Judges and commercial common sense

The principles applicable to the interpretation of contracts are well settled. Over the last 10 years or so, there have been a number of authoritative statements (possibly too many) on the proper approach (Rainy Sky SA v Kookmin Bank [2011] UKSC 50; Arnold v Britton [2015] UKSC 36; Wood v Capita Insurance Services [2017] UKSC 24; Hoe International v Andersen 2017 SC 313; and Ashtead Plant Hire v Granton Central Developments 2020 SC 244).

Fundamentally, the exercise is an objective one with the court seeking to understand what the parties meant by the language that they chose to use. The exercise is both textual, in that primacy is given to the natural and ordinary meaning of the words of the contract (and indeed, if the words are unambiguous, the court must apply them: see Lord Clarke, Rainy Sky); and contextual, in that, where the words are ambiguous, the court can give greater weight to external factors such as the purpose of the agreement, the factual background and commercial common sense.

The extent to which the court is entitled to have regard to commercial common sense has been a vexed question for a number of years now. There are various problems that arise when one asks whether a contract is commercially sensible, and prior to Arnold there was a growing tendency among practitioners (and courts) to declare wording ambiguous and then reach whatever conclusion suited them under the guise of it being the more commercially sensible construction (a problem identified by Lord Grabiner QC in a 2012 article, “The Iterative Process of Contractual Interpretation” 128 LQR 41). 

This tendency ought to have disappeared after Arnold but, in Scotland at least, it has not. It is often part of one party's litigation strategy to seek to sow the seeds of doubt in the mind of a judge as to the commercial sense of a contractual provision, even where the wording of the contract is clear, so as to survive a legal debate on the terms of the contract and force the other party to settle in order to avoid the very extensive costs of proof. Scottish judges can be reluctant to take bold decisions at debate even where the words of the contract are not susceptible to more than one interpretation.

In practice, disputed contractual provisions which are entirely unambiguous are rare but, as Lord Sumption explained in his Harris Lecture in 2017 entitled “A Question of Taste: The Supreme Court and the Interpretation of Contracts”, “it is a fallacy to say that language is meaningful only in relation to some particular background. Most language and all properly drafted language has an autonomous meaning”. Emphasising the importance of language and an approach which elucidates the words of the contract, Lord Sumption continued: “It is I think time to reassert the primacy of language in the interpretation of contracts. It is true that language is a flexible instrument. But let us not overstate its flexibility. Language, properly used, should speak for itself and it usually does. The more precise the words used and the more elaborate the drafting, the less likely it is that the surrounding circumstances will add anything useful.” 

Accordingly, even where the language of a disputed provision is not crystal clear, it may often be the case that, read in its contractual context, the meaning of the words is clear without the need to refer to extrinsic evidence or commercial sense.

Commercially minded judges?

The main problem with commercial common sense is that when you ask the question, “Is the proposed interpretation commercially sensible?”, from whose perspective are you asking it? I am sure that I am not alone among commercial litigators when I say that my day-to-day practice involves interpreting contracts which I might not have been willing to agree myself because, from my perspective, they are not commercially sensible. But they make sense to the parties involved (or one of the parties at least). 

In “Fundamental Issues for Reform of the Law of Contractual Interpretation” (2011) 15 Edin L Rev 406, Professor Martin Hogg at the University of Edinburgh points out that judges have themselves commented on the risk that they may take a different approach to commercial sense than that of the parties themselves.

In particular, Lord Reed in Credential Bath Street v Venture Investment Placement [2007] CSOH 208 notes previous warnings “against excessive confidence that a judge's view as to what might be commercially sensible necessarily coincides with the view of those actually involved in commercial contracts”. Neuberger LJ in Skanska Rashleigh Weatherfoil Ltd v Somerfield Stores Ltd [2006] EWCA Civ 1732 warns of similar risks, saying that “Judges are not always the most commercially-minded, let alone the most commercially experienced, of people, and should, I think, avoid arrogating to themselves overconfidently the role of arbiter of commercial reasonableness or likelihood.” 

Moreover, judges will always be reluctant to reach uncommercial results, but as Lord Mustill explains in Torvald Klaveness A/S v Arni Maritime Corporation (The Gregos) [1994] 1 WLR 1473, this has its risks: “Naturally no judge will favour an interpretation which provides an obviously absurd result when the words drive him to it, since it is unlikely that this is what the parties intended. But where there is no obvious absurdity, and simply assertions by either side that its own interpretation yields the most sensible result, there is room for error.”

