Construction of Contracts

Anna Cook examines judicial views on the weight to be attached to extrinsic evidence when interpreting contracts.

There have been a number of relatively recent decisions about the use by the courts of extrinsic evidence of negotiations to interpret contracts.  These have brought some clarity to a difficult area of the law, although it is likely that there will be more litigation on this subject.  These decisions, although arising in other fields, are likely to be of relevance to anyone negotiating or interpreting an IT-related agreement.

 

 

Investors Compensation Scheme Limited v West Bromwich Building Society [1998] 1 WLR 898

 

It is well established that evidence of the facts about which the parties were negotiating is admissible to explain the meaning that was intended. Also evidence about what the parties said in negotiations is admissible to show that the parties negotiated on an agreed basis and that the words used bore a particular meaning.[1]   However, the use of material showing what the parties said or did whilst the matter was in negotiation, the use of drafts or preliminary documents and the evidence of the parties' subjective intentions is not generally considered to be admissible.  The House of Lords decision in Investors Compensation Scheme Limited v West Bromwich Building Society [1998] 1 WLR 898 set out the relevant legal test:

 

1.      Interpretation is the ascertainment of the meaning which the document would convey to a reasonable person having all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract.

2.      The background was famously referred to by Lord Wilberforce[2] as the 'matrix of fact', but this phrase is, if anything, an understated description of what the background may include. Subject to the requirement that it should have been reasonably available to the parties and to the exception to be mentioned next, it includes absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man.

3.      The law excludes from the admissible background the previous negotiations of the parties and their declarations of subjective intent.  They are admissible only in an action for rectification.  The law makes this distinction for reasons of practical policy and, in this respect only, legal interpretation differs from the way we would interpret utterances in ordinary life.  The boundaries of this exception are in some respects unclear.  But this is not the occasion on which to explore them."

 

Egan v Static Control Components (Europe) Limited [2004] EWCA Civ 392

 

The Court of Appeal decision in Egan v Static Control Components (Europe) Limited [2004] EWCA Civ 392 dealt with the interpretation of a guarantee.  The judgment of Arden LJ cited with approval the earlier decisions,[3] including the restriction on the use of evidence of negotiations and expressed declarations of intent.  However, she held that:

 

When the court interprets a document, it is not bound to make the unreal assumption that the parties expressed themselves with accuracy or precision.  The court looks to the parties' common aim or intention in reducing an agreement in writing and the evidence as to the background information may lead to the conclusion that the parties have failed to express themselves accurately.

 

She then stated that the terms which were offered at a meeting during which the disputed guarantee was negotiated and signed were admissible in evidence.  The rationale for this was that, since the terms had been accepted by the appellant, they had been removed from the realm of mere negotiation into a concluded agreement between the parties and this concluded agreement was part of the relevant background.

 

A change of approach?

 

There could be a very fine distinction between points made in negotiation that are accepted (becoming part of the relevant factual background), which can be used in evidence, and any points that are rejected, which cannot.  Lord Nicholls suggested a change of approach in his Chancery Bar Lecture published in (2005) 121 LQR 577:

 

…there will be occasions where the pre-contract negotiations do shed light on the meaning the parties intended to convey by the words they used. There will be occasions, for instance, when the parties in their pre-contract exchanges made clear the meaning they intended by language they subsequently incorporated into their contract.  When pre-contract negotiations assist in some such way, the notional reasonable person should be able to take that evidence into account in deciding how the contract is to be interpreted…

 

This would not be a departure from the objective approach.  Rather, this would enable the notional reasonable person to be more fully informed of the background context. This would recognise that pre-contract negotiations are themselves part of the background of a contract and that, like other background material, they may be relevant when interpreting a contract.  They differ from other background material in that, unlike other background material, they may afford direct evidence of the parties' actual intentions. This is not a reason for banning their use.  That would be perverse.  That would mean that in deciding the meaning intended to be conveyed by the language chosen by the parties the notional reasonable person would always be barred from having regard to what may be the best evidence of all. He must always conjecture, he must never know.  The preferable approach is to recognise that pre-contract negotiations are relevant and admissible if they would have influenced the notional reasonable person in his understanding of the meaning the parties intended to convey by the words used.

 

Whether the notional reasonable person would have been so influenced in a particular case depends on the facts of that case.

 

Beazer Homes Limited v Stroude [2005] EWCA Civ 265

 

In Beazer Homes Limited v Stroude [2005] EWCA Civ 265, the Court of Appeal dealt with the interpretation of a s.106 Agreement.  The issue in this case was whether inconclusive negotiations for another contract could be used in evidence to assist in the interpretation of the s.106 Agreement.  The Court held that mere negotiations for a contract that was never agreed were irrelevant and unhelpful.  Again, the earlier decisions as to the exclusion of evidence of negotiations and the subjective intentions of the parties were approved.[4]  A passage from Prenn v Simmonds [1971] 1 WLR 1381 was cited:

 

By the nature of things, where negotiations are difficult, the parties' positions, with each passing letter, are changing and until the final agreement, though converging, still divergent.  It is only the final document which records a consensus…at this stage there is no consensus of the parties to appeal to.

