Third parties, please leave your assumptions at the door – the construction of commercial contracts under English law

Written on 16 Oct 2014

The assumption problem

It goes without saying that careful attention to the words used is needed when drafting legal documents. But sometimes the parties might use a word or phrase without precisely defining what is meant by it – because they both assume it carries an accepted, natural meaning. Problems can arise later if the parties disagree over what that “ordinary” meaning is, and what was in fact intended by that choice of words.

Clearly, the best course of action is to ensure that the drafting is as unambiguous as possible (and, in particular, terms which are commercially key are expressly defined), but where litigation ensues and the issue comes before a court, it will analyse the words used by applying well-established legal principles on the construction of contracts. In this article we look at one example of where the parties took opposing views on what was meant by a term which is commonly used (but often not specifically defined) in legal documents, and one of the leading English judgments on the construction of contracts – Rainy Sky.

What is meant by “third party”?

The term “third party” is often used in a variety of legal documents without being defined – one dictionary definition of “third party” is “A person or group besides the two primarily involved in a situation, especially a dispute”, but often parties assume that it connotes someone unrelated; a person at arm’s length. This can cause problems when a group company of one of the parties enters the picture – a entity with distinct legal personality, but connected to the other in a parent/subsidiary relationship or by way of common ownership. Can that group company be said to be a “third party”?

In the 2004 Scottish case of Neff v Offshore Rentals Limited (which appears to be the only reported case where the point has been directly considered) the court found that a group company was a “third party” for the purposes of triggering a bonus in an employee’s service contract (which paid out in “the event that a material part of the assets of the company are (sic) sold or transferred to a third party”). The business of the company was sold to a group company as part of an intra-group reorganisation, and the employee sued for the bonus. In doing so, the employee contended that “third party” meant anyone other than the two parties to the contract, whereas the company argued that the parties never intended for intra-group transactions to be caught.

The judge found as follows:

“In my view, the words ‘third party’ have a plain and ordinary meaning particularly when used in a bilateral contract. The words refer to a party other than the two parties to the contract. If the said words were not to be given their ordinary meaning there is no reason why they should not have been qualified so as to exclude companies in the Orwell Group, if that had been intended. Thus, in my view, there is no ambiguity in the use of the words ‘third party’ and the plain and ordinary meaning of clause 10 of the pursuer’s contract of employment is that payment of the pursuer’s bonus is triggered by, inter alia, a transfer of a material part of the assets of Fishing Services Ltd to a party who is not a party to the contract.”

Judgment was given in favour of the employee accordingly.

Rainy Sky and the rules on construction of contracts under English law

So, at least as far as Scottish law goes, the term “third party” is likely to mean anyone who is not a party to the relevant contract – especially where the term is used in a bilateral contract. But would the decision be different if the question came before an English court?

It appears there is no general rule laid down in earlier case law that the term “third party” impliedly includes or excludes the group company of a contracting party, and so therefore the question would be one of the proper construction of the words used in the contract, in all the circumstances. Where there is any ambiguity, the court may opt for the commercially sensible construction. One of the leading English cases on construction is the 2011 Supreme Court decision in Rainy Sky SA & Ors v Kookmin Bank. In that judgment, the following key principles were expressed:

The court will adopt a commercially sensible construction where the language used is capable of different meanings

The language used in a contract will often have more than one potential meaning. The exercise of construction is one to 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 constructions, the court is entitled to prefer the construction which is consistent with business common sense and to reject the other.”

Where the language is capable of having more than one meaning, the reason for favouring a commercially sensible construction is because it is:

“likely to give effect to the intention of the parties. Words ought therefore to be interpreted in the way in which a reasonable commercial person would construe them. And the reasonable commercial person can safely be assumed to be unimpressed with technical interpretations and undue emphasis on niceties of language”.

Where the language used is unambiguous, the court must apply it

However, the court implied that instances of genuinely unambiguous wording will be rare. Lord Clarke, delivering the unanimous judgment of the court, quoted from an earlier Court of Appeal judgment (Co-operative Wholesale Society Ltd v. National Westminster Bank plc) in which it was held that:

“This robust declaration does not, however, mean that one can rewrite the language which the parties have used in order to make the contract conform to business common sense. But language is a very flexible instrument and, if it is capable of more than one construction, one chooses that which seems most likely to give effect to the commercial purpose of the agreement.”

In the event that a particular construction would lead to a commercially improbable result, the most unambiguous language will be needed in order for the courts to give effect to it.

So, it could be that an English court would follow the decision in Neff and consider the term “third party” to unambiguously mean any person who is not a party to a contract (perhaps having regard to the fact that this accords with the use of the term in the Contracts (Rights of Third Parties) Act 1999), and apply that construction regardless of the outcome. But that seems unlikely. The more “commercially improbable” the result of that construction the more the court will, following the principles laid down in Rainy Sky and the cases which preceded it, “strive to attribute to it a meaning which accords with business common sense”, and in doing so will most likely consider that the term is capable of different interpretations in different contractual contexts – meaning that, in an appropriate case, where to do otherwise might lead to a commercially improbable result, the use of the term “third party” may well be construed so as to exclude group companies.