The Role of Common Sense in Interpreting Commercial Contracts: A Historical View, Study notes of Business

Download The Role of Common Sense in Interpreting Commercial Contracts: A Historical View and more Study notes Business in PDF only on Docsity! 279 MAKING SENSE OF COMMERCIAL COMMON SENSE Suzanne Robertson QC* The article examines the use of "commercial common sense" in the interpretation of commercial contracts. It reviews the origins of the test of commercial common sense and traces the application of the test in relatively recent New Zealand and United Kingdom appellate decisions. The author's contention is that the test is only properly applied when a court asks itself which of the interpretations put forward by the parties is most consistent with the contracting parties' mutual commercial purpose. The test is not properly applied when a court prefers one interpretation to another simply because it is the court's view that the alternative would mean one party made a particularly bad bargain. I INTRODUCTION The purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed.1 A welcome reminder to be wary about interpreting commercial agreements according to commercial common sense has been given by the United Kingdom Supreme Court. In the words of Lord Neuberger SCJ:2 The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language. 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. * Suzanne Robertson is a Queen's Counsel at Bankside Chambers. She provides advice and advocacy in commercial and civil disputes, including breach of contract disputes. 1 Arnold v Britton [2015] UKSC 36, [2015] AC 1619 at [20] per Lord Neuberger SCJ (with whom Lord Sumption and Lord Hughes SCJJ agreed). 2 At [19]. 280 (2018) 49 VUWLR The test of commercial common sense is only properly applied when the common sense is judged in the light of the objectively ascertained purposes of both parties to the agreement at the time the agreement was made. The test is not properly applied when a court prefers one interpretation over another simply because the alternative would mean one party made a particularly bad bargain. It is inherent in the nature of a bad bargain that it is likely to be contrary to commercial common sense for one party to the bargain. However, for the other party to the bargain, it is likely to be the epitome of commercial common sense. It is only when an agreement is not consistent with the commercial objective both parties are trying to achieve that it will be contrary to commercial common sense for both parties. This is the only way that commercial common sense can be said to be "common". This article discusses the origin of the concept of commercial common sense and its use in recent New Zealand and United Kingdom decisions. The notions of whether an agreement is consistent with the parties' overall commercial purpose and whether a party has made a bad bargain can overlap to a degree. However, it is important to recognise the difference and to be wary of arguments or decisions based on the latter. Recent decisions in both countries suggest the courts are less inclined to decide between competing contractual interpretations by attempting to identify the most commercially sensible conclusion. II EVOLUTION OF COMMERCIAL COMMON SENSE The ultimate objective in a contractual interpretation dispute is to establish the meaning the parties intended their words to bear.3 This exercise has been described as one in which the court:4 … must consider the language used and ascertain what a reasonable person, that is a person who has all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract, would have understood the parties to have meant. In doing so, the Court must have regard to all the relevant surrounding circumstances. If there are two possible interpretations put forward, the court is entitled to prefer the interpretation that is consistent with business common sense and to reject the other.5 However, determining that one interpretation is more consistent with business common sense than another is far more easily said than done. The genesis of the concept of business common sense as an aid to interpretation of contracts is most often attributed to the judgment of Lord Diplock in Antaios Compania Naviera SA v Salen 3 Vector Gas Ltd v Bay of Plenty Energy Ltd [2010] NZSC 5, [2010] 2 NZLR 444 at [19]. 4 Rainy Sky SA v Kookmin Bank [2011] UKSC 50, [2011] 1 WLR 2900 at [21]. 