How to read Business Contracts and Agreements (in 4 stages)

What is Contract Interpretation?

The overall aim of interpreting contracts is to determine what the parties meant by it when it was signed.

Being able to read a contract means you're in a better position, before you sign the contract, to:

1. decide whether the contract will do what you want it to do
2. find the holes in your contract
3. work out where you stand in a contract dispute
4. identify the legal intention of the parties in the contract as a whole, and not individual words
5. figure out why someone else reads it a different way
6. promote certainty of outcome at the review stage.

As you will see below, business people are probably the best people to interpret their own contracts. And make more informed decisions during contract reviews before signing as a result.

You can see where the problems might lie and focus your efforts when negotiating it.

It's not a process of applying technical legal rules.

It's a larger, less technical process which takes into account how a "reasonable person" would read it.

That involves finding out what a reasonable person would have understood the parties to the contract to have meant to agree to (Get it wrong and it means you're in the territory of breach of contract).

I'll come back to that in a moment.

How to read contracts and agreements

When you break it down, contractual interpretation is made up of several stages.

The steps are:

1. Find out the background: Establish the background facts – the “matrix of fact” which existed the moment before the contract was signed. This sets the context for interpreting the contract.
2. Ascertain the overall meaning: This is the commercial purpose of the contract.
   It is the overall meaning of the contract to the parties having access to those background facts.

3. Interpret the words used in the contract: Read the words used in the contract in the way that the contracting parties objectively understood them to mean. This is done without reference to the negotiations leading into the contract or either party’s subjective intentions.
   Unless ambiguity (in the legal sense) arises, the contract means what it says.

4. Resolve the ambiguities: where there is ambiguity in meaning, business common sense prevails to resolve it.
   The exact selection of words in a contract takes a back seat to business common sense – with the commercial purpose of the contract in the forefront of your mind.

 

What’s all that mean?

Once you have the background to the contract and its commercial purpose, you’re in a position to work out what the contract means. How a court is likely to read it.

And it’s not that hard to get a good idea within a narrow range of interpretations.

The method is said to be a flexible approach. Courts apply a practical and repeatable process to interpretation.

It has less emphasis on strict rules of interpretation or historically important “canons of construction”.

You’ll like this:

“The overriding objective of interpretation of a contract is to give effect to what a reasonable person rather than a pedantic lawyer would have understood the parties to mean”.

That was said a case named Jumbo King Ltd v Faithful Properties Ltd HKCFA (1999), by Lord Hoffman. He’s the doyen of contractual interpretation. He may be retired. But the central principals of  reading contracts are based on what he has said in legal cases.

 

Who’s this Reasonable Person?

A hypothetical person interprets contracts. The person doesn’t actually exist. It’s a person that courts make up. The person is considered to be "reasonable".

Well, what does that mean?

The reasonable person is one that has:

1. business common sense
2. the same knowledge as the parties to the contract
3. access to all the terms of the contract which were agreed
4. the experience and expertise of the contracting parties.

These qualities are taken as at the point in time that the agreement was made. Not at some point after the contract was signed. You might want to read that again and let it sink in.

This reasonable person gives the words used in the contract their plain, ordinary and popular use.

And that’s how the “reasonable person” reads contracts.

More on that below.

But first, the matrix of fact.

 

1. The Matrix of Fact: Background to the contract

Contracts and the words in them aren’t interpreted in a vacuum.

By using the background to the contract, courts get themselves into the same position of knowledge that the parties were in at the time they made the agreement: the background to the contract.

This "matrix of fact" is the surrounding circumstances leading into the signing of the contract. It includes “absolutely anything” which would affect the way in which the language of the document would be understood by a reasonable person.

That "absolutely anything" has two exceptions. The matrix of fact does not include:

1. the negotiations of the parties, whether spoken or in writing, and
2. what the contracting parties personally intended by the contract, ie their subjective intentions.

Pre-contractual negotiations are only considered in cases for rectification of contracts. All things considered, rectification cases are rare. And hard to win, most of the time.

 

What can be taken into account?

Let's categorise the types of information that can form part of the matrix of fact.

