Originally published on Mondaq, July 2002
The dichotomy between the literal and the purposive approach on interpretation of written contracts has been a very hot topic during the last twenty years. A lot of words have been spent in order to decide which was the best approach on interpretation for the interests of the commercial community: certainty and predictability on one side and the possibility to have more flexibility on the other.
The English approach to interpretation is based on the intention of the parties in the construction of contracts and commercial textbooks confirm this assumption. However this assumption is modified by the idea that the intention of the parties is relied upon by the law only to extent of the outward manifestations of contractual intent. This means that there is no space for subjective considerations. As Justice Holmes commented one hundred and five years ago: "Nothing is more certain than that parties may be bound by a contract to things which neither of them intended, and when one does not know of the other's assent"1.
For the literalist methods of Lord Simonds it is not important what the parties meant but what is the "natural meaning" of the words. In recent times Hobhouse L.J. said: "A contracting party cannot escape liability by saying that he has his fingers crossed behind his back"2 However, there is an apparent contrast between the scope of the interpretation of the contract, that is to give effect to the intentions of the parties3, and the objective approach to interpretation. Underlining this discrepancy Lord Steyn, in apparent defence of the traditional approach, in Deutsche Bank stated: "It is true that the objective of the construction of contract is to give effect to the intention of the parties. But our law of construction is based on an objective theory. The methodology is not to probe the real intentions of the parties but to ascertain the contextual meaning of the relevant contractual language. Intention is determined by reference to expressed rather than actual intention"4
The objective approach on interpretation has been well described by Oliver Wendell Holmes in an article about legal interpretation: "we ask, not what this man meant, but what those words would mean in the mouth of a normal speaker of English, using them in the circumstances in which they were used"5.
As Gerard McMeel said it is undisputable that there has been a change during the last twenty years from the strict objective approach to a so-called "purposive", "commercial" or "modern" approach6. This point of view can be found also, for example, in a speech of Lord Steyn in Mannai v. Eagle Star7 where he substantially accepted with certainty that there has been a swift in the approach to the construction of commercial contracts from a more orientated objective approach to a different approach based on the background of the contractual situation.
It is very important to emphasize that this shift has been only about interpretation of contracts because, as Lord Steyn pointed out in the above mentioned judgement: "There are obvious differences between the processes of interpretation in regard to private contract and public statutes. It is better to speak of a shift towards commercial interpretation"8. This is why I am not going to rely on any of the articles, speeches or judgements concerning the interpretation of the statutes.
Leaving aside to the analogous topic of the interpretation of statutes, the important point is that the swing of the pendulum did not simply move from a literalist approach to a purposive approach and the victory of the modern approach is not the result of this change. As we will see later the modern approach is probably formed by elements of the objective approach and purposive approach together in order to better accomplish and give effect to the reasonable expectations of commercial people. The first person emphasize a connection with the concept of the "Reasonable expectations of honest man" has been Lord Steyn9 followed by many other judges and authors. Gerard McMeel, for example, considered that the reasonable expectations of honest men as described by Lord Steyn are indeed the "motivating purpose of English Commercial Contract Law"10. The aim of this new school is to protect and to serve these expectations.
But what is the new approach? How does it differ from the traditional method of interpretation?
Lord Hoffman in Investors Compensation Scheme v. West Bromwich Building Soc.11 recapitulated the concept of the modern approach emphasising the role of language. The case was about a number of homeowners who had, on the recommendation of financial advisers, entered into home income plans involving the mortgages of their homes and suffered economic loss. The investors claimed compensation from ICS by completing a claim form stating that the investors had assigned all claims to ICS except any claim they had against the society in which they claimed an abatement of sums or which they had otherwise to repay the society. ICS brought proceedings against the West Bromwich Building Society and many law firms involved in the mortgages. While some of the investors commenced separate actions against the West Bromwich, ICS appealed against a Court of Appeal decision that they could not sue the Defendant. The judgement of the House of Lords said that it was clear that, referring in particular to the accompanying explanatory note, all claims for damages and compensation by the investors had been lawfully assigned to ICS and consequently allowed the appeal.
In effect the legal interpretation can be considered a tool in order to accomplish the needs of the commercial community: the aim of protection of the reasonable expectations of honest men was driving this judgment and the result can be welcomed.
The modern approach on interpretation of commercial contracts, as clearly summarized by Lord Hoffman in ICS12, is based on the following points:
- Interpretation is the ascertainment of the sense that the text could suggest to a reasonable person that knows all the background information that would be reasonably at disposition of the parties at the time of the contract. The interpretation is objective but the utilization of the context can be a very useful tool.
