Alex Shattock and Gideon Shirazi consider recent case law on contractual interpretation and what it might mean for IT contracts by reference to a common scenario in IT outsourcing
In the last year, the Supreme Court has given a number of key judgments relating to contract law. They cover a range of areas and, in some cases, mark a decisive shift from the law as previously understood and will have implications for many contracts. This is the first in a series of articles which consider the practical implications of these decisions and their implications for IT and outsourcing contracts.
These decisions reveal a trend in which the courts are becoming more reluctant to depart from the literal meaning of the terms used and will assume that the wording of a contract has been deliberately chosen, especially where the parties are professionally advised. This makes it more important than ever to get the drafting absolutely right at the negotiation stage.
There have been a long line of cases in which the courts have set out ground rules for how to interpret the terms of a contract. The latest chapter is Arnold v Britton  UKSC 36, a recent Supreme Court decision.
Before this case, it appeared that the courts were moving away from a strict adherence to the literal meaning of the words used in a contract towards an approach that emphasised commercial common sense. The previous leading Supreme Court case, Rainy Sky v Kookmin  1 WLR 2900 found that '[i]f there are two possible constructions, the court is entitled to prefer the construction which is consistent with business common sense and to reject the other'. The decision in Arnold v Britton marks a return to the emphasis on the ordinary meaning of the language used in the contract as the key to interpreting the meaning of the contract.
Arnold v Britton considered a service charge provision in leases of holiday chalets which provided both for the payment of a service charge being a 'proportionate part of the expenses and outgoings incurred by the Lessor in the repair, maintenance, renewal and renewal of the facilities of the Estate' and also in the yearly sum of £90 plus VAT for the first year, increasing by 10% every three years thereafter. Some of the leases were amended so that the 10% increase would take place on a yearly basis.
The leases were granted in the 1970s and the 1980s and were for terms of up to 99 years. The service charge provision would grow considerably, on a compound basis, during the life of the lease. By 2072, those leases which had an annual increase in service charge could face liability for annual payments of up to £1,025,004, far in excess of the cost of providing the service.
The heart of the case was whether an interpretation of the service charge provision that was more in line with the ordinary language of the words used could stand notwithstanding that it resulted in commercially crippling results for one of the parties. The tenants argued that the service charge provisions should be construed to give due weight to the first part of the clause which referred to a payment of a 'proportionate' part of the expenses incurred by the landlord. They argued that the calculation mechanism of the clause should be interpreted as a maximum amount payable rather than as the amount payable. To find otherwise would result in a commercially absurd result.
Lord Neuberger (for the majority) summarised the modern approach to interpretation as follows:
When interpreting a written contract, the court is concerned to identify the intention of the parties by reference to 'what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean', … And it does so by focussing on the meaning of the relevant words … in their documentary, factual and commercial context. That meaning has to be assessed in the light of (i) the natural and ordinary meaning of the clause, (ii) any other relevant provisions of the lease, (iii) the overall purpose of the clause and the [contract], (iv) the facts and circumstances known or assumed by the parties at the time that the document was executed, and (v) commercial common sense, but (vi) disregarding subjective evidence of any party's intentions.
The Supreme Court noted that reliance on notions of commercial common sense 'should not be invoked to undervalue the importance of the language of the provision which is to be construed'. Further, when interpreting the contract, the court is entitled to assume that the parties would have focussed on the issue covered by the provision when agreeing the wording of the provision that was used. And, while commercial common sense is a very important factor, a court should be slow to reject the natural meaning of a provision simply because it was a 'very imprudent' term for a party to have agreed.
The majority found that the service charge provisions should be construed in accordance with their natural and ordinary meaning. That construction did not allow the court effectively to add words to the clause so that the calculation mechanism operated as a cap. It was not relevant that the effect for the lessees was 'highly unsatisfactory' – the words were clear and should be given effect.
