In interpreting a service charge provision in a number of long leases, the Supreme Court has concluded that arguments based on commercial common sense should not be used to undervalue the importance of the actual words used, and that the correct interpretation was one which applied the natural meaning of the term: Arnold v Britton & Ors  UKSC 36.
This is a relatively rare Supreme Court decision on the principles of contractual interpretation. It does not purport to make new law. However it re-emphasises that whilst commercial common sense can be an aid to construction, the starting point must be the "natural meaning" of the words used. The case is likely to be often cited in the future for the principles which Lord Neuberger sets out, which include four points concerned with the interaction between the "natural meaning" and "commercial common sense".
The case concerned the interpretation of service charge contribution provisions in the 99 year leases of a number of chalets in a caravan park in South Wales granted between 1977 and 1991. The terms of the clause varied slightly between the relevant leases, but in essence there were two parts – the first part provided for the lessee to pay a "proportionate part" of the maintenance and service costs, whilst the second part provided for the payment of a yearly sum of £90 for the first year, and for each ensuing year a fixed sum representing a 10% increase on the previous year.
The landlord argued that the correct construction of the clause was to provide 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 practical effect was that for a lease granted in 1980 the annual service charge in 2015 would be £2,500, increasing to over £550,000 by 2072.
The current tenants argued that the landlord's construction would result in such an absurdly high annual service charge in the later years of the leases that it could not be right. Instead, the words "up to" should be read into the clause such that the tenants were required to pay a fair proportion of the landlord's costs, subject to a cap, which was £90 in the first year and increased by 10% each year on a compound basis.
The surrounding evidence making up the "factual matrix" by reference to which the contract was to be interpreted was limited to the documents themselves and the published Retail Price Index (RPI) for each of the years 1970-2010.
The Supreme Court favoured the landlord's construction of the lease by a four to one majority, upholding the decision of the Court of Appeal and the High Court (which had overturned the County Court decision).
Lord Neuberger delivered the leading judgment. Summarising the leading authorities, including Chartbrook Ltd v Persimmon Homes Ltd  UKHL 38 and Rainy Sky SA v Kookmin Bank  UKSC 50, he said the court was 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”. The court does so by focussing on the meaning of the relevant words in their documentary, factual and commercial context.
Lord Neuberger concluded that the natural meaning of the words used in this clause, at least until one considered the commercial consequences, seemed clear. The reasonable reader would see the first half of the clause as descriptive of the purpose of the clause, namely to provide for an annual service charge, and the second half as a quantification of that service charge. The fact that, in the future, its quantum might substantially exceed the parties' expectations at the grant of the lease was not a reason for giving the clause a different meaning. The interpretation contended for by the tenants would, he said, 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. Whilst there were “one or two very small errors in the drafting”, he did not consider that anything had gone significantly wrong with the clause.
Lord Neuberger said that he was far from convinced by the commercially-based argument that it was inconceivable that a lessee would have agreed a service charge provision with the effect the landlord contended, at least in the 1970s and much of the 1980s. Whilst annual inflation in the last 15 years had hardly ever been above 4%, it was well over 10% per annum between 1974 and 1981, indeed over 15% per annum for six of those eight years. The parties were taking a gamble on inflation, but it was at least a bilateral gamble on the landlord's interpretation, whereas on the tenants' interpretation, it was a one-way gamble and they could not lose.
Lord Neuberger set out various factors which he said it was important to emphasise, including four concerned with the interaction between the natural meaning of a clause and commercial common sense:
- The reliance placed in some cases on commercial common sense and surrounding circumstances should not be invoked to undervalue the importance of the language of the provision. Save perhaps in a very unusual case, the meaning that would be conveyed to a reasonable reader is most obviously to be gleaned from the language of the provision.
- The less clear the words 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. It is only relevant to the extent of how matters would or could have been perceived by the parties, or by reasonable people in the position of the parties, as at the date the contract was made.
- 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, even ignoring the benefit of wisdom of hindsight.
Lord Carnwath delivered a dissenting judgment in which he said that it was clear to his mind that something had gone wrong with the drafting of the clause. In his analysis, the clause imposed an obligation to pay, but with two different descriptions of the payable amount – first, the reference to the "proportionate part" and secondly, reference to a "yearly sum", leading to an inherent ambiguity which needed to be resolved.
He regarded the consequences of the landlord's interpretation as so commercially improbable that only the clearest words would justify the court in adopting it. In his view, the limited addition to the clause proposed by the tenants did not do such violence to the contractual language as to justify a result which he described as "commercial nonsense".
The basic approach to modern contractual construction is clear, and remains so following this decision. It is to determine the objective meaning of a clause, being the meaning it would convey to a reasonable person having all the background knowledge which would have been available to the parties at the time the contract was made.
There is however some tension in the authorities as to the respective roles to be played in that exercise by, on the one hand, the “natural meaning” of the words used and, on the other, perceptions of “commercial common sense”.
The Rainy Sky v Kookmin case (considered here) confirmed that where there are two possible constructions of a contract the court is entitled to prefer the construction which is consistent with business common sense and to reject the other. However, the Supreme Court in that case also made it clear that commercial common sense would not relieve a party who has made a bad bargain from the implications of his decisions where the wording of the contract is clear and unambiguous.
In the present case, the majority and the minority disagreed both as to whether there was an ambiguity or lack of clarity in the clause and as to the impact of considerations of commercial common sense. However, there is certainly a sense that the majority were keen to rein in the role of commercial common sense in contractual interpretation and to set some boundaries through Lord Neuberger's principles. Whilst no reference was made to the Court of Appeal decision in BMA Special Opportunity Hub Fund Ltd & Ors v African Minerals Finance Ltd  EWCA Civ 416, where the Court of Appeal concluded that "commercial common sense" is not to be elevated to an overriding criterion of construction, the present decision is very much in line with that case (see our post on that decision here).
For further discussion of this decision from our Real Estate colleagues please see their e-bulletin here.