Cases involving the proper approach to contractual interpretation only infrequently warrant determination by the Supreme Court as the ‘rules’ have been comparatively settled for some time. There have, however, been indications of a growing tendency of the courts to resolve unattractive interpretations based on the strict wording of contracts by reference to ‘commercial common sense’ that requires an alternative interpretation. In response to these decisions, the Supreme Court’s decision inArnold v Britton & ors  has re-established the supremacy of the principle that the intention of the parties to a contract should, with very limited exception, be derived from the natural meaning of the words they have chosen to use.
The dispute concerned the proper interpretation of service charge contribution provisions in the leases of a number of chalets in a leisure park on the Gower peninsula. Twenty one of the leases had been granted between 1978 and 1991, for a term of 99 years from 1974. The relevant clause in those 21 leases was contained within the lessee’s covenants and provided (with some variations) as follows:
‘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 and renewal of the facilities of the estate and the provision of services hereinafter set out the yearly sum of £90 and value added tax (if any) for the first year of the term hereby granted increasing thereafter by £10 per hundred for every subsequent year or part thereof.’
The leases also contained a covenant that the lessor would ensure that leases of other chalets:
‘… shall contain covenants on the part of the lessees thereof to observe the like obligations as are contained herein or obligations as similar thereto as the circumstances permit’.
In contrast to these 21 leases, the leases of the remaining 70 chalets in the park, all of which had been granted prior to 1978, provided that the service charge would increase by £10 per hundred every three years.
Arnold, the landlord, contended that the service charge contribution provisions should be taken at face value and had the effect of providing for a fixed annual charge of £90 for the first year of the term, increasing each subsequent year by 10% on a compound basis.
The result of this interpretation would be an obligation on a lessee granted a lease in 1978 to pay over £700,000 per annum in respect of service charge by the end of the term.
The lessees primarily contended that the landlord’s construction resulted in such an increasingly absurdly high annual service charge in the later years that it could not be right. They argued that, properly read, each service charge clause required the lessee to pay a fair proportion of the lessor’s costs of providing the services, subject to a maximum, which was £90 in the first year of the term, and increased every year by 10% on a compound basis; in effect, the words ‘up to’ should be read into the clause between the words ‘the provision of services hereinafter set out’ and ‘the yearly sum of £90’.
Lord Neuberger, delivering the leading judgment, summarised the duty of the court when interpreting a written contract in familiar terms:
‘… the court is concerned 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”… it does so by focussing on the meaning of the relevant words… in their documentary, factual and commercial context. 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 lease, (iii) the overall purpose of the clause and the lease, (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…’
His Lordship went on to set out seven factors he deemed important in the context of the case, the following five of which are of general application:
- The reliance placed on commercial common sense should not be invoked to undervalue the importance of the language of the provision that is to be construed. The exercise of interpreting a provision involves identifying what the parties meant through the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision.
- When it comes to considering the centrally relevant words to be interpreted, the less clear they are, 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.
- commercial common sense is not to be invoked retrospectively. The mere 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.
- While commercial common sense is a very important factor to take into account 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.
- In some cases, an event subsequently occurs which was plainly not intended or contemplated by the parties. In such a case, if it is clear what the parties would have intended, the court will give effect to that intention.
In Neuberger LJ’s opinion, the natural meaning of the words used in the relevant clause seemed clear (‘at least until one considers the commercial consequences’): the first half of the clause stipulated that the lessee is to pay an annual charge to reimburse the lessor for the costs of providing the services which they covenant to provide, and the second half of the clause identified how that service charge is to be calculated. The fact that, in the future, its quantum may substantially exceed the parties’ expectations at the time of the grant of the lease is not a reason for giving the clause a different meaning.
Neuberger LJ recognised that the consequence of this interpretation of the clause was ‘alarming’ in light of the fact that annual inflation had hardly ever been over 4% in the last 15 years. In these circumstances, he suggested it was tempting to latch onto the absence of words such as ‘quantified in the sum of’, and to see the two halves of the clause as mutually inconsistent in their effect. However he concluded that to do so would involve the court inventing a lack of clarity in the clause as an excuse for departing from its natural meaning, in the light of subsequent developments.
Further, while an annual 10% compound increase may be unacceptable as looked at in 2015, Neuberger LJ did not think it impossible that the parties would have assumed the cost of providing the services would increase at or around such a rate at the time of executing the leases. In this regard he noted that interest had been running at a rate of well over 10% per annum between 1974 and 1981 (indeed over 15% per annum for six of those eight years) and almost reached 10% again in 1990.
In his dissenting judgment, Lord Carnwarth considered the result of such an interpretation to be ‘grotesque’.
In contrast to the analysis of the relevant precedents offered by Neuberger LJ and Hodge LJ, Carnwarth LJ highlighted those judgments that have favoured commercial common sense. Starting with the judgment of Lord Clarke JSC in Rainy Sky SA v Kookmin Bank , he commented that:
‘… in view of the importance attached by others to the so-called “natural meaning” of [the service charge clause] it is important to note that Lord Clarke specifically rejected Patten LJ’s proposition that “… unless the most natural meaning of the words produces a result so extreme as to suggest that it was unintended, the court must give effect to that meaning.” In Lord Clarke’s view it was only if the words used by the parties were “unambiguous” that the court had no choice in the matter.’
He ended his review of the case law with reference to Aberdeen City Council v Stewart Milne Group Ltd , which he described as ‘a useful recent illustration in this Court of how these various principles may be deployed, to enable the court to achieve a commercially sensible result in the face of apparently intractable language’ that supports the proposition that:
‘… where an ordinary reading of the contractual words produces commercial nonsense, the court will do its utmost to find a way to substitute a more likely alternative, using whichever interpretative technique is most appropriate to the particular task’.
Contrasting the disputed leases with the earlier leases that provided for a triennial increase, Carnwarth LJ calculated that, on the majority’s interpretation, by the end of the lease period each lessee’s service charges would have totalled over £11m, more than 200 times the amounts payable by the earlier lessees. He found that this consequence was:
‘… so commercially improbable that only the clearest words would justify the court in adopting it’.
He found that the inconsistency between the first part of the clause that required the payment by the lessee of a ‘proportionate’ part of the service charge, and the second part containing the formula was sufficiently ambiguous as to allow for the ‘limited addition’ proposed by the lessees.
Lord Carnwarth’s judgment will, no doubt, be deemed by many to reach the ‘right’ conclusion. However, despite the potentially catastrophic financial result of the judgment for the lessees, the decision is, from a purely legal standpoint, a helpful one. It goes a long way towards resolving the tension that has been building in recent years between, on the one hand, the principle that the parties’ common intentions should be derived from the words they use and, on the other, the desire to avoid commercially nonsensical results. While Neuberger LJ justified his conclusion commercially, the tenor of his judgment would indicate that this commercial justification was not in fact necessary: commercial common sense will, except in the most extreme circumstances, play second fiddle to the clear wording of an agreement.
This decision may not represent new law but it may herald a more consistent and therefore more predictable approach. The Court of Appeal in Wood v Sureterm Direct Ltd & Capita Insurance Services Ltd , following this decision, favoured an interpretation of an indemnity clause based on the language of the contract despite the fact that that interpretation made the contract wholly uncommercial for the buyer.
By Alex Radcliffe, associate, Cooley UK LLP.