The background to the contract can include and excludes:

• Assumed knowledge: Knowledge a reasonable observer would have expected, believed and assumed both contracting parties to have had:
  • specialist or unusual knowledge, for the type of contract entered into
  • inferred knowledge: information and knowledge that they must have had from their actions
  • knowledge that they had or must have had.
    It does not include what the parties might have both known. It is not what reasonable enquiries or investigations might have revealed to a contracting party.

Assumed knowledge does not extend to knowledge which a reasonable observer might think that they have. It must be close to certain that the knowledge was known by both of the contracting parties.

• Knowledge not shared: Information which only one of the parties knew cannot be information both of them knew.

So for background facts to be relevant, they must have been known by both of the contracting parties. So facts known only to one of the contracting parties can’t assist when interpreting a contract.

• Commonly known legal principles: These are those principles which affect the legal relationship governed by the contract.

For instance, contracting parties know that products or services need to be paid for, unless it is clear that they do not.

 

Examples of the Matrix of Fact

So the background can include a lot of information. for any given case.

What kind of information can this mean. So much can be relevant.

A few examples:

• general commercial knowledge that a party to the type of contract is expected to have
• common assumptions, even where they are mistaken
• background of the persons and subject matter (say provision of IT services) dealt with by the contract
• knowing how the parties came together to first place
• the context of the transaction brought about by the contract:
  • the events that were affecting the parties at the time
  • the commercial incentive for the transaction
  • the practical purpose of the contract
• the markets within which the parties were operating and commercial practices within that market
• hardships to be alleviated by the contract
• the situation that was expected to take effect after the contract was signed
• social practices within which the contract will operate
• other contracts that were agreed at the same time
• the quality of materials to be used, whether good or bad
• whether goods to be supplied were perishable

So this background or “matrix of fact” is the backstory that both of the parties knew and shared, their skill sets, their industry, and their general commercial knowledge.

This background sets the context within which the contractual words were used.

All of this aids the legal interpretation of the contract.

It reveals the objective of the parties and the aim of the transaction - the commercial purpose of the contract.

 

Negotiations & Subjective Intentions

Here are the big exclusions to what can fall within the matrix of fact.

It usually comes as a big surprise to the uninitiated.

Courts are not able to take into account what the parties said or did while negotiating the contract. It’s not available for working out what the contract means.

Also, what was personally intended by each of the parties can’t be taken into account. It’s not admissible evidence for that purpose.

One judge said:

[…] evidence of negotiations, or of the parties’ intentions, […] ought not be received, and evidence should be restricted to evidence of the factual background known to the parties at or before the date of the contract, including evidence of the ‘genesis’ and objectively the 'aim' of the transaction

More directly, another judge said this

court[s] [are] not privy to the negotiation of the agreement – evidence of such negotiations is inadmissible – and has no way of knowing whether a clause which appears to have an onerous effect was a quid pro quo for some other concession. Or one of the parties may simply have made a bad bargain.

If the subjective intentions of a party are relevant, it is not an interpretation problem. It is a problem only the remedy of rectification can cure.

Courts are not engaged in a task of deciding what the parties intended to do. It is an exercise in deciding what the language used in the contract showed what they agreed. The words used in the contract is what is relevant, not the subjective intentions of the parties behind the words.

By extension, this means that negotiating drafts, aids for interpretation, and conversations can’t be taken into account. Material such as this can be put before the court for the purposes of showing the background. The court just can’t take it into account when deciding the (objective) intentions of the parties.

There you have it.

That’s the first of the four stages of contractual interpretation. The next is to work out what the commercial purpose of the contract is.

That’s usually pretty straightforward.

 

Stage 2: Overall Meaning of the Contract

Business documents and contracts are presumed to have commercial aims and results.

Contracts are interpreted against the backdrop of the commercial purpose of the particular transaction.

Usually, it isn’t a complicated task. To take some straightforward examples, the commercial purpose might be to:

1. “supply software as a service for analytics on a real-time basis”
2. “ship PCs by road from Manchester to London”
3. “loan money on a short-term basis”
4. “establish the employment relationship with a person, with post-contractual restrictions”
5. “lease the premises for a fixed term”

The commercial purpose sets the backdrop to assess rival interpretations of a contract within their commercial setting, and to investigate the commercial consequences of the interpretation.

