Interpreting a Contract

Contracts may seem clear cut but there can still be room for misunderstandings that cause confusion between parties.

25 August 2023


Disputes that arise out of commercial contracts will often involve a disagreement on the meaning of a contractual term or the extent of a contractual obligation. The courts are tasked with determining the meaning of that contract or term, which involves balancing a number of competing principles.

The courts do not assign a strictly literal meaning to every contract, particularly where this would produce an unreasonable result. Instead, they will consider the contract as a whole in its factual, legal, and commercial context, while remaining cautious that they do not stray too far from the text of the contract itself.


The Approach

The courts should take an objective approach to contract interpretation. The starting point is the natural meaning of the words in the document. In recent years, the senior courts have warned that the importance of the language of a provision should not be undervalued. Where the wording of a contractual term is unambiguous the court must take this literally and apply the natural meaning.

However, in commercial contracts, wording is very rarely unambiguous, and the natural meaning is not always clear. In these cases, the courts should consider the contractual document as a whole and not focus excessively on a particular word or phrase. This often means that a particular clause or term could be construed in more than one way.

In such an instance, the courts in both Scotland and England will take a more liberal approach to contract interpretation. This involves ascertaining the meaning of the words, taking into consideration the context and what they would mean to a reasonable person with the relevant background and knowledge, that was available to the parties at the time the contract was formed.

The courts must consider:

  • The meaning of the words;
  • The factual, legal, and commercial background to the contract;
  • The commercial purpose of the contract; and
  • Business common sense.

However, the courts shouldn’t place too much weight on any one of these factors at the expense of another.


Context and Background

In order to establish how a reasonable person would interpret a contract, it is necessary to consider the origin, background, and context of the transaction, as well as the market conditions at the time of the transaction. For example, in the case of Smith v Wilson (1832) 110 ER 266, a dispute emerged over the meaning of the number ‘10,000’.

On the face of the contract, the number 10,000 appeared to be unambiguous. However, in the part of the country in which the contract was concluded it was accepted that the term thousand, as applied to rabbits, actually meant 100 dozen. Accordingly, the court took this into account and applied the contextual meaning to the term.

The courts have followed a similar approach to interpretation in more recent years. In a case concerning the meaning of a deed of assignment, Lord Hoffman held that:

‘The meaning of words is a matter of dictionaries and grammars; the meaning of the document [i.e. the contract] is what the parties using those words against the relevant background would reasonably have been understood to mean.’

He went on to explain:

‘[If one would conclude] from the background that something must have gone wrong with the language, the law does not require judges to attribute to the parties an intention which they plainly could not have had.'

While the courts are encouraged to adopt a contextual approach where appropriate, there are limits on the background factors that may be considered. It should be noted that background information must be that which the parties could reasonably be expected to know and does not cover extrinsic facts.

The courts are generally precluded from considering:

  • Direct evidence of the subjective intention of a party to the contract;
  • Evidence of pre-contract negotiations, such as term sheets; and
  • Any circumstances that have occurred since the contract was formed.


Commercial Common Sense

Where there is more than one meaning that can be attributed to a contractual term, the court may prefer the meaning that is most consistent with the commercial purpose of the contract and business common sense.

This approach was adopted by the Inner House of the Court of Session in British Overseas Bank Nominees Ltd v Stewart Milne Group Ltd Ltd [2019] CSIH 47.

In this case, a contractor was employed by a developer to design and build a retail development and car park. As part of the deal, the contractor granted a collateral warranty in favour of any person who might acquire an interest in the development, subject to the development being designed and built with reasonable skill, care, and attention.

In May 2013, it became apparent that the car park was susceptible to flooding. In June of the same year, the developer sold the development to the purchaser, who was the pursuer in this case. In 2018, the purchaser went on to raise an action against the contractor for breach of their collateral warranty. The court had to determine whether the claim had prescribed, or expired, and more specifically when the prescriptive period began. This would depend on the meaning of the collateral warranty.

To determine this meaning, the courts considered the underlying commercial purpose of the warranty. In this case, it was to provide the purchaser with rights against the contractor that were equivalent to those of the developer, no more and no less. Consequently, the prescriptive period began in May 2013 and the purchaser’s claim was time-barred.

The courts are willing to give weight to the most commercially sensible interpretation of a contract where there are rival meanings. Similarly, if an interpretation lacks commercial common sense, the courts will be less likely to adopt it.


Balancing the principles

The principles that the courts ought to consider when interpreting a contract are relatively well understood. However, the courts have not yet settled on a single, unified method of weighing up these factors. This will ultimately depend on the facts and circumstances of each individual case.

In Ashtead Plant Hire Co Ltd v Granton Central Developments Ltd 2020 S.C. 244, the Inner House of the Court of Session observed that ‘commercial common sense was an important aid to the construction of contracts and commercial dealings of every sort.’ Meanwhile, in ScottishPower Energy Retail Limited v Equorium Property Company Limited [2021] CSOH 98, the court noted that they were required to ‘interpret the language used rather than what it is argued could have been used’ and subsequently placed a greater emphasis on the literal interpretation of the words in the contract.

Clearly, balancing the principles of interpretation is not an exact science. It is important for parties to a contract to minimise the risk of confusion and ambiguity where they can.


Minimising Confusion

The courts have expressed that they will not rewrite a contract to avoid a bad bargain, therefore it is important that contractual terms are drafted carefully. Parties should strive to make the intended meaning of a contract objectively clear to the reader.

This can be achieved by:

  • Avoiding the use of ambiguous phrases and terms;
  • Defining key terms at the outset of the contract;
  • Carefully considering the wording of each clause in a contract and ensuring that there are no inconsistencies across the document; and
  • Keeping the contract as specific and concise as possible.


If you would like to find out more about commercial contracts and the common issues our clients face, visit our Commercial Contracts video and article series.