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Brief Counsel

Contract interpretation: context is everything, but not everything is context

11 August 2009

New Zealand courts may feel more emboldened to prefer the intended meaning of a contract over the precise wording following a recent decision in the United Kingdom.

The UK House of Lords overturned a case in which the plain language of a contract’s pricing provision had been given effect despite arguments that the way it read did not tally with the commercial purpose of the transaction.

The result will be controversial among business people and lawyers, but the Law Lords did place some limits on the power of the courts to “rewrite” contracts.  In this Brief Counsel we look at the judgment and its implications.

Contract interpretation, in principle

The case is Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38 (1 July 2009).  Its starting point is the fundamental rule in interpretation of contracts, that every contract must be read in its ‘factual matrix’ – a phrase which captures the essential idea that contracts are not written in a vacuum; there is always an underlay of objective facts in which a contract is embedded.  That rule is synonymous with a 1997 House of Lords decision known as Investors Compensation Scheme v West Bromwich Building Society.  There, Lord Hoffmann asserted that contractual documents must be interpreted to reflect the parties’ intention.  To read the text is necessary but not sufficient.  Also necessary is evidence of the surrounding circumstances known to the parties, but not of the parties’ negotiation or of their subjective intentions.

Thus a contract which may be clear on its face may – as a matter of law; that is, construction – have a quite different meaning.  A stark example is a case called Mannai Investment, where “13 January” was read as “12 January”.  In context, the court accepted that when the parties said the 13th they meant the 12th.

Now, in 2009, the Investors Compensation principles are practically irreversible.  And they have been adopted by New Zealand courts, which have even said that the parties’ behaviour in performance of the contract may well influence how a court construes their obligations under it (Wholesale Distributors).  We’ll come back to that case, a decision of our local ‘law lords’, the Supreme Court.

But with such broad powers of error correction, the limits of the rule become critical.  Sanctity of contract is an equally important goal of the law – and the courts.  And so the question arises, what are the limits?  Well, according to the Chartbrook decision, they are two.

The first is that “it should be clear that something has gone wrong with the language”.  The second is that evidence of the parties’ negotiations and of their respective aims in them, are excluded from the factual matrix.

Chartbrook v Persimmon – facts

The facts are complex but gave rise to a clear-cut dispute in which competing contractual interpretations – one literal, the other purposive – gave rise to a price difference of over £3.5 million.

The background was a property development deal to which Chartbrook contributed the land and Persimmon the labour.  In particular, Persimmon agreed to obtain planning permission, construct under a licence what Lord Hoffmann neatly described as a “mixed residential and commercial development (commercial premises below, flats above, parking in the basement)”, sell the properties on long leases, receive the proceeds and then, pursuant to a pricing provision, pay Chartbrook the Total Land Value (TLV) plus overage.  ‘Overage’ is basically a proportion of the increase in land value due to development.

The dispute was around the overage, even although the relevant clause was, as Lord Hoffmann put it, “outwardly uncomplicated”.  It provided as follows:

“23.4% of the price achieved for each Residential Unit in excess of the Minimum Guaranteed Residential Unit Value [MGRUV] less the Costs and Incentives [C&I].”

The MGRUV was agreed at £76.34 per square foot, which given the footprint of the flats in question, amounted to £53,438 per flat.

On a straight reading of the clause, the overage payable was the price achieved, minus the MGRUV and the C&I times 23.4%. 

Or algebraically; overage, O = (P – MGRUV – C&I)0.234.

Chartbrook urged this construction, which each of the judges up to and including the House of Lords agreed was “certainly in accordance with conventional syntax.”

Inevitably, Persimmon saw the deal somewhat differently.  It argued for a more ‘purposive’ or end-driven interpretation, one which tallied with the commercial purpose of dividing the price into TLV plus overage.  That purpose, they said, was “to give Chartbrook a minimum price for its land, calculated on current market assumptions, and to allow for the possibility of an increase if the market rose and the flats sold for more than expected.”

It was common ground that the expected sale price was “£200,000 or so, or maybe slightly more.”  Persimmon also pointed out that £53,438 was 26.7% of £200,000, and 23.4% of £228,000.  On that basis, it invited the inference that the parties’ intention was for overage to equate with the amount by which 23.4% of the net sale price exceeded £53,438.

Algebraically, O = [(P – C&I)0.234] – MGRUV.

