Key takeaways
Unambiguous contractual wording
Court must apply it even if outcome is commercially unfavourable to one party.
Two possible interpretations
Court can choose interpretation that is in line with business common sense.
Commercial common sense
Assessed as at time contract entered into.
In Rainy Sky SA & Ors v Kookmin Bank [2011] UKSC 50 (2 November 2011), the UK Supreme Court dealt with the construction of shipbuilder’s refund guarantees given pursuant to six shipbuilding contracts.
In particular, the Supreme Court considered the scope for applying business common sense in determining what the parties meant by the language used in their contract.
The dispute highlighted the importance of ensuring that the terms of a refund guarantee closely align with termination triggers, payment obligations and default provisions of the underlying shipbuilding contract.
The Supreme Court decision’s importance extended beyond the shipbuilding sector and to the construction of commercial contracts generally. This is because, as the case showed, the language used by parties in their contract may be capable of more than one reasonable interpretation, particularly where provisions overlap or have not been drafted consistently.
Therefore, the clearer and more precise the contractual drafting, the less scope there is for dispute as to what the parties meant. Where drafting is ambiguous or inconsistent, the parties risk the court adopting an objective interpretation that does not correspond with what one or both of them may privately have intended.
This article looks at what the Supreme Court said about the role of commercial common sense in the interpretation of contracts. It then considers what two subsequent Supreme Court decisions, Arnold v Britton & Ors [2015] UKSC 36 (10 June 2015) and Wood v Capita Insurance Services Ltd [2017] UKSC 24 (29 March 2017), said about the Rainy Sky approach.
Rainy Sky: the background facts
In May 2007, the claimant Buyers entered into six shipbuilding contracts (Contracts) with a Korean shipyard as Builder.
The Contracts
Pursuant to the Contracts, the Builder agreed to build and sell one vessel to each of the six Buyers for US$33.3m, payable in five equal instalments.
Article X.8 of the Contracts provided that payment of the first instalment was conditional upon the Builder providing the Buyer with a satisfactory refund guarantee from a first-class Korean bank.
Article X.5 gave the Buyer a right to a full refund in the event that the Buyer exercised their right to reject the vessel or to terminate, cancel or rescind the Contract.
Article XII.3 of the Contracts gave the Buyers further rights to repayment of instalments paid in the event of a default by the Builder. Specifically, Article XII.3 stated that if the Builder became subject to certain insolvency proceedings, the Buyer could require the Builder to refund immediately all amounts already paid by the Buyer.
The Bonds
In August 2007, the Korean Bank issued each of the Buyers with materially identical Advance Payment Bonds (Bonds).
Paragraph 2 of the Bonds stated that, under the terms of the Buyer’s Contract with the Builder, the Buyer was entitled to a refund in the event that they exercised their right to reject the vessel or to terminate, cancel or rescind the Contract.
Paragraph 3 of the Bonds stated that the Bank promised to pay the Buyer ‘all such sums due to you under the Contract’ in consideration of the Buyer’s ‘agreement to make the pre-delivery instalments under the Contract’.
Paragraph 4 stated that payment would be made upon receipt of a written demand from the Buyer stating that the Builder had failed to fulfil the terms of the Contract and specifying the amount claimed.
Paragraph 5(v) stated that the Bank’s liability under the Bonds would not be affected by any insolvency, re-organisation or dissolution of the Builder’.
The dispute
The six Buyers all paid the first instalment of US$6.66 million due under the Contracts. One of the Buyers also subsequently paid the second instalment under its Contract.
In 2008, the Builder suffered financial difficulties, and, in January 2009, it entered into Korean corporate restructuring proceedings.
In April 2009, the Buyers made written demands to the Bank for repayment of the instalments that had been paid to the Builder under the Contracts. The Bank refused, arguing that, on the true construction of the Bonds, it had not undertaken to guarantee payment of refunds arising under Article XII.3 of the Contracts.
The lower court decisions
The Commercial Court found in the Buyers’ favour and granted summary judgment against the Bank.
