Interpreting contracts and implying terms: the approach of the Supreme Court
In the preceding article, Reyhan Yilmaz looked at anti-oral variation clauses, which are designed to limit the ability of parties to make subsequent changes to their agreement. Lord Justice Beatson had said in the Globe Motors1 case highlighted by Reyhan that:
“The professed object of a common law court in interpreting or construing a written contract is to discover the mutual intention of the parties.”
Jeremy Glover takes a look at what the Supreme Court has said about how parties should go about interpreting their contract.
The seven principles for contract interpretation
At the end of 2015, the Supreme Court, in the case of Arnold v Britton,2 considered the court’s approach to the principles of contract interpretation. Lord Neuberger emphasised seven issues which were key to interpreting the contract in question. The seven factors were:
(i) the reliance placed on commercial common sense and surrounding circumstances should not be invoked to undervalue the importance of the language of the provision which is to be construed;
(ii) the less clear the relevant words are, or the worse their drafting, the more ready the court can properly be to depart from their natural meaning;
(iii) commercial common sense is not to be invoked retrospectively;
(iv) 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;
(v) when interpreting a contractual provision, one can only take into account facts or circumstances which existed at the time that the contract was made, and which were known or reasonably available to both parties;
(vi) in some cases, an event subsequently occurs which was plainly not intended or contemplated by the parties, judging from the language of their contract. In such a case, if it is clear what the parties would have intended, the court will give effect to that intention; and
(vii) service charges are not subject to any special rules of interpretation.3
Previously, in the case of Kookmin Bank v Rainy Sky SA,4 the Supreme Court had had to consider how to interpret a bond. Should it adopt a literal or common sense approach? Lord Clarke quoted with approval from the dissenting Court of Appeal judgment of Sir Simon Tuckey:
“As the Judge said, insolvency of the Builder was the situation for which the security of an advance payment bond was most likely to be needed. The importance attached in these contracts to the obligation to refund in the event of insolvency can be seen from the fact that they required the refund to be made immediately. It defies commercial common sense to think that this, among all other such obligations, was the only one which the parties intended should not be secured. Had the parties intended this surprising result I would have expected the contracts and the bonds to have spelt this out clearly but they do not do so.”
Therefore, the buyer’s construction was to be preferred because it was consistent with the commercial purpose of the bonds in a way in which the bank’s construction was not. However, parties must take care not to place too much emphasis on “commercial common sense” at the expense of the actual words used. Lord Neuberger noted at item four of his list of seven principles that:
“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.”
Therefore, whilst the Arnold case should not be taken as signalling any change in the approach of the courts, it does confirm that the starting point for contract interpretation is always the plain words of the contract in question. Lord Neuberger held that the court was:
“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’… and it does so by focussing on the meaning of the relevant words… in their documentary, factual and commercial context.”
Implied terms of contract
Terms can be implied into a contract as a matter of law (for example through statute, say the Supply of Goods and Services Act) and as a matter of fact. The second approach includes terms implied by the “business efficacy” or “officious bystander” tests. In 1977 in the case of Liverpool City Council v Irwin5 Lord Wilberforce had noted that ultimately the test was one of necessity: is the implied term necessary to make the contract work? Lord Neuberger also made a number of interesting comments in the case of Marks & Spencer v BNP Paribas where he considered the test for the implication of terms. Unsurprisingly, he adopted a similar approach to the Arnold v Britton case.
The Marks & Spencer case related to a claim by a tenant who argued that a term should be implied into a lease to the effect that certain advance payments relating to a period after the lease ended should be refunded. It is important because the Supreme Court took the opportunity to clarify the legal test for implying terms into contracts and also to comment upon what the following words of Lord Hoffman in the 2009 case of Attorney General of Belize v Belize Telecom actually meant:
“There is only one question: is that what the instrument, read as a whole against the relevant background, would reasonably be understood to mean?”
Whilst the Supreme Court confirmed that the judgment was not to be read as involving any relaxation of the traditional, highly restrictive approach to the implication of terms, Lord Neuberger stressed that these words did not mean that Lord Hoffman was suggesting that reasonableness alone was a sufficient ground for implying a term. Indeed, because the Supreme Court considered that some had wrongly suggested that this was what Lord Hoffman had meant, Lord Neuberger noted that these words should be treated as observations and: “characteristically inspired discussion rather than authoritative guidance on the law of implied terms”.
This led the Supreme Court to restate the law on the implication of terms. There are two types of contractual implied term. The first, with which this case was concerned, is a term which is implied into a particular contract, in the light of the express terms, commercial common sense, and the facts known to both parties at the time the contract was made. The second type arises because, unless such a term is expressly excluded, certain statutes can impose certain terms into contracts – for example through the Supply of Goods & Services Act 1982.
In relation to the first type of implied term, the Supreme Court went back to the 1977 Privy Council case of BP Refinery (Westernport) Pty Ltd v President, Councillors and Ratepayers of the Shire of Hastings,6 where Lord Simon said that for a term to be implied, the following five conditions must be satisfied:
“(i) it must be reasonable and equitable;
(ii) it must be necessary to give business efficacy to the contract, so that no term will be implied if the contract is effective without it;
(iii) it must be so obvious that ‘it goes without saying’;
(iv) it must be capable of clear expression; and
(v) it must not contradict any express term of the contract.”
