The recent High Court case of Honeyrose Bakery Ltd v Lola's Kitchen Ltd (t/a Lola's Cupcakes) has reinforced the principles of contractual interpretation set out in the judgement of Arnold v Britton.
Lola's Cupcakes is a London-based bakery company that has started to subcontract a proportion of its baking in order to meet the growing demand for its sweet treats. Honeyrose Bakery entered into an agreement with Lola's to bake their cupcakes. Under the contract, Honeyrose was defined as Lola's exclusive supplier of cupcakes.
A clause in the contract stated: "[Lola's] will initially manufacture concurrently with the Supplier; at commencement of the contract, the Supplier will manufacture 20% of the forecasted volume, gradually increasing to 100% over a period of 2 months."
And the next clause specified: "For the avoidance of doubt [Lola's] may manufacture the Products for itself."
Although the terms might seem, at first glance, to be fairly comprehensive, there was later a disagreement between the bakeries as to whether Lola's could carry on producing cupcakes after the initial two months.
On one hand, the two clauses could be read as contradictory to one another, leading to ambiguity in the contract. This was the position of Honeyrose, who submitted that the court should consider pre-contract information when interpreting the contract, in order to restrict the manufacturing rights of Lola's Bakery.
Conversely, it could be said that even if ambiguity can be found in the first clause detailed above, the ambiguity is eliminated by the later clause.
The court followed the principles in the Supreme Court's decision of Arnold v Britton in order to resolve the issue of contractual interpretation.
Prior to Arnold, 'commercial common sense' was used to aid the interpretation of contracts, first in Investors Compensation Scheme Ltd v West Bromwich Building Society  1 WLR 896, and later in the Supreme Court case of Rainy Sky S.A. & Ors v Kookmin Bank  UKSC 50, which held that if the language of a contract has more than one potential meaning, it is usually better to interpret it in the way that best coincides with commercial common sense.
The judgement of Arnold v Britton later limited the application of 'commercial common sense' in the interpretation of contracts, supporting a literal interpretation of the natural meaning of the contract's words - unless absolutely necessary.
The case involved a dispute between a landlord and his tenants, over the service charge that was to be paid for each 99-year lease. The lease agreements stated that the annual service charge payable would be £90, increasing by 10% each year. The tenants claimed that the £90 stated in the contract was intended to be a cap on the service charge rather than a fixed amount. They submitted that the words 'up to [£90]' should be read into the contract, as the annual 10% rate of increase would cause the charge to become absurdly expensive over the lease period, if it was interpreted otherwise.
The court held that the wording of the contract was not ambiguous, and the fact that a party had entered into a bad bargain did not mean the contract should be re-interpreted so they could escape it.
Lord Neuberger's judgement (with which the majority agreed) summarised that the intention of the parties should be identified by what a reasonable person, with all the background knowledge available to the parties, would have understood the language in the contract to mean. Any subjective evidence of a party's intentions should not be considered.
The following aids to construction were set out:
The clause in dispute should be given its natural and ordinary meaning. Any other relevant provisions of the agreement should be taken into consideration. The overall purpose of the clause in dispute and the agreement should be considered. Facts and circumstances known or assumed by the parties at the time that the document was executed are admissible. Commercial common sense can be applied
The court ruled that commercial common sense could be an aid to construction, though Lord Neuberger made clear that there is a limited degree to which the court may use it in order to depart from the actual language of a contract.
He set out guidelines for the use of commercial common sense:
Commercial common sense and surrounding circumstances should not be invoked to undervalue the importance of the language of the provision which is to be construed. The clearer the natural meaning of the words in the contract the more difficult it is to depart from it. Commercial common sense is not to be invoked retrospectively. The mere fact that the natural meaning of a contract leads to a disastrous result for one party is not a reason for departing from the natural language. The purpose of interpretation is to identify what the parties have agreed not what they should have agreed. A court should be slow to depart from the natural meaning simply because it appears to be an imprudent term for one of the parties, even at the time that they entered into it… there must nevertheless be a basis in the words used and the factual matrix for identifying a rival meaning. When interpreting a contract, only those facts or circumstances which existed at the time that the contract was made and which were known or reasonably available to both parties should be taken into account When an event occurs which, judging from the language used, was plainly not intended or contemplated by the parties, the court will give effect to the intention of the parties, if it is clear what the parties would have intended in that situation.
Lord Neuberger's judgement was followed conscientiously by the court in Lola's Cupcakes case, and the court ruled that there was no ambiguity, so a 'common sense' interpretation could not be applied; if the parties had intended to limit Lola's production of its own cupcakes to the initial two months, then that should have been clearly set out in the agreement.
The decisions in Arnold and now this case emphasise the importance of ensuring that the actual words used in a contract sufficiently cover the issues intended to be dealt with by the agreement. They emphasise the importance of carefully considering the language used, so all parties have the same appreciation of how clauses will function, before agreeing to a provision.
Although there remains some scope for parties to rely on a 'commercial common sense' rather than literal interpretation, the preferred approach seems to be that, since the parties to a contract have complete control over the words used, those words should be interpreted according to their natural meaning - regardless of whether the result of the literal interpretation is a 'bad bargain' for one party.in: Contract, News