Construction of contractual terms

Surrounding Circumstances
Notwithstanding the question of what is meant by ambiguity and when it may arise, the fact of the matter is that, as a matter of practice, courts are not reluctant to find the existence of ambiguity. However, as Leeming JA said in Zhang v ROC Services (NSW) Pty Ltd,⁷⁵ ‘[w]here there is more than one legal meaning, a court looks at the text, context and purpose, with a view to determining which potential meaning best accords with those considerations.evidence of surrounding circumstances can be admitted to aid in the construction of the term’. The question that then arises is, what falls within the description of ‘text, context and purpose’ or what may also be described as ‘evidence of surrounding circumstances’.
In Bank of Credit and Commerce International SA v Ali⁷⁶ Lord Hoffmann said that admissible background or surrounding circumstances included ‘anything which a reasonable man would have regarded as relevant’, and that ‘there is no conceptual limit to what can be regarded as background’. This statement of principle was cited with approval by Campbell JA in Franklins Pty Ltd v Metcash Trading Ltd⁷⁷ who then went on to say that a ‘contract should be construed bearing in mind those facts that the parties knew, or that it can reasonably be assumed they knew, that can impact upon the meaning of the words of the contract’.
In Codelfa Construction Pty Ltd v State Rail Authority of New South Wales⁷⁸ Mason J said:
Generally speaking facts existing when the contract was made will not be receivable as part of the surrounding circumstances as an aid to construction, unless they were known to both parties, although … if the facts are notorious knowledge of them will be presumed.
In a similar vein, in Newey v Westpac Banking Corporation⁷⁹ Gleeson JA said:
The scope of the legitimate surrounding circumstances, knowledge of which is to be attributed to a reasonable person in the position of the contracting parties, is to be understood by reference to what the parties knew in the context of their mutual dealings. Whilst it does not involve a species of constructive notice, ‘the reasonable person may be taken to know of things that go beyond those that the parties thought to be important or those to which there was actual subjective advertence by the parties’: QBE Insurance Australia Ltd v Vasic [2010] NSWCA 166 at [35].
Finally, in Mount Bruce Mining Pty Limited v Wright Prospecting Pty Limited⁸⁰ French CJ, Nettle and Gordon JJ said the following as to what constituted ‘surrounding circumstances’:
What may be referred to are events, circumstances and things external to the contract which are known to the parties or which assist in identifying the purpose or object of the transaction, which may include its history, background and context and the market in which the parties were operating. What is inadmissible is evidence of the parties’ statements and actions reflecting their actual intentions and expectations.
It should also be noted that facts and circumstances that would otherwise be admitted as an aid to the construction of a contract, will be available for that purpose even if they were communicated between the parties on a ‘without prejudice’ basis.⁸¹
Where evidence of surrounding circumstances is admissible, it is clear that there are limits on what a court can do with that evidence when construing the contract. Thus, in Skanska Rashleigh Weatherfoil Ltd v Somerfield Stores Ltd⁸² Neuberger LJ said:
[I]t seems to me right to emphasise that the surrounding circumstances and commercial commonsense do not represent a licence to the court to re-write a contract merely because its terms seem somewhat unexpected, a little unreasonable, or not commercially very wise.
In Sattva Capital Corporation v Creston Moly Corporation⁸³ the Supreme Court of Canada said the following in relation to the use of surrounding circumstances:
While the surrounding circumstances will be considered in interpreting the terms of a contract, they must never be allowed to overwhelm the words of that agreement. The goal of examining such evidence is to deepen a decision-maker’s understanding of the mutual and objective intentions of the parties as expressed in the words of the contract. The interpretation of a written contractual provision must always be grounded in the text and read in light of the entire contract. While the surrounding circumstances are relied upon in the interpretive process, courts cannot use them to deviate from the text such that the court effectively creates a new agreement. The nature of the evidence that can be relied upon under the rubric of ‘surrounding circumstances’ will necessarily vary from case to case.  It does, however, have its limits. It should consist only of objective evidence of the background facts at the time of the execution of the contract, that is, knowledge that was or reasonably ought to have been within the knowledge of both parties at or before the date of contracting … [T]his includes, in the words of Lord Hoffmann, ‘absolutely anything which would have affected the way in which the language of the document would have been understood by a reasonable man’⁸⁴. Whether something was or reasonably ought to have been within the common knowledge of the parties at the time of execution of the contract is a question of fact.
