UK: The Supreme Court Adopts A Purposive Approach To The Construction Of A Commercial Contract

Last Updated: 15 November 2011

Article by Paul Herring, Jamila Khan and Reema Shour

Rainy Sky S.A. and others v. Kookmin Bank [2011] UKSC 50

"The ultimate aim of interpreting a provision in a contract, especially a commercial contract, is to determine what the parties meant by the language used, which involves ascertaining what a reasonable person would have understood the parties to have meant". This seemingly straightforward statement by Lord Clarke of the Supreme Court in the judgment handed down in this case belies the considerable amount of English judicial discussion there has been regarding the construction of commercial contracts where one or more provisions in the contract is ambiguous and the language used by the parties lends itself to more than one potential meaning. In favouring a purposive over a literal approach, where a term of a contract is open to more than one interpretation, the Supreme Court unanimously held that it is generally appropriate to adopt the interpretation which is most consistent with "commercial common sense".

The dispute in this case related to the proper meaning of certain provisions in advance payment bonds issued pursuant to shipbuilding contracts in order to guarantee the buyers' pre-delivery instalments. The significance of their Lordships' unanimous decision, however, is much wider in scope and extends beyond the construction of refund guarantees and advance payment bonds to the construction of commercial contracts in general.

The background facts

This litigation arose out of six identical shipbuilding contracts, pursuant to which the builder agreed to build and sell one vessel to each of the buyers. The price of each vessel was payable in five equal instalments due at specified times, with the final instalment payable on delivery. Under the shipbuilding contracts, the builder was obliged to obtain refund guarantees to guarantee the buyers' pre-delivery instalments ("Article X.8 REFUND GUARANTEE"). Each contract gave the buyer the right to a full refund in the event that the buyer exercised its right to reject the vessel or to terminate, cancel or rescind the contract ("X.5 REFUND BY THE BUILDER"). Each buyer also had a further right to repayment of instalments in the event of a default by the builder ("Article XII:BUILDER'S DEFAULT"), one such event of default being insolvency (Article XII.3). Insolvency was not, however, expressed to be an event entitling the buyers to reject the vessel under Article X.5.

 

Kookmin Bank ("the bank") issued six identical advance payment bonds at the builder's request. Under paragraph 2 of the bonds, the buyers were entitled to repayment of any pre-delivery instalments if they rejected the vessel. Paragraph 2 referred to a right of refund "upon your rejection of the Vessel in accordance with the terms of the Contract, your termination, cancellation or rescission of the Contract or upon a Total Loss of the Vessel..." Crucially, paragraph 2 made no mention to a right of refund in the event of an insolvency. Paragraph 3 of the bonds set out the bank's guarantee obligation and stated that the bank undertook to pay the buyers "all such sums due to you under the Contract...".

 

The buyers paid the first instalments under the contracts but subsequently, the builder experienced financial difficulties and entered into a formal Korean debt workout procedure. The buyers sought repayment under the bonds of the instalments they had paid to the builder but the bank refused to pay, arguing that, on the true construction of the bonds, it had not agreed to guarantee payment of refunds arising under Article XII.3, namely the builder's insolvency.

The point that the court had to decide was a narrow one and turned on the meaning of the words "all such sums" in paragraph 3 of the bonds. Simply put, did these words mean that the pre-delivery instalments had to be repaid in all or any of the circumstances set out in the shipbuilding contracts or was repayment confined to the circumstances set out in paragraph 2 of the bonds? There was no real dispute between the parties that the relevant provisions could be construed either way.

The first instance and Court of Appeal decisions

At first instance, Mr Justice Simon found in favour of the buyers that the obligation to repay the instalments in the event of insolvency was covered by the bonds. Mr Justice Simon described the bank's construction of the bonds as having the surprising and uncommercial result of the guarantees not being available to meet the builder's repayment obligations in the event of insolvency.

This decision was reversed by a majority decision of the Court of Appeal (Sir Simon Tuckey dissenting), who held that the bank's construction of the relevant wording would not produce an absurd result and that the court should not impose its own view of what was commercial over what the parties had agreed, as objectively recorded in the bonds. Although Lord Justice Patten acknowledged that cover for insolvency was, objectively speaking, desirable, in his view that was not of itself sufficient to justify a departure from what would otherwise be the natural and obvious construction of the bonds. He stated as follows:

"Unless the most natural meaning of the words produces a result which is so extreme as to suggest that it was unintended, the Court has no alternative but to give effect to its terms. To do otherwise would be to risk imposing obligations on one or other party which they were never willing to assume and in circumstances which amount to no more than guesswork on the part of the Court".

