Supreme Court endorses commercial common sense as an aid to construction

On Wednesday 2 November the Supreme Court handed down a judgment with significant implications for how commercial contracts are construed: Rainy Sky SA and others v Kookmin Bank [2011] UKSC 50. Lord Clarke, who gave the judgment of the court, held that where a term is open to more than one interpretation, it is generally appropriate to adopt the one which is most consistent with business common sense.

The decision is likely to encourage those who wish to challenge the most obvious meaning of a contractual provision on the basis that it goes against the commercial purpose of the contract. To minimise the risk of such a challenge, clear drafting and, where practical, establishing a consistent commercial rationale for key provisions across a contract (for example through recitals) will be important.

Background

The case concerned the construction of advance payment bonds given by the defendant bank in favour of the claimant buyers pursuant to shipbuilding contracts. The shipbuilder experienced financial difficulties and the buyers demanded repayment under the bonds of the instalments paid under the contracts. The bank argued that, on their true construction, the bonds did not cover refunds to which the buyers were entitled on the insolvency of the shipbuilder.

Lord Clarke noted that for the most part the correct approach to construction of the bonds, as any other contract, was not in dispute. The ultimate aim of interpreting a contractual provision is to determine what the parties meant by the language used. This involves ascertaining what a reasonable person, who had all the background knowledge reasonably available to the parties at the relevant time, would have understood the parties to have meant.

Commercial common sense

The issue between the parties was the role to be played by considerations of business common sense in determining what the parties meant.

The majority of the Court of Appeal (Patten LJ, with whom Thorpe LJ agreed) held in favour of the bank’s construction of the bonds, while accepting that the buyer’s alternative construction was arguable. Patten LJ stated, “Unless the most ordinary meaning of the words produces a result which is so extreme as to suggest that it was unintended, the Court has no alternative but to give effect to its terms.”

In the Supreme Court, Lord Clarke disagreed with this statement of principle. Preferring the approach of the judge and Sir Simon Tuckey (who was in the minority in the Court of Appeal), Lord Clarke held that the correct approach is that, if there are two possible constructions, it is generally appropriate to adopt the interpretation which is most consistent with business common sense.

Decision

The Supreme Court overturned the Court of Appeal judgment and restored the judge’s decision in favour of the buyers’ construction of the bonds.

Lord Clarke agreed with Sir Simon Tuckey that it made no commercial sense for the bonds to cover each of the situations in which the buyers were entitled to a refund of advance payments apart from the insolvency of the shipbuilder. Indeed, that was the situation for which the security was most likely to be needed. For that reason, of the two arguable constructions, the buyers’ was to be preferred.

The implications for contractual construction

This decision does not mean that the courts can ignore the clear language of a contract just because it appears to produce an uncommercial result for one or other party. Lord Clarke agreed with Lord Hoffmann’s comments in Chartbrook v Persimmon [2009] UKHL 38 that the mere fact that a term appears to be particularly unfavourable to one party or another is irrelevant – the term may have been agreed in exchange for some other concession, or it may simply have been a bad bargain. As Lord Clarke said, “Where the parties have used unambiguous language, the court must apply it.”

However, Lord Clarke said that where (as is often the case) the language used by the parties is capable of more than one meaning, the court is entitled to prefer the construction which is consistent with business common sense and reject the other.

Lord Clarke held that the exercise of construction is essentially one unitary exercise in which the court will have regard to business common sense (together with other surrounding circumstances) in determining what a reasonable person with the relevant background knowledge would have understood the parties to have meant and, in general, the most commercially sensible construction is likely to be preferred.

The court rejected the two-stage approach adopted by the majority in the Court of Appeal, which is essentially that the “most natural meaning” must first be determined, and can only be rejected if it produces an absurd or irrational result.

Comment

This decision is significant for the Supreme Court’s consideration of the proper role of business common sense when construing contractual provisions. Despite Lord Clarke’s recognition that where the language of the contract is clear it must be applied, even if it seems unfavourable to one or other party, the decision may be seen as broadening the scope for courts to step in and substitute their own views of what is reasonable.

One way of reconciling the authorities might be that where the language used is clear, it must be applied unless (as in Chartbrook) that would produce such an absurd or irrational result that it is obvious something has gone wrong with the language. On the other hand, where there is genuine ambiguity, the court is entitled to prefer the most commercially sensible result. However, it remains to be seen how the lower courts will apply the court’s reasoning. 

On any view, there remains considerable scope for argument where the courts are called upon to construe the terms of a contract in any given case. As the case law illustrates, reasonable views may differ not only as to whether language used in a contract is clear or ambiguous, or indeed whether a particular interpretation is arguable at all, but also as to which competing interpretation is most commercially sensible.

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