The Supreme Court⁸⁵ also noted that ‘the parol evidence rule does not apply to preclude evidence of surrounding circumstances when interpreting the words of a written contract’.
Finally, it must be kept in mind that the practical effect of the decision in Codelfa Construction Pty Ltd v State Rail Authority of New South Wales⁸⁶ ‘is that surrounding circumstances cannot be relied on to give rise to an ambiguity that does not otherwise emerge from a consideration of the text of the document as a whole, including whatever can be gleaned from that source as to the purpose or object of the contract’.⁸⁷
PRINCIPLES OF CONSTRUCTION
As already noted, in determining the objective intention of the parties to the contract no hard and fast rules apply. Rather the court applies what are best described as ‘principles’ of construction.⁸⁸ A number of these principles are discussed below. However, it must be kept in mind that these principles are not binding rules and will not apply in the face of facts to the contrary.
Presumption that unreasonable results are not intended
It is presumed that parties to written contracts do not intend the terms of their contract to operate unreasonably. Thus, the more unreasonable the result a particular construction of the terms would produce, the less likely it is that such an interpretation reflects the parties’ intentions. However, if the parties intend to produce an unreasonable result, such an intention must be abundantly clear from the words used.⁸⁹
However, this principle relating to the reasonableness or otherwise of the contract cannot be taken too far. In Chartbrook Ltd v Persimmon Homes Ltd⁹⁰ Lord Hoffmann observed:
[T]he fact that a contract may appear to be unduly favourable to one of the parties is not a sufficient reason for supposing that it does not mean what it says. The reasonable addressee of the instrument has not been privy to the negotiations and cannot tell whether a provision favourable to one side was not an exchange for some concession elsewhere, or simply a bad bargain.
Whether a court gives effect to an unreasonable interpretation depends upon the circumstances of the case. If the language used is open to two constructions, preference is to be given to the one that avoids an unreasonable result.⁹¹ Where the words of a contract are unambiguous and give rise to a capricious or unreasonable result, the court will give effect to them, even if one could reasonably surmise that the parties did not intend such a result.⁹²
However, even in cases where there is no ambiguity, a court may decline to apply the plain meaning of the words used if:
(i) it would lead to an irrational result;⁹³

(ii) if it would lead to a meaning that is repugnant to the objectively determined intention of the parties;⁹⁴

(iii) if it makes no commercial sense.⁹⁵ In such cases the plain meaning must be manifestly absurd - mere unreasonableness is not enough.⁹⁶ As was pointed out by Ward JA in International Petroleum Investment Company v Independent Public Business Corporation of Papua New Guinea⁹⁷ ‘[t]he Court has no mandate to rewrite agreements merely to give them a more commercial operation’. Establishing absurdity is not easily achieved.⁹⁸ In relation to what is meant by absurdity, in National Australia Bank Ltd v Clowes⁹⁹ Leeming JA said:
In my opinion this is a clear case where the literal meaning of the contractual words is an absurdity, and it is self-evident what the objective intention is to be taken to have been. Where both those elements are present … ordinary processes of contractual construction displace an absurd literal meaning by a meaningful legal meaning … [T]he principle is premised upon absurdity, not ambiguity, and is available even where … the language is unambiguous.
Later in his judgment, Leeming JA¹⁰⁰ said:
The principle is not confined to linguistic errors such as ‘inconsistent’ being read as ‘consistent’ or ‘shorter’ being read as ‘longer’ [as occurred in Saxby Soft Drinks Pty Ltd v George Saxby Beverages Pty Ltd¹⁰¹]. The principle extends to obvious conceptual errors, such as ‘lessor’ being read as ‘lessee’ as in McHugh Holdings Pty Ltd v Newtown Colonial Hotel Pty Ltd,¹⁰² or [as on the facts of this case] words denoting a mortgage of company title flat being read as a mortgage of the shares in the company which entitle their owner to that flat. In all those cases, it is perfectly clear what legal meaning is to be given to the literally absurd words.
