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Brief Counsel

Tips from the top on commercial contract interpretation

26 February 2010

The Supreme Court, in determining a dispute surrounding a gas supply contract, has taken the opportunity to discuss the principles which should be applied in interpreting commercial contracts and what evidence is admissible in aid of that task.

This Brief Counsel looks at whether the decision indicates a new approach to the interpretation of commercial contracts, and its likely impact on litigation involving such issues.

Brief background

The case, Vector Gas Limited v Bay of Plenty Energy Limited (BoPE), developed from a dispute over whether Vector (then NGC) had validly terminated a 1995 Agreement for supply of gas to BoPE, a Todd Group company.  BoPE maintained it had not and sought to enforce continued performance of the contract in the High Court.  While this dispute was proceeding, the parties agreed that Vector would continue supply gas to BoPE on an interim basis, on the terms of the 1995 Agreement.

In the event that BoPE’s action was unsuccessful, the interim agreement provided that BoPE would “pay NGC on demand, for each GJ supplied, the difference between the price set out in the Agreement and $6.50 per GJ...”.  BoPE was unsuccessful in its principal claim, and Vector sought payment under this clause.

The price contained in the 1995 Agreement included transmission costs.  The issue was whether the $6.50 price in the interim agreement also included these costs, or whether Vector was entitled to charge extra for transmission.  At stake was approximately $3.26 million. 

The Supreme Court held unanimously that transmission costs were not included, reversing a Court of Appeal decision and restoring the original judgment of the High Court.  Vector was represented throughout by Jack Hodder and Kate Hadfield of Chapman Tripp. 

The sensible answer

Though each member of the Court chose a slightly different route, each agreed that regardless of whether the words of the interim agreement could potentially bear the ‘inclusive’ meaning favoured by BoPE, the only sensible and commercial interpretation was that the price was exclusive of transmission costs. 

It was clear that the purpose of the interim agreement was to deliver to Vector the difference between the price already paid by BoPE under the 1995 Agreement, and the market price which Vector could otherwise have obtained from BoPE.  It was a substitute for an interim injunction, which inevitably would have been granted on a similar basis. 

At the time of the interim agreement, the market rates for gas were approximately $6.50 per GJ plus transmission costs.  Therefore “only commercially sensible conclusion” was that the transmission costs were intended to be met separately under the interim agreement, outside the $6.50/GJ price.  

Extrinsic evidence

So far, so good.  But the case is significant for its discussion of the proper approach to interpretation of contracts and the admissibility of extrinsic evidence, particularly concerning prior negotiations when a written contract is being interpreted. 

In broad terms, the Supreme Court adheres to the orthodox position.  Words only have meaning in context.  To interpret a contract, one looks to the background circumstances in which it was concluded (dubbed the ‘factual matrix’ by Lord Wilberforce in Reardon Smith Line Ltd v Hansen-Tangen).  Similarly, an interpretation which makes no commercial sense should be rejected in favour of one which does.   

But the more difficult question concerns the scope of the factual matrix, what evidence may be led to establish it, and how the Courts ought to factor that evidence into the interpretive exercise.  This is an important issue.  It affects parties’ ability to mount arguments that the ‘plain meaning’ of a contract’s words are not a reflection of its true interpretation.  Increasing the scope of potentially admissible material also increases the scope of pre-hearing discovery and the amount of evidence likely to be placed before the Court, which in turn increases both time and cost in litigation. 

On this question each of the members of the Court offers a different view and it is difficult to decide at some points how material those differences are. 

Pre-contractual negotiations

Of particular interest are the Court’s comments on the admissibility of pre-contractual negotiations.  The negotiations at issue were a chain of correspondence between the solicitors for the parties, culminating in the interim agreement.  Both parties sought to rely on this correspondence to explain their interpretation of the price clause. 

Traditionally, evidence of pre-contractual exchanges is inadmissible.  It offends the basic principle that contracts are to be interpreted objectively, based on the words chosen by the parties to record their bargain.  Evidence of subjective intent, by way of statements made prior to the parties reaching consensus, is simply irrelevant to this task.  This position has recently been confirmed by the House of Lords in Chartbrook Ltd v Persimmon Homes Ltd, and still applies in Australia.

