Manner in Which a Contract Is Interpreted

The manner in which a contract is interpreted has always been a contentious issue. It is broadly accepted that the technique for interpretation has moved from literalism to contextualism. This move has greatly changed the manner in which companies and individuals do business.

The case of Lovell & Christmas Ltd v Wall [1] outlines the literal approach to contractual interpretation. Within that case, Lord Cozens-Hardy MR explained that “It is the duty of the court … to construe the document according to the ordinary grammatical meaning of the words used therein”. This literal approach is best explained in that when interpreting a contract, the court will look exactly to the normal meaning of the words, regardless of the intention of the parties. This approach was further addressed in Hankey v Clavering [2] . Lord Greene said in his judgement that the courts should only look within the “four corners” of the document, using this approach to justify the acceptance of a minor error by one of the parties.

This literal approach lends itself to the desirable quality of legal certainty, and is very much in favour with the American commercial sector. The Neo Formalist movement prefers this method of interpretation, as it can in essence remove most of the grounds for legal confusion should a difference of opinion arise. A literalist would propose that the large upfront costs of drafting the contract are entirely worthwhile in comparison with the lengthy legal process that could face a party under the contextual approach to be addressed later. This commercial preference for literal interpretation was mentioned by Lord Lloyd in the Investors Compensation Scheme v West Bromwich Building Society [3] , his lordship was concerned that should the literal approach be abandoned, its gains should be lost as well, namely that members of the commercial sector should be able to rely on the wording of contracts which they have signed.

Formalists generally resort to an Entire Agreement Clause (EAC), with the idea of limiting the imposition of exterior ideas to the interpretation. An entire agreement clause states that the written contract contains all the clauses which are to take effect, to the exclusion of implied clauses and the like. Such clauses were regulated in Lowe v Lombank [4] , which sets out three requirements that must be satisfied in order for these types of clauses to be effective.

Contrary to the literal approach, the courts have taken an approach of contextualism tempered with business sense. This move was affected as a result of the lack of common sense in many decisions, for instance the case of Hankey v Clavering2 as mentioned earlier, whereby a minor error was permitted to bind the parties. This change was arguably set in motion by the decision in Prenn v Simmonds [5] , which gave rise to the ‘Matrix of fact’ [6] concept to be later adopted. The concept has however been present in the legal sector as far back as 1918 in the Towne v Eisner [7] case, in which Holmes J was of the opinion that “A word … may vary greatly in colour and content according to the circumstances and time in which it is used”. That case was of course decided within the United States, but the point it makes stands. Furthermore, the case of Mannai Investment Co. Ltd v Eagle Star Assurance [8] , in which Lord Steyn described how the court should examine the ‘contextual scene’ which led to Lord Hoffman’s Ruling in Investors Compensation Scheme3.

The statement upon which this essay is based comes from within the Investors Compensation Scheme v West Bromwich Building Society3 case, the seminal case on the contextual approach. Within this case, Lord Hoffman proposed a move in approach based on five common sense principles [9] . Firstly that the interpretation should be examined from the point of view of the reasonable person, given the knowledge that the parties had. Secondly the court should draw upon a ‘matrix of fact’ to decide how the reasonable person would interpret the words. Thirdly, previous negotiations would be excluded; an exception which will be dealt with later. Fourth, the meaning of words should be decided in light of all the relevant information, the court does not have to resort to the literal approach any more, and can thoroughly examine and consider the meaning. Finally that where the words used couldn’t reflect the intentions of the parties, the law doesn’t require that the parties be bound by them.

It is thought that the inspiration for this judgement was in part derived from Lord Wilberforce’s much cited opinion in the Reardon Smith Line v Yrgrar Hansen-Tangen [10] case, that “no contract is made within a vaccum” and “the court should know the commercial purpose of the contract”. From these statements it can be inferred that Lord Wilberforce wished to examine the surrounding circumstances to reach his decision rather than keep with the “four corners”2 approach mentioned earlier. This idea was also reinforced by Lord Hoffman’s judgement in Charter Reinsurance Co Ltd v Fagan [11] that “In some cases the notion of words having a ‘natural’ meaning is not a very helpful one. Because the meaning of words in one sentence may be quite unnatural in another” [12]