Leeming JA’s observations bring into focus the relationship between the process of construction and the remedy of rectification. In relation to the issue of whether a court corrects errors in written documents by the process of construction or by the remedy of rectification, in W & K Holdings (NSW) Pty Ltd v Mayo¹⁰³ Sackar J said the following:
As part of the process of construction, as distinct from the remedy of rectification, the court has power to correct obvious mistakes in the written expression of the intention of the parties … Although there is clearly a conceptual similarity, and perhaps an overlap, between correction by construction and the doctrine of rectification, there is a difference in their respective scopes of application … [A] a common view is that the dividing line between cases where correction by construction is available and where only correction by rectification is available, is to be drawn on the basis of whether the party seeking the correction is seeking to rely on prior negotiations between the parties, the actual or subjective intentions of the parties or parol evidence or on whether the ‘error’ calling for correction is so obvious simply from the face of the document.
Avoidance of inconsistencies
Where contractual terms appear to be inconsistent with each other, the court will ‘do its best to reconcile them if that can conscientiously and fairly be done.¹⁰⁴ The question of inconsistency is determined objectively.¹⁰⁵ An inconsistency will arise where the terms of a contract ‘cannot sensibly be read together’.¹⁰⁶ In Re Media Entertainment & Arts Alliance; Ex Parte Hoyts Corp Pty Ltd (No 1)¹⁰⁷ Mason CJ, Brennan, Dawson, Toohey, Gaudron and McHugh JJ said:
A conflict ... involving apparently inconsistent provisions in the one instrument, is to be resolved, if at all possible on the basis that one provision qualifies the other and, hence, that both have meaning and effect. That rule is an aspect of the general rule that an instrument must be read as a whole.
In Metropolitan Gas Co v Federated Gas Employees’ Industrial Union¹⁰⁸ Isaacs and Rich JJ said the following about the need to construe an instrument as a whole:
It is a received canon of interpretation that every passage in a document must be read, not as if it were entirely divorced from its context, but as part of the whole instrument: Ex antecedentibus et consequentibus fit optima interpretatio. In construing an instrument ‘every part of it should be brought into action, in order to collect from the whole one uniform and consistent sense, if that may be done; or, in other words, the construction must be made upon the entire instrument, and not merely upon disjointed parts of it; the whole context must be considered, in endeavouring to collect the intention of the parties, although the immediate object of inquiry be the meaning of an isolated clause’.
More recently, in AFC Holdings Pty Ltd v Shiprock Holdings Pty Ltd¹⁰⁹ Ball J said:
The general principle is that the words of a contract should be interpreted in a way which gives them an effect rather than a way in which makes them redundant. That principle does not operate as an invariable rule. In some cases, it may be appropriate to interpret words in a way that makes them redundant. That may be appropriate where the alternative construction of the words is inconsistent with other provisions of the contract or where the alternative construction is inconsistent with the commercial purpose of the contract or where it appears that the words have been included out of abundant caution.
Thus, in order to avoid inconsistencies it may be necessary to depart from the ordinary meaning of the words approach to construction.¹¹⁰
However, in cases where parties contract on the basis of a standard form contract (the primary contractual document) and incorporate further terms that they have negotiated (the incorporated document), if an inconsistency arises between the two documents, a court will ‘almost always’ give effect to the terms set out in the incorporated document:¹¹¹ In Homburg Houtimport BV v Agrosin Private Ltd (The Starsin)¹¹² Lord Bingham of Cornhill said:
[I]t is common sense that greater weight should attach to terms which the particular contracting parties have chosen to include in the contract than to pre-printed terms probably devised to cover very many situations to which the particular contracting parties have never addressed their minds.
Of course, there is the preliminary question of whether an inconsistency has arisen. On this issue, in Pagnan SpA v Tradax Ocean Transportation SA¹¹³ Dillon LJ said:
What is meant by inconsistency? Obviously there is inconsistency where two clauses cannot sensibly be read together, but can it really be said that there is inconsistency wherever one clause in a document qualifies another clause? A force majeure clause, or a strike and lock out clause, almost invariably does qualify the apparently absolute obligations undertaken by the parties under other clauses in the contract; so equally with an extension of time clause, for instance in a building agreement. So equally, with a lease, the re-entry clause qualifies the apparently unconditional demise for a term of years absolute, but no one would say they were inconsistent.