5 At [21]. MAKING SENSE OF COMMERCIAL COMMON SENSE 283 Lord Hoffmann's yardstick of commercial common sense was applied by finding the interpretation considered to be most consistent with the commercial purpose of the parties' agreement. He did not consider what the different consequences of the alternative interpretations might be for each party. Rather, he focused on what construction was most consistent with the Court's understanding of what the parties were attempting to achieve. Lord Hoffmann's five principles for interpretation of contracts were cemented into New Zealand law in Boat Park Ltd v Hutchinson.15 The parties had entered into an agreement for the sale and purchase of land which included a vendor mortgage. The agreement for sale and purchase limited the vendor mortgage to 75 per cent of a "registered valuer's valuation of the property", which was to be obtained "by and at the expense of the purchaser". The purchaser produced a valuation which was over twice the purchase price and which had been carried out on the basis that a hypothetical subdivision was successfully carried out. The vendor obtained a valuation based on current market value of the land in its existing state, which was similar to the purchase price. Of the alternative interpretations proffered to the Court of Appeal in Boat Park, there surely can have been little doubt that the vendor's interpretation was the correct interpretation. The Court adopted this interpretation with little difficulty. The position and behaviour of the appellants seems to have been somewhat opportunistic. As the Courtsaid "[a]ny other conclusion would defy both common sense and valuation theory and practice."16 As the correct interpretation could be arrived at so easily, the question before the Court required little discussion of principles of interpretation. The Court of Appeal reiterated in full Lord Hoffmann's five principles of interpretation and applied those principles to reject the purchaser's valuation. The next landmark decision concerning commercial common sense in interpretation of contracts was the House of Lords decision in Chartbrook Ltd v Persimmon Homes Ltd.17 It also concerned an agreement for sale and purchase of land. In this case all parties were aware the land was going to be developed. The vendors were not to be paid for the land until sometime after the development had been completed. The purchase price was to be calculated as a payment for total land value (the calculation of which was set out in the contract) and a balancing payment defined as the "Additional Residential Payment" (ARP). The issue before the Court was the correct interpretation of the contractual definition of the ARP. 15 Boat Park Ltd v Hutchinson [1999] 2 NZLR 74 (CA). 16 At 85. 17 Chartbrook Ltd v Persimmon Homes Ltd [2009] UKHL 38, [2009] AC 1101. 284 (2018) 49 VUWLR The first instance Judge and the majority of the Court of Appeal adopted an interpretation based on the syntax used in the definition of ARP.18 Lord Justice Lawrence Collins, dissenting in the Court of Appeal, and the House of Lords adopted the alternative interpretation having been persuaded that to interpret the definition of ARP in accordance with ordinary rules of syntax made no commercial sense. Part of what persuaded the House of Lords to adopt the alternative construction was the other terms of the contract and the particular words (as opposed to the syntax) used. In particular, the interpretation suggested by the appellant recognised an element of contingency about the payment of the ARP and the respondent's did not. The words used and other terms of the contract supported the concept of a contingent payment. Lord Hoffmann recognised the uncertainty that can be introduced through judges interpreting contracts in order to be consistent with commercial common sense. He said:19 It is, I am afraid, not unusual that an interpretation which does not strike one person as sufficiently irrational to justify a conclusion that there has been a linguistic mistake will seem commercially absurd to another … His Lordship also recognised that a bad bargain in the eyes of the court, on its own, does not constitute commercial common sense. He said:20 It is of course true that the fact that a contract may appear to be unduly favourable to one of the parties is not a sufficient reason for supposing that it does not mean what it says. The reasonable addressee of the instrument has not been privy to the negotiations and cannot tell whether a provision favourable to one side was not in exchange for some concession elsewhere or simply a bad bargain. But the striking feature of this case is not merely that the provisions as interpreted by the Judge and the Court of Appeal are favourable to Chartbrook. It is that they make the structure and language of the various provisions of Schedule 6 appear arbitrary and irrational, when it is possible for the concepts employed by the parties ... to be combined in a rational way. What made commercial sense was again determined by reference to the overall purpose and other provisions of the contract. One interpretation was not found to be more commercially sensible because the provisions of the contract were more favourable to one party than the other. 