- The idea of the background relies to the "matrix of facts" expressed by Lord Wilberforce in many of his judgements13 but this expression is just a description of what the background may include. Lord Hoffman explains that the background "includes absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man"14
- Previous negotiations of the parties and their subjective declarations are excluded by law from the admissible background. The reason why the modern approach does not permit the utilization of the previous negotiations in order to better understand the meaning of the contract will be analysed later.
- "The meaning which a document (or any other utterance) would convey to a reasonable man is not the same thing as the meaning of its words. The meaning of words is a matter of dictionaries and grammar; the meaning of the document is what the parties using those words against the relevant background would reasonably have been understood to mean"15. The role of the background is not simply to enable the reasonable man to choose between different meanings in order to solve the eventual ambiguity of some words: the use of the background may be very helpful also to reach the conclusion that the parties, for whatever reason, have used the wrong words or syntax. The use of the background is, in other words, in order not only to better understand the meaning of the words but also to correct mistaken expressions.
- Following Lord Hoffman, even if we do not easily accept that people have made linguistic mistakes in formal documents someone can conclude from the background that there is some fault or inaccuracy and the law does not oblige judges to attribute the parties a purpose which they clearly never have had. It is indeed very important to point out that Lord Hoffman is talking about the common intention of the parties, not of a subjective intention of one of them.
With ICS the starting point of a new way of interpreting written contracts was born: Lord Clyde in Ali16 quoted the words of Lord Hoffman saying that "In the construction of a contract the problem is to determine the meaning which the document would convey to a reasonable person having all the background knowledge which would have reasonably been available to the parties in the situation in which they were at the time of the contract"17
However, how can this different approach be helpful? And how clear is the difference between the literalist and modern approach? What is the limit between the need for certainty and the necessity to fulfil the reasonable expectations of the parties? Is it really true that certainty is not protected by the modern approach?
In Deutsche Genossenschaftsbank v. BurnHope18 the plaintiff bank held securities for the indebtedness of a customer company. Mr Smith, the controlling mind of the latter, agreed to return the same or similar acceptable securities the same day. The plaintiff was insured by the defendant against the financial consequences of "property being lost" through theft by persons acting "on the premises of the Assured". The difficulty of this judgement was whether the word "person" included a corporate person and whether the theft had to be committed on the premises. In this case, for example, Lord Keith of Kinkel19 accepting the argument of the defendant that the word "person" was limited to human beings was at the same time rejecting the technical meaning of the word "person" that in a legal sense always comprises corporations. In other words a defendant of the literalist approach was giving a purposive and contextual significance to the word "person". Moreover, in the same judgement, Lord Hoffman, considered one of the fathers of the modern approach, agreed with the majority decision in favour of insurance because the terminology might create an arbitrary line between cover and no cover20. As a matter of fact the line between the modern and the literalist approach is not very clear and the traditional distinction between this two schools is sometimes not so evident. However a careful reading of the judgement reveals that Lord Hoffman is protecting certainty and, in consequence of this, the reasonable expectations of honest men: the line between whether or not someone is bound by a contract is arguably very clear.
It is very interesting to note how difficult it is to decide whether a judge can be regarded as a follower of the modern approach. See, for example, the judgement of Lord Wilberforce, considered one of the exponents of the modern interpretation, against the utilization of the subsequent conduct with the purpose of finding the common intention of the parties in L. Schuler A.G. Appellants v. Wickman Machine Tool Sales Ltd21.
Even if the leading followers of the commercial approach have been found in disagreement surprisingly often, this does not mean that a new approach on interpretation has not been created22.
The starting point for the interpretation and the consequent refusal of the "natural meaning" as created by the literalist has been set up by Lord Hoffman in Charter Reinsurance Co. Ltd v. Fagan: "I think that in some cases the notion of words having a natural meaning is not a very helpful one. Because the meaning of words is so sensitive to syntax and context, the natural meaning of words in one sentence can be quite unnatural in another. Thus a statement that words have a particular natural meaning may mean no more than that in many contexts they will have that meaning. In other contexts their meaning will be different but no less natural"23 In order to prevent inadequate results, the context also called the "matrix of facts" is the primary source identified by Lord Hoffman of where to find the significance of a word.
It is very important to point out again that both literalist and modern supporters rely on the common intention of the parties. Even Lord Hoffman accepted that subjective evidence of intention should be excluded24 for reasons of practical policies. In the same judgement and for the same reasons he also excluded the use of evidence with reference to the previous negotiations between the parties. Sir Christopher Staughton reached the same conclusion for different reasons assuming that the evidence for intention and for previous negotiations has to be excluded because it does not help to tell anything about the common intention of the parties when the contract was made25
The difference between these two approaches is clear: Hoffman says that you have to remember the practical effects of your interpretation with the implication to better fulfil the reasonable expectations of the parties and Staughton is simply following a rule.