An illustration of the application of the principle that contracts should be construed as a whole is the case of Howe v Botwood.¹¹⁴ In that case a lease imposed an obligation upon the tenant to ‘pay and discharge all rates, taxes, assessments, charges, and outgoings whatsoever which now are or during the said term shall be imposed or charged on the premises or the landlord or tenant in respect thereof (land tax and landlord’s property tax only excepted)’. The landlord had an obligation to ‘keep the exterior of the said dwelling-house and buildings in repair’. A relevant public authority served a notice that required a drain to be replaced. The issue before the court was whether the cost of so doing fell upon the tenant or upon the landlord. In ruling that the landlord was liable for the cost of the work, Channell J¹¹⁵ said:
The expense of executing the work would under this covenant fall on the [landlord]. If therefore that covenant by the [landlord] had stood alone without the covenant by the [tenant], that is how I should construe it. That covenant, however, has to be read with the earlier covenant by the tenant to pay and discharge all outgoings. There are thus two covenants, one placing the burden on the tenant and the other placing it on the landlord. We must construe the lease as a whole so as to make it consistent in both its parts. In my opinion the covenant by the tenant must be read as if it contained the words ‘except such as are by this lease imposed upon the landlord’. By reading that exception into the covenant by the tenant the two covenants can be read together.
Presumption in favour of business common sense
Where a detailed semantic and syntactical analysis of a written contract leads to a conclusion that is inconsistent with business common sense, the contract must be made to yield to business commonsense.¹¹⁶ In this respect, in International Air Transport Association v Ansett Australia Holdings Ltd¹¹⁷ Gleeson CJ said:
In giving a commercial contract a businesslike interpretation, it is necessary to consider the language used by the parties, the circumstances addressed by the contract, and the objects which it is intended to secure. An appreciation of the commercial purpose of a contract calls for an understanding of the genesis of the transaction, the background, and the market.
In Mount Bruce Mining Pty Limited v Wright Prospecting Pty Limited¹¹⁸ French CJ, Nettle and Gordon JJ said:
Unless a contrary intention is indicated in the contract, a court is entitled to approach the task of giving a commercial contract an interpretation on the assumption ‘that the parties … intended to produce a commercial result’: Electricity Generation Corporation v Woodside Energy Ltd.¹¹⁹ Put another way, a commercial contract should be construed so as to avoid it ‘making commercial nonsense or working commercial inconvenience’.
The justification for this approach to the construction of commercial agreements was explained in Mannai Investment Co Ltd v Eagle Star Life Assurance Co Ltd¹²⁰ where Lord Steyn said:
In determining the meaning of the language of commercial contracts … the law therefore generally favours a commercially sensible construction. The reason for this approach is that a commercial construction is more likely to give effect to the intention of the parties. Words are therefore interpreted in the way in which a reasonable commercial person would construe them. And the standard of the reasonable commercial person is hostile to technical interpretations and undue emphasis on niceties of language.
When a court looks at commercial common sense it does so by looking at the facts and circumstances that existed at the time of the contract. In this respect in Arnold v Britton¹²¹ Lord Neuberger said:
[C]ommercial common sense is not to be invoked retrospectively. The mere fact that a contractual arrangement, if interpreted according to its natural language, has worked out badly, or even disastrously, for one of the parties is not a reason for departing from the natural language. Commercial common sense is only relevant to the extent of how matters would or could have been perceived by the parties, or by reasonable people in the position of the parties, as at the date that the contract was made.
On the question of whether the contract is one that flouts business common sense, in LB Re Financing No 3 Ltd v Excalibur Funding No 1 Plc¹²² Briggs J said:
In this context, a distinction must be made between absurdity and irrationality on the one hand, and apparent unfairness or one-sidedness on the other. The former may compel the court to conclude that something must have gone wrong with the language, but it is no part of the court’s task to mend businessmen’s bargains. Commercial absurdity may require the court to depart even from the apparently unambiguous natural meaning of a provision in an instrument, because ‘the law does not require judges to attribute to the parties an intention they plainly could not have had’.¹²³ Questions of commercial common sense falling short of absurdity may however enable the court to choose between genuinely alternative meanings of an ambiguous provision. The greater the ambiguity, the more persuasive may be an argument based upon the apparently greater degree of common sense of one version over the other.
