May 10, 2016

By Malcolm Webb

Commercial common sense

In Arnold v Britton, the UK Supreme Court elaborates on the use of commercial common sense in interpreting contracts.

Background

Arnold v Britton [2015] UKSC 36 was a decision of the UK Supreme Court last year.  The case involved a set of leases for chalets at a beach holiday park in South Wales.  The leases were mainly entered into in the 1970s and 1980s and were for a term of 99 years. 

The leases contained a clause (clause 3(2)) that required the tenants to pay a service charge to the lessor for maintenance of the holiday park.  There were a number of minor variations to clause 3(2), but the version that the Court mainly focussed on was as follows:

“To pay to the Lessor without any deductions in addition to the said rent as a proportionate part of the expenses and outgoings incurred by the Lessor in the repair maintenance renewal and renewal of the facilities of the Estate and the provision of services hereinafter set out the yearly sum of Ninety Pounds and Value Added tax (if any) for the first Year of the term hereby granted increasing thereafter by Ten Pounds per hundred for every subsequent year or part thereof.”

Some of the tenants were the appellants in this case and they argued that it would be an absurd interpretation of clause 3(2) to require them to pay a service charge at a 10% compounding rate.  The result would be staggering in the later years of the leases and likely devastating for the tenants or their successors.  For a lease terminating in 2072, the annual maintenance charge would reach over a million pounds.

Instead, they argued that the proper construction of clause 3(2) was that the lessee was required to pay a fair proportion of the lessor’s costs of providing the services, subject to a maximum, which is £90 in the first year of the term, increasing every year by 10% on a compound basis.  The respondent, the lessor, argued that the proper interpretation was that there was no such cap.

Key points of the case

Lord Neuberger, giving the judgment for the majority, rejected the appeal.

The Judge set out the familiar test that “[w]hen interpreting a written contract, the court is 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”, to quote Lord Hoffmann in Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38, [2009] 1 AC 1101, para 14”.

The importance of this case revolves around the Judge’s comments related to the use of commercial common sense in interpreting contracts. 

The key point of the judgment seems to be this:

“…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. The purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed.”

The stark consequences of this for the tenants is that the majority of the Supreme Court saw clause 3(2) as having a clear meaning, that the tenants were obliged to pay the service charge on a 10% compounding basis.  The fact that the implications were dire was the result of what appears today to have been a bad bargain on the tenants’ part.

Clause 3(2) could have been interpreted differently.  The first part of the clause set the context for the service charge (to pay “a proportionate part of the expenses and outgoings incurred by the Lessor in the repair maintenance renewal and renewal of the facilities of the Estate and the provision of services”) and the second part of the clause the mechanism for achieving this (a fixed service charge compounding annually).  If the second part of the clause was interpreted in light of the context provided by the first part of the clause, then the interpretation may have been that the service charge should not exceed the proportionate part of the expenses and outgoings.

Lord Carnwath, dissenting, saw an inherent ambiguity in the clause that needed to be resolved.  “A figure can be determined as a proportionate part of some other variable amount, or it can be a yearly sum, fixed by a predetermined formula; but it cannot be both”.  Lord Neuberger did not see any ambiguity.

Lord Neuberger further pointed out that commercial common sense should not be invoked retrospectively.

“Commercial common sense 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 that the contract was made”.

The Judge referenced the difficult economic conditions in Britain in the 1970s, with inflation reaching very high levels, caused by the oil price shocks and other conditions of the time.  Inflation reached as high as 24.2% in 1975.  The judge pointed out that, with volatile inflation rates which were often in double figures, a 10% compounding charge may well have been a sensible bargain for the tenants.  The lessor could have lost out if inflation remained high.  But the fact that the deal had proven to be a poor one for the tenants was not the point.

Conclusion

The New Zealand Court of Appeal has stated that “The day has long since passed in our Courts where words are to be given a purely literal meaning” (Mount Joy Farms Ltd v Kiwi South Island Co-operative Dairies Ltd CA 297/00).  Burrows, Finn and Todd have stated that the Court of Appeal’s support for the statements of Lord Hoffman in Investors Compensation Scheme Ltd v West Brunswick Building Society [1998] 1 WLR 896 “…heralds a move from a literal approach to a more common-sense purposive approach to the interpretation of contracts” (page 178).

However, it may well be that our Courts, faced with the same set of factual circumstances, would have decided the same way as the majority of the Supreme Court in Arnold v Britton.  The contract, in the majority’s eyes, was clear and unambiguous and the circumstances of the 1970s suggested that the commercial bargain may have been fair at the time. 

For commercial lawyers drafting contracts, this case emphasises that, where a contract has a clear meaning, it is likely to be given effect to.  The Court will be reluctant to dig deeper and question the commercial sense of the provision where the wording is clear on its face.    

This further emphasises the fact that drafting must be clear and unambiguous, but also that it has to mean what the parties intend it to mean.

Disclaimer

This article is necessarily brief and general in nature. You should seek professional advice before taking any action in relation to the matters dealt with in this article.