Other judges have warned of these risks when speaking extrajudicially. In his Harris Society Lecture referenced above, Lord Sumption observed that “judges are not necessarily well-placed to determine what commercial sense requires. Judges start from the answer and work backwards. They come to the question of construction after the dispute has arisen, when the parties are at loggerheads. They understandably focus on what has gone wrong and look to the contract to put it right. Their instinct about what the parties must have intended is therefore likely to be quite different from that of the parties at the time that the contract was originally agreed, when they did not have the eventual catastrophe in mind”. 

Lord Sumption goes on to say that judges' “notions of commercial common sense tend to be moulded by their idea of fairness. But fairness has nothing to do with commercial contracts. The parties enter into them in a spirit of competitive co-operation, with a view to serving their own interest. Commercial parties can be most unfair and entirely unreasonable, if they can get away with it. The problem about measuring their intentions by a yardstick of commercial common sense is that in practice it transforms the judge from an interpreter into a kind of amiable compositeur. It becomes a means of saving one party from what has turned out to be a bad bargain. The question is no longer what the parties agreed. It is: what would they have agreed if they were the objective, just and fair-minded people that in practice they are not”. 

Natural meaning

In his role as a judge, Lord Sumption was always very reluctant to speculate as to where commercial common sense lay, preferring to concentrate on the natural and ordinary meaning of the words in context. Arnold is a good example of that, but so is his judgment in the lesser known case of Krys v KBC Partners LP [2015] UKPC 46. Krys is rarely cited in the Scottish courts, but is an important example of an approach to interpretation which elucidates the words of the contract. 

Krys concerned the interpretation of the articles of a limited partnership following a dispute which had arisen about the distribution of the partnership assets on dissolution. The principal limited partner was a company owned by Russian billionaires Boris Berezovsky and Arkady Patarkatsishvili. That company had contributed US$320 million to the partnership. There was a general partner (a professional fund manager), and special limited partners each of whom made nominal capital contributions of $100, their role being to represent the interests of the general partner and others in the management of the partnership and to sell, realise and distribute the investments contributed by the principal limited partner.

The partnership went into liquidation with none of its assets having been sold but with the value of its investment having increased significantly, and a dispute arose as to the entitlement of the special limited partners to a success fee of 30% of the profits or gains made on the sale of the investments. The principal limited partner argued that all that the special limited partners were entitled to was the return of their nominal capital of $100. 

Having disposed of the “ingenious” arguments of the special limited partners on the words of the contract, Lord Sumption addressed their argument based on commercial common sense to the effect that it was “extraordinary” or “absurd” that they were only entitled to return of their nominal capital of $100. While the whole passage is worth reading, the most interesting part is that Lord Sumption says that “There is little to be gained by imagining more or less far-fetched examples of cases in which the articles of partnership would operate harshly if construed according to the ordinary meaning of the words,” and that it was “far from clear by what standards of commercial normality any particular provisions are to be measured”. He ultimately found that it was not uncommercial for the special limited partners to receive only their initial capital investment back, despite their work in increasing the value of the partnership investment.

However, adherence to the words in preference to commercial common sense is rarely unanimous amongst the judiciary. Lord Sumption's approach (and that of the majority in Krys) was heavily criticised in a powerful dissenting opinion by Lord Mance, who accused the court of failing to learn the lessons of cases such as Aberdeen City Council v Stewart Milne Group Ltd [2011] UKSC 56 by attaching too much weight to the words and too little to the context and commercial purpose. Similarly, in Arnold the judgment of the majority (which came with a well-known warning about over-reliance on commercial common sense) was criticised as lacking in common sense in Lord Carnwath's dissent. Indeed, the majority recognised in Arnold that Lord Carnwath's approach was a more satisfactory result in common sense terms but refused to accept it due to the words of the contract pointing in the other direction.

Scotland: inconsistent approaches

In Scotland, while the principled approach is followed, the weight given to commercial common sense in different cases can hardly be described as consistent. In Grove Investments Ltd v Cape Building Products Ltd [2014] CSIH 43 the phrase “to pay the landlords the total value of the schedule of dilapidations” was interpreted by the Inner House as meaning that the landlords should only recover their actual loss, largely for reasons of commercial sense. While Grove was pre-Arnold, the court in Ashtead has recently cited it with approval. 

In Grove the court recognised the warnings given by judges about relying on their own understanding of commercial common sense, but added the following: "Nevertheless, many judges tend to develop considerable experience of commercial contracts over the years, both in practice in the legal profession (where they may have advised on the terms of contracts as they were being concluded) and on the bench. For that reason, although they must be sensitive to the possibility of trade-offs and bad bargains, they will usually be in a good position to decide what is commercially sensible.”