It is worthy of note that Lord Hoffman neglected to define the scope of the ‘matrix of fact’ to be used when interpreting contracts. This lack of clarification is, I believe to provide flexibility to judges in this area. This view is shared by Gerard McMeel in his article ‘The Rise of Commercial Construction in Contract Law’, where he stated that “no-one misunderstood Mrs Malaprop when she invoked her allegories on the Nile. No judge should feel constrained by a supposed rule of strict construction, to give words, a meaning which neither party could reasonably have understood them to have.” [13] . Lord Steyn further agreed with this view, speaking extra judicially [14] , saying that the beauty of the reasonable man’s presence in Lord Hoffman’s five tenants is that it can be adapted to suit society’s needs, giving the courts the flexibility to assess cases individually if need be. Further, my opinion is that the introduction of the ‘Reasonable Man’ test brings Contract Law in line with many other areas of the law.

There are two major exceptions to the ‘matrix of fact’ permitted under Investors Compensation Scheme; that of pre-contractual negotiations and post-contractual conduct. Prenn v Simmonds [15] discussed the pre-contractual negotiations exclusion. This exception was created to reduce the level of subjective opinion which the court could be subjected to. It seems clear that whilst one might say something during negotiations, one might mean something completely different when the contract is signed. These negotiations are always subject to the opinions of the involved parties, and as such cannot compare to the objective fact portrayed in permissible evidence, such as the common trends of the sector, financial position of the parties, and any other knowledge. Further reasons for the exclusion include the uncertainty that would be created if two conflicting opinions could be fought over to decide the meaning. The scope of agreement on information could affect the interpretation of the contract. Perhaps the most convincing reason to preserve the exclusion is that a contract is intended to settle all pre-contractual disputes, a concept that implies dispute before the contract, so it follows that a single, correct view would not only be difficult to achieve, but it would be unrepresentative of the actual meaning of the terms, largely because they are not yet in existence.

It is arguable that the negotiations of the parties should be allowed, because today’s case management processes would not permit the admittance of any evidence that is purposeless, so a party would have to know which part of their communications they wanted to use before requesting it’s admittance. Thus the policy argument Lord Hoffman was concerned about in Investors Compensation Scheme Ltd can be avoided. Lord Nicholls shared this view, stating in his article ‘My Kingdom for a Horse: The Meaning of Words’ that:

“It is Difficult to see how this exclusion, as a rule of universal application, can be justified, how it can be sensibly rationalised. Suppose one clause of an agreement, cl.15, were introduced into the agreement at the drafting stage under cover of a letter from one party’s solicitor to his opposite number. In his letter the solicitor explained why his client wished to include this clause in the contract. He stated the purpose of the new clause, the aim it was intended to achieve. Without further ado cl.15 was duly incorporated into the signed agreement … To my mind it would be absurd if the correspondence between the parties’ solicitors could not be admitted in evidence. Why should the matter be left as one of disputed conjecture when there is evidence which would afford useful insight? Why should the judge have to guess when he can know?” [16]

This statement shows that Lord Nicholls wanted to approach cases in a manner based on common sense, essentially looking at each case individually, rather than building a general rule. Furthermore, Lord Nicholls expresses a view in the same article that to permit pre-contractual negotiations would not be a true departure from the objective approach, as in general, these negotiations are focused on fact.

Recently, the area of pre-contractual negotiations has been under review in the Oceanbulk Shipping and Trading SA v TMT Asia Ltd [17] . The case provided that an exception to the general rule against pre-contractual negotiations should be made where those negotiations are without prejudice facts. The meaning of this is that the Supreme Court is willing to consider expanding the scope of the ‘matrix of fact’ to situations where the negotiations are purely on matters of fact. The judgement of Lord Clarke however presents a differing opinion, that prejudicial and non prejudicial statements should be construed in the same manner, that it would be unfair to treat them differently.

There is even a question over what can be regarded as negotiations for the purposes of interpretation. In Patenreederei MS Karen Oltmann v Scarsdale Shipping Co Ltd (Karen Oltmann) [18] , a question was raised regarding a term with two possible meanings, where the correct one could be identified simply by examining a telex message. The judges were willing to look at the negotiations here, arguably confirming the existence of the non-prejudiced/factual basis exception for pre-contractual negotiations.