But there are significant exceptions to this rule.  Evidence of negotiations may be relied upon to establish the background and context of the transaction, and the subject matter of the intended contract.  It may be also be relied upon to support alternative arguments, such as claims for rectification or an estoppel by convention.

Three members of the Supreme Court adhered to this orthodoxy.  Blanchard, Gault and McGrath JJ all accepted that pre-contractual material may be relied upon to establish the background and subject matter of the contract. 

However, both Tipping and Wilson JJ appear to favour extending the admissibility of pre-contractual negotiations to any circumstance where that evidence is relevant to the objective meaning of the contract.  This is consistent with the Supreme Court’s earlier judgment in Gibbons Holdings Ltd v Wholesale Distributors Ltd, which expresses the same view of post-contractual conduct.  Notably, Blanchard J also does not exclude this possibility, but says that the issue “can be left for another day”.

To this extent, the decision may indicate a development of the trend in Wholesale Distributors to allow any evidence which is relevant to the objective meaning of the contract.  This has the benefit of simplicity, and imposes no arbitrary limits on the evidence available to the parties.  But it also raises the spectre of parties canvassing vast quantities of only marginally relevant evidence in an attempt to escape the effect of a contract which is fundamentally clear and unambiguous, and thereby adding unnecessarily to the length and cost of trial. 

Ambiguity

Also of interest are the various comments on the role of ambiguity in the contract in regulating what evidence may be used to interpret it. 

Blanchard, Tipping and McGrath JJ all agree that no ambiguity is required before evidence of background circumstances is admissible.  But Wilson J requires that there be a “genuine and relevant ambiguity” before such evidence may be looked at.  “[A]ssertions by parties of possible different meanings will not suffice.”  He goes on to conclude that there is no ambiguity in the interim agreement, since it incorporates the terms of the 1995 Agreement which fixed the point of supply of gas to BoPE at a valve on its Edgecumbe site.  Since the cost of transmission had been incurred by Vector at this point, the price should be regarded as inclusive of that cost.

How significant is this point?  Arguably, not very.  The members of the Court themselves differ over whether the interim agreement was ambiguous.  Blanchard J considers it was, since there was no guidance on whether the price stated was inclusive or exclusive of transmission costs.  Gault J seems to take the same view.  McGrath J differs, for the same reasons given by Wilson J.  That judges can differ so readily over essentially the same term may suggest that a finding of ambiguity is not hard to make where it is required as a precondition to getting at evidence that a Court regards as helpful.  If so, then the better view may be that ambiguity is unnecessary, and that the better approach is to recognise that where the express terms are clear, a Court will need powerful evidence to justify it coming to a different interpretation. 

Conclusion

So what are the practical implications of this case?  Subtle questions of the law on contractual interpretation may be of academic interest, but the decision does not shift the goalposts significantly. 

It may indicate that pre-contractual material is acquiring broader relevance to interpretation but, as several of the members of the Court note, the same evidence is likely to be admissible anyway to establish relevant background facts, or in support of an alternative submission based on estoppel or rectification.  Indeed, even McGrath and Wilson JJ, who refused to consider the pre-contractual material as a direct aid to interpretation, used it as the basis for finding an estoppel in favour of Vector.

It is also noteworthy that the argument that removing controls of extrinsic evidence leads to expensive, lengthy and ultimately futile raking over of pre-contractual exchanges did not receive much favour.  Unlike the House of Lords in Chartbrook, the Court was not inclined to exclude otherwise relevant evidence on merely practical grounds.  However, Tipping J did raise the possibility of a costs award where a party is unsuccessful in such an exercise. 

If we are to take a more expansive approach to evidence in contract interpretation cases, it remains to be seen whether this will prove a realistic disincentive to parties taking the ‘kitchen sink’ approach.  But even if costs prove to be an adequate control on the scope of evidence at trial, a more expansive approach is still likely to increase the cost and complexity of advising on, and litigating, the meaning of a commercial contract. 

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