IntroducƟon “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn't, pays it.” Albert Einstein The law on contractual interpretaƟon has changed liƩle since Lord Hoffmann’s landmark judgment in Investors CompensaƟon Scheme Ltd v West Bromwich BS  UKHL 28. When construing a contract the court must ascertain what a reasonable person would have understood the parƟes to have meant by the language used, that person having all the background knowledge reasonably available to the parƟes at the Ɵme of the contract. The appellate courts do, on occasion, however, add a gloss to this fundamental principle of contractual interpretaƟon or aƩempt to restate its correct applicaƟon. One such restatement came in the Supreme Court case of Rainy Sky v Kookamin Bank  UKSC 50. The majority judgment in Rainy Sky placed emphasis on the concept of ‘business common sense’. Perhaps the most quoted passage is the following from the judgment of Lord Clarke: “If there are two possible construcƟons, the court is enƟtled to prefer the construcƟon which is consistent with business common sense and to reject the other.” This gave some the impression that business common sense would play a greater role in the interpretaƟon of contracts. The thinking was that the courts would be more willing to depart from the natural reading of a clause if that reading resulted in a commercially absurd result. In the recent case of Arnold v BriƩon and others  UKSC 36, the Supreme Court has re-examined the concept of business common sense and clarified when it will be a relevant factor in the courts’ interpretaƟve analysis. Background Mrs Arnold was the owner of Oxwich Leisure Park in south Wales (“the Park”). There were 91 chalets in the Park, each of which was let by Mrs Arnold on very similar terms. The leases were granted in the period from 1974 to 2000, but each was expressed as being for a term of 99 years starƟng from 25 December 1974. Clause 3(2) of each lease contained a covenant by the lessee to pay an annual service charge. In return, the lessor was to provide services to the Park, such as maintaining roads and paths, mowing lawns, and removing rubbish. There were several different versions of the annual service charge clause, but twenty five of the leases contained the following wording: “To pay to the Lessors without any deducƟons in addiƟon to the said rent as a proporƟonate part of the expenses and outgoings incurred by the Lessors in the repair maintenance and renewal of the faciliƟes of the Estate and the provisions of the services hereinaŌer set out in the yearly sum of Ninety pounds and Value Added Tax (if any) for the first year of the term hereby granted increasing thereaŌer by ten pounds per hundred for every subsequent year of part thereof.” The issue between the parƟes was the correct interpretaƟon of this clause. Mrs Arnold’s contenƟon was that the clause had the effect of providing for a fixed annual charge of £90 for the first year of the term, increasing each subsequent year by 10% on a compound basis. The appellants, the current tenants under 24 of the 25 leases with the above wording, argued that the clause required the lessee to pay a proporƟonate part of the lessor’s costs of providing the relevant services, subject to a cap of £90 in the first year, increasing by 10% every year on a compound basis. Although at first glance the sums involved are small, and hardly merit pursuing a dispute all the way to the Supreme Court, on Mrs Arnold’s interpretaƟon the compounding of these sums over a term of 99 years resulted in enormous amounts falling due. Lord Carnwath helpfully set out the relevant interest calculaƟons in his judgment. His conclusion was stark: in 1974, the annual service charge for each chalet was £90; by 2072, it would be £1,025,044. The total amount payable in service charges for each of the 24 chalets during the period from 2013 unƟl the end of the term in 2072 would be £11,238,016 - expensive refuse collecƟon by anyone’s standards.
The appellants argued that this interpretaƟon was commercially absurd and could not have been what the parƟes intended. Mrs Arnold, on the other hand, contended that this was the natural meaning of clause 3(2), which should be given effect to irrespecƟve of the commercial consequences. Principles of Contractual InterpretaƟon The majority of the Supreme Court agreed with Mrs Arnold. The compounded sum in clause 3(2) was not a cap but was the fixed amount that the lessee had agreed to pay. Lord Neuberger, with whom Lords SumpƟon, Hughes and Hodge agreed, gave the leading judgment. He began his analysis with a summary of the exisƟng case law. He stated that when interpreƟng a wriƩen contract, the court is concerned to “idenƟfy the intenƟon of the parƟes by reference to what a reasonable person having all the background knowledge which would have been available to the parƟes would have understood them to be using the language