Contracts and business common sense

Many years ago, a landlord served a notice on his tenant to terminate a tenancy, but inadvertently put the wrong date in the notice. Although it was clear that the landlord had made an error, the court refused to correct matters and held that the notice was invalid. The court interpreted the notice literally.

Nowadays, things are different. Courts prefer a purposive approach rather than a literalist one. In other words, they try to ascertain what the parties to the contract can reasonably be taken to have meant, given the background against which they made their agreement.

In a case that will provide useful guidance to lawyers, adjudicators and many others who need to interpret contracts, the Supreme Court has recently reaffirmed the purposive approach.

When the shipbuilder went insolvent, the buyers called on the bank for payment under the bond. The bank denied liability. One might have thought that the bond was there to protect the buyers in just this sort of eventuality

The case, Rainy Sky SA and Others vs Kookmin Bank, concerned an advance payment bond. The bond was given by a bank in favour of the buyers of a ship. It was designed to allow the buyers to get their payments back if the shipbuilder did not complete the work. In other words, the scenario was similar to that in many construction projects.

When the shipbuilder went insolvent, the buyers called on the bank for payment under the bond. The bank denied liability. Pausing there for a moment, this was a little surprising. One might have thought that the bond was there to protect the buyers in just this sort of eventuality.

The bank had agreed to pay “all such sums due to you under the [shipbuilding] contract”. However the drafting was poor, and it was unclear whether “such sums” referred to the words in the preceding part of the same clause, or to words in an earlier clause. The bank said that the words referred to the earlier clause - otherwise that earlier clause would have no meaning at all. Courts don’t like the idea that a clause in a contract cannot be given any meaning, and that was enough to give the bank a win in the Court of Appeal.

Before the Supreme Court, the buyers said that if the bank’s interpretation was right, then the bond was of no use on an insolvency - which was very odd, to say the least, especially as the buyers could certainly call the bond after a termination following serious delays. This argument impressed the Supreme Court. They reversed the earlier decision and found in favour of the buyers. The decision was therefore a triumph for that trusty tool, business common sense.

One of the key points in the case is that the Court of Appeal had suggested that you only use the “business common sense” test if there would otherwise be an absurd result. No, said the Supreme Court. You can use it so long as there are at least two possible meanings to the words under consideration.

So can you use the “business common sense” rule if the words are clear? In a case heard last year, William Hare Ltd vs Shepherd Construction Ltd, a main contractor had drafted a “pay when paid” provision in a subcontract. This is allowed under the Construction act, of course, so long as the employer goes insolvent. Unfortunately, the definition of insolvency in the “pay when paid” clause did not cover the rare form of administration that occurred and that had in fact only existed after the contract had been made. Tough, said the court. The drafting made complete sense, and there was no ambiguity. In those circumstances, it was not up to the court to rescue one of the parties from a drafting error.

Of course, one can envisage parties arguing over whether there are two valid interpretations of a contract (in which case, business common sense comes into play) or only one - as in the William Hare case. This may be fertile ground for arguments in future cases.

Another issue is what “business common sense” actually is. Ultimately the phrase is a loose one. In effect, it allows a court to reach a decision that does justice between two conflicting interpretations of a contract, taking a wide range of matters into account as part of the commercial background.

One thing is clear. Rainy Sky is a further nail in the coffin of the literalist approach to the interpretation of contracts. Business common sense and the law are becoming ever more aligned - which is no bad thing.

Ian Yule is a partner at Weightmans