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UK Supreme Court ruling on contract interpretation

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UK Supreme Court ruling on contract interpretation

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This article was featured in Tech Bytes, our technology law newsletter.

How should the courts interpret a contract clause that has two possible meanings?  This question was answered by the UK's Supreme Court in a judgment issued on 2 November 2011.

The Supreme Court had to decide whether and in what circumstances the courts are allowed to take into account business common sense when deciding between two alternative constructions of a contract term.  The court began by re-stating the general principle of contract construction:  that is, the court must consider the language used and decide what a reasonable person with all the background knowledge that was reasonably available to the parties at the time of the contract would have understood the parties to have meant.

But what if, applying that principle, there are two possible constructions?  In those circumstances, the Supreme Court ruled, the court is entitled to prefer the meaning which is most consistent with business common sense.

The dispute in this case concerned refund guarantees in the form of bonds under six ship-building contracts.  Under the contracts, the ship-builder agreed to build and sell one vessel to each of the buyers.  The buyers were to pay for the vessels in installments with the final payment due on delivery.  Under one possible interpretation of the contracts, the buyers had the right to call in the guarantee and obtain a refund of the instalments on the occurrence of one of a number of specified events, including the ship-builder's insolvency; on the other possible interpretation, insolvency was not among the events that triggered a refund under the guarantee.

In the Court of Appeal, Patten LJ had said that the court should follow the natural meaning of the words used, unless this produces an absurd or irrational result.  In this case, the narrower interpretation of the clause did not produce an absurd result.  There could have been any number of reasons why the builder was unable or unwilling to arrange a guarantee to cover insolvency events, and it was not for the Court of Appeal to substitute its own view of the commerciality of the transaction for the view of the parties.  The Supreme Court rejected this approach, stating that it is not necessary to show that one of the possible interpretations flouts business common sense in order for the court to be allowed to take into account the commercial purpose of the transaction.

The Supreme Court pointed to the fact that the builder's insolvency was exactly the sort of event for which a refund guarantee was most likely to be needed; and it was consistent with the commercial purpose of the bonds that payment under the guarantee should be triggered on insolvency. The clause should be construed so that an insolvency event triggered payment under the guarantee. 

Comment and practice tip:

This is not the first time that the UK's top court has taken this approach.  Lord Clarke, whose judgment forms the basis of the ruling, cites several other House of Lords decisions where the court has taken into account the commercial purpose of the transaction where a clause has two possible meanings.  In that sense, by overturning the Court of Appeal decision, the Supreme Court has restored business-as-usual.  Nonetheless, the case highlights the importance of ensuring that contract terms are clearly drafted and open only to one interpretation.  A clause that is both open to more than one interpretation and commercially unusual is particularly vulnerable.  In order to avoid uncertainty and mitigate the risk of a dispute, the parties could consider incorporating into the contract an explanation of the rationale for any commercially unusual provisions.

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