On this basis, Persimmon claimed Chartbrook was entitled to overage of £897,051.  Chartbrook maintained the straightforward interpretation should prevail, so that they were entitled £4,484,862.  The trial judge and a majority of the Court of Appeal agreed with Chartbrook, the Court of Appeal expressly declining to “rewrite” the contract.  It said to do so would “[distort] the meaning and arithmetic of the definition.”

The third Court of Appeal judge, Lord Justice Lawrence Collins, dissented.  Persuaded by Persimmon’s interpretation, he also held it was confirmed by the evidence of pre-contractual negotiations.  Persimmon appealed to the House of Lords, and invited their Lordships to adopt Lawrence Collins LJ’s approach, or to rectify the contract.

House of Lords judgment

Lord Hoffmann gave the leading judgment allowing Persimmon’s appeal.  It dealt with three issues: first, the contract interpretation point; second, the admissibility of evidence of pre-contractual negotiations, and third, aspects of the law of rectification.  The other Law Lords delivered broadly concurring opinions.

In relation to the issue of interpretation, Lord Hoffmann accepted Persimmon’s argument saying that “to interpret the definition of [overage] in accordance with the ordinary rules of syntax makes no commercial sense”.  In particular, his Lordship considered that the term ‘Minimum Guaranteed Residential Unit Value’ was obviously intended to be “a minimum land value, not a minimum sale price”. 

Moreover, had the parties intended it as a minimum sale price, so as to protect Chartbrook against a catastrophic collapse in land values, this would have been “speculative”, and so they would have used a round number, like “£50,000 or £60,000, or £100,000.”

There is obvious force in that argument, and Chartbrook’s position was not helped by one of its key witnesses being found to have calculated overage in a way that was consistent with Persimmon’s interpretation, shortly before the contract was put into writing.  But could Persimmon’s interpretation be accepted, when to do so required re-writing the pricing provision?  Yes, in Lord Hoffmann’s view.  He said:

What is clear… is that there is not, so to speak, a limit to the amount of red ink or verbal rearrangement or correction which the court is allowed.  All that is required is that it should be clear that something has gone wrong with the language and that it should be clear what a reasonable person would have understood the parties to have meant.  In my opinion, both of these requirements are satisfied…. To say, as Rimer LJ said, that it requires ‘rewriting’, or that it ‘distorts the meaning and arithmetic of the definition’ is only to say that it requires one to conclude that something has gone wrong with the language….”

Pre-contractual negotiations

Given this, Lord Hoffmann did not need to deal with the other points.  However, he considered it was appropriate to do so.

Some additional background is necessary.  Evidence of the parties’ negotiation has long been excluded as irrelevant to the issue of what a contract means.  It has however been admitted in relation to claims for rectification, which have increasingly been brought in conjunction with interpretation claims.

That, and the apparent breadth of the term ‘factual matrix’, has led some to argue that the exclusionary rule is so shot full of holes that it should go.

The counter-arguments are manifold but essentially matters of public policy:

  • to admit evidence of the parties’ negotiation would create too much uncertainty of outcome in disputes over interpretation and add to the cost of advice and litigation
  • the law of contract was designed to enforce promises with a high degree of predictability; if conventional meanings and syntax may be displaced by inferences drawn from pre-contractual negotiations, the less predictable the outcome will be
  • the availability of equitable remedies (eg rectification and estoppel) is a safeguard which in most cases would prevent any injustice that might be caused by the exclusion of the evidence, and
  • the exclusionary rule is of high authority and has stood for over 130 years.  If the rule needs changing, that is a matter for Parliament, not the courts.

Although he accepted that evidence of the parties’ negotiation may in principle be relevant, Lord Hoffmann considered that it should be excluded:

“The conclusion I would reach is that there is no clearly established case for departing from the exclusionary rule.” 

The other Law Lords concurred.  The result is a huge relief for many business people and lawyers, after at least a decade of academic debate, including by some senior judges.

Conclusion

The judgment is a bit of a mixed bag.  Despite rhetoric that a “clear” or “strong case” is required, Lord Hoffmann’s willingness to “correct mistakes by construction” will be disconcerting for some contracting parties.  On the other hand, the ruling that not everything, and more particularly not the parties’ negotiations, is part of the factual matrix is comforting.

So what does this mean for New Zealand?  Well, our Court of Appeal has tended to be somewhat less liberal with the “red ink”.  However, it is also true that in the Wholesale Distributors case our Supreme Court received, considered, and rejected many of the same public policy arguments that Lord Hoffmann considered went to a more conservative approach to contract interpretation issues.  Watch this space…