The Court of Appeal, by a majority, found in the Bank’s favour and granted the Bank summary judgment.
The Supreme Court decision
The Supreme Court unanimously allowed the appeal, agreeing with the Commercial Court judge and the dissenting judgment in the Court of Appeal.
Under paragraph 3, the Bank had agreed to pay all sums due under the Contracts. The central issue was whether the Bank’s promise to pay ‘all such sums due to you under the Contract’ was confined to refunds arising in the circumstances described in paragraph 2 or extended to pre-delivery instalments repayable under other provisions of the Contracts, including Article XII.3.
The Buyers contended that ‘all sums’ encompassed the pre-delivery instalments referred to in paragraph 3 and all the circumstances entitling repayment under the Contracts. The Bank argued that ‘all sums’ was limited to the circumstances set out in paragraph 2, which did not refer to any right of refund in the event of insolvency.
In general terms:
If the contractual language is unambiguous, the Court must apply it, even if the result appears commercially unattractive to one party. An extreme or irrational result may, however, cause the Court to examine particularly carefully whether the language is truly capable of only one meaning.
Where the language is reasonably capable of more than one meaning, the Court may prefer the interpretation that is more consistent with business common sense. It is not necessary to show that the competing interpretation would be irrational.
The Supreme Court highlighted that the Contracts were entirely separate from the Bonds, even though they were the reason the Bonds had been entered into. The Contracts and the Bonds were also between different parties.
If the language of the Bonds was entirely clear and led only to one conclusion, then the Court must apply it even if it produced a surprising result. However, the Supreme Court decided that there was more than one possible interpretation of paragraph 3 of the Bonds. It was, therefore, entitled to apply the interpretation that was most consistent with business common sense. It did not need to conclude that the other interpretation would produce an irrational outcome.
It was not clear why paragraph 2 was included in the Bonds in the first place. However, to construe paragraph 3 as excluding the Builder’s insolvency from the situations that triggered the Bank’s obligation to refund advance payments made by the Buyers would make no commercial sense. Indeed, the Builder’s insolvency was the situation for which the security of an advance payment bond was most likely to be needed. If this was what the parties had intended, then they would and should have spelt it out expressly in the Contracts and the Bonds.
Accordingly, the Supreme Court restored the Commercial Court judge’s order.
Arnold -v- Britton
The dispute related to 25 leases for holiday chalets that were for 99 years each. The term started in 1974. The parties disagreed on how to interpret the service charge provision.
On the interpretation argued for by the landlords, the service charge was £90 a year, increasing by 10% compounded per annum for the duration of the term. This meant that for some of the tenants, the service charge could be over £1 million by the end of the 99 years.
The tenants argued that there should be a maximum cap of £90 on the service charge because it could not have been intended to impose an extortionately high service charge on them.
The majority of the Supreme Court found in the landlords’ favour. They held that the language of the provision was clear. Commercial common sense should not be used to undermine the importance of the language actually used in a contract.
Commercial common sense also had to be assessed as at the time that the contract was concluded. In this case, inflation was very high at the time that the leases were entered into and it was not inconceivable that a fixed-sum charge of this type would have been agreed. That it turned out to have been imprudent from the tenants’ point of view did not alter the parties’ agreement.
Unlike Rainy Sky, the Supreme Court considered that the language was not reasonably capable of the alternative interpretation advanced by the tenants. Commercial common sense therefore provided no basis for displacing the meaning conveyed by the words used.
Wood -v- Capita Insurance Services
In this case, the Supreme Court considered competing interpretations of an indemnity provision in a share purchase agreement (SPA).
Capita Insurance Services Ltd (Capita) bought Sureterm Direct Limited (Sureterm) under a sale and purchase agreement (SPA). The Sellers under the SPA were Mr Wood, a majority shareholder and director of Sureterm, and others.
Pursuant to the SPA the Sellers agreed to indemnify the Buyer against all liabilities arising out of any mis-selling or similar claims or complaints registered with the FSA or other financial authority relating to the period prior to the sale.