This issue was again addressed in Rugby Group Ltd v Proforce Recruit Ltd, a case which concerned the use of unusual and undefined words (in this case ‘preferred supplier status’). Lady Arden permitted the use of pre-contractual negotiations here in order to discern the meaning of these undefined words,

“The court may hear evidence as the pre-contractual communications where it is said that one party made a representation to another on which that other acts” [19] . Furthermore Lady Arden clarified that “the court would be hearing that evidence not with a view to taking the parties subjective intent into account for the purposes of interpretation … but for the purposes of identifying the meaning that the parties in effect incorporated into their agreement” [20] .

In this manner it is clear that whilst the court is prepared to extend the scope of the ‘matrix of fact’, they will only do so where they can assess fact rather than subjective intent, and where they already know what evidence will be produced, and the contents of that evidence.

A further clarification of the manner in which terms should be interpreted can be found in the ‘contra proforentem’ rule, whereby a clause which is inserted at the insistence of one party will always be construed against them. This will take preference over the other rules, so commercially speaking, it is a highly sought after fallback option where one party wants to escape liability. To avail of this option, a party must only accept the terms proposed by the other party, at their insistence.

There have been calls to totally remove the limits on pre-contractual negotiations from evidence, in part due to the difficulty to sustain “judicial ‘tunnel vision’” [21] required to separate fact from opinion within communications. The House of Lords, however, was given the opportunity to do so recently in Chartbrook Ltd v Persimmon Homes Ltd [22] , but declined to do so for a number of reasons. Firstly, a written contract is intended as a final settlement of all disagreement, which naturally implies disagreement prior to the contract. To pursue evidence on the position of a party would lead the court to trawl through all the communications between the parties to try and find something that supports the position suggested. Clearly such communications would only grant an insight into the subjective intent of the parties, and that is unlikely to give any real insight at to the real meaning of a term. Trawling through a set of negotiations might occasionally reveal something useful, but will add little useful information. Whilst studies might help to clarify how useful the examination of pre-contractual evidence could be, the courts cannot order an empirical study. It should be noted that an escape route exists from the exemption of this evidence, via the equitable remedy of rectification. [23]

In the aftermath of the Investors Compensation Scheme [24] decision, lawyers and academics have sought to develop the degree to which background information can be used, but the two exceptions do to a large degree remain as areas that cannot be used. The second exception is that of post contractual performance of the contract, as described in the Schuler AG v Wickman Machine Tools Ltd [25] case. This case discussed the introduction of post contractual conduct into the ‘matrix of fact’, deciding that it should not be permissible because it might allow the parties to vary the meaning of a contract over time according to their interests. This is a very important point, because parties usually give insufficient regard to the detail of their contracts until a problem occurs. Whilst party relationships remain amenable, one may decide to overlook a minor breach by the other party, and in that case, whenever the other party finally loses patience or money, the original good faith decision may reflect poorly on the first party, and bind them. The case was arguably inspired by the decision in Miller & Partners v Whitworth [26] . The exception was furthermore confirmed in the case of Full Metal Jacket Ltd v Gowlain Building Group [27] , in which Lady Arden reinforced “that the courts in general should not have regard to subsequent conduct when interpreting written contracts” [28] .

This judicial restraint in considering post contractual performance was carried through the case of Amalgamated Investment & Property Co Ltd v Texas Commerce International Bank ltd [29] , whereby Lord Denning opted to enforce an estoppel rather than consider the conduct of the parties after their contract. This exception is of course to be expected under the Investors Compensation Scheme ruling, as it was not available to the parties at the time of contract. To me the exception seems perfectly logical, whilst the information of conduct might indeed be useful to judges, the road of expansion in this area is a dangerous one to travel, as parties might take it upon themselves to attempt to influence the interpretation of a contract by applying it in a completely different way to the meaning of its words at face value.

A rival argument, in favour of post contractual negotiations was however put forward in the New Zealand case of Vector Gas Ltd v Bay of Plenty Energy Ltd [30] , wherein four of the five judges ruled in favour of post-contract conduct, and stated that it would aid them in deciding upon the approach to use. The court recognised the integral nature of assent within a contract, and emphasised that the court should be reluctant to remove from itself any information that would help to ascertain the intentions of the parties. Justices Tipping and Anderson only admitted mutual evidence, mirroring the rulings regarding pre-contractual negotiations. One justice, however, abstained and another took the idea further, permitting evidence which was not mutually agreed by both parties. The latter view gained obiter support from Justice Wilson, and follows in the opinions of Lord Nicholls in his article, stating “such content is one of the matters the court should be able to take into account” [31] .