The dissenting judge, on the other hand, agreed with Mr Justice Simon that it defied commercial common sense to conclude that the shipbuilder's insolvency was the only event which the parties intended should not be guaranteed by the bonds, given that that was the situation in which the security of an advance payment bond was most needed.

The Supreme Court decision

Lord Clarke gave the judgment on behalf of all five Law Lords, allowing the buyers' appeal.

He reviewed a number of cases which discussed the correct approach to be taken by the court in construing commercial contracts where the meaning of a contractual provision is ambiguous and can be construed in more than one way. In very broad terms, the relevant case-law can be divided into the following two categories:

  1. Decisions where the court has adopted a literal approach to the construction of the ambiguous wording, refusing to take into account what would appear to have been the underlying purpose of the provision in question. Adopting the literal approach means that the fact that a term in the contract appears to be particularly unfavourable to one or other party is irrelevant. The term may have been agreed in exchange for some concession elsewhere in the transaction or it may simply have been a question of one party making a bad bargain.
  2. Decisions where the court has favoured a purposive or more liberal approach to construing contractual language where there are competing interpretations. This approach treats the commercial purpose of the contract as more important than the niceties of language. It does not mean that the court should rewrite the language used by the parties in order to make the contract conform to business common sense but, where more than one construction is possible, it does permit the court to choose that construction which seems more likely to give effect to the commercial purpose of the parties' agreement.

Lord Clarke concluded that the appropriate construction of the ambiguous wording in this case should be that which was most consistent with business common sense, in other words preferring the more liberal approach. He then proceeded to apply that purposive approach to the facts of this case. Lord Clarke acknowledged that the buyers' construction would rob paragraph 2 of the bonds of any effect because if the bonds were intended to guarantee the repayment of instalments regardless of the circumstances in which they came to be repayable, then there was no good reason to include paragraph 2. Nonetheless, Lord Clarke disagreed with Lord Justice Patten in the Court of Appeal that the bank's construction was "the natural and obvious construction" of the bonds. He rejected the argument that paragraph 2 had been incorporated in order to clearly state the relevant repayment obligations under the shipbuilding contracts which were covered by the bonds, rather it was a preamble or recital to paragraph 3, which was the operative provision.

In order to resolve the question what a reasonable person would have understood the parties to have meant, Lord Clarke considered the relevant terms of the shipbuilding contracts which formed the background to the issue of the bonds. He concluded that neither Article X.5 nor Article X.8 were intended to set out all the circumstances in which the refund guarantees should operate, further that Article X.8 did not dictate the final scope of the bonds which was left to the parties to agree and, in particular, did not require the guarantees to cover only the refund obligations under Article X.5 and X.6 (total loss).

Lord Clarke agreed with Sir Simon Tuckey's view that the importance attached in the shipbuilding contracts to the obligation to refund in the event of insolvency could be seen from the fact they required the refund to be made immediately and that it therefore made no commercial sense for the parties to have intended that an insolvency event would not lead to repayment of the instalments under the bonds. In the words of Sir Simon Tuckey: "Had the parties intended this surprising result I would have expected the contracts and the bonds to have spelt this out clearly but they do not do so".

Comment

Advocates for the literal approach to the construction of ambiguous contractual terms argue that adopting a more liberalized stance leads to uncertainty and unpredictability as to the outcome, given that there will inevitably be a divergence of opinion among the judges as to what was the true commercial intention of the parties. It is submitted, nonetheless, that the Supreme Court decision in this case confirms what any reasonable person would have concluded in the circumstances, namely that the parties intended an insolvency event to be covered by the guarantees in question. The protracted litigation in this case emphasises the importance of watertight drafting of commercial contracts and careful consideration of the language used in expressing the contracting parties' intentions.

Paul Herring, Jamila Khan and Catherine Earnshaw of Ince & Co LLP acted for the successful parties in this case. Please contact Paul Herring or Jamila Khan in case of any query.

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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