Really? Which judges? And how are practitioners to distinguish between those who do and those who don't have the requisite experience to make comment on commercial common sense? The caveat added at the end of that warning is not a caveat that either Lord Reed or Neuberger LJ chose to add to their warnings. It is virtually the opposite of what Lord Sumption has said. There is no doubt that some judges (including the three mentioned there) are exceptionally gifted commercial lawyers. However, there are many others who are less commercially experienced and yet will, nevertheless, be hearing disputes about commercial contracts. Further, those who are commercially experienced may find it difficult to separate their view of how a contract should read with how it actually reads, unless they set aside the idea that they are entitled to approach the question from the standpoint of commercial common sense.

Shortly after Grove (and again before Arnold), the Outer House issued a very similar decision in @SIPP Pension Trustees v Insight Travel Services Ltd [2014] CSOH 137, a case in which dilapidations were again at issue and the obligation appeared to be, on the face of the words, simply to pay the landlord a specified sum on demand. The Outer House disagreed and fell back on commercial common sense as a means of interpreting the provision in such a way that the landlord effectively only recovered its actual loss. 

In either case, interpreting the words of the contract in the way in which the courts did in Grove and @SIPP takes considerable judicial imagination. In each case, the court reached a fairer result than it would have done by applying the wording, but doing justice in individual cases should not come at the expense of legal certainty in all cases. The reality is that, as Leggatt LJ said in the Court of Appeal in Investors Compensation Scheme v West Bromwich Building Society (affd [1997] UKHL 28), a purposive interpretation, or one which focuses on commercial sense, must not be allowed to shade into a creative interpretation. That is another thing altogether and has to be avoided. It is very difficult to avoid if primacy is not accorded to the words of the contract.

Following Arnold, the Extra Division in @SIPP ([2015] CSIH 91) took a very different view to the Lord Ordinary, with Lady Smith, in her judgment, recognising that “Commercial contracts may… be hard fought with each party intent on securing their own particular objective. As senior counsel for the respondents accepted in the course of discussion, parties enter into contracts for their respective benefit.” The Extra Division was also sceptical of the approach taken in Grove, saying that "Care must also be taken to avoid reading anything said in Grove as being to the effect that the court can correct a bad bargain or even an unfair one; there is no general rule that a commercial contract requires to be fair.” 

Further, because Grove predated Arnold, the Extra Division suggested that the guidance should be viewed with “an appropriate degree of caution”. Accordingly, the Inner House appeared to accept that a light touch approach was appropriate when it came to commercial common sense.

Since then, however, we have had the Inner House's decisions in Hoe International and Ashtead. In the former, the court suggests that the principles in Arnold were not of general applicability but relevant to that particular problem (which was not the approach taken in @SIPP). The latter cites Grove with approval and the judgment contains a lengthy section on the importance of construing contracts in accordance with commercial common sense when the words are capable of more than one meaning. It is a remarkable passage in which the Inner House tries to explain that commercial common sense is far from a subjective and nebulous idea but is, instead, an objective standard against which parties' rights and obligations can be assessed. Contrasting that approach with Lord Sumption's approach in Krys is instructive when we try and understand how the principles are being applied in practice in this jurisdiction.

Uncertain future

The problem with the analysis by the Inner House is partly that it ignores the practical reality, acknowledged by the Supreme Court, which is that parties very often enter into contracts which make no commercial sense. Even where the parties' agreement is drawn up by experienced commercial lawyers it will often be the case that the final version of the agreement fails to properly reflect precisely what one party wanted and will, therefore, be open to the argument that it does not make commercial sense for them to have agreed it. That is not an argument that should be open to them, and it is only an available argument because they have confidence that Scottish judges will not always accord primacy to the words but will instead, to use Lord Sumption's words in Krys, apply what they regard is an appropriate standard of commercial normality and measure the particular provision against that standard. Indeed, it seems that that is exactly what the court did in Ashtead.

In his essay on “Interpretation” in Challenging Private Law: Lord Sumption in the Supreme Court, Ewan McKendrick discusses the “mood” or “tone” of judgments of the higher courts and emphasises their importance in addition to the substance of the judgment. On the issue of contractual interpretation, the Inner House aligns itself with the jurisprudence of the Supreme Court. But the tone of its judgments suggests a different approach. While judges south of the border and the court in London are giving warnings about reliance on commercial common sense, the court in Edinburgh appears to be doing its best to make light of these warnings in order to allow itself as much leeway as possible in using commercial common sense as an interpretative tool. 

Looking at these decisions as fairly as possible, the difference between London and Edinburgh may only be a difference in tone, but tone matters and while the Inner House is doing justice in individual cases, it ought to be providing legal certainty in all cases. When it comes to contractual interpretation, providing that sort of certainty is difficult unless commercial parties can be sure that the words they use are given effect by the court.