However, a court needs to be careful in seeking an interpretation that is inconsistent with commercial common sense. In Skanska Rashleigh Weatherfoil Ltd v Somerfield Stores Ltd¹²⁴ Neuberger LJ said:
[T]he court must be careful before departing from the natural meaning of the provisions in the contract merely because it may conflict with its notions of commercial common sense of what the parties may have or should have thought or intended. Judges are not always the most commercially-minded, let alone the most commercially experienced, people, and should … avoid arrogating to themselves over confidently the role of arbiter of commercial reasons or likelihood. Of course, in many cases, the commercial common sense of a particular interpretation, either because of peculiar circumstances of the case or because of more general considerations, is clear. Furthermore, sometimes it is plainly justified to depart from the primary meanings of words and give them what might, on the face of it, appear to be a strange meaning, for instance where the primary meaning of the words leads to a plainly ridiculous or unreasonable result.
A common instance of the application of this principle is where there is ambiguity. In such cases, ‘the court is entitled to prefer the construction which is consistent with business common sense and to reject the other’.¹²⁵ However, in such cases the courts needs to also be careful for the reasons set out in Jireh International Pty Ltd v Western Export Services Inc¹²⁶ where Macfarlan JA said:
So far as they are able, courts must of course give commercial agreements a commercial and business-like interpretation. However, their ability to do so is constrained by the language used by the parties. If after considering the contract as a whole and the background circumstances known to both parties, a court concludes that the language of a contract is unambiguous, the court must give effect to that language unless to do so would give the contract an absurd operation. In the case of absurdity, a court is able to conclude that the parties must have made a mistake in the language that they used and to correct that mistake. A court is not justified in disregarding unambiguous language simply because the contract would have a more commercial and businesslike operation if an interpretation different to that dictated by the language were adopted.
Similarly, in Arnold v Britton¹²⁷ Lord Neuberger said:




[T]he reliance placed in some cases on commercial common sense and surrounding circumstances … should not be invoked to undervalue the importance of the language of the provision which is to be construed. The exercise of interpreting a provision involves identifying what the parties meant to the eyes of a reasonable reader, and, save perhaps in a very unusual case, that meaning is most obviously to be gleaned from the language of the provision. Unlike commercial common sense and the surrounding circumstances, the parties have control over the language they use in a contract. And, again save perhaps in a very unusual case, the parties must have been specifically focusing on the issue covered by the provision when agreeing the wording of that provision … [W]hile commercial common sense is a very important factor to take into account when interpreting a contract, a court should be very slow to reject the natural meaning of a provision as correct simply because it appears to be a very imprudent term for one of the parties to have agreed, even ignoring the benefit of wisdom of hindsight. The purpose of interpretation is to identify what the parties have agreed, not what the court thinks that they should have agreed. Experience shows that it is by no means unknown for people to enter into arrangements which are ill-advised, even ignoring the benefit of wisdom of hindsight, and it is not the function of a court when interpreting an agreement to relieve a party from the consequences of his imprudence or poor advice. Accordingly, when interpreting a contract a judge should avoid re-writing it in an attempt to assist an unwise party or to penalise an astute party.

An illustration of the business common sense approach to construction is the decision in Idya Pty Ltd v Anastasiou.¹²⁸ In that case a tenant of retail premises under a registered strata plan used them as a fast food outlet. Pursuant to Clause 19.1(a) of the relevant strata plan documentation the ‘owners’ of the premises were not permitted to ‘use’ them as a fast food outlet. The word ‘owners’ was defined to mean the registered proprietors of the premises. The tenant claimed that, as it was not the owner of the premises, the prohibition against using them as a fast food outlet did not apply to it with the consequence that it could not be prevented from operating its fast food outlet for the duration of the lease. The Court of Appeal rejected this argument. Beazley JA¹²⁹ said:
In my opinion, having regard to the wide meaning that the word ‘use’ bears, depending upon its context, the proper construction of cl 19.1(a) is that it is a prohibition upon the owners of the Retail Shops on using, including permitting to be used, the premises as a fast food outlet. Any other construction would be commercially nonsensical. If the construction for which the [tenant] contend was the correct one, it would mean that an individual could be the proprietor of the Retail Shops and by the mere device of entering into a lease or licence with a company of which the proprietor was the sole shareholder, thereby avoid the prohibition on use. The reverse, of course, would also operate, that is, a company could be the owner of the Retail Shops and lease or licence the premises to its sole shareholder. Reasonable commercial persons would readily reject that as being available under a clause in the terms of cl 19.1(a).