The parties’ aims are identified. It sets the direction for resolving ambiguity.

That then, with the matrix of fact, sets the context for interpreting the words in the contract.

That’s next.

 

Stage 3: Interpreting the Words: Ordinary Meaning

Meaning of Words in Contracts

In ICS Ltd v West Bromwich Building Society, it was said that the meaning of a contract is not the same as the meaning of the words used in it.

The meaning of a contract:

is what the parties using those words against the relevant background would reasonably have been understood to mean [in the particular contract]

This meaning of the contract was contrasted with the meaning of words in dictionaries and grammar books.

On one hand you have the meaning of words in dictionaries – and on the other – the meaning of the words used by parties in the contract itself.

So it is the "natural and ordinary meaning" of the words you are looking for.  Not their dictionary meaning. The approach is not without its critics, but that's the law.

 

The “Natural and Ordinary Meaning”

The natural and ordinary meaning of words is the meaning words are generally understood to mean. It isn’t necessarily the dictionary meaning. It’s the popular sense.

The ordinary meaning of words in contracts relies upon the context in which it is used. That is, against the matrix of fact.

For instance, in the context of software as a service contract, a reference to a "computer" might be taken as a reference to a high-performance server.

Types of Words

You have different categories of words used in a contract.

Here’s a rundown of the main types:

1. private dictionaries: words with common adopted usage in a trade or industry.
   It includes words which have a special meaning in a particular market (provided that the background supports it). It may be that words have a custom meaning adopted by the parties. This is known as a "private dictionary".
   That usage or custom of a particular place or industry can displace would otherwise be the ordinary and natural meaning of the words. For instance, a contract to deliver a bakers’ dozen of pies would be 13 pies rather than 12.

2. technical words: technical words take their technical meaning. Words used in science, art, or translate a foreign language take their technical meanings.
3. parties adopt a special meaning of the words: The special meaning of words as used by the parties displace the otherwise ordinary and natural meaning.
   These are usually set out in a definitions section in the agreement, so when you read the agreement, they're central to interpreting it.
4. historical documents: Words in old contracts bear the meaning that they had at the time, rather than the modern meaning.
5. judicially decided words: The meaning of words which have been judicially decided usually take that meaning. If the contract uses legal terminology the parties are accepted to know what they mean. Examples include “termination”, “damages”, “indemnity”.

To decide the meaning of words, you can have regard to:

• words used in the contract;
• the provisions of the contract, considered as a whole;
• the surrounding circumstances in so far as they were known to both parties as they existed at the time of the contract; and
• commercial common sense,

read by that hypothetical person. 

 

4. Resolving Ambiguities in Business Contracts

When does ambiguity arise?

Courts don’t easily accept that contracting parties make mistakes in the words that they use in important documents, such as contracts.

Consequently, courts will intervene and start re-interpreting the natural and ordinary meaning of words easily or lightly.

It requires a strong case.

If the ordinary meaning of the words makes sense in relation to the rest of the document and the factual background, then courts give effect to that language; even though the consequences may appear hard for one side or the other.

The party raising the point of interpretation will need to show something has gone wrong with the language by showing:

1. a clear mistake in the contract. The words used produce a result which is so commercially nonsensical that the parties could not have intended it. However, the mistake doesn’t need to appear in the contract itself.
   This is because a reasonable person must be taken to have knowledge of the surrounding circumstances or factual matrix. It is what a reasonable person would understand the parties to mean by the words of the contract to be construed.
2. the required correction is clear: What is needed to fix the mistake is clear, and be identified with confidence. “It must be clear what a reasonable person would have understood the parties to have meant”.

With those conditions satisfied, a correction may be made to the contract “as a matter of construction”. Then:

• the correction to the wording is applied to properly express the parties’ contractual intentions.
• once corrected, the contract is interpreted in its corrected form
• The court implies the minimum words necessary for the clause to make grammatical sense.