 

Proforce Recruit Ltd v The Rugby Group Ltd [2006] EWCA Civ 69

 

Most recently, the Court of Appeal decision in Proforce Recruit Ltd v The Rugby Group Ltd [2006] EWCA Civ 69 debated the current law.  The judgment dealt with an undefined term in a contract: 'preferred supplier status'.  The appellant argued that it should be entitled to rely on evidence of the negotiations in which the parties reached an agreed understanding about what the term meant.  It relied on the decision in The Karen Oltmann [1976] 2 Lloyds Rep 708 at 712:

 

If the contract contains words which, in their context, are fairly capable of bearing more than one meaning, and if it is alleged that the parties have in effect negotiated on an agreed basis that the words bore only one of the two possible meanings, then it is permissible for the Court to examine the extrinsic evidence relied upon to see whether the parties have in fact used the words in question in one sense only, so that they have in effect given their own dictionary meaning to the words as the result of their common intention.  Such cases would not support a claim for rectification of the contract because the choice of words in the contract would not result from any mistake.

 

Arden LJ held that a distinction could be drawn from the 'usual situation in which, during the course of negotiations, the parties agree a matter which is to become binding on them (only) when a written agreement has been drawn up and signed'She was clear though that:

In admitting evidence as to those communications, the court would be hearing that evidence not with a view to taking the parties' subjective intent into account for the purpose of interpretation (a purpose precluded by the principles laid down by Lord Hoffmann in the ICS case) but for the purpose of identifying the meaning that the parties in effect incorporated into their agreement in circumstances where the court was satisfied that on their true interpretation the terms of the agreement were to have this effect.

 

It was also held that an 'entire agreement clause', which provided that the agreement superseded all prior representations, agreements, negotiations or understandings, was ineffective to prevent a court from considering pre-contract materials as an aid to interpreting the agreement:

 

There is a reasonably arguable distinction between, on the one hand, ascertaining the contents of a written contract or setting up a collateral or side contract by reference to prior representations, agreements, negotiations and understandings and, on the other hand, ascertaining the meaning of a term contained in a written contract by reference to pre-contract materials.

 

Conclusion

 

The decisions in Egan v Static Control Components (Europe) Limited and Proforce Recruit Ltd v The Rugby Group Ltd deal with the extent to which evidence of negotiations can be used as an aid to interpreting contracts.

 

It is clear that no evidence of the parties' subjective intentions will be admissible.  However, material showing the common intention of the parties will be admissible, if this can be said to have been agreed.  Therefore, there is no blanket prohibition on the use of evidence of negotiations. 

 

In practice, this may create a number of difficulties, especially in complex negotiations where the parties trade points ('I will give you this if you concede that').  This process of offer and counter-offer can make it difficult to deduce what matters have been agreed and to separate them from what is inadmissible.  It would be a strange result if only part of the negotiations could be included as part of the admissible background.

 

This point has not been lost on the Court of Appeal: the decision in Proforce Recruit Ltd v The Rugby Group Ltd refers to Lord Nicholls' Chancery Bar Lecture.  Arden LJ also noted that:

 

The exclusion of pre-contractual negotiations is not on the face of it consistent with the general principle that a contract should be interpreted in the light of its context.  Nor, on the face of it, is the application of a meaning which is not that which the parties themselves gave to a term consistent with the general approach of contract law, which is to respect party autonomy.  The results may be anomalous…

 

It is likely that there will be more decisions on this subject.

 

 

Anna Cook is a partner specialising in IT and dispute resolution at Wedlake Bell: acook@wedlakebell.com

 

 



[1] Chitty on Contracts, para 12.119.

[2] Reardon Smith Line Limited v Yngvar Hansen-Tangen [1976] 1  WLR 989 at 995-996.

[3] Mannai Investment Ltd v Eagle Star Life Assurance Co Limited [1997] AC 749, Prenn v Simmonds [1971] 1 WLR 1381 at 1383 and Investors Compensation Scheme Ltd–v West Bromwich Building Society [1998] 1 WLR 896.

[4] Prenn v Simmonds [1971] 1 WLR 1381, Reardon Smith Line–v Yngvar Hansen-Tangen [1976] 1 WLR 989 and Investors Compensation Scheme v West Bromwich Building Society [1998] 1 WLR 896.

Published: 2006-07-01T00:00:00

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