in the contract to mean”. That meaning is to be assessed in the light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provision in the contract, (iii) the overall purpose of the clause and the contract, (iv) the facts and circumstances known or assumed by the parƟes at the Ɵme the document was executed, and (v) commercial common sense, but (vi) disregarding subjecƟve evidence of any party’s inten- Ɵons. In addiƟon to the above general points, Lord Neuberger set out seven addiƟonal principles that were parƟcularly relevant to the dispute before him: “First, the reliance placed in some cases 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. The exercise of interpreƟng a provision involves idenƟfying what the parƟes meant through the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision. Unlike commercial common sense and the surrounding circumstances, the parƟes have control over the language they use in a contract. And, again save perhaps in a very unusual case, the parƟes must have been specifically focussing on the issue covered by the provision when agreeing the wording of that provision.” In a thinly veiled reference to the Rainy Sky decision, Lord Neuberger reaffirms the importance of the language the parƟes have used. ParƟes have control over the words they insert into their contracts, and are deemed to have given them some thought. This means that the language used in a contract will take precedence over the concept of commercial common sense, over which the parƟes have no control. “Secondly, when it comes to considering the centrally relevant words to be interpreted, I accept that the less clear they are, or, to put it another way, the worse their draŌing, the more ready the court can properly be to depart from their natural meaning. That is simply the obverse of the sensible proposi- Ɵon that the clearer the natural meaning the more difficult it is to jusƟfy deparƟng from it. However, that does not jusƟfy the court embarking on an exercise of searching for, let alone construcƟng, draŌing infeliciƟes in order to facilitate a departure from the natural meaning. If there is a specific error in the draŌing, it may oŌen have no relevance to the issue of interpretaƟon which the court has to resolve.” Lord Neuberger stresses that it is improper for the courts to strive to find ambiguiƟes in the draŌing of a clause where there are none. While this guidance is sound in principle, many judges have found it difficult to follow in pracƟce. The temptaƟon to reach a ‘fair’ result by discovering phantom ambiguiƟes in the draŌing can be hard to resist. “The third point I should menƟon is that commercial common sense is not to be invoked retrospecƟvely. The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parƟes is not a reason for deparƟng from the natural language. Commercial common sense is only relevant to the extent of how maƩers would or could have been perceived by the parƟes, or by reasonable people in the posiƟon of the parƟes, as at the date that the contract was made.” This is another reminder to judges to stay focused on what the language would reasonably be understood to mean when the contract was entered into. One should not be distracted by subsequent disastrous commercial events which might make it appear fair to adopt one interpretaƟon over another. “Fourthly, while commercial common sense is a very important factor to take into account when interpreƟng 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 parƟes to have agreed, even ignoring the benefit of wisdom of hindsight. The purpose of interpretaƟon is to idenƟfy what the parƟes 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 funcƟon of a court when interpreƟng an agreement to relieve a party from the consequences of his imprudence or poor advice. Accordingly, when interpreƟng a contract a judge should avoid re-wriƟng it in an aƩempt to assist an unwise party or to penalise an astute party.”
Lord Neuberger restates English law’s long-standing commitment to freedom of contract. ParƟes are free to enter into commercially ruinous bargains. It is not the role of the courts to save an imprudent or unlucky party from those consequences. “The fiŌh point concerns the facts known to the parƟes. When interpreƟng a contractual provision, one can only take into account facts or circumstances which existed at the Ɵme that the contract was made, and which were known or reasonably available to both parƟes. Given that a contract is a bilateral, or synallagmaƟc, arrangement involving both par- Ɵes, it cannot be right, when interpreƟng a contractual provision, to take into account a fact or circumstance known only to one of the parƟes.” If a fact or circumstance is to be used as an aid to construing a contract, it must be established that it was within the knowledge of both parƟes at the date of the contract. “Sixthly, in some cases, an event subsequently occurs which was