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If you know that the other party has misunderstood a term of a draft contract, can you simply sit back and take advantage?
A recent Court of Appeal decision shows this approach to be potentially dangerous where the term is intended to give effect to a prior understanding. It is better to raise the issue with the other party and seek clarity, even if this means alerting the other party to its own mistake.
The pension liability issue
The case concerned the transfer of housing stock from Daventry District Council (DDC) to a registered social landlord, Daventry & District Housing Ltd (DDH). The key facts were:
- employees from DDC's housing department transferred to DDH, and there was a related pension fund shortfall estimated at £2.4 million for which liability had to be allocated between the parties;
- after commercial discussions, the parties reached a (non-binding) agreement in principle that £2.4 million would be deducted from the purchase price, and DDH would pay this to the pension fund. DDC would then receive an increased portion of a separate fund over time, so effectively the liability was shared;
- the agreement in principle, known as the "Valuation", was put in writing and signed by the parties. It was expressed ambiguously, and the previous paragraph states what the court later held the Valuation to mean, as determined on an objective basis;
- the Valuation was not correctly reflected in the draft of the formal transfer contract. The relevant clause provided for DDC, and not DDH, to pay £2.4 million to the pension fund, yet that sum was still deducted from the purchase price; and
- at the suggestion of DDH's bank, the clause was amended shortly before signing of the contract to oblige DDC to discharge the payment by a certain date.
So how did this situation arise? The understanding between each party's respective negotiators, consultants and boards (both internally and externally) was complicated and confused. Further, the parties' solicitors were not sufficiently involved in or instructed on the commercial discussions, and it was not appreciated that there was a major disparity between the draft contract and the Valuation.
Only DDH's negotiator, R, knew the true position on both sides. However, he led DDH's board to believe that DDC had agreed to meet the shortfall, and did not correct DDC's misunderstanding. DDC's negotiator simply thought, wrongly, that the contract reflected the Valuation, even though the clause was clear and he approved it initially and again following the amendment.
When the disparity was discovered, DDC sought the discretionary remedy of rectification of the contract on the grounds of common mistake.
Grounds for succeeding on appeal
At first instance this was refused, but the Court of Appeal allowed the appeal by a 2-1 majority. The contract was rectified to conform to the Valuation.
At first sight, it seems surprising that DDC's appeal succeeded. DDC ought to have read the draft contract carefully, especially when the clause was amended. The dissenting judge thought that by proposing the amendment, DDH had shown clearly that it no longer accepted the terms of the Valuation, and accordingly there was no common continuing intention to adhere to the Valuation at the point of signature.
Ultimately, the majority in the Court of Appeal was strongly influenced by the behaviour of R. He had never asked DDC to revisit the Valuation, and had not proposed any variation of the Valuation in correspondence accompanying the draft contract. It was unrealistic to say that he thought DDC had conceded the point since it would make no commercial sense for DDC to give DDH such a windfall. The proposal of the amendment by DDH was therefore not sufficient to displace the common continuing intention.
A strange result?
The outcome, as the court acknowledged, may appear counter-intuitive. In particular:
- DDH was held to a contract which its board would not have willingly entered into;
- there was found to be a "common mistake" when in fact DDH's board understood and was entirely happy with what the contract provided; and
- one majority judge held that a reasonable hypothetical observer would have assumed DDH to have been making a mistake when proposing the amendment, even though this was not DDC's argument.
It was not necessary to consider the alternative doctrine of rectification for unilateral mistake, which arises where one party mistakenly believes the contract accurately reflects the prior agreement, and the other party knows of this and takes unconscionable advantage. The majority indicated that this remedy would have been granted too if it had been at issue, even though previous caselaw showed dishonesty to be a requirement and the trial judge had found that DDC had failed to prove this on the part of R.
Lessons from the case
By remaining silent and hoping this would work to his advantage, R caused DDH to be held to a contract that its board would not have willingly accepted. It would have been much better if R had reopened the pension liability issue and the parties had compromised on this.
The judgment does not impose a definitive duty to point out a counterparty's misunderstanding. But if working from a heads of terms or another form of preliminary agreement, it is advisable to draw the other party's attention to any intended departure from that agreement in the covering correspondence. Amending the contract itself may not necessarily be sufficient, and the court was plainly minded to punish sharp practice more severely than carelessness.
DDC was nevertheless fortunate. It should have ensured that its negotiator, board and solicitors were all clear on the commercial bargain, and that this was accurately reflected in the legal contract. It should not be assumed that an order for rectification is easily obtainable, and the facts of this case were undoubtedly highly unusual.
The full judgment of the case discussed is available here.
Daniel Hooke, Senior Associate (PSL), Corporate at Fieldfisher.