Are we all singing from the same song sheet? Interpreting contracts in Europe

On 11 July 2001, the European Commission published its Communication on European Contract Law. The purpose of the Communication is to seek views on whether further action is required at EC level to harmonise contract law between member states.

One of the options under review is the adoption of new comprehensive legislation at EC level. If the Commission chooses that option, there is already in existence a draft code published by the Commission on European Contract Law which could be adapted to form the basis for that legislation. It is called the "Principles of European Contract Law" and contains principles which are intended to be applied as general rules of contract law in the European Union.

These Principles currently contain the following provisions:

• "The parties' prior statements may be used to interpret the contract" (Article 2:105(3)).
• "A contract is to be interpreted according to the common intention of the parties even if this differs from the literal meaning of the words" (Article 5:101(1))

These statements would be anathema to English lawyers practising in the early part of the last century. Then, as a general principle, extrinsic evidence of the parties' intentions would not be permitted as evidence to assist in the interpretation of a contract. The contract would be construed objectively, using the natural meaning of the actual words used, even if that achieved a result which could not possibly have been intended by the parties at the time of making the contract. This can be seen from the comments of Lord Wright in the House of Lords' decision in the 1935 case Inland Revenue v Raphael: "... the court, while it seeks to effect to the intention of the parties, must give effect to that intention as expressed, that is, it must ascertain the meaning of the words actually used ... The principle of the common law has been to adopt an objective standard of construction and to exclude general evidence of actual intention of the parties ...".

However, the principles of contractual interpretation have developed since Lord Wright made his comments. Do the Principles prepared by the Commission on European Contract Law seem as alien to English lawyers practising today?

The factual matrix

Since cases such as Prenn v Simmonds in 1971, the Courts have been prepared to look at what is referred to as the "factual matrix" to the contract (i.e. the factual background in which the contract is set) to assist in the interpretation of the contract. It has been said that, when the Court interprets commercial contracts, it should understand the commercial purpose of the contract. This pre-supposes that the Court will know of the origins of the transaction and the background and context of it and of the market in which the parties are operating (see, for example the comments of Lord Wilberforce in Reardon Smith Line v Hansen-Tangen in 1976).

The development of the law in permitting the examination of the factual matrix when interpreting contracts was remarked on by Lord Hoffman in his judgment in Investors Compensation Scheme v West Bromwich Building Society in 1998. In that case, he set out some general principles to be adopted when interpreting contracts:

• "Interpretation" is the ascertainment of the meaning which the contract 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; This background is the factual matrix, and (subject to the exclusion in the bullet point below) would include absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man;
• The factual matrix does not include the previous negotiations of the parties and declarations of subjective intent. These are not admissible (unless being presented in claims for rectification);
• The meaning which a document would convey to a reasonable man is not the same thing as the meaning of its words. The factual matrix does not merely enable the reasonable man to choose between the possible meanings of words which are ambiguous, but it may also lead the reasonable man to conclude that the parties must (for whatever reason) have used the wrong words or syntax;
• The rule that words should be given their natural and ordinary meaning reflects the common sense proposition that the Courts do not easily accept that people have made linguistic mistakes, particularly in formal documents. Nevertheless, if one would conclude from the factual matrix that something must have gone wrong with the language, the law does not require the Courts to attribute to the parties an intention which they plainly could not have had.

These principles were subsequently clarified by Lord Hoffman in his judgment in BCCI v Ali earlier this year. This clarification could perhaps be seen as a limitation on the wide-ranging principles set out above. He explained that admissible evidence of the factual matrix of the contract would include anything relevant which would have affected the way in which the language of the document would have been understood by a reasonable man. He emphasised, however, that the primary source for understanding what the parties meant is the language used in their contract, interpreted in accordance with conventional usage.

Even where the Courts do have regard to the factual matrix, however, they will not have regard to the subjective intention of one or other of the parties. Evidence of negotiations leading up to the execution of a contract is still inadmissible as a guide to what the parties intended. The comments by Judge MacDuff QC in Sykes v Pannell Kerr Forster earlier this year, to the effect that such evidence is admissible (or that, if it is not, it should be) are, it is submitted, going too far.

Whilst the Courts will occasionally give a contract a meaning other than that which would be achieved through adopting the literal meaning of the words used, they will not look at the parties' subjective intentions when interpreting their contracts. The Principles set out above do not, therefore, represent the law of contractual interpretation as it currently stands in England and Wales. It is submitted that the law is unlikely to develop to reflect those Principles - at least in the foreseeable future - without legislative intervention.

For further information please contact Victoria Peckett at victoria.peckett@cms-cmck.com or on +44 (0)20 7367 2544.