It is interesting to note however that prior performance of contracts is thought to be relevant, for instance a Baird v Marks & Spencer [32] style case could be taken into consideration. Such information could clearly be of benefit to a party who is in regular dealings with a company.

The court is not entitled to deny the examination of background circumstances due to lack of ambiguity according to Static Control Components Ltd v Egan [33] . Such an allowance means that where terms are largely clear, parties may still introduce evidence to the contrary.

Recently more restrictions have been introduced on the use of background material, most likely because of the sheer volume of information allowed under the wide definition of Investors Compensation Scheme. The case of BCCI v Ali [34] states that there has to be something to indicate that the natural and ordinary meaning of the word produces an unreasonable result. This seems to contradict the judgement in Static Control Components v Egan31, and shows the recent trend. The reasoning given by Lord Hoffman in Malik and Mahmud v BCCI [35] supports this trend, having expressed his feeling that the words in the contract were very broad and that their meaning was clear to see, so it would be unnecessary to investigate them further. It should however be noted that in this case, the majority of the House of Lords felt that the parties couldn’t have meant to exclude a claim of which they weren’t aware at the time.

As with pre-contractual negotiations, there is a further strategy for circumvention, via estoppel by convention. [36]

The state of the law is arguably coming around full circle again, with the advent of the Neo Formalist movement. The judgement in Union Eagle v Golden Achievement [37] appears to have almost moved back to the ‘clear and obvious meaning’ test from Rowell, ruling that because the buyer registered their completion ten minutes after the deadline, they had failed to satisfy the terms required to reclaim their deposit. The commercial sector is returning to the idea of literalism, and certainly appreciates the certainty aspect, which appealed to Lord Steyn in Deustche Genossenshaftsbank v Burnhope [38] . In that case, Lord Steyn emphasised the need for judicial restraint and the concept of objectivity when dealing with interpretation. Where contracting parties can examine a contract at face value, and instantly tell its meaning, a great many cases will be released from the legal system.

Sir Christopher Staughton was very critical of the vague nature of the ‘matrix of fact’ permitted by Lord Hoffman, his opinion was that it is “hard to imagine a ruling more calculated to perpetuate the vast cost of commercial litigation” [39] , that the idea of a ‘matrix of fact’ simply creates a vast amount of work for the courts, and serves only to line the pockets of the legal personnel who argue over it. Staughton was further concerned that Lord Hoffman appeared to be extending the meaning of the ‘matrix’ far beyond what was imagined in Prenn v Simmonds [40] .

Even Lord Hoffman has expressed concern over the direction in which his principle is heading, in Chartbrook v Persimmon [41] he compared the introduction of extra evidence to the introduction of Hansard in interpreting statutes, fearing that a judge might be overwhelmed with the volume of information presented by parties, hopeful of finding something relevant that might be permitted. Lord Hoffman stated that

“Such evidence will be produced in any case in which there is the remotest chance that it may be accepted and that even these cases will be only the tip of a mountain of discarded but expensive investigations. Pepper v Hart has also encouraged ministers and others to make statements in the hope of influencing the construction which the courts will give to a statute and it is possible that negotiating parties will be encouraged to improve the bundle of correspondence with similar statements.” [42] .

Lord Hoffman was concerned about the direction in which interpretation was travelling in the Bank of Credit and Commerce v Ali [43] case, in which he observed in his dissenting speech that “I did not think it necessary to emphasise that I meant anything which a reasonable man would have regarded as relevant … I was certainly not encouraging a trawl through ‘background’ which could not have made a reasonable person think that the parties must have departed from conventional usage” [44] .

It seems clear from this statement that Lord Hoffman was concerned that parties would seek to negotiate in a manner that forces a favourable construction upon the court, in other words that they might structure their negotiations and policies in such a way as to limit the options available to the court when interpreting the document.

Much of contract law is based around the negotiations of companies, who of course have a large resource base to examine their contractual obligations prior to contract, as well as the weight to ensure the contract is carried in the manner they wish. Where an individual is involved of course, the manner of interpretation should vary; private individuals do not have the same level of resources to devote to understanding all the possible meanings of terms.

My opinion is that contracts should be interpreted in a contextual manner, granting only the current level of background information to the court. I feel that the current level is the most appropriate, as the court considers only facts, and is not swayed by opinion. I do however believe that it should be possible to include a clause in the contract to state how it should be interpreted. The commercial sector desires literal interpretation to keep the wheels of business turning, and there are strong arguments regarding that case.