Lord Neuberger added six comments to those principles:
(i) The implication of a term was “not critically dependent on proof of an actual intention of the parties” when negotiating the contract. If you approach the question by reference to what the parties would have agreed, what matters is not the hypothetical answer of the actual parties, but the answer of notional reasonable people in the position of the parties at the time at which they were contracting.
(ii) A term should not be implied into a detailed commercial contract merely because it appears fair or merely because one considers that the parties would have agreed it if it had been suggested to them. Those are necessary but not sufficient grounds alone for including a term.
(iii) It was questionable whether Lord Simon’s first requirement (reasonableness and equitableness) will usually, if ever, add anything. If a term satisfied the other requirements, it was hard to think that it would not be reasonable and equitable.
(iv) Business necessity and obviousness can be alternatives in the sense that only one of them needs to be satisfied, although the Judge suspected that in practice it would be a rare case where only one of those two requirements would be satisfied.
(v) If one approaches the issue by reference to the officious bystander, it is vital to formulate the question to be posed by that bystander with “the utmost care”.
(vi) The necessity for business efficacy involves a value Judgement. A more helpful test would be that a term can only be implied if, without the term, the contract would lack commercial or practical coherence.
The Supreme Court said that in most, possibly all, disputes about whether a term should be implied into a contract, it is only after the process of construing the express words is complete that the issue of an implied term falls to be considered. Until you have decided what the parties have expressly agreed, it is difficult to see how you can decide whether or not a term should be implied and, if so, what term. Remember that no term can be implied into a contract if it contradicts an express term.
Therefore when deciding whether or not a term can be implied as a logical starting point, you cannot proceed to decide whether a term should be implied until the express terms of a contract have been considered and understood.
Applying the Marks & Spencer case to adjudication
Mr Justice Edwards-Stuart applied this decision in the case of Manor Asset Ltd v Demolition Services Ltd7 when he had to consider when the final date for payment was. As part of the contract arrangements, the parties had agreed that the contractor’s invoice (which would stand as payment notice) had to be served immediately after reaching the corresponding milestone, and the final date for payment was only 72 hours after the invoice was served. The problem was that the contract also required that any payless notice was served up to five days before the final date for payment, in other words before the invoice was served. This was not only technically impossible but also understandably prohibited by the HGCRA. The same problem would arise if the Scheme was said to apply. The Judge began by noting that:
“I shall therefore approach Lord Hoffman’s observations in Belize Telecom in the light of the qualifications made by Lord Neuberger in Marks & Spencer. However, the overriding point to be borne in mind is that before implying any term the court must conclude that the implication of that term is necessary in order to give business efficacy to the contract or, to put it another way, it is necessary to imply the term in order to make the contract work as the parties must have intended.”
When considering the true construction of the amendment to the contract, he said:
“65. The only solution to this problem that I can identify is the one that I mentioned to counsel both at and following the hearing, namely that when making the amendment the parties impliedly agreed that the prescribed period was to be reduced to nil. Thus MAL could issue a payless notice at any time before the final date for payment: that is to say, within the 72 hour period between receipt of the invoice and the final date for payment 72 hours later.
...
71. Faced with a stark choice between rendering the amendment wholly ineffective or enabling it to work, the parties must surely have intended the latter… The only way in which it can be made to work, whether by so construing the contract or implying a term, is to say the prescribed period was to be nil – thus enabling MAL to serve a payless notice at any time within 72 hours after receipt of the invoice. In my judgment such an agreement is necessary and it is not inequitable…
72. I therefore declare that, as a result of the amendment, the final date for payment is 72 hours after receipt by MAL of [Demolition Services] invoice following achievement of a milestone.”
The Judge concluded that the decision reached by the adjudicator that MAL’s notice of 28 October 2015 was not a valid payless notice was correct, albeit for the wrong reasons, and accordingly the breach of natural justice had not had a material effect on the outcome of the adjudication.
Whilst it is tempting to suggest that this case may well give rise to more arguments in the future about implied terms in contractual payment mechanisms, that is unlikely. This case was an unusual one, and the solution proposed by the Judge was itself an unusual one as it was not one considered previously by the parties.
Conclusions
The Supreme Court in the Marks & Spencer case effectively endorsed the traditional approach to the implication of terms. What matters, as Mr Justice Edwards-Stuart said, is whether or not it is necessary to imply the term in order to make the contract work as the parties must have intended. This means that a term will not be implied into a detailed construction contract simply because it appears fair or because the court considers that the parties would have agreed it, had it been suggested to them.
And you cannot begin to consider whether or not to imply a term into a contract until the express terms of the contract have been construed or interpreted. One of the key points to come out of the decision of more or less the same panel of Supreme Court Judges in the Arnold case was that where the contractual wording is clear, the courts are reluctant to depart from that clear and plain meaning and consider principles of commercial good sense. Lord Neuberger said:
“there is no principle of interpretation which entitles a court to re-write a contractual provision simply because the factor which the parties catered for does not seem to be developing in the way in which the parties may well have expected.”