Literal or Contextual? What is the Correct Approach to Contractual Interpretation?

Over the last twenty years or so, the approach of the English courts to contractual interpretation has moved between a strict literal approach and a more purposive approach. From recent decisions, the courts seemed to be trending back towards the literal approach (as in the Supreme Court decision of Arnold v Britton), moving away from the contextual approach (as in the earlier Supreme Court decision of Rainy Sky SA v Kookmin Bank). However, the Supreme court has recently weighed in yet again on the question of the correct approach to contractual interpretation.

In Wood v Capita Insurance Services Ltd, the Supreme Court has sought to smooth over the differences and bring together the seemingly divergent guidance on contractual interpretation in cases such as Arnold v Britton and Rainy Sky, confirming the validity of both literal and contextual approaches.

Wood v Capita concerned the construction of an indemnity clause in a sale and purchase agreement entered into by the parties by which Capita purchased the entire issued share capital of a specialist insurance broking company. Shortly thereafter, an internal review identified issues which led to Capita making a report to the Financial Services Authority (FSA) concerning miss-selling and detriment to customers following which a compensation and remediation scheme was agreed with the FSA. Capita subsequently claimed its costs of the scheme plus interest, in total some £2.42 million, under the indemnity clause.

At first instance, the High Court held that the indemnity required Wood to indemnify Capita even if there had been no claim or complaint by a customer. The Court of Appeal disagreed and held, based on the wording of the clause, that the indemnity was confined to loss arising out of a customer claim or complaint. Capita appealed, maintaining that the indemnity was not confined to such losses. It argued that the Court of Appeal had placed too much emphasis on the submission by Wood’s counsel that in Arnold v Britton the Supreme Court had ‘rowed back’ from the contextual approach to interpretation in Rainy Sky and the Court of Appeal had therefore placed too much emphasis on the wording of the contract and given insufficient weight to the factual matrix.

Giving the leading (unanimous) judgment of the Supreme Court, Lord Hodge stated that it was not appropriate to reformulate the guidance in Rainy Sky and Arnold v Britton, however he took the opportunity to explain why Arnold v Britton was not a recalibration of the approach in Rainy Sky. Instead, Lord Hodge asserted that both authorities were saying the same thing.

In summary, Lord Hodge’s analysis is as follows: the court’s task is to ascertain the objective meaning of the language chosen by the parties to express their agreement. This is not a literalist exercise focussed solely on a syntactic analysis of the wording of the clause in question but instead the court has to look at the contract as a whole and, depending on the nature, formality and quality of the drafting of the contract, apportion weight to elements of the wider context. Interpretation is a unitary exercise – where there are rival interpretations, these should be checked against the contractual provisions and the commercial consequences of each rival interpretation should be investigated. It does not matter whether the court starts with a close analysis of language or with the factual background and implications of the rival constructions, so long as the court balances the indications of each. In doing so, the court should consider the quality of the drafting, be alive to the possibility that one side may have agreed something which (in hindsight) did not serve its interests, and not lose sight of that a provision may be a negotiated compromise or that negotiators were unable to agree more precise terms.

Lord Hodge explained the various considerations as follows:

“The extent to which [textualism or contextualism] will assist the court in its task will vary according to the circumstances of the particular agreement or agreements. Some agreements may be successfully interpreted principally by textual analysis, for example because of their sophistication and complexity and because they have been negotiated and prepared with the assistance of skilled professionals. The correct interpretation of other contracts may be achieved by a greater emphasis on the factual matrix, for example because of their informality, brevity or the absence of skilled professional assistance. But negotiators of complex formal contracts may often not achieve a logical and coherent text because of, for example, the conflicting aims of the parties, failures of communication, differing drafting practices, or deadlines which require the parties to compromise in order to reach agreement. There may often therefore be provisions in a detailed professionally drawn contract which lack clarity and the lawyer or judge in interpreting such provisions may be particularly helped by considering the factual matrix and the purpose of similar provisions in contracts of the same type. ...”

Lord Hodge then demonstrated, on the facts of the case, the application of both approaches and the exercise of balancing the indications of each. Ultimately, the Supreme Court agreed with the Court of Appeal that the circumstances which trigger the indemnity are to be found principally in a careful examination of the language used by the parties and dismissed Capita’s appeal.

Although not advancing new law, Wood v Capita is an important decision as it seeks to reconcile the prior authorities on contractual interpretation. The Supreme Court’s endorsement of both literal and contextual approaches affords English courts with considerable flexibility in determining questions of interpretation. Though it remains to be seen whether in practice this decision will influence the recent trend of a preference by the courts for a more literal approach. Arguably, it may result in less certainty or predictability for parties, particularly in cases where (as in Wood v Capita) the different approaches might result in different conclusions. However, the Supreme Court has made it clear that it views the guidance on contractual interpretation as settled and it sees no need, at least for the time being, to offer any further reformulation.

Cara Dowling is Senior Knowledge Lawyer at Norton Rose Fulbright.

Aimee Denholm is Knowledge Assistant at Norton Rose Fulbright.