Thanks to the contextual approach, slight linguistic slips that are evident to the other party should be not interpreted by their literal meaning. In Mannai26 the intention of the tenant was clear and obvious and the landlord, that did not suffer any prejudice, could not rely to the fact that the tenant had been 24 hours out in indicating the appropriate day. The modern approach that prevailed in this case ignoring a well know rule in the commercial property field: precedent specified strict compliance in the form of such notices. What was the reason? In Antanios Compania Naviera S.A. v. Salen Rederierna A.B.27 Lord Dilpock, cited by Lord Steyn in Mannai28 assumed: "if detailed semantic and syntactical analysis of a word in a commercial contract is going to lead to a conclusion that flouts business common sense, it must be made to yield to business common sense". "Business common sense" in order to protect the reasonable expectations of "honest business people". Again, quoting Lord Steyn, who continued: "In determining the meaning of the language of a commercial contract, and unilateral contractual notices, the law therefore generally favours a commercially sensible construction. The reason for this approach is that a commercial construction is more likely to give effect to the intention of the parties. Words are therefore interpreted in the way in which a reasonable commercial person would construe them and the standard of the reasonable commercial person is hostile to technical interpretations and undue emphasis on niceties of language"29
The modern interpretation of contracts, continued Lord Steyn, does not allow any longer the creation of confusion between the meaning of words and the question of what significance in a particular background and with reference to a determined context the use of words was intended to express.
It is moreover very remarkable to note how many times in the speeches of Lord Hoffman and Lord Steyn the word "reasonable" appears. Reasonable interpretation for reasonable results: reasonableness is the key word for the modern interpretation of contracts. As a matter of fact there exists no rule that obliges judges to interpret a contract in a way that neither party could reasonably expect.
For the same reasons in ICS a badly drafted clause has been interpreted in the significance given by the legal and commercial background rather than the basic view of a presumed lay investor30. However in the same judgement Lord Lloyd warned about the danger of such interpretation. Certainty in commercial transactions is fundamental for the protection of the interests of the merchant community: "Purposive interpretation of a contract is a useful tool where the purpose can be identified with reasonable certainty. But creative interpretation in another thing altogether. The one must not be allowed to shade into the other"31 In the modern approach the purpose must be identified with "reasonable" certainty because the honest business men rely on the certainty of what they have written.
Actually, the principles of the so called "modern" approach are indeed not so revolutionary as they appear at first sight: even a protector of the literalist approach, such as Sir Cristopher Staughton, admitted the importance of the surrounding circumstances for the interpretation of a written contract32 He talked about the immediate context as opposed to facts happening in the past but he definitely relied on the circumstances, elsewhere called the "background" or "matrix of facts".
Sometimes the differences between the two schools are only a matter of words and not of substance: Sir Staughton described, for example, the necessity of the courts to take into account the consequences of one interpretation or another in order to avoid unreasonable results and, it could be said, to protect the reasonable expectations of honest men. Even if he did not admit it, he was using a modern approach (that is indeed not so modern) in admitting the importance of what he called "surrounding circumstances". Simply, he said that it is a totally separated rule just based on common sense!33
As evidence to the theory that the so called modern approach is not so recent and it is indeed based on the protection of the reasonable expectations of honest man I have to make another citation. Lord Hoffman in Mannai said: "The fact that the words are capable of a literal application is no obstacle to evidence which demonstrates what a reasonable person with a knowledge of the background would have understood the parties to mean, even if this compels one to say that they used the wrong words. In this area, we no longer confuse the meaning of words with what meaning the use of the words was intended to convey"3. Despite the criticism of Sir Staughton this way of interpretation is based on old merchant law and, if it is true that the scope of the commercial law is to fulfil the needs of the merchant community, it is difficult to understand why the scope of the interpretation of commercial contracts should not include the defence of the reasonable expectations of honest men who have the right to rely on what they really meant when they were writing a contract.
