Contract interpretation: ‘the rule’ against the use of prior negotiations and subsequent conduct

Background

There used to be a rule about no ‘prior’ or pre-contract negotiations and no subsequent conduct which limited what evidence outside the words of the contract should be allowed to assist with the task of interpretation.

The rule was the lawyer’s way of dealing with the question, merely looking at the words. However, it was not always easy to justify. Interpretation of a written contract, as of any written document, is an exercise in the ascertainment of meaning. In principle, therefore, everything which is logically relevant should be admissible.

In many ways, the better justification for the rule is pragmatic. In Chartbrook Ltd v Persimmon Homes Ltd, [2009] UKHL 38, Lord Hoffmann explained:

“The admission of pre-contractual negotiations would create greater uncertainty of outcome in disputes over interpretation, and add to the cost of advice, litigation or arbitration.”  

Yet, as the Supreme Court has said, “[j]ust where to draw the line” in terms of evidence extrinsic to the contract “is an important issue in contractual interpretation cases.”[1] It’s not always clear whether evidence is of prior negotiations or context or ‘factual matrix’.

Also, courts can often be faced with alternative arguments based firstly on interpretation and/or secondly that the literal meaning is absurd, so the contract should be rectified or alternatively that the defendant should for some reason be estopped from advancing its position. In such cases, a clever pleader can circumvent the rule without too much difficulty.

The rule’s misleading clarity has led to differing views about its validity. However, in Bathurst Resources Ltd v L&M Coal Holdings Ltd[2021] NZSC 85 (14 July 2021), the Supreme Court offers a consensus around how to approach these issues. It also examined the distinction between interpretation and implication and the appropriate test for the latter.

Interpretation issues

In Bathurst Resources, the Supreme Court argues that concerns about length and cost of contract litigation are better addressed not by imposing artificial limits on the evidence admissible to assist in contractual interpretation, but by requiring evidence to be admissible in terms of Evidence Act criteria, chiefly: relevance and probative value under s 8 of the Evidence Act.

Evidence of what a party intended words to mean which was communicated during negotiations and shows a common mutual understanding as to the meaning is relevant and, subject to the s 8 Evidence Act assessment, admissible.

Evidence of uncommunicated subjective intent is irrelevant to the objective approach to contractual interpretation.

As to evidence of a party’s or all parties’ conduct in undertaking their contractual obligations after the agreement has been entered, and while the ban on such evidence was understood to be lifted by the Supreme Court in Wholesale Distributors Limited v Gibbons Holdings Limited [2007] NZSC 37, the Bathurst Resources Court appears to suggest the original ban was not so much a canon of construction as a counsel of caution.

Thus, it says, subsequent conduct may be relevant but “not…often” and“[c]are will be needed to assess the probative value of that evidence”. Post dispute conduct is likely to be looked upon with most scepticism, for obvious reasons.

In practice, whether evidence of prior negotiations and subsequent conduct is admissible will depend on whether such evidence proves anything relevant to the objective task of interpretation. Evidence will be irrelevant to the extent that it demonstrates only one party’s subjective intention or understanding of the text, or what their undeclared negotiating stance was. Evidence of subsequent conduct will not carry probative value where it does not represent the views of a party at the time the contract was made.

Implication of contractual terms

The Supreme Court also addressed the relationship between contractual interpretation and implication.

The Court confirmed that the issue of implication arises only after the express terms of the contract have been interpreted and found not to provide for the eventuality. If a contract does not provide for an eventuality, the usual inference is that no contractual provision was made for it.

The standard to imply a term is one of strict necessity. As with the task of interpreting the contract, the inquiry for the court when considering the implication of a term is an objective one. It is the understanding of the notional reasonable person with all the background knowledge reasonably available to the parties that is the focus of this assessment.

An unexpressed term may only be implied if it would spell out what the contract, read against the relevant background must be understood to mean. The implication of a term does not depend upon proof of the parties’ actual intentions, nor does it require the court to speculate on how the parties would have wanted the contract to regulate the eventuality if confronted with it prior to contracting.

The Court also affirmed that the ‘old’ BP Refinery[2] test is still a useful test, while adding some necessary qualifications. Whilst the conditions that the term must be capable of clear expression and not contradict any express terms must always be met before a term will be implied, the conditions that the term must be necessary to give business efficacy to the contract, that it be so obvious that it goes without saying, and that it must be reasonable and equitable, can be better viewed as analytical tools which overlap.

Despite confirming that a more expansive approach to contract interpretation can be taken, the admissible extrinsic evidence was found to provide little assistance to the interpretation of terms. Ultimately, the Majority’s interpretation was firmly rooted in the text of the contract.

The Majority also declined to imply a term to the extent that there was already a coherent contract involving sophisticated parties. This revealed a high degree of unwillingness by the Court to imply a term for the purpose of fixing a bad bargain, providing important perspective as to how stringent the standard of ‘strict necessity’ really is.

[1] Bathurst Resources Ltd v L&M Coal Holdings Ltd [2021] NZSC 85 at [40].

[2] BP Refinery (Westernport) Pty Ltd v President, Councillors, Ratepayers of the Shire of Hastings (1977) 180 CLR 266 (PC)