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Home | Status quo for construction of contracts

Status quo for construction of contracts

13 August 2009

A House of Lords case has reaffirmed the principles courts will apply when interpreting a contract.

It has also reiterated the long-standing rule that evidence of pre-contractual negotiations is not admissible to assist with contractual interpretation – the exclusionary rule.

The case serves as a useful reminder of the importance of ensuring contract terms are clearly understood and precisely drafted.

The case concerned a dispute between a landowner and property developer over the correct interpretation of a term in the parties’ development agreement.

The agreement contained a formula for calculating an additional sum payable to the landowner. The parties disagreed over the construction of the formula to the tune of more than £3.5 million, and so went to court to resolve their differences.

The House of Lords confirmed that an objective approach must be taken when interpreting contractual terms. What would a reasonable person – having all background information available to the parties at the time of the contract – have understood the parties to have meant by the language they used?

Taking into account the background and context of this particular agreement (but not the parties’ pre-contractual negotiations), the court concluded that something had clearly gone wrong with the language and drafting, and it was clear what a reasonable person would have understood the parties to have meant.

For the court to have interpreted the disputed term along the ordinary rules of syntax would have made no commercial sense, and so substituted its own construction of the contract.

Although the case was decided upon the basis of construction, the House of Lords did go on to consider issues raised in relation to the admissibility of pre-contractual negotiations.

The court confirmed that there was still no good reason to depart from the exclusionary rule in determining disputes regarding the construction of contracts.

However, it pointed out that pre-contractual negotiations could be potentially relevant as part of the factual background, which might cast light on what was meant by the language used. Whilst the court acknowledged that pre-contractual negotiations may be admissible only in ‘exceptional cases’, the line between facts and pre-contractual negotiations has arguably been blurred.

What does this mean?

• When interpreting a contract, the court will look at the actual language used in light of the context and surrounding circumstances of the contract as a whole, as well as its commercial purpose.
• This judgment has ensured that the exclusionary rule remains firmly entrenched in English law.
• Parties involved in litigation might tender evidence of pre-contractual negotiations to provide factual background and bolster their view of how the contract should be interpreted. As some commentators have observed, this could result in increased contractual uncertainty, and more costly and time consuming litigation.
• The purpose of having a formal contract is to circumvent the disputes that arise where no concluded contract exists and parties are left to consider what was discussed during negotiations. To allow such negotiations to be admissible as evidence in construction of contract disputes would defeat the purpose of having a formal contract, and so it is not surprising the Lords wished to clarify this position.

What should you do?

• Ensure your contractual terms are clearly understood by all parties, and then drafted precisely.
• If a contract includes a formula, consider using a worked example of the formula to clearly show how the parties intend it to operate.
• Fully document pre-contractual negotiations and agreements. These might assist in establishing background information and evidence of the context and business purpose of the contract. They could also support other claims, in relation to which the exclusionary rule does not apply; or in circumstances where a party can demonstrate grounds for the judiciary to consider departing from the exclusionary rule. This aspect is beyond the scope of this update. However, if in any doubt, please seek further advice.
• Pre-contractual negotiations and agreements will provide valuable context when parties choose to use alternative dispute resolution procedures to resolve a dispute, especially if no formal contract has been executed by the parties.
• In the wise words of Lord Hoffman, it is ‘usually possible to avoid surprises by carefully reading the documents before signing them’.

Chartbrook Limited v Persimmon Homes Limited

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Jon Bartley

Partner
T: 03700 86 8730
I: +44 (0)118 965 8730
E: jonathan.bartley@shoosmiths.co.uk