After the acquisition, Capita discovered that Sureterm had possibly mis-sold insurance to customers and reported this to the FSA. Capita subsequently sought to recover from the Sellers the remediation sum paid to the affected customers as required by the FSA.
Mr Wood argued that the indemnity did not apply because the compensation did not result from a claim or complaint by a customer, rather it was due to self-reporting.
The Commercial Court found in Capita’s favour. The Court of Appeal found in Mr Wood’s favour.
The Supreme Court dismissed Capita’s appeal. It decided that the natural meaning of the language used in the SPA and the overall context of the parties’ agreement pointed to a more restrictive interpretation of the clause.
A key consideration for the Supreme Court was that the indemnity provision was part of an overall risk allocation regime incorporated in the SPA. Therefore, it had to be read in conjunction with, and interpreted in light of, the extensive contractual warranties.
In this instance, therefore, to construe the indemnity narrowly was not contrary to commercial common sense.
The Supreme Court rejected the suggestion that Rainy Sky and Arnold -v- Britton represented conflicting approaches. Contractual interpretation is a unitary exercise in which the Court considers both the language used and the relevant context. The weight attached to each will vary. Detailed, professionally drafted agreements will ordinarily invite close textual analysis, while less formal or poorly drafted provisions may require greater reliance on context and commercial purpose.
Beyond the Supreme Court
How have the lower courts approached the construction of contracts in the light of these three Supreme Court decisions? Two examples below.
In 2017, the Court of Appeal in Persimmon Homes Ltd v Ove Arup & Partners Ltd & Anor [2017] EWCA Civ 373 (25 May 2017) held that an exemption clause in a consulting and surveying services contract that stated that ‘liability for any claim in relation to asbestos is excluded’ was drafted sufficiently widely to exclude liability for negligence where the party relying on it had allegedly failed to identify asbestos at an early stage.
The Court of Appeal emphasised that the traditional contra proferentem rule, whereby any ambiguous exemption clause is construed against the party relying on it, plays a very limited role in the modern approach to interpreting commercial contracts between parties of equal bargaining power. Where an exclusion clause was clear in its wording, the Court should give it effect.
In Gard Shipping AS v Clearlake Shipping PTE Ltd [2017] EWHC 1091 (Comm) (12 May 2017), the Court construed a bespoke demurrage provision in a voyage charterparty. The clause gave the charterers liberty to require the vessel to stop and wait for orders, in which case waiting time was to count as laytime and demurrage was to be paid at an escalating and enhanced rate. The charterers did not give any such stop and wait order. After the vessel tendered Notice of Readiness at the discharge port, the charterers gave no orders at all for two months.
The owners argued that the clause intended the charterers to pay the enhanced rates where they used the vessel as a floating storage. Otherwise, it would make no commercial sense because charterers could simply avoid the enhanced rate by giving no orders.
The Court disagreed. The enhanced rate was not triggered and the ordinary demurrage rate applied. The Court distinguished between the commercial purpose alleged by the owners and the contractual mechanism selected by the parties. The fact that the charterers obtained a commercially similar benefit did not justify treating the express trigger as having occurred.
Comment
Ultimately, the Court seeks to identify the objective meaning of the language the parties have chosen, considered in the context of the contract as a whole and the relevant factual matrix. Clear language will ordinarily be decisive. Commercial common sense is an aid to interpretation, not a licence to rewrite an imprudent bargain.
Therefore, it is important to ensure that commercial contracts are drafted carefully to prevent ambiguity. Inconsistencies and conflicting provisions should be avoided. Individual provisions should be tested against the contract as a whole and its overall allocation of risk.
For bespoke or industry-specific transactions, the drafting should be tested by lawyers familiar with both the relevant contractual form and the commercial allocation of risk. In the shipbuilding context, particular attention should be paid to whether the refund guarantee responds to every repayment event under the shipbuilding contract and whether any demand, certification or documentary requirements are workable in practice.
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