1.01  The ultimate purpose of contractual interpretation is to find out what the parties intended.

1.02  This follows from the basic concept that the law of contract is about the voluntary assumption of liability. In the words of Professor Brian Coote:¹ ‘The one characteristic essential to a contract is that it should be a means by which legal contractual liability can effectively be assumed by the party or parties to it.’ The law of contract gives effect to promises made for consideration or by deed, and the extent of those promises ultimately depends on what the parties agreed. In practice, most contractual disputes are concerned with establishing the precise scope of the promise.

1.03  Sir Christopher Staughton, writing extra-judicially,² has said, in relation to contractual interpretation, that: ‘Rule One is that the task of the judge when interpreting a written contract is to find the intention of the parties. In so far as one can be sure of anything these days, that proposition is unchallenged.’ And in The Starsin,³ Lord Bingham said: ‘When construing a commercial document in the ordinary way the (p. 14) task of the court is to ascertain and give effect to the intentions of the contracting parties.’⁴

1.04  In common law jurisdictions (unlike many civil law ones), the intention of the parties is established objectively. We are not concerned with the parties’ actual, subjective intentions, but with the outward manifestation of those intentions. The question is how a reasonable person would interpret their intentions from what they have said, written, and done.⁵

1.05  This is a very important qualification. Although the law is striving to find the intention of the parties, it will not look into their minds. It will only look at what has passed between them. And in doing so, it is not concerned with their actual intention, but with how a reasonable person would understand their common intention from its objective manifestation.

1.06  The principle was expressed by Lord Wilberforce in Reardon Smith Line v Yngvar Hansen-Tangen:⁶

1.07  Lord Steyn expressed it this way in Deutsche Genossenschaftsbank v Burnhope:⁷

1.08  It is this emphasis on objectivity which enabled Lord Hoffmann, in Investors Compensation Scheme v West Bromwich Building Society,⁸ to express the principle rather differently:

(p. 15) 1.09  Here, there is no reference at all to the intention of the parties—just to the meaning of the document. What is important is not what the parties thought, but what they wrote.

1.10  This might suggest that intention is really a chimera. Although we purport to strive for it, we do not really do so.⁹ What we really do is look at the document.¹⁰

1.11  Sir George Leggatt has asked:¹¹ ‘If actual intentions are irrelevant, what purpose, if any, is served by using the language of “intention” at all?’ It is a good question. But to say that subjective intention is irrelevant is not to deny the importance of the objective manifestation of intention. It is important to know what we are ultimately trying to achieve, even if we do not carry it out completely. Even though we adopt an objective test, what we are ultimately trying to elicit is what the parties meant. The common law has this at least in common with the civil law tradition—which tends to adopt a more subjective approach.

1.12  The common law does not carry this to its logical conclusion and try to establish the subjective intention of the parties. But anyone interpreting a contract is still trying to work out what the parties really meant from what they have done.

1.13  Of course, the establishment of intention is sometimes fictional. In some cases, the parties may simply not have considered the matter in hand. David McLauchlan has said that: ‘the great majority of interpretation disputes that come before the courts have the common feature that the parties did not, at the time of formation, contemplate the situation that has arisen’.¹² But, even here, it is surely true to say that what we are trying to do is to establish what the parties would have intended if they had set their minds to it. We do this by extrapolation from what they have agreed (and have not agreed) and in the light of the background facts at the time the contract was entered into. It is a difficult matter of judgement, but what the parties would have intended must be what is guiding the person interpreting the contract.

1.14  It is therefore suggested that it is still important to recognize that what underlies the principles of interpretation is a desire to establish the common intention of the (p. 16) parties, albeit objectively. Lord Bingham made the point clearly in Bank of Credit and Commerce International v Ali:¹³

1.15  The objective theory of the common law tradition is frequently distinguished from the more subjective approach of the civil law tradition.¹⁴ One example of the civil law approach that is easily accessible by common lawyers is Article 4.1 of the Unidroit Principles of International Commercial Contracts (2010 edition),¹⁵ which says:

1. (1)  A contract shall be interpreted according to the common intention of the parties.

2. (2)  If such an intention cannot be established, the contract shall be interpreted according to the meaning that reasonable persons of the same kind as the parties would give to it in the same circumstances.

1.16  Here, the objective approach is a fallback mechanism if it is not possible to establish the subjective common intention of the parties. Why does the common law not adopt the same approach? If the law of contract is concerned with the voluntary assumption of liability, why not carry it to its logical conclusion and say that what matters is what the parties actually intended?

1.17  One reason is that the objective approach to interpretation sits well with the objective theory of the common law of contract. Whether there is a contract and, if so, what are its terms, is broadly determined objectively.¹⁶

1.18  The requirement for objectivity in relation both to the formation of contracts and to their interpretation has been stressed recently by Heydon and Crennan JJ in the High Court of Australia in Byrnes v Kendle.