Do contracts have to make ‘business sense’?

If the parties cannot resolve the disagreement between them, a court can be asked to interpret the contract. How will the court do this and what will it be looking for?

The court’s approach

A contract term may make perfect sense at the outcome of a new relationship or contractual arrangement. However, it may later be less clear when something unforeseen or out of the ordinary crops up.

The role of the court is to interpret a contract and not to re-write it. Judges will focus on identifying the agreement made between the parties with a view to giving the wording used the purpose and effect that the parties intended it to have. But what about 'business sense'? Should this override the court’s interpretation of the wording in order to give commercial efficacy to the term?

Business sense

In a recent Court of Appeal decision the court was asked to interpret a clause in an agreement between the buyer and seller of an insurance business. Following the sale, an investigation was carried out by the Financial Services Authority (FSA) and it was found that the insurance business had been over-charging customers for insurance policies. The investigation resulted in large redress payments being made to the expense of the buyer who sought to rely on the indemnity in the sale and purchase agreement against the seller.

The seller argued that the indemnity was limited to claims for redress actively pursued by customers, and should not include those that the buyer had been told to pay by the FSA. None of the company’s customers had brought their own complaint and so the seller argued that none of the sums claimed fell within the indemnity.

The court initially favoured the buyer’s interpretation of the contract and relied heavily on the wider commercial context of the agreement, seeking to find a way to allow the buyers to rely on the indemnity and recover its losses from the seller.

The Court of Appeal has overturned that decision, finding that the wording used was clear and rejecting the buyer’s right to invoke the indemnity. The court wholly rejected the buyer’s argument that this interpretation lacked any commercial sense. The Judge, in reaching this decision said “businessmen sometimes make bad or poor bargains for a number of different reasons such as a weak negotiating position, poor negotiating or drafting skills, inadequate advice or inadvertence. If they do so it is not the function of the court to improve their bargain or make it more reasonable by a process of interpretation which amounts to rewriting it.”

Comment

This case clarifies that where the wording used is clear and unambiguous, the court will not step in to remedy a party's bad deal. Commercial parties are treated as having equal bargaining power and it is therefore not the court’s place to interfere. Unless the wording used is so badly drafted that it results in absurdity, the plain and everyday meaning of the words should be the court’s primary tool for interpretation.

Commercial parties should therefore treat this case as a reminder to make sure that contractual terms are drafted clearly to avoid interpretation disputes at a later date. If one party has concerns that the terms are unclear or could be interpreted to their detriment they should raise these before entering into the agreement.