plainly not intended or contemplated by the parƟes, judging from the language of their contract. In such a case, if it is clear what the parƟes would have intended, the court will give effect to that intenƟon.” Lord Neuberger states that it must be ‘clear’ what the parƟes would have intended, if something not contemplated by the par- Ɵes occurs, before the courts will give effect to that intenƟon. Finally, Lord Neuberger’s seventh point was to reject the argument that service charge clauses should be construed “restricƟvely”. He said that there is no basis for saying that such clauses are subject to any special rule of interpretaƟon. It will be apparent that none of Lord Neuberger’s seven principles contradict established principles of contractual interpretaƟon. Lord Neuberger’s concern was instead to ensure that parƟes were placing the correct emphasis on the various canons of construcƟon. The clear theme was a warning to contractual parƟes not to aƩach too great an importance to the concept of commercial common sense, especially in circumstances where the ordinary meaning of the language used was readily ascertainable. Having set out these seven addiƟonal principles, Lord Neuberger proceeded to apply them to the service charge clause in dispute. ApplicaƟon to Clause 3(2) Lord Neuberger considered that that meaning of clause 3(2) was clear. The reasonable reader of the clause would interpret the first half of the clause as describing the purpose of the clause, namely to provide for an annual service charge, and the second half as a quanƟficaƟon of that charge. The quanƟficaƟon was plainly sƟpulated as £90 for the first year of the term, increasing each subsequent year by 10% on a compound basis. That could have been the end of the analysis of the majority of the Supreme Court. This reasoning alone was sufficient to dispose of the case. Lord Neuberger did, however, take the Ɵme to address the arguments the appellants had made and apply the principles that he had set out. The appellants had argued that because the first half of clause 3 (2) states that each lessee was to pay “a proporƟonate part of the expenses …” but the second half specifies a fixed sum, there was an ambiguity in the clause. The court, they argued, could therefore modify or reject one half of the clause to resolve this ambiguity and give effect to the real intenƟon of the parƟes. Lord Neuberger rejected this approach, saying that this would involve the court “invenƟng a lack of clarity” as an excuse for deparƟng from its natural reading. It was enƟrely possible for there to be inaccuracies in the draŌing of a clause without materially affecƟng its natural meaning. The court must find that something has gone wrong with the language of the clause before it will intervene in the manner requested by the appellants. The appellants had placed great emphasis on the extreme unlikelihood, in their view, that the parƟes would ever have intended to agree to such an exorbitant service charge. Lord Neuberger was unconvinced by this argument. It involved deparƟng from the natural meaning of the clause and inserƟng words that were not there. If the language of a clause was clear, the commercial consequences were irrelevant. Further, the appellants were unjusƟfiably focused on the commercial consequences as they appeared today. In the 1970s and early 1980s, when most of the leases were entered into, inflaƟon was running at well over 10% per annum. In those circumstances it was not inconceivable that the lessees would have considered a 10% compound interest rate to be an aƩracƟve, or at least an acceptable, opƟon. In a final blow to the interpretaƟon of clause 3(2) put forward by the lessees, Lord Neuberger pointed out that they had not offered a plausible alternaƟve construcƟon of the contract. While it might be unlikely that a lessor and lessee would agree to such an absurdly high annual charge, it was not much more likely that they would have agreed to a cap on the annual charge which would itself become so high as to be meaningless. Lord Carnwath Dissents Lord Carnwath was the sole dissenƟng judge in the Supreme Court. He was concerned that the interpretaƟon of the majority would result in “extreme and arbitrary differences between the treatment of different groups of leases” and “potenƟally catastrophic financial consequences for the lessee directly concerned”. The foundaƟon for Lord Carnwath’s alternaƟve approach was the well-known dictum of Lord Diplock in The Antaios  AC 191, 201: “If detailed syntacƟcal analysis of words in a commercial contract is going to lead to a conclusion that flouts business common sense it must yield to business common sense.”He accepted that where parƟes have used unambiguous language the courts must apply it. But it was clear to him that something had gone wrong with the draŌing of clause 3(2), which made it open to more than one interpretaƟon. In