The idea of Sir Staughton that business men would prefer a general rule that words mean what they say in ordinary English35 can be quite easily subjected to criticism if we think about the language used in drafting a modern contract. It is indeed a very technical and obscure language, exceptionally difficult to understand for people who do not have a legal background. In this particular situation the parties can often write something which is unclear or that they did not mean or that they did not completely understand. When this happens the modern approach is welcome so as to protect the real common intention of the parties and if the legal interpretation is a tool so as to fulfil the reasonable expectations of honest men, the courts should use this tool. Of course there is a limit in the power recognized to the courts but this limit is set up and well accepted by modern commercial judges and therefore the criticism of Lord Mustill in Charter Reinsurance36 is open to objection. Also open to objection, in the same judgement, is the idea of Simon Brown L.J. that when the words are clear the courts must be given that clear meaning however unreasonable the result can be37. If that was not the common intention of the parties arguably the courts have the right to correct the misunderstood words to their accurate meaning in order to satisfy the common expectations of the parties at the time that the contract was made. One can agree with the view of Lord Hoffman that analyses the intention of the parties in the light of the history, language and commercial background in order to find eventual imperfections or even mistakes38.
Actually, even when one talks about the modern interpretation one is not giving predominance to the subjective intentions of the parties. The proof that basically the modern or purposive approach is objective can be found in Mannai and again in the speech of Lord Steyn: "The question in not how the landlord understood the notices. The construction of the notices must be approached objectively. The issue is how a reasonable recipient would have understood the notices and in considering this question the notices must be construed taking into account the relevant objective contextual scene"39
Certainty and predictability are taken into account by modern judges and when they refer to the concept of the reasonable expectations of honest men they are adopting an external and "objective" standard. Because of the fact that the that the function of the law is to provide an effective and fair framework for commercial transactions and that it is unlikely to protect unreasonable expectations the assumption can be redefined coherently with the words of Lord Stein: "the law must respect the reasonable expectations of the contracting parties"40. Even though the reasonable man pursues his own interests he is, by definition, considered honest and the honest business person must be protected even against his own words.
"Reasonable expectations of the parties", "honesty", "reasonable results", "fair framework" are concepts that can be related to the doctrine of good faith. The concept of good faith has been developed by civil law jurisdictions following the principles established in the ancient Iure romanorum: almost every civil law jurisdiction has developed a doctrine of good faith. Perhaps the reasonable expectations of business people and the new trend of modern interpretation can be, despite of the hostility of English lawyers, the starting point for the acceptance of this useful tool. The doctrine of good faith has been hardly criticized because it was considered a subjective theory but, in defence of this position, one can quote again the words of Lord Steyn: "Undoubtedly, good faith has a subjective requirement: the threshold requirement is that the party must act honestly. But good faith additionally sets as an objective standard the observance of reasonable commercial standards of fair dealing in the conclusion and performance of the transaction concerned"42.
It could be argued that the rule that the courts do not accept the pre-contractual negotiations with the scope of interpretation of contracts, rule followed by all the modern judges and clearly accepted by Lord Hoffman, is a proof of the inconsistency of the modern approach. Despite of first appearances the modern or contextual approach is based on the objective theory of interpretation of contracts that provides certainty in the law and predictability in the results of the disputes42
As a matter of fact the modern approach and the following trend of purposive construction of contracts does not mean that the courts have the power to rewrite the contracts but they only have a better tool in order to fulfil the reasonable expectations of the contractual parties and to point out the real significance of the words of the contract that is the outward manifestation of a particular determination.
In conclusion, one looks to the words of Lord Steyn, that are indeed very similar to the words of civil law judges or professors talking about the doctrine of good faith: "Modern judges always have well in mind the reason for a rule and in a contract case that means approaching the case from the point of view of the reasonable expectations of the parties. Where contract law is still deficient it will usually be found that the cause is that the reasonable expectations of the parties have been ignored or given inadequate weight".
1 Oliver Wendell Holmes, "The Path of the Law" (1897) 19 Harvard L. Rev. 457.
2 Boverman v. Association of British Travel Agents  C.L.C. 451 at 463. The principle of the objective approach on interpretation of contracts is not recent. See, for example, Blackburn J. in Smith v. Hughes (1871) L.R. 6 Q.B. 597 at 607. For the same approach see the House of Lords judgement in The Hannah Blumenthal  2 A.C. 854.
3 For the scope of the interpretation see E.g. Sir Christopher Staughton, "How do the Courts interpret commercial constracts?"  CLJ 303 at 305.
4 Deutsche Bank  1 Lloyd's Rep. 113 at 122.
5 Oliver Wendell Holmes, "The Theory of Legal Interpretation" (1897) 12 Harv. L.R. 417.
6 Gerard McMeel, "The rise of commercial construction in contract law"  L.M.C.L.Q. 382 at 383.
7 Mannai v. Eagle Star  A.C. 749 at 770.
9 Lord Steyn, "Contract Law and the Reasonable Expectations of Honest Men" (1997) 113 L.Q.R. 433.
10 Gerard McMeel, "The rise of commercial construction in contract law"  L.M.C.L.Q. 382 at 383.
11 Investors Compensation Scheme v. West Bromwich Building Soc.  1 W.L.R. 896.
12 ibid. at 912-913.