 

Examples of Ambiguity: Overview

Here are a few markers to know about to spot ambiguity:

• Degree of analysis: A court will not carry out a detailed analysis of the connotations of the words used or related words used in a contract (ie “a detailed syntax or semantic analysis”).
  Courts should read business contracts “fairly and broadly, without being too astute or subtle in finding defects”. This approach is not limited to contracts drawn up by businessmen for themselves without legal assistance. The approach applies to all contracts.

• Unfavourable/favourable results: The fact that the ordinary and natural meaning of the words produces "a bad bargain" for one of the parties or an "unduly favourable" result for another, is not enough to justify the conclusion that something has gone wrong or the wrong language has been used
• First impressions: The words of a contract may have a meaning which is (1) not that which they may appear to have if read out of context, or (2) may appear to have had on a first reading
• Commercial results: Courts tend to lean towards to the more commercial interpretation where there are two competing interpretations. Put another way: where one interpretation has a more commercial result, it prevails over the less commercial outcome. Common sense applies.
• Apparent nonsense wording: There will be cases where the words in question are attributed a meaning which they usually would not be attributed with the usual use of the language. This is because that hypothetical reasonable person would be satisfied that something had gone wrong with the wording, due to the matrix of fact.

 

Ambiguity arises when the ordinary, natural and common sense meaning is:

1. Not consistent with common usages in a trade: the trade as a whole has adopted a different meaning of the words used
2. Out of context: the context of use points to a different meaning, such as:
   1. inconsistency: the words used create an absurdity or conflict;
   2. obvious mistake in language: the wrong words have been used. “It is [the matrix of fact] which enables us, not only to choose the intended meaning when a word has more than one dictionary meaning but also … to understand [the contract’s meaning], often without ambiguity, when he has used the wrong words.”
   3. clear clerical error
   4. words have been omitted: The clause does not make grammatical sense as it stands, and it is obvious that words have been omitted
3. Bears ambiguous references: a reference to a person or thing in the contract could be a reference to more than one person or thing
4. Unusual or uncharacteristic context: The words used are somehow out of place in the context of the document.

 

How does a court resolve ambiguity?

The words used in the contract are the important ones.

It needs to be shown that the plain and obvious meaning of the words was not intended. The further the departure from the usual meaning, the more compelling the evidence needs to be to achieve the outcome.

• Courts will not re-write contracts. It is what a reasonable person would have meant, with the matrix of fact in mind
• Courts will not attribute to the parties an intention which a reasonable person would not have understood them to have had
• Corrections are simply aspects of the single task of interpreting the agreement in its context, in order to get as close as possible to the meaning which the parties intended.

 

Here is an indication of the breadth of the power of the court to make corrections:

• “[…] there is not, so to speak, a limit to the amount of red ink or verbal rearrangement or correction which the court is allowed”
• The evidence to clarify an ambiguity is “within the range of meaning which the words are capable of bearing in their ordinary and natural sense having read to the aim and purpose of the transaction”.
• “[...] the task is to discover what the parties meant from what they have said, and that to force upon the words a meaning which they cannot fairly bear is to substitute for the bargain actually made one which the court believes could better have been made. This is an illegitimate role for the court”.

 

Getting to the right interpretation

Where the words are capable of more than one interpretation, the interpretation which is most likely to give effect to the commercial purpose of the agreement is the appropriate interpretation.

How do you decide?

The leading statement is probably this:

[…] the resolution of an issue of interpretation in a case like the present is an iterative process, involving checking each of the rival meanings against other provisions of the document and investigating its commercial consequences: In Re Sigma Finance Corporation (2009).

When you have competing meanings, you’re looking for:

• consistency:
  1. does the meaning slot in with the overall intention of the contract? Look for the commercial purpose of the contract.
  2. Is it inconsistent with the other clauses in the contract?
• its commercial consequences: does the meaning have commercial commonsense within the context of the surrounding circumstances?

