Causing a stir

The House of Lords decision in Chartbrook v Persimmon Homes [2009] UKHL 38 has created a stir in what was considered to be a settled area of the law concerning the interpretation of contracts: the principle that evidence of pre-contractual negotiations are inadmissible. The House of Lords statement of the law 12 years previously in ICS v West Bromwich [1997] UKHL 28 held that while the task was to find the meaning that the document would convey to a reasonable person with all the background knowledge available to the parties, previous negotiations of the parties were excluded from that background knowledge for reasons of 'practical policy'.

The contract in question concerned an agreement between Chartbrook and Persimmon Homes for the development of a site in Wandsworth acquired by Chartbrook. The dispute concerned provisions in the agreement for calculating any additional residential payments (ARP) '“ an amount due by reference to the profit made from the sale of residential flats. Chartbrook claimed that Persimmon owed nearly £4.5m in ARPs. Persimmon considered the contractual calculation resulted in ARPs of less than £900,000.

On appeal to the House of Lords, there was no dispute about the principles on which a contract should be interpreted: both parties accepted the objective approach as set out in ICS.

Lord Hoffmann reiterated that the courts do not easily accept that people have made linguistic mistakes, particularly in formal documents. In this instance he found there was a sufficiently strong case to persuade him that something had gone wrong with the language.

Chartbrook's reading of the clause appeared to be, as a matter of grammar, correct. However, it did not make any commercial sense. Furthermore, Chartbrook's literal interpretation would render various provisions in the contract schedules arbitrary and irrational. For these reasons alone Lord Hoffmann was willing to grant the appeal without the need to revisit the rules surrounding the admissibility of previous negotiations prior to the formation of the contract.

Rectification and estoppel by convention

Two exceptions to the general rule on admissibility in evidence of prior negotiations already exist '“ rectification and estoppel by convention. Commonly (as in this case) when a dispute over contract interpretation is litigated, evidence of the pre-contractual negotiations is tendered in support of an alternative claim for rectification or an argument based on estoppel by convention; sometimes in the hope that even if such an alternative claim does not succeed, the judge will have read and possibly been influenced by the evidence '“ effectively undermining the exclusionary rule.

To successfully argue rectification the party must show that:

1. The parties had a continuing intention, whether or not amounting to an agreement, in respect of the particular matter in the instrument to be rectified.

2. There was an outward expression of accord.

3. The intention continued at the time of the execution of the instrument sought to be rectified.

4. By mistake, the instrument did not reflect that common intention.

Once these criteria have been satisfied, there is no limit to the amount of red ink the court could use to rework the contractual provisions to give effect to the parties' intentions.

Estoppel by convention operates in similar fashion: where parties negotiate and contract on a shared assumption or understanding, they will be bound to that shared assumption or understanding. If, for example, the parties have negotiated an agreement upon some common assumption, which may include an assumption that certain words will bear a particular meaning they may be estopped from arguing that the words should be given a different meaning. With both rectification and estoppel by convention the test for establishing the intention of the parties is still what an objective observer would perceive their intentions to be based on their outward acts.

Abandonment of the exclusionary rule

The decision of the majority in the House of Lords, albeit obiter (Lords Hope and Rodger dissenting on this point), was that pre-contractual negotiations with potentially relevant background are now prima facie admissible. As a result of abandoning the exclusionary rule, a smoking gun in the contractual negotiations may now be produced directly without the party seeking to rely on it by first pleading rectification or estoppel by convention.

In the present case, the smoking gun was a letter from Chartbrook calculating the ARP due in a manner consistent with the interpretation being argued for by Persimmon.

This decision has created a stir but should not be taken as driving a horse and cart through the principles of contract interpretation. In the leading judgment on this point, Lord Hoffmann stated that such evidence would still usually be inadmissible as it would be irrelevant to the question before the court: namely what a reasonable person having the background knowledge possessed by the parties would understand the language as eventually used in the agreement to mean. Thus, while the exclusionary rule has been relaxed, the test before the court has not changed. Further, in this very subjective area it is inevitable that there may be disagreements within the judiciary whether in a particular case evidence of the pre-contractual negotiations is helpful or not.

The practical result is that for the time being there has been a shift in favour of parties seeking to admit prior negotiations as evidence, but it is doubtful whether there will be any let up in the satellite litigation that often follows about its admission.