13 See E.g. Prenn v. Simmonds  1 W.L.R. 1381 at 1384.
14 Investors Compensation Scheme v. West Bromwich Building Soc.  1 W.L.R. 896 at 912.
15 ibid. at 913.
16 Bank of Credit of Commerce v. Munawar Ali  1 All E.R. 961
17 Investors Compensation Scheme v. West Bromwich Building Soc.  1 W.L.R. 896 at 912.
18 Deutsche Genossenschaftsbank v. BurnHope  1 Lloyd's Rep. 113. See also the House of Lord judgement in Deutsche Bank  1 W.L.R. 1580.
19 Deutsche Genossenschaftsbank v. BurnHope  1 Lloyd's Rep. 113 at 120.
20 ibid. at 124.
21 See E.g. the judgement of Lord Wilberforce, considered one of the fathers of the modern approach, against the utilization of the subsequent conduct with the purpose of finding the common intention of the parties in L. Schuler A.G. Appellants v. Wickman Machine Tool Sales Ltd  A.C. 235 at 262.
22 Gerard McMeel, "The rise of commercial construction in contract law"  L.M.C.L.Q. 382 at 383.
23 Charter Reinsurance Co. Ltd v. Fagan  A.C. 313 at 391.
24 Investors Compensation Scheme v. West Bromwich Building Soc.  1 W.L.R. 896 at 913.
25 . Sir Christopher Staughton, "How do the Courts interpret commercial constracts?"  CLJ 303 at 306.
26 Mannai v. Eagle Star  A.C. 749.
27 Antanios Compania Naviera S.A. v. Salen Rederierna A.B.  A.C. 191 at 201.
28 Mannai v. Eagle Star  A.C. 749 at 770-771.
29 ibid. at 771.
30 See Gerard McMeel, "The rise of commercial construction in contract law"  L.M.C.L.Q. 382 at 390.
31 Investors Compensation Scheme v. West Bromwich Building Soc.  1 W.L.R. 896 at 904.
32 Sir Christopher Staughton, "How do the Courts interpret commercial constracts?"  CLJ 303 at 308.
33 Sir Christopher Staughton, "How do the Courts interpret commercial constracts?"  CLJ 303 at 308.
34 Mannai v. Eagle Star  A.C. 749 at 779.
35 Sir Christopher Staughton, "How do the Courts interpret commercial constracts?"  CLJ 303 at 310.
36 Charter Reinsurance Co. Ltd v. Fagan  A.C. 313 at 388. See also the judgement of Staughton L.J. at 353.
37 ibid. at 368-369.
38 Charter Reinsurance Co. Ltd v. Fagan  A.C. 313 at 395.
39 Mannai v. Eagle Star  A.C. 749 at 766.
40 Lord Steyn, "Contract Law and the Reasonable Expectations of Honest Men" (1997) 113 L.Q.R. 433 at 434.
41 ibid. at 438.
42 ibid. at 440.
Antanios Compania Naviera S.A. v. Salen Rederierna A.B.  A.C. 191 at 201.
Bank of Credit of Commerce v. Munawar Ali  1 All E.R. 961.
Boverman v. Association of British Travel Agents  C.L.C. 451.
Charter Reinsurance Co. Ltd v. Fagan  A.C. 313 at 391.
Deutsche Genossenschaftsbank v. BurnHope  1 Lloyd's Rep. 113 at 122.
Investors Compensation Scheme v. West Bromwich Building Soc.  1 W.L.R. 896.
L. Schuler A.G. Appellants v. Wickman Machine Tool Sales Ltd  A.C. 235 at 262.
Mannai v. Eagle Star  A.C. 749.
Smith v. Hughes (1871) L.R. 6 Q.B. 597.
The Hannah Blumenthal  2 A.C. 854.
HOLMES, Oliver Wendell, "The Path of the Law" (1897) 19 Harvard L. Rev. 457.
HOLMES, Oliver Wendell, "The Theory of Legal Interpretation" (1897) 12 Harv. L.R. 417.
MCMEEL, Gerard, "The rise of commercial construction in contract law"  L.M.C.L.Q. 382 at 383.
STAUGHTON, Sir Christopher, "How do the Courts interpret commercial constracts?"  CLJ 303.
STEYN, Lord Johan, "Contract Law and the Reasonable Expectations of Honest Men" (1997) 113 L.Q.R. 433.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.