Contractual interpretation and business common sense

The principles

• It is well-established that the courts can have regard to business common sense when interpreting contracts under English law.  However, the extent to which they can take business common sense into account has been the subject of considerable debate in recent years.

• In the Rainy Sky case of 2011, Lord Clarke said that the process of construction is “one unitary exercise” and that the court “must have regard to all the relevant surrounding circumstances”. He said that, where a court is faced with two possible constructions, it is entitled to “prefer the construction which is consistent with business common sense”.

• In the Arnold v Britton case of 2015, the Supreme Court upheld a literal interpretation of a contractual provision, despite the fact that it had disastrous commercial implications for one of the parties. Lord Neuberger (giving the leading judgment) emphasised the importance of giving effect to the natural meaning of the contractual wording used by the parties.

• The Arnold case has been interpreted by some practitioners as signalling a slight shift by the English courts, from the use of business common sense as an aid to interpretation to a more literal approach towards contractual wording. This is consistent with Lord Neuberger’s suggestions (made extra-judicially) that judges should be wary of placing too much emphasis on business common sense. Lord Neuberger has recently said, however, that he did not intend to change the law on contractual interpretation through his judgment in Arnold.

Recent developments

• In the recent case of Wood v Capita, the Supreme Court was asked to interpret an indemnity provision in an Supreme People's Assembly (SPA), relating to Capita’s purchase in 2010 of shares in a company involved in the sale of motor insurance policies. Following the acquisition, Capita discovered that the company had potentially mis-sold various policies between 2009 and 2011. Capita agreed with the Financial Services Authority (FSA) to pay compensation to the affected customers and subsequently brought a claim against the seller of the company pursuant to the indemnity provision.

• The specific issue to be decided in this case was whether, under the wording of the indemnity provision, the seller was liable to indemnify Capita even if there had been no claim or complaint made by a customer. The High Court held that the seller was so liable, but this was overturned by the Court of Appeal, with which the Supreme Court agreed.

• Lord Hodge (giving the only judgment) arrived at this decision principally on the basis of the wording of the indemnity provision, which he analysed in considerable detail (paragraphs 29-38). He also briefly considered the commercial context, which he said supported this interpretation (paragraphs 39-41)). 

• Lord Hodge made a number of comments about contractual interpretation (particularly at paragraphs 8-15). He emphasised that Arnold and Rainy Sky were consistent with each other and that the court should undertake both a textual and contextual analysis in interpreting contractual language. Lord Hodge endorsed Lord Clarke’s approach in Rainy Sky to the interpretation exercise.

We have produced a longer note containing further analysis of Lord Hodge’s comments, which can be found here.

What this means

• It can now safely be said that the Arnold case did not fundamentally change the law on contractual interpretation. Accordingly:
  • Lord Clarke’s formulation of a single exercise, involving the wording of the agreement and the surrounding circumstances, still represents the courts’ approach to contractual interpretation, and
  • Business common sense is therefore still a relevant consideration in the contractual interpretation process.
• However, Lord Neuberger’s emphasis in Arnold on the natural meaning of contractual wording, and his comments about business common sense, should not be ignored. We still expect that English courts will be wary of the extent to which they will allow business common sense to affect their interpretation of parties’ contracts. Accordingly, contracting parties should ensure that:
  • They continue to consider carefully the precise wording they include in their contracts. In the Wood case, the relevant provision appeared to be cogent and comprehensive, but in fact, contained a subtle ambiguity.
  • They consider all of the possible commercial scenarios in which their contractual provisions could become relevant. The courts will not rescue the parties if their contract leads to a bad bargain. Any possibility of this should be cured at the drafting stage.

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