Rules for Interpretation of Contracts

Contractual Interpretation becomes relevant at three stages of the contract, namely-

  1. At the stage of formation;
  2. At the stage of performance, and
  3. At the stage of dispute settlement

Difference between Contractual Interpretation and Statutory Interpretation

  1. A contract operates inter se the parties and thus being private law it only affects the rights and obligations of the parties to it. On the other hand, a statute operates in rem, i.e. not against a particular person but public in general. Therefore, the basic premise of a contract is different from the basic premise of a statute.
  2. Law of contract is governed by the principle of autonomy of the parties. Therefore, conduct of the parties has a greater say in interpreting the terms of the contract, whereas Statutory laws are interpreted in the light of legislative intent and parliamentary discussions behind them.

Three notions of Intention:

  1. Actual
  2. Hypothetical/Constructive and
  3. Reasonable

Two approaches to Contractual Interpretation: Subjective and Objective

  1. A subjective approach to contractual interpretation would answer the question of whether a particular fact situation falls within the scope of a particular contractual clause exclusively on the basis of what the parties actually or subjectively intended.
  2. An objective approach to contractual interpretation would answer the question exclusively with reference to external factors which can be ascertained without taking into account the actual or subjective intentions of the parties.

Lord Hoffman’s Five Principles for Interpretation of Contracts:

Lord Hoffman laid down his five principles for interpretation of contracts in Investors Compensation Scheme Ltd vs. West Bromwich Building Society, [1998] 1 All ER 98-

  1. the right meaning is what the document conveys to a reasonable person;
  2. this includes everything in the “matrix of fact”, or relevant background circumstances;
  3. prior negotiations are excluded from this (a point which has been much criticised since);
  4. the meaning of words is not a literal meaning, but the one reasonably understood from the context, and
  5. the meaning should not contradict a common sense view of what a contract required.

The five canon approach adopted by Lord Hoffman in this case is still relied upon and was affirmed in Chartbrook Limited v Permisson Homes Limited & Ors., [2009] UKHL 38.

In Chartbrook, the House of Lords referring to Investors Compensation Case observed that the law rarely accepts that parties made mistakes in formal commercial agreements. However, it was affirmed in Chartbrook that there may be cases where the literal definition or interpretation would lead to a commercially irrational outcome; and that in such situations, the courts should be prepared to correct those mistakes. The House of Lords also mentioned in Chartbrook, though as obiter, that although prenegotiations remain inadmissible when interpreting contracts, it is nonetheless important that these negotiations are well documented and retained as evidence. Such evidence may well be determinative in claims for estoppel or obtaining an order for rectification.

One year later, Thomas Crema vs. Cenkos Securities Plc, [2010] EWCA Civ 1444, added to these five principles saying that general market practice could also be admissible as part of the factual matrix when interpreting contracts.

Note: These approaches to interpretation of contracts are more popular in common law countries, like UK, India, Australia, etc. There are certain inherent problems associated with the subjective approach and therefore Civil law countries are now gradually shifting away from the subjective approach.

Importance of ‘Context’ in Interpretation of Contracts (Novartis Vaccines and Diagnostics Inc. vs. Aventis Pharma Limited, 2010(2) Bom CR 317)-

  1. Ordinary Meaning: There is a presumption that the words to be construed should be construed in their ordinary and popular sense, since the parties to the contract must be taken to have intended, as reasonable men, to use words and phrases in their commonly understood and accepted sense. The object of the inquiry is not necessarily to probe the ‘real’ intention of the parties, but to ascertain what the language they used in the document would signify to a properly informed observer.
  2. Businesslike Interpretation: It is an accepted canon of construction that a commercial document should be construed in accordance with sound commercial principles and good business sense, so that its provisions receive a fair and sensible application. If a detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business common sense, it must be made to yield to business common sense.
  3. Commercial Object: The commercial object or function of the clause in question and its relationship to the contract as a whole will be relevant in resolving any ambiguity in the wording.
  4. Construction to avoid unreasonable results: If the wording of a clause is ambiguous, and one reading produces a fairer result than the alternative, the reasonable interpretation should be adopted. It is to be presumed that the parties, as reasonable men, would have intended to include reasonable stipulation in their contract.

At paragraph 40 and 42 of the judgment, it was observed-

  • “The contract/agreements need to be read as a whole considering the nature & the purpose of the business. The clause and the contract as a whole even if is clear and unambiguous, the court needs to consider the same in the facts and circumstances of the case. It is necessary to see relationship between words; sentences; clauses; chapters and the whole document. It cannot be read in isolation. The aspect of faith, trust, fiduciary relationship and understanding between the parties, just cannot be overlooked, while interpreting any such private commercial documents.”
  • “Merely because there is no negative covenant, that itself is not sufficient to permit other partners to do rival or competing business of the same nature.”

The Bombay High Court also relied on M.O.H. Uduman and Ors. v. M.O.H. Aslum, AIR 1991 SC 1020, wherein it was held –

“It is settled canon of construction that a contract of partnership must be read as a whole and the intention of the parties must be gathered from the language used in the contract by adopting harmonious construction of all the clauses contained therein. The cardinal principle is to ascertain the intention of the parties to the contract through the words they have used, which are key to open the mind of the makers. It is seldom that any technical or pedantic rule of construction can be brought to bear on their construction. The guiding rule really is to ascertain the natural and ordinary sensible meaning to the language through which the parties have expressed themselves, unless the meaning leads to absurdity.”

Documents which serve as tools for interpretation of contracts:

  1. Antecedent Agreements and Pre-contractual Documents
  2. Documents which are supplemented to the main contract. (Annexure, schedules, price lists, job order, etc.)
  3. Documents forming part of the same transaction (e.g. long term construction contracts)
  4. Deleted (crossed out) Words

Read our subsequent posts on Interpretation of Contracts-

  1. Rules for Interpretation of Contracts: Importance of Deleted Words
  2. Rules for Interpretation of Contracts: Pre-Contractual Documents/Draft Agreements


Author: Vivek Verma

2 responses to “Rules for Interpretation of Contracts

  1. very good article one should go through and take note of since all of us are bound to deal with such cases. Thanks a lot for valuable information passed on.

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