parƟcular, he found it difficult to reconcile the reference to each lessee paying a “proporƟonal part of the expenses … incurred” with the reference to a “yearly sum” determined by reference to a fixed formula. Having concluded that the wording of the clause was ambiguous, Lord Carnwath promoted Lord Hoffmann’s “reasonable person” to the more acƟve role of “officious bystander”, in order to interrogate the parƟes as to their common intenƟons. He reasoned that if an officious bystander had asked the parƟes at the Ɵme of the contract whether they intended the service charge to reach such enormous sums, they would have immediately rejected that interpreta- Ɵon. In Lord Carnwath’s view, it followed that he was enƟtled to interpret the clause in a way that gave effect to the true intenƟons of the parƟes, namely that each tenant should pay an equal propor- Ɵon of the costs actually incurred by the lessor in the provision of services to the Park. On this interpretaƟon the yearly sum was merely a cap on the amount that each lessee would have to pay. Comment The unusual facts of Arnold v BriƩon serve to underline the limitaƟons of the concept of business common sense. The majority of the Supreme Court took the view that no maƩer how commercially disastrous their interpretaƟon might be for the lessees, it could not allow that fact to affect their reasoning if the language of the clause was unambiguous. In contrast, Lord Carnwath thought that where an ordinary reading of the contractual words produces a commercially absurd result, the court “should do its utmost to find a way to subsƟtute a more likely alternaƟve”. He aƩached less importance to the words chosen by the parƟes and more to ensuring that the contract was given a reasonable interpretaƟon. Lord Carnwath went so far as to state: “The courts have a responsibility in my view to ensure that such clauses are interpreted as far as possible not only to give effect to their intended purpose, but also to guard against unfair and unintended burdens being placed on the lessees.” The approach of the majority is to be preferred. The majority’s interpretaƟon of clause 3(2) was clearly the most natural one. The alternaƟve interpretaƟon, that the yearly sum was a cap on the amount payable by each lessee, was supported neither by the words used by the parƟes nor by the factual evidence before the court. Lord Carnwath was loathe to give effect to an interpretaƟon that would lead to financial ruin for the lessees of the 24 chalets and result in an enormous windfall to the lessor. Although one might sympathise with this posiƟon, that in itself does not jusƟfy the strained and implausible analysis of the contract he subsequently carried out. Indeed it is difficult not to infer from his judgment that he had already decided what the outcome of the case should be before aƩempƟng to arrive at an accommodaƟng interpretaƟon of the contract. The interpretaƟon of a contract must not be dependent on a judicial value judgment about the balance of equiƟes in each case. It is a fundamental tenet of the rule of law that parƟes should be able to idenƟfy, with the help of legal advice if necessary, how the law will be applied and what the likely outcome will be if a maƩer came before the courts. The best way to further this objecƟve in relaƟon to the construcƟon of a contract is for the courts to give priority to unambiguous language over what the court might consider to be business common sense. Contrary to Lord Carnwath’s statement, the courts do not have a responsibility under common law to protect parƟes from unfair or unintended burdens from being placed on them. Parliament has conferred such protecƟon on parƟes in limited circumstances by enacƟng primary legislaƟon, such as the Unfair Contract Terms Act 1977 (which, unfortunately for the lessees in Arnold, does not apply to contracts relaƟng to the creaƟon or transfer of interests in land). Outside of these limited circumstances, English law has always deemed it inappropriate for the courts to interfere with a bargain freely entered into between parƟes at arm’s length. In fact, Parliament has provided for relief from unfair service charge clauses in the Landlord and Tenant Act 1987. Pursuant to secƟon 60 of that Act, a service charge is limited to the amount which reflects the costs “reasonably incurred” by the lessor in the provision of services. However, that secƟon only applies to service charges that vary according to the costs incurred. The raƟonale behind this disƟncƟon is presumably that if a service charge is calculated by reference to a fixed amount the parƟes would be able to determine that amount before entering into the contract, and cannot then claim it is unfair when that fixed amount falls due. The lessors in Arnold therefore fell outside the statutory scheme. Lord Neuberger thought the facts of the present case suggested there was a strong case for extending the