11 May 2007

From text to context in interpreting contracts - what does it mean for your contracts?

by Gina Elliott, Zoe Millington-Jones

The shift from text to context may result in an increase in the cost of litigation, and add further risks to contractual dealings. Entire agreement clauses may be a practical method of avoiding the costs and risks inherent in the new contextual approach to contractual interpretation.

In a recent keynote speech given at Clayton Utz' annual Risky Business conference, the Chief Justice of New South Wales, the Hon JJ Spigelman AC, outlined the trend "from text to context" in contractual interpretation.

According to the new "contextual" approach, the courts may have greater regard to the surrounding circumstances of a contract when interpreting the meaning of its words.

The shift from text to context may lead to an increase in the cost of litigation, and add further risks to contractual dealings. It may also cause difficulties for third parties who rely upon the words of a contract, to which they are not a party.

Entire agreement clauses may be a practical method of avoiding the costs and risks inherent in the new contextual approach to contractual interpretation.

Codelfa - Focus on text

For many years, the orthodox rule for contractual interpretation has been that evidence of surrounding circumstances is inadmissible to assist in the interpretation of a contract, unless the words of the contract were "ambiguous or susceptible of more than one meaning": Codelfa Construction Pty Ltd v State Rail Authority of New South Wales (1982) 149 CLR 337.

The Chief Justice pointed out that the word "ambiguity" itself has more than one meaning. The usual meaning of "ambiguity" refers to a word or phrase with two different meanings by reason of a verbal or grammatical ambiguity. The word "ambiguity", however, can also be used to describe a situation where, for example, the scope or application of a particular clause in a contract is doubtful. His Honour's view is that this is what Justice Mason had in mind when, in Codelfa, he stated "If the language is ambiguous or susceptible of more than one meaning".[1]

Shift to context

Recent decisions of the English courts, which have been followed in part by the High Court of Australia, mean that the Codelfa "rule" can no longer be regarded as certain.

As the Chief Justice put it, "Codelfa has been superseded, without being overruled".

The judgment that underpins the contextualist movement is found in the speech of Lord Hoffmann in Investors Compensation Scheme Limited v West Bromwich Building Society [1998] 1 WLR 896. His Lordship set out a five-point scheme for contractual interpretation. For present purposes, it is sufficient to quote the first two points:

"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. … Subject to the requirement that it should have been reasonably available to the parties and to the exception [that evidence of pre-contractual negotiations is inadmissible], [the admissible 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". [emphasis added]

The breadth of matters to which His Lordship considered a court may have regard in contractual interpretation is emphasised by the words "absolutely everything".

The High Court first considered Lord Hoffmann's formulation in Royal Botanic Gardens & Domain Trust v South Sydney Council (2002) 76 ALJR 436 where it stated that if any difference existed between Codelfa and Lord Hoffmann's formulation, lower courts should follow Codelfa. However, in subsequent decisions, the High Court has explicitly adopted the first point of Lord Hoffmann's approach.

In Toll (FGCR) Pty Limited v Alphapharm Pty Limited (2004) 219 CLR 165, the High Court said:

"[40] … The meaning of the terms of a contractual document is to be determined by what a reasonable person would have understood them to mean. That, normally, requires consideration not only of the text, but also of the surrounding circumstances known to the parties, and the purpose and object of the transaction".

The Court made a similar pronouncement in Pacific Carriers Limited v BNP Paribas (2004) 218 CLR 451 at 461-462.

Chief Justice Spigelman said of this development that "contrary to the suggestion in Codelfa, if it be such, there is no need to find an 'ambiguity' before looking at 'surrounding circumstances known to the parties'".

If the Chief Justice's view that Codelfa has been superseded is correct, what does this mean?

Increased costs, increased risk

If the surrounding circumstances known to the parties may properly be considered for the purpose of contractual interpretation, even where clear words are used, contractual certainty diminishes, and the costs and risks associated with contracts correspondingly increase.

Moreover, according to point two of Lord Hoffmann's scheme, the courts may have regard to "absolutely anything". The breadth of this formulation greatly increases the amount of evidence that can be called in commercial litigation. More evidence means more complexity, more time, and more costs. As one former English judge put it:

"It is hard to imagine a ruling more calculated to perpetuate the vast cost of commercial litigation".[2]

Lord Hoffmann subsequently qualified his "absolutely anything" remark as being limited to anything which a reasonable man would have regarded as relevant:BCCI v Ali [2002] 1 AC 251. Nevertheless, this formulation continues to allow a wide scope for evidence of surrounding circumstances of even the clearest contractual expression.

Impact for third parties

The Chief Justice noted that Lord Hoffmann's emphasis on all the facts that the parties would have known ignores the fact that many third parties rely upon the clear words of contracts. More often than not, large commercial transactions involve a series of interconnected contractual arrangements in which third parties, such as financiers, rely upon the clear wording of contracts to which they are not party. Third parties will be unwilling to rely upon the words of a contract if those words can be ignored because of surrounding circumstances of which only the parties are aware. Similar concerns arise for a person who has been assigned a contractual right.

The way forward

The High Court has not yet addressed the scope of the admissible circumstances for the purpose of contractual interpretation and there remains a question as to where Australian courts will draw the line.

The Chief Justice considered that there remains an opportunity for Australian courts to restrict the scope of admissible surrounding circumstances for the task of contractual interpretation more narrowly than in England.

His Honour spoke with approval of Lord Justice Saville's judgment in National Bank of Sharjah v Dellborg (unreported, 1 July 1997), which expressed dissatisfaction with Lord Hoffmann's approach.

A practical solution - Contracting out of contextualism

The move to contextualism means that now, more than ever, parties should consider whether to include entire agreement clauses in their contractual documents.

Entire agreement clauses may allow parties to contract out of contextualism, and of the corresponding costs and risks associated with the new trend in contractual interpretation.

An entire agreement clause, which states that the words of the contract, and nothing else, comprise the entire agreement between the parties, has been effective in preventing courts from having regard to the circumstances surrounding a contract: Inntrepreneur Pub Company v East Crown Limited (Ch D) [2000] 3 EGLR 31. The relationship between entire agreement clauses and the developing contextualism has not been fully addressed by the courts, however, and there may be circumstances where courts will have regard to surrounding circumstances in spite of such a clause.


[1] His Honour has expressed this view in South Sydney Council v Royal Botanic Gardens [1999] NSWCA 478 at [34].


[2] Sir Christopher Staughton, "How do Courts Interpret Commercial Contracts?" (1999) 58 Cambridge Law Journal 303.

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