18 Chartbrook Ltd v Persimmon Homes Ltd [2007] EWHC 409 (Ch); and Chartbrook Ltd v Persimmon Homes Ltd [2008] EWCA Civ 183. 19 Chartbrook, above n 17, at [15]. 20 At [20]. MAKING SENSE OF COMMERCIAL COMMON SENSE 285 III VECTOR GAS The well-known New Zealand Supreme Court decision of Vector Gas Ltd v Bay of Plenty Energy Ltd has attracted substantial comment in relation to admissibility of extrinsic evidence, particularly evidence of prior negotiations, in disputes over the proper interpretation of written contracts.21 It is also noteworthy because some of the judges appear to have adopted the reasoning of discounting an interpretation put forward by one party which appeared "unduly favourable to one of the parties".22 The facts can be restated quite briefly. A dispute arose over Vector Gas's obligation to continue supplying gas to Bay of Plenty Energy under an agreement between the parties. Bay of Plenty Energy said it was going to refer the dispute to the court and the parties negotiated an agreement to govern supply pending resolution of that dispute. If the court ultimately found, as contended by Vector Gas, that it was entitled to terminate supply, Bay of Plenty Energy agreed to pay the difference between the price in the terminated agreement to supply and $6.50 per GJ plus interest for gas supplied in the interim. The Supreme Court and all the courts below agreed that Vector Gas's termination of supply was lawful and therefore Bay of Plenty Energy became liable to pay for the gas supplied according to the interim agreement reached. The parties disagreed about whether the "$6.50 per GJ" did or did not include transmission costs. The contract before the court in Vector Gas differed in a significant way from those before the courts in the cases discussed above. The agreement before the court had been reached through an exchange of correspondence. There was no formal written contract recording the parties' agreement. It seems at least possible, if not probable, that had the parties decided to draw up a formal written agreement, in the process of drafting that agreement, they would have expressly addressed the issue of transmission costs. This would have avoided the need for the court to reach a conclusion as to what the parties had intended from their correspondence. The Supreme Court did not explicitly refer to the informal nature of the agreement. In the author's view, this is a relevant factor. Lord Hoffmann's fifth principle of contractual interpretation in Investors Compensation Scheme is:23 The "rule" that words should be given their "natural and ordinary meaning" reflects the common sense proposition that we do not easily accept that people have made linguistic mistakes, particularly in formal documents. 21 Vector Gas Ltd v Bay of Plenty Energy Ltd [2010] NZSC 5, [2010] 2 NZLR 444. 22 Contrary to Lord Hoffmann's caution in Chartbrook, above n 17, at [20]. 23 Investors Compensation Scheme, above n 9, at 913 (emphasis added). 288 (2018) 49 VUWLR As the English and Welsh Court of Appeal said in Bank of Nova Scotia v Hellenic Mutual War Risk Assoc (Bermuda) Ltd:33 It is nonetheless important, in attributing a purpose to a commercial transaction, to be sure that it is the purpose of both parties and not just one. If the purpose of the transaction is seen through the eyes of one party only an unbalanced view of the transaction may result. Many contracts represent a compromise between what one party wishes to obtain and the other is willing to give. The concern with the Supreme Court's judgment in Vector Gas is not the outcome. The outcome could have been reached by applying conventional principles on the interpretation of contracts. The concern is the reasoning in relation to the concept of commercial common sense. The commercial common sense test requires a court to ascertain what interpretation is more likely to be consistent with the purpose of both parties to the transaction. An interpretation that is contrary to that mutual purpose is contrary to commercial common sense. An interpretation is not contrary to commercial common sense because it results in one party being held to its bad bargain. IV NEW ZEALAND APPELLATE DECISIONS AFTER VECTOR GAS A Technix Group Ltd v Fitzroy Engineering Group Ltd More recent appellate decisions fortunately seem to apply the commercial common sense yardstick in a more orthodox way. An illustration of the test properly applied is found in both the High Court and Court of Appeal judgments in Technix Group Ltd v Fitzroy Engineering Group Ltd.34 In 1992 Fitzroy purchased from Technix an industrial manufacturing and boat-building business in New Plymouth. At the time Fitzroy could not afford to purchase the land on which the business operated and it entered into a