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In Rainy Sky v Kookmin Bank, in which judgment was handed down on Wednesday, the Supreme Court has confirmed that it will take above all a commercial approach towards interpreting ambiguities in commercial contracts.  The case follows in a line of recent decisions, such as Persimmon Homes, Sigma Finance and Muller, where the Supreme Court / House of Lords has continued the move away from a strict and overly literal approach to contractual construction, to a wider and more flexible doctrine based on common business sense.  As such, the decision in Rainy Sky is evolutionary rather than revolutionary: no new ground is broken here.  Nevertheless, the sole judgment of the Court (given by Lord Clarke) is admirably short and contains a useful statement of the existing principles, and so is well worth a read for commercial practitioners.  The Court, consisting of Lords Clarke, Phillips, Mance, Kerr and Wilson, unanimously allowed the appeal of Rainy Sky, thereby overturning the decision in the Court of Appeal.

Facts

The facts of the case, insofar as are relevant, are quite straightforward.   The appellants, Rainy Sky and five other shipowning companies, each contracted to buy a ship from a shipbuilding company called Jinse Shipbuilding Co in Korea.  The ships would cost $33m each and payment of the first instalment was conditional upon provision by a first class Korean bank of a refund guarantee, pursuant to which the bank would commit to paying the buyers a refund if the ships were ultimately not built.

Kookmin bank duly provided the refund guarantees in the form of advanced payment bonds, governed by English law.  However, the drafting of the bonds unfortunately did not match the drafting of the shipbuilding contracts.  Whereas the latter had stated that if Jinse entered into an insolvency procedure, that would trigger a right to rescind and therefore the refund guarantee (Article XII.3), the bonds did not.  Paragraph 2 of the bonds simply stated that the buyers would be entitled to a refund if they exercised their right to “termination, cancellation or recission” their shipbuilding contracts; and paragraph 3 provided the guarantee obligation, namely that Kookmin would pay the buyers “all such sums due to you under the [shipbuilding] Contract”.

Jinse suffered financial difficulties and entered into an insolvency procedure under Korean law; the ships were not finished; and the buyers sought refunds under the terms of the bonds.  In response, Kookmin argued that insolvency was not a trigger for repayment under the terms of the bonds; there had been no right to “terminate, cancel or rescind”.  The buyers’ case was that this literal interpretation made no business sense: there was no good commercial reason why insolvency should be excluded.  This argument succeeded at first instance before Mr Justice Simon, who found Kookmin liable; however, that judgment was overturned by the Court of Appeal (Patten and Thorpe LJJ; Tuckey LJ dissenting).

The Law

Lord Clarke confirmed that the correct approach to contractual construction is that set out by Lord Hoffman in Investors Compensation Scheme [1998] 1 WLR 896, as adopted in subsequent cases including Pink Floyd v EMI [2010] EWCA Civ 1429 (Lord Neuberger MR):

“The ultimate aim of interpreting a provision in a contract, especially a commercial contract, is to determine what the parties meant by the language used, which involves ascertaining what a reasonable person would have understood the parties to have meant [. . .] the relevant reasonable person is one who has all the background knowledge which would reasonably have been available to the parties in the situation in which they were at the time of the contract” (para 14)

So far, so clear: but what happens if the reasonable business man is capable, as in this case, of reaching two different interpretations from the same words?  Then, following Lord Reid in Wickman v Schuler [1974] AC 235, the Court “is entitled to prefer the construction which is more consistent with business common sense” – even if this means an element of judicial creativity, which Patten LJ in the Court of Appeal felt unable to do.  The approach adopted by Lord Justice Patten was that the Court should give effect to the natural meaning of the words, unless this produced a result that was so extreme that it could not have been intended.  Citing a number of other authorities who had endorsed a more flexible approach (including Lords Bridge, Bingham, and Mance – see paragraphs 26 to 28), Lord Clarke held that this was too restrictive.  Rather than uphold unless an extreme (or absurd, or irrational) result was produced, the Court when faced with two competing interpretations should consider what the most commercial construction would be and then give this effect.  Lord Clarke repeated a useful quotation of Longmore LJ from Barclays Bank plc v HHY Luxembourg SARL [2010] EWCA Civ 1248:

“If a clause is capable of two meanings…it is quite possible that neither meaning will flout common sense.  In such circumstances, it is much more appropriate to adopt the more, rather than the less, commercial construction” (para 26)

Conclusions

In this case, commercial logic suggested that if the shipbuilder became insolvent, the refund guarantee would be triggered – indeed, as the trial judge had found, this was “the most likely reason” why the security of an advance payment bond would be needed.  The appeal was therefore allowed and Kookmin was ordered to pay.

What lessons can commercial practitioners take away from this judgment?  Clearly, the key is to draft contracts clearly at the outset, so as to avoid any ambiguity.  But if that fails and ambiguity remains, the Courts are more willing than ever before to apply a commercial rather that literal interpretation, and technical challenges that are inconsistent with business common sense will fail.  One critique of this approach may be that “business common sense” is an abstract concept which may be hard to pin down.  In Rainy Sky, it was clearly significant to this conclusion that Kookmin had been unable to advance any commercial reason why insolvency should be excluded.  There may of course be cases where the line is finer and far harder to draw and in future cases this could be fertile ground for counsel and indeed for expert evidence.