Arnold should probably be viewed as a change in the tide by the courts to focus upon the wording of the contract. It represents a new perspective by a strongly constituted Supreme Court. It contains a clear statement of the relevant principles. And its facts are sufficiently extreme that it sends a clear message that the courts will generally give effect to the ordinary meaning of the words used by the parties. As such, it will probably remain the leading decision in this area for some years to come.
However, given the sheer volume of recent decisions on how to interpret contracts, each with subtle differences of emphasis, and the enormous number of ways in which contracts can be drafted, it can be difficult to predict with confidence how a court will react when presented with two interpretations. Even the Supreme Court in the Arnold case was not a unanimous decision. Perhaps the key points to bear in mind are:
We now consider how these principles might apply in a typical outsourcing situation which goes wrong (with issues based in part on the recent case of BT Cornwall v Cornwall Council  EWHC 3755 (Comm)).
A multinational corporation's UK offices (BigCorp) enter into a long-term outsourcing agreement (the Agreement) with an outsourcing contractor (SourceSolutions) for the management of its IT estate. The Agreement begins with a transformation of BigCorp's IT estate, aimed at reducing the size of the estate, bringing it up to date and reducing the operating costs (the Transformation). This includes the rollout of new hardware, new software, a server virtualisation project, migration to new data centres and the development of some business software. The contract is initially loss-making for SourceSolutions as it invests in the Transformation but it recovers its investment and becomes profitable in later years.
The parties agreed various means of measuring and incentivising performance, including:
(i) liquidated damages in the event that certain milestones in the Transformation are not achieved; and
(ii) Key Performance Indicators (KPIs), reported monthly, which provide a quantitative measure of SourceSolutions' performance under the agreement.
Anticipating that the Transformation may suffer delays, the Agreement includes a mechanism for extending time for performance, which requires SourceSolutions to serve 'Delay Notices' when delays arise. Unfortunately, the Transformation programme slipped, and SourceSolutions missed two milestones. SourceSolutions claimed that BigCorp was responsible for the delays because of dependencies on BigCorp that delayed the project. SourceSolutions did not serve Delay Notices at the time but provided them when the dispute arose.
KPI3 measures performance on incident resolution (the Agreement defines 'KPI3 = percentage of incidents closed within their time limit in the past month'). Users report IT problems to the service desk, which then has a certain amount of time (which varies depending on the severity of the problem) to resolve the incident. Service credits are payable where the performance falls below a target of 95%, and BigCorp can terminate the Agreement if performance falls below 90% for three out of six consecutive months. Unfortunately, when the Transformation project had problems, the number of incidents escalated and the KPI3 performance also fell considerably. A backlog grew of outstanding incidents. Performance fell below 90% for four months in a row, with performance of 82% and 78% in the two latter months.
The dispute was escalated to management and resulted in a variation to the contract (the 'Amendment'). Unfortunately there was a high degree of commercial pressure to execute and finalise the Amendment so that the project could continue and savings could be realised. A minimal amount of drafting time was allowed before the deal had to be finalised. The Amendment included a new Transformation project schedule, and some changes to the work items that SourceSolutions was required to provide. It included a term:
A1 This Amendment is in full and final settlement of all legal rights accrued by each party against the other party falling within the Dispute.
Following the Amendment, SourceSolutions invested a large amount in the contract to get the Transformation project back on track and to clear the backlog of outstanding incidents. As a result of clearing these incidents, performance on KPI3 remained below 90% for the next two months. At this stage, BigCorp threated to terminate the contract.
The issues in dispute between the parties included:
(1) In the original dispute, could SourceSolutions claim an extension of time when they did not serve Delay Notices at the time?
(2) In the original dispute, would BigCorp have been entitled to service credits of £7.8m and £8.2m for the two months before the Amendment?
(3) Are BigCorp now entitled to terminate the contract following the Amendment?