lease. In order to give Fitzroy some security, the parties agreed to include an option to purchase clause in the lease. The lease also gave Fitzroy a right of pre-emption if Technix wanted to sell the land in the future or received an offer. Fitzroy wanted to buy the property and triggered the option to purchase process by giving written notice. The process in the lease required Technix to investigate the cost and procedure involved in subdividing the land. If, following that investigation, Fitzroy wished to proceed it had to formally exercise the option to purchase. After Fitzroy gave written notice to Technix triggering the option to purchase process, Technix received an offer from a "third party" to purchase the property. The third party was a charitable trust associated with a Technix director. Having received the offer, 33 Bank of Nova Scotia v Hellenic Mutual War Risk Assoc (Bermuda) Ltd [1990] 1 QB 818 (CA) at 870. 34 Technix Group Ltd v Fitzroy Engineering Group Ltd [2011] NZCA 17. An application for leave to appeal was dismissed by the Supreme Court: Technix Group Ltd v Fitzroy Engineering Group Ltd [2011] NZSC 57. MAKING SENSE OF COMMERCIAL COMMON SENSE 289 Technix purported to trigger the pre-emptive right subclause under the lease, which would require Fitzroy to agree to match the third party's offer within 14 days if it wished to purchase the property. The issue in the appeal was whether Technix could invoke the pre-emption subclause when Fitzroy had already triggered the option to purchase process. Under the option to purchase provision, Fitzroy had only to purchase the land and premises it used. Under the right of pre- emption Fitzroy would be required to purchase additional land. The parties also anticipated that the price payable under the option would be less than the third party offer. The lease provided that the right of pre-emption may be triggered "at any time during the term of the lease". Technix argued there was no justification for going beyond the plain and ordinary meaning of "any time" and therefore that the right of pre-emption could be triggered during periods when the option to purchase process was underway. As the Court of Appeal concluded, the construction put forward by Technix gave Technix the right to "render valueless" the option granted to Fitzroy.35 The Court thought "it impossible that the parties could have intended such a result".36 The option to purchase was always going to require a subdivision and the High Court and Court of Appeal noted that the parties must also have understood and accepted that the investigation and subdivision process was always going to take considerably longer than 14 days.37 Therefore this was one of the occasions:38 … when the plain and ordinary meaning of a contract could not have been what the parties intended, flouts business common sense and so must yield to the interpretation which does not do so. The Court of Appeal also had regard to the background to the option to purchase clause and the importance that the parties had attached to it when it was inserted into the agreement.39 At that time there was a mutual expectation that it would probably be invoked. This strengthened the Court's conclusions that the parties could not have intended that option to be so easily frustrated by Technix. The interpretation of the contract argued by Technix, was contrary to the commercial purpose of the option to purchase and the pre-emptive clause. In this sense the interpretation for which Technix contended was contrary to commercial common sense. The Court of Appeal favoured the interpretation most aligned to the purpose of the contract seen through both parties' eyes. 35 Technix Group Ltd v Fitzroy Engineering Group Ltd (CA), above n 34, at [11]. 36 At [11]. 37 At [13]. 38 At [16] citing Antaios, above n 6, at 201; aff'd Investors Compensation Scheme, above n 9, at 913. 39 At [20]–[22]. 290 (2018) 49 VUWLR B Firm PI 1 Ltd v Zurich Australian Insurance Ltd The Supreme Court returned to the concept of commercial common sense in Firm PI 1 Ltd v Zurich Australian Insurance Ltd. 40 The case concerned whether the sum insured under the insurance contract for earthquake damage was inclusive or exclusive of the amount payable by the Earthquake Commission (EQC). By a majority, the Court held the sum insured was inclusive of the amount payable by EQC and the insurer was only liable to pay the difference between the sum the insured received from the EQC and the reinstatement value recorded in the contract. This conclusion was reached on the language of the relevant clause read in the context of the entire insurance contract. The majority (in a judgment delivered by Arnold J) acknowledged the tension between recognising arguments based on commercial absurdity and steering clear of arguments based on