Commercial common sense: not as common as you might think

Parties frequently fall into dispute over the meaning of clauses
which one party considers plain and obvious on its face, but which the other
argues flies in the face of commercial common sense.  The Supreme Court has given helpful new guidance on this. 

In recent years, decisions such as the Supreme Court’s judgment in Rainy Sky SA v Kookmin Bank [2011] UKSC 50 have underlined the importance of commercial common sense in construing ambiguous terms. However, in the latest decision on the issue, the Supreme Court has emphasised the limits of this approach. The majority of the judges held that a clause which was clear on its face should be given its natural meaning, despite producing an “alarming outcome” commercially. 

This case is a reminder that commercial common sense can rarely override clear contractual wording. 

Arnold v Britton and Others: the issues

In Arnold v Britton and Others [2015] UKSC 36, the Supreme Court was asked to interpret service charge contribution provisions in the leases of a number of chalets at Oxwich Leisure Park in the Gower Peninsular, South Wales. The holiday park consisted of 91 chalets, which had each been let on 99 year leases, from 25 December 1974. 

Each of the leases contained a service charge provision. The wording of the clauses, although differing in minor respects, required the respective lessor to pay “a proportionate part of the expenses and outgoings incurred by the Lessor…” In each case the starting point was £90, rising by 10% every three years, for 66 of the chalets, and every year for 25 of the chalets.

The present case was bought by those 25 lessees, who argued that the service charge should not be construed as rising at a rate of 10% compounded annually. By the end of the 99 year lease the annual service charge for each chalet would be over £1m. The lessees contended that this would be “absurdly high”, well in excess of the costs incurred by the landlord and could not therefore be right. Instead, they argued that the obligation under this clause was to pay a fair proportion of the landlord’s costs, capped at £90 in the first year, with the cap rising by 10% compounded annually thereafter.

Principles of contractual interpretation 

Lord Neuberger, giving the leading judgment, set out the key principles in contractual interpretation arising out of case law including Rainy Sky. To determine the meaning of a contractual provision, the court will look to identify the parties’ intention. It will do so by focussing on the meaning of the relevant words, in light of their ordinary natural meaning and in their documentary, factual and commercial context. That intention is to be determined objectively; the parties’ subjective intentions are irrelevant.

Lord Neuberger highlighted seven key factors, which were particularly relevant in the present case:

• Reliance on commercial common sense and the background factual matrix should not undervalue the importance of the language used in the clause being construed; 
• The worse the drafting of a clause, the more readily a court will depart from the natural meaning of the words used in that clause;
• Commercial common sense cannot be invoked retrospectively . A court will not depart from the natural meaning of the words to rescue a party from a contract that has worked out disastrously; 
• Likewise, whilst commercial common sense is clearly important, a court will be slow to depart from the natural meaning of the words used just because it seems an imprudent term for one party to have agreed to; 
• In interpreting a provision of a contract, a court will only take into account facts or circumstances which existed at the time of the contract and which both parties were aware of;
• If circumstances arise which the parties had not contemplated at the time of the contract, but it is clear what the parties would have intended had they contemplated those circumstances, a court will give effect to that intention; and
• Specifically in relation to service charges for leasehold properties, there is no special rule of interpretation that requires them to be interpreted “restrictively”.

No need for perfectionist drafting

Having set out the key principles, Lord Neuberger had no trouble finding in favour of the landlord. As he saw it, the service charge provision had a clear and natural meaning. The first part of the clause established an obligation on the part of the lessee to pay a service charge and the second part set out how that charge was to be calculated.

The judge acknowledged that, for some of the leases at least, “perfectionist drafting” might suggest the inclusion of additional wording to make clear the link between the two halves of the clause. However, he dismissed this as a “really pedantic argument” and held that it was enough that a reasonable reader would understand the link between the two parts of the clause. 

Although Lord Neuberger did not consider that the clause needed to be construed according to commercial common sense, he did look at the lessors arguments on commerciality, which he found unconvincing. A fixed level of service charge was perfectly explicable, as he saw it, to avoid disputes around the actual level of charge due. Likewise, it was understandable that the charge would rise with inflation, and whilst the annual rate of 10% seems high now, inflation was around this level or higher for much of the 1970s and the start of the 1980s. 

Lord Neuberger therefore dismissed the lessee’s appeals and three of the other four judges agreed (Lord Hodge adding his own, brief judgment). The remaining judge, Lord Carnwath, disagreed. Lord Carnwath referred to other parts of the judgment in Rainy Sky and other leading authorities, which underscore the relevance of commercial common sense in interpreting a contract. The more unreasonable a result is produced by a particular interpretation, the less likely it is that the parties intended it, and the clearer the drafting needs to be to make it clear that that was the intention.

A balancing exercise 

Ultimately, the principles cited by Lord Carnwath and Lord Neuberger are all part of the “unitary exercise” of interpreting the parties’ objective intentions . Lord Neuberger’s and Lord Hodge’s judgments, supported by the majority, perhaps indicate a shift of emphasis away from commercial common sense and towards the natural meaning of the words. However, Lord Carnwath’s dissenting judgement highlights that this may often be a difficult balancing exercise. 

Had the majority been more convinced by the lessee’s commercial arguments, this exercise could have been more difficult still. 

Practice points 

• The starting point for interpreting a contract will always be the words of the contract themselves. The clearer the wording, the less likely it is that a court will find reason to depart from the natural meaning of those words. 
• The court will not rescue a party from a bad bargain, and the mere absence of commercial common sense will not be enough to depart from what the parties originally intended. 
• However, although this case emphasises the primacy of the contractual wording, the commercial effect remains important. If the contractual intention may produce a commercially harsh result, the party who stands to benefit should ensure that there is no ambiguity in the wording.