(1) Delay Notices
Problems facing contractors as a result of delays and failing to serve delay notices is a feature that crops up regularly in disputes and there are a number of cases considering this problem. While the starting point is that a failure to provide a notice is normally not fatal to a claim for the consequences of delay, each case must be considered on its facts because it is ultimately sensitive to the wording of the particular contract. Here, the Agreement states:
SourceSolutions shall serve a Delay Notice in writing to BigCorp within seven days … If SourceSolutions does not provide a Delay Notice in accordance with this clause, then SourceSolutions will be deemed to be liable for the delay and shall not be entitled to an extension of time or any other remedy as a result of the delay.
Thus, if SourceSolutions did not serve the Delay Notice 'in accordance with this clause', then its claim would fail and it would have to take responsibility for the delays. SourceSolutions may argue that the words 'in accordance with' merely requires the Delay Notice to be served, and that the seven-day period is merely directory. It would point to the extreme commercial consequences of its delay claim being denied because the Delay Notices were served late. However, the difficulty with this interpretation is that, by focussing on the commercial consequences, it does not give effect to the ordinary meaning of the words chosen by the parties. There are also clear commercial considerations against this argument: the purpose of the clause is to promote certainty and avoid these arguments, and to ensure that the delay can be investigated (and potentially remedied) at the time. And, while the literal meaning may have serious consequences for SourceSolutions (including significant liquidated damages), in the post-Arnold v Britton world, the literal meaning is likely to prevail.
(2) Service credits
BigCorp are entitled to service credits where the KPI3 performance falls below a target value. The Agreement states:
If the performance on KPI3 falls below 95%, then BigCorp is entitled to a service credit of £100,000 per percentage point in respect of that month.
BigCorp's argument is simple: KPI3 performance in the two pre-Amendment months were 78% and 82% respectively, so it is entitled to service credits of 78 x £100,000 and 82 x £100,000 for each of the months. SourceSolutions would argue that this interpretation is commercially absurd: if correct, it would mean that the better the performance, the higher the service credits – and the purpose of the service credits cannot be to punish better performance.
Here, it seems clear that something has gone wrong with the wording: the parties cannot have intended that SourceSolutions would be penalised for better performance. Faced with this clear discrepancy, a court would almost inevitably reject BigCorp's argument and adopt a more commercially sensible approach. Indeed, in Arnold v Britton, the court noted that the overall purpose of the clause and commercial common sense are relevant in every case. To give effect to the parties' intention, the words 'below 95%' should be read in after the words 'percentage point', so that the clause provides increasing service charges for decreasing performance, and awards no service charges for performance of 95% or above.
The Agreement states that BigCorp is entitled to terminate 'If the performance on KPI3 falls below 90% for three out of six consecutive months'. This appears to be satisfied: performance fell below 90% for six consecutive months, four before the Amendment and two after. But the poor performance before the Amendment resulted entirely from the problems that formed part of the Dispute, and the poor performance after the Amendment are caused by closing the backlog of outstanding incidents.
The real question is whether the termination is prevented by the operation of clause A1:
This Amendment is in full and final settlement of all legal rights accrued by each party against the other party falling within the Dispute.
Intuitively, it feels unfair for BigCorp to terminate the contract for a breach which includes a month before the settlement, particularly where the subsequent months' poor performance resulted from problems that were known before the settlement. On the other hand, this possibility was certainly foreseeable when the Amendment was negotiated and, if the parties had intended to prevent termination, this could easily have been written into the Amendment. It is not clear what the parties intended in this situation.
Focussing on the wording, this clause settles 'all legal rights' that were 'accrued'. The meaning of 'legal rights' alone might be ambiguous but, in the context of the clause as a whole, it is relatively clear that it refers to contractual or other rights that each party might have against the other (eg rights to service credits, to liquidated damages payments for delay, to terminate the contract, etc). And, in order to be settled, the right must have 'accrued': in other words, it must exist before the Amendment comes into force. But, arguably, the earliest this right of termination could arise was when the KPI3 performance was reported, two months after the Amendment. Thus, applying the ordinary meaning of the clauses, it appears that BigCorp would be entitled to terminate.
Alex Shattock is an associate solicitor in Dispute Resolution at Slaughter and May.
Gideon Shirazi is a barrister at 4 Pump Court.
All views are the authors' own.