bad bargains. Justice Arnold said:41 But if consideration of the relevant background forces a court to the conclusion that something has gone wrong with the contractual language, it is not required "to attribute to the parties an intention which they plainly could not have had".42 Just as the courts have accepted that understanding the commercial purpose of a commercial contract is relevant to its interpretation, so have they accepted that … if a particular interpretation produces a commercially absurd result, that may be a reason to read the contract in a different way than the language might suggest.43 However, it has also been accepted that a court is not justified in concluding that a contract does not mean what it seems to say simply because the court considers that, so interpreted, the contract is unduly favourable to one party.44 There is an obvious tension between these two positions, and it will often be difficult to determine whether particular cases fall within one category or the other.45 His Honour went on to consider both, what he described as, the "general structure of the bargain" and "commercial absurdity".46 Refreshingly, the majority of the Court recognised "reason 40 Firm PI 1 Ltd v Zurich Australian Insurance Ltd [2014] NZSC 147, [2015] 1 NZLR 432 at [89]. 41 At [89]. 42 Investors Compensation Scheme, above n 9, at 913 per Lord Hoffmann. See also Chartbrook, above n 17, at [14] per Lord Hoffmann. 43 As occurred, for example, in Investors Compensation Scheme, above n 9; and Chartbrook, above n 17. See also Vector Gas, above n 21, at [8]–[10] per Blanchard J. 44 Chartbrook, above n 17, at [20] per Lord Hoffmann. 45 See the discussion in David McLauchlan "Contract Interpretation in the Supreme Court – Easy Case, Hard Law?" (2010) NZBLQ 229 at 236–238. 46 Firm PI 1, above n 40, at [77] and [88]. MAKING SENSE OF COMMERCIAL COMMON SENSE 293 If a clause is capable of two meanings, as on any view this clause is, it is quite possible that neither meaning will flout common sense. In such circumstances, it is much more appropriate to adopt the more, rather than the less, commercial construction. The trial Judge had found that "the most likely reason" why the security of an advanced payment bond would be needed was in the event the ship builder became insolvent.57 In argument, Kookmin Bank had been unable to advance any commercial reason for the bonds not to cover the ship builder's insolvency. The contracts, looked at as a whole, placed a lot of emphasis on the need for an immediate refund in the event of insolvency. Therefore it made most commercial sense for the repayment obligations in the bond to be interpreted consistently with the repayment obligations in the ship building contracts and to provide for repayment of instalments paid in the event of the ship builder's insolvency.58 Lord Clarke SCJ thought that if the parties had intended the "surprising and uncommercial" result that insolvency could not trigger repayment, the documents would no doubt have spelt this out clearly and they did not.59 The United Kingdom Supreme Court determined which interpretation made more commercial sense by reviewing the overall purpose and other provisions of the contract. That brings us to the decision of the United Kingdom Supreme Court in June 2015 in Arnold v Britton.60 The case concerned the interpretation of service charge contribution clauses in the leases of a number of chalets in a caravan park in New South Wales. Lord Neuberger SCJ delivered the majority judgment. He emphasised seven general principles in relation to interpretation of contractual provisions. Three related to the Court's use of commercial common sense. They are worth repeating in full and were: [17] First, the reliance placed in some cases on commercial common sense and surrounding circumstances (eg in Chartbrook at [16]–[26]) should not be invoked to undervalue the importance of the language of the provision which is to be construed. The exercise of interpreting a provision involves identifying what the parties meant through the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision. Unlike commercial common sense and the surrounding circumstances, the parties have control over the language they use in a contract. And, again save perhaps in a very unusual case, the parties must have been specifically focussing on the issue covered by the provision when agreeing the wording of that provision. ... 57 Rainy Sky, above n 4, at [41]. 58 At [44]–[45]. 59 At [41]. 60 Arnold v Britton, above n 1. 294 (2018) 49 VUWLR [19] The third point I should mention is that commercial common sense is not to be invoked retrospectively. The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language. 