Canada: Contract Interpretation Basics: Beware What You Warrant

Contracts define and control most business transactions. Therefore, clarity about what has been agreed in them is critical. This does not mean being able to explain what you thought you agreed to or intended to agree to. It means understanding how the words of your contract will be interpreted by a court or an arbitrator if a dispute about their meaning arises. That understanding at the outset can save much angst and litigation expense later.

The courts have developed rules of contract interpretation that sound fairly straight forward. The words chosen by contracting parties to express their bargain are to be given meaning if at all possible. They are to be given their plain, literal and grammatical meaning (unless absurdity would result), construed in the context of the entire contract and taking into account the factual circumstances in play when the contract was made. Except in specific circumstances, evidence of how the parties have performed the contract and of their subjective intention is not admissible to inform the court's interpretation of the contract.

To many business people it may be counter-intuitive that in a contract dispute contracting parties are not usually permitted to explain to the decision-maker what they intended. In fact, evidence of what they intended is not admissible unless the disputed provision is found to be ambiguous. If a court decides that a provision is not ambiguous, then the starting point (and sometimes the end point) for interpreting that provision is the words used by the parties.

Even a cursory review of the vast body of legal decisions on contract interpretation reveals that, despite the apparent certainty about the rules of contract interpretation, there is wide variation among judges in the way those rules are applied, and therefore in the results reached. Particularly problematic are the rules about ambiguity and the admissibility of extrinsic evidence (evidence beyond the words of the contract themselves). One judge may find that a term of a contract is ambiguous, and therefore go beyond the plain words of the contract and consider extrinsic evidence to determine the intention of the contracting parties. But frequently the same term will be found by another court (say on appeal) to be unambiguous, therefore not permitting resort to any evidence other than the contractual words themselves.

A recent decision by the British Columbia Court of Appeal illustrates this pattern. The case involved a contract for the sale of 60 acres of land in Salmon Arm. The purchaser intended to develop the property for retail use, including a 'big box' store and residential properties. After the property was transferred but before full payment had been made it became clear that the property could not be developed as planned. There were three critical problems: (1) a third of the property could not be developed because of legislation restricting development for environmental/riparian reasons; (2) the city had not re-zoned the property as expected; and (3) there was strong public opposition to the development of a 'big box'.

The purchaser claimed damages from the vendor. The case was decided based on whether the vendor had breached its contractual warranties. That turned on the courts' interpretations of their wording. The determinative issue was whether the vendor's contractual warranties about disclosure of material information were limited to information actually known to the vendor.

As is common in commercial contracts, the purchase and sale agreement set out vendor's warranties. The critical wording was as follows (emphasis added):

3.1 Representations of the Vendor. The vendor covenants, represents and warrants to and in favour of the Purchaser that, as of the date of this Agreement, or such other date as may be specified: ...

(i) Full Disclosure. So far as the Vendor is aware, the Vendor has disclosed to the Purchaser all material information pertaining to the Purchased Lands, whether solicited by the Purchaser or not. Neither this Agreement nor any other document referred to in this Agreement or any Schedule to this Agreement nor any statement, schedule or certificate furnished or to be furnished to the Purchaser pursuant to this Agreement contains or will contain any untrue statement or omits or will omit to state a material fact. All material information pertaining to the Purchased Lands is set out in this Agreement or contained in the Property Documents.

The essence of the dispute was whether the vendor had breached its warranty by not informing the purchaser of the three problems set out above, even though the vendor did not actually know that information.

This case is a very clear example of the attention that must be paid to the wording of contractual warranties and the importance of understanding what you are warranting. Once there is a dispute about breach of warranty, the rules of contract interpretation may prevent you from explaining to a court the scope of the warranty you intended to give.

In this case, the Supreme Court judge found that the warranty was ambiguous. It was uncertain whether the opening words "So far as the Vendor is aware" modified only the remainder of the first sentence or the entire warranty. The second sentence was the critical one, because it required the vendor to disclose all material facts. The purchaser alleged that the proper interpretation of the agreement was that whether or not the vendor knew those facts was irrelevant. The purchaser alleged that the vendor omitted information about the three critical issues.

The judge found that a warranty by a vendor that it had disclosed all material facts, including those outside its knowledge, would be "extremely far reaching" and of an "extraordinary nature". Given the magnitude of the risk to the vendor, the judge reasoned that the agreement should have clearly confirmed its undertaking of that risk. As there was no such confirmation, the judge found that there was ambiguity in the warranty, allowing him to look at extrinsic evidence to determine the parties' intention. He ruled that the second sentence of the warranty was also limited by the opening words of the clause. The vendor only warranted that it had disclosed all material information within its knowledge. The vendor had not breached that warranty.

But the Court of Appeal found that the judge had been too quick to refer to extrinsic evidence. Unlike the judge, the Court found that the warranty was not ambiguous at all. The clause was found to have two essential parts: the statement by the vendor that it had disclosed all material information known to it at the time of making the statement (the first sentence), and the statements that all material facts were contained in the vendor's disclosures and that these facts were true (the second sentence). Contrary to the judge's finding, the Court ruled that only the first sentence of the warranty was qualified by the phrase "So far as the vendor is aware". Therefore, the second sentence obligated the vendor to disclose all material facts, whether or not they were known to it.

The Court of Appeal observed that, although such a provision might be harsh, contractual warranties are used to allocate risk and parties are free to do that as they see fit. Despite the judge's finding, the Court questioned whether the provision was extraordinary, and found that, even if it was, that did not mean it was ambiguous, so as to allow resort to extrinsic evidence. It is perhaps strange that the Court did not see any ambiguity in the two parts to the warranty. Why was the first sentence necessary if the second was unqualified and required the vendor to disclose to the purchaser all material information, whether or not known to the vendor?

This decision emphasizes that courts may look to extrinsic evidence to determine what agreement the parties actually made only where there is ambiguity. But courts may not look to extrinsic evidence to resolve an uncertainty about the legal consequences of the agreement made by the parties.

Having found no ambiguity in the warranty provision, the Court's reading of the warranty made it irrelevant whether the vendor knew of the undisclosed facts. The vendor's failure to disclose was a breach of warranty, even though the vendor had not known of them. The court accepted that the vendor had not been willfully blind or recklessly disregarded facts that were there to be known.

It simply did not know about the problems. But, because they were material, the failure to disclose them was a breach of warranty, entitling the purchaser to damages.

Is there anything surprising in this case? Arguably not, if you accept that the warranty was not ambiguous and, though onerous, simply represented an allocation of risk between the contracting parties. But the result confirms that parties should be cautious when agreeing to warranties (or other contractual provisions).

This case also illustrates that you can obligate yourself to communicate to the opposite party information of which you are not even aware. If you do, it is not enough to be honest about your actual state of knowledge. If you agree to a warranty of this nature, then you are obligating yourself to conduct due diligence to discover all material facts (even though you are the vendor), to monitor any developments involving those material facts, and to report accurately, truthfully, and comprehensively to the purchaser. Not everyone would take on this type of obligation. If you do, you certainly want to understand what you are doing.

The best protection against unexpected outcomes is careful, effective contract drafting, and a clear understanding of what obligations and rights are created by the agreed contractual wording.

About BLG

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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