 

Reading a Contract like a Lawyer

Here’s what you should be thinking about in terms of priorities:

• Give all provisions of a contract legal effect, if possible.
• A reasonable interpretation, please:
  The more unusual and far-fetched an asserted interpretation is, the better the evidence is required to support it.
  The further divorced the asserted interpretation from the norm, the less likely it is to reflect the parties’ intentions.
  Again, the words must bear the meaning that which they would convey to a reasonable person having all the background knowledge of the parties in the situation they were in at the time of the contract. We keep repeating this because it is such a central concept to contract interpretation
• When you have conflicts between clauses or provisions:
  1. Sometimes different terms of a contract cannot be reconciled and harmonised with the rest of the contract. They contradict one another, and effect cannot be given to both clauses.
  2. The term which does not carry the intention of the parties into effect is rejected and not given any legal effect. Analogous to striking the out of the contract. The clause or provision which carries the intention of the parties in effect is preserved.
• Assume the parties intended to act lawfully. If one interpretation would mean the contract was unlawful, it is rejected
• The clause which reflects the intention of the parties is probably the one that does not make it void, ineffective or meaningless, frustrate the commercial purpose of the contract or produces a commercial absurdity
• Missing words: When it is clear that words have been omitted, and what those words are, then the court is likely to read the contract with those words. It is not necessary that the precise words are known. It is sufficient that a court knows their gist
• The unexpected: Most contracts don’t and can’t cater for all contingencies. When those contingencies materialise, there’s nothing in the contract to say what should happen, or where the loss should lie

The answer lies in the background to the case - what the parties had in mind when they entered into the contract.

When it is clear what the parties intended from the background, that intention is applied. A court is not about to adopt an approach which would defeat the parties' clear objectives. Check out Arnold v Britton (2015).

All the while, you should test the consequences of the interpretations for their commercial purpose and common sense to ascertain the meaning of the disputed clauses.

 

Reading Business Contracts made by Businessmen and Businesswomen

Sometimes important contracts are written in a rough and ready way. The terms used are not familiar to those not involved in the industry.

Contracts such as these should be interpreted “fairly and broadly, without being too astute or subtle in finding defects”. This approach is not limited to contracts drawn up by businessmen for themselves without legal assistance.

In one case it was said:

the poorer the quality of the drafting, the less willing the court should be to be driven by semantic niceties to attribute to the parties an improbable and unbusiness-like intention, if the language used, whatever it may lack in precision, is reasonably capable of an interpretation which attributes to the parties an intention to make provision for contingencies inherent in the work contracted for on a sensible and businesslike basis.

Even professionally drafted contracts can contain conflicts which are not able to be resolved solely by reference to the text of the document.

Confusion arises for any number of reasons, including:

• The parties may have been under time pressure to get the contract signed and cut corners
• Different drafting styles came into play and conflict with one another
• Compromises in negotiations affected the overall meaning of what was to be achieved. 

A court will have a minimum of reluctance resorting to the background of the contract to resolve it.

Commercial common sense plays a significant part to ascertain what the parties actually meant.

Court aims to reach a balanced, fair and reasonable result from the materials able to be drawn upon. But it is not able to rewrite the language used by the parties where it is clear and unambiguous.

 

Wrapping Up: Main Points

Courts interpret contracts by reference to what a reasonable person having all the background knowledge which would have been available to the parties would have understood them to be using the language in the contract to mean. It does so by focusing on the meaning of the relevant words in their documentary, factual and commercial context.

This interpretation takes place with the help of:

• the natural and ordinary meaning of the clause
• any other relevant provisions of the contract
• the overall purpose of the clause and the contract
• the facts and circumstances known or assumed by the parties at the time that the document was executed, and
• commercial common sense, but
• disregarding subjective evidence of any party's intentions.

 

Negotiations

A few suggestions for negotiating your own contracts, to have a better idea of how it would be interpreted:

• Set the context for the contract: exchange information to the intended contracting party to show what you both know.
• The emphasis is on commercial common-sense in interpretation of contracts
• If you use technical legal words in contracts, make sure you know what they mean
• Emphasis is on the clear intention of the parties in the contract as a whole, and not individual words. Single words or phrases rarely detract from the overall intention of the contract
• Clarity trumps legal speak:
  1. ambiguity works against you. Short sentences and writing in active voice reduces ambiguity
  2. If it might not make sense, add the context into the contract
• Use the recitals section to set out the objective intended objective outcome

 

Contract Legal Advice: Specialist Commercial Contract Lawyers

We're specialist business contract lawyers, and advise on preparing and reviewing commercial contracts.