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. … [20] Fourthly, 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. Experience shows that it is by no means unknown for people to enter into arrangements which are ill-advised, even ignoring the benefit of wisdom of hindsight, and it is not the function of a court when interpreting an agreement to relieve a party from the consequences of his imprudence or poor advice. Accordingly, when interpreting a contract a judge should avoid re-writing it in an attempt to assist an unwise party or to penalise an astute party. The reader will by now realise that Lord Neuberger SCJ's fourth principle expresses the premise of this article far more eloquently than the author does. The landlord contended that the effect of the provisions in the lease was that there was a fixed annual service charge for the first year, increasing each year by 10 per cent on a compound basis. The lessees' argued for an alternative interpretation. One of their primary contentions was that the lessor's construction resulted in such an increasingly absurdly high annual service charge in the latter years of each lease that it could not be correct. Lord Neuberger SCJ was not persuaded by arguments based on the assertion that the lessor's interpretation had come to have unattractive consequences for the lessees. In accepting the lessor's construction, primarily because it was more consistent with the express language of the contract, Lord Neuberger SCJ also said: [37] ... People enter into all sorts of contracts on the basis of hopes, expectations and assessments which no professional expert would consider prudent, let alone feel able to "predict with accuracy". I have little doubt that many fortunes have been both made and lost (and sometimes both) by someone entering into such a contract. Writing extrajudically Lord Neuberger has said:61 61 Lord Neuberger "The Impact of Pre- and Post-Contractual Conduct on Contractual Interpretation" (paper presented to Banking Services and Finance Law Association Conference, Queenstown, New Zealand, 11 August 2014) at [20]. MAKING SENSE OF COMMERCIAL COMMON SENSE 295 We have to be very wary of relying on commercial common sense. First, a judge's idea of commercial common sense may be thought by some to be about as reliable as a businessman's idea of legal principle. Secondly, the judicial view of commercial common sense in a particular case is almost bound to be influenced by the facts as they have transpired since the contract, which should plainly be irrelevant to the exercise of interpretation. This statement has been described as somewhat surprising, particularly since judges are called upon to make judgments concerning other broad notions, for example good faith and unconscionability.62 However, commercial common sense is not the same as good faith or unconscionability. Determining arguments about good faith and unconscionability is most likely to primarily involve issues of justice and fairness, which are well within the range of topics a judge should be expected to decide. Outside the limits of the mutual purpose of parties to a contract, commercial common sense is, as titled, dependent on the commercial circumstances, goals, knowledge, experience and acumen of the parties. It is not something a judge is necessarily best placed to decide. There are risks in encouraging parties to attempt to persuade a judge towards a particular interpretation by virtue of the commercial common sense test. It is conceivable that parties could call expert evidence to establish the commercial common sense of a particular transaction. Alternatively a party may seek to admit extrinsic evidence around the commercial common sense of the transaction, in addition to its context and surrounding facts. Any use of the commercial common sense test that encourages judges to rank commercial decisions or parties to expand the extrinsic evidence that can be called in aid of a particular contractual interpretation ought to be avoided. It has been suggested that the more recent decisions signal a shift in the approach to interpretation of contracts generally and a return to a more conservative approach under which disputes are resolved primarily on the basis of textual analysis with limited resort to external context, including considerations of commercial common sense.63 The trend does appear to be towards a more conservative approach to interpretation of contracts. To the extent that conservative approach gives rise to greater certainly and predictability in the law, that is desirable. However, the New Zealand courts at least, still show a willingness to look outside the particular document which is the subject of the dispute and to consider the commercial purpose of the parties to determine the proper interpretation.64 62 McLauchlan, above n 10, at 432. 63 At 432. 64 See for example Body Corporate 341188, above n 50.