as an arbitrary and irrational commercial result, while the interpretation of the property developer combined the elements of the formula in a rational way. From this perspective, the commercially sensible interpretation offered by the property developer was ‘compelling’.

Pre-contractual negotiations

The property developer therefore won on the interpretation of the wording of the clause. However, in support of its case it invited the House of Lords to overturn the bar on the admissibility of pre-contractual negotiations in interpreting the meaning of a contract. This gave the House of Lords the opportunity to review the exclusionary rule. Lord Hoffman accepted that pre-contractual negotiations could be helpful when interpreting a contract. Indeed, he noted that it would not be inconsistent with the English objective theory of contractual interpretation to do so. However, there were pragmatic reasons for the existence of the rule:

• First, and most importantly, admission of pre-contractual negotiations would create greater uncertainty of outcome as to the meaning of a contract, and add to the costs of dispute resolution.
• Secondly, there would be scope for disagreement as to whether the evidence affected the interpretation of the contract, or was irrelevant.
• Thirdly, in Lord Hoffman’s view, while surrounding circumstances tend to be uncontroversial facts, evidence about pre-contractual negotiations is less likely to be reliable, particularly evidence of oral negotiations: ‘statements in the course of pre-contractual negotiations will be drenched in subjectivity and may, if oral, be very much in dispute’.
• Fourthly, admitting evidence of negotiations may be unfair to third parties who relied on the contract terms, for example by taking an assignment of a contract or lending on its security, when it would be difficult for them to know the content of pre-contractual negotiations.
• Fifthly, if evidence was admissible, parties might conduct negotiations to gain a later advantage, by making it appear a particular meaning had been agreed when it had not been.

Lord Hoffmann also noted that the exclusionary rule had been in existence for many years (possibly centuries) and had been affirmed on several occasions. While the House of Lords had the power to depart from previous decisions, by practice it did so only where those decisions were thought to be impeding the proper development of the law or to have led to results that were unjust or contrary to public policy. This could not be said to be the case in relation to the exclusionary rule. The House of Lords therefore declined to do so.

Limitations and exceptions to the rule

There are exceptions to the exclusionary rule:

• Rectification. The court has power to correct mistakes in a contract so that it accurately reflects the true agreement between the parties. A claim to rectification must be specifically pleaded. Evidence of negotiations is admissible in rectification proceedings.
• Estoppel by convention. Where parties have relied on a shared understanding, assumption or agreement about certain facts, for example the meaning of a contractual obligation, the court may not permit any of them later to depart from that position if it would be unjust or unconscionable to do so. Again, evidence of negotiations may be admissible in the context of such a claim.
• Private dictionary rule. Evidence of pre-contractual negotiations is admissible to establish that parties habitually used words in an unconventional sense, in support of an argument that words in a contract should bear a similarly unconventional meaning. In Chartbrook, Lord Hoffman considerably narrowed the circumstances in which this rule could apply, regarding as wrongly decided a first-instance decision that evidence of negotiations was admissible where the contract was capable of bearing more than one meaning and it was alleged that the parties had negotiated on the basis that the words bore one of these meanings. In these circumstances, rectification is the appropriate route.
• Misrepresentation. A claim for misrepresentation requires the defendant to make a false statement, which is untrue, which induces the claimant to enter into the contract, and which causes loss. By definition, a misrepresentation is likely to occur during pre-contractual negotiations, and therefore evidence about those negotiations would be admissible.

Conclusion

Many practitioners and commercial clients will agree with the position that evidence of contractual negotiations is inadmissible when interpreting a contract, unless a claim for rectification is made. The contrary position would make contractual disputes less predictable and would add to their cost. As Lord Hope stated in the Chartbrook case:

‘The purpose of a formal contract is to end the disputes which would inevitably arise if the matter were left upon what the parties said or wrote to each other during the period of their negotiations.’

This is only after resolving the inevitable disputes about what was said or what the contents of letters or e-mails meant. In negotiations parties’ positions are changing until the final agreement is reached.

By Antonio Suarez-Martinez, solicitor, Edwards Angell Palmer & Dodge UK LLP.E-mail: This e-mail address is being protected from spambots. You need JavaScript enabled to view it .