scheme to cover fixed sum services charges, in order to protect unsophisƟcated lessees, but, correctly, he said that was a maƩer for Parliament and not for the courts. A final point of interest is the Supreme Court’s discussion of their own recent decision in Aberdeen City Council v Stewart Milne Group  UKSC 56. The contract in that case provided for payment to the vendor of a further sum on disposal of the land by the purchaser. On the face of the contract that sum was to be calculated by reference to the “gross sales proceeds” of the disposal. The purchaser sold the site at an under-value to an associated company, which significantly reduced the amount payable to the vendor. The vendor argued that, on a true construcƟon of the clause, the parƟes had intended that the sum should be calculated by reference to the market valuaƟon of the land in circumstances
where the sale was not at arm’s length. The purchaser contended that the court must give effect to the unambiguous words in the clause, irrespecƟve of any commercial consideraƟons. The Supreme court agreed with the vendor’s interpretaƟon and implied a term into the contract to that effect. Baroness Hale commented that: “… unlike Rainy Sky, this is not a case in where there are two alternaƟve available construcƟons of the language used. It is rather a case in which, notwithstanding the language used, the parƟes must have intended that, in the event of an on sale, the appellants would pay the respondents the appropriate share of the proceeds of sale on the assumpƟon that the on sale was at a market price.” Lord Carnwath latched onto this decision as illustraƟng how a court can “achieve a commercially sensible result in the face of intractable language”. Lord Neuberger, however, disƟnguished Aberdeen on the ground that one of the parƟes had done something which was not contemplated by the contract. The court was jusƟfied in implying a term to give effect to the parƟes’ intenƟons, in circumstances where those intenƟons were clearly determinable as at the date of the contract. Lord Neuberger viewed this case as an illustraƟon of his sixth principle he had set out earlier in his judgment. In contrast, the parƟes in Arnold must have contemplated the effect of the 10% per annum increase because that was the essence of the clause: to provide for a mechanism to adjust the service charge annually in an aƩempt to account for inflaƟon. This is somewhat of a fine disƟncƟon: why was it that the parƟes in Aberdeen could not be said to have contemplated that the purchaser might sell the land to an associated company for less than the market value? Lord Neuberger hinted that the answer lay in the fact that in Aberdeen the purchaser could dispose of the land how it pleased, and therefore, on the purchaser’s interpretaƟon, had control over whether to take advantage of what was in effect a loophole in the parƟes’ agreement. In Arnold, on the other hand, neither party had control over the factor that would make the service charge clause advantageous or otherwise to the lessee, namely inflaƟon. It was inherently less likely that parƟes would agree to the former than to the laƩer. Conclusion In a characterisƟcally forthright statement, Lord Denning MR had the following to say about contractual interpretaƟon in Gillespie Bros & Co Ltd v Roy Bowles Transport Ltd  1 QB 400: “judges have … Ɵme aŌer Ɵme, sancƟoned a departure from the ordinary meaning. They have done it under the guise of ‘construing’ the clause. They assume that the party cannot have intended anything so unreasonable. So they construe the clause ‘strictly’. They cut down the ordinary meaning of the words and reduce them to reasonable proporƟons. They use all their skill and art to that end.” The Supreme Court’s decision in Arnold v BriƩon is a reminder that the courts will only go so far to ‘construe’ a contract to avoid commercially disastrous consequences. The courts will not look for ambiguity where there is none, and parƟes will be held to bad bargains as well as to good. Lord Neuberger took no pleasure in handing down the majority judgment. He expressed considerable sympathy with Lord Carnwath’s conclusion, which he said was a “much more saƟsfactory outcome”. However, in a twist that might restore one’s faith in humanity, it was recorded in both Lord Neuberger’s and Lord Carnwath’s judgment that Mrs Arnold wished the following to be stated openly: “… [Mrs Arnold] is willing for the appellants’ leases to be renegoƟated on terms that would, among other things, involve the leases being varied by subsƟtuƟng an adjustment linked to the Consumer Price InflaƟon index instead of the current fixed adjustment of 10% per annum.” Happily, therefore, we may end up with a principled judgment from the Supreme Court to add to our library of decisions on contractual interpretaƟon, and the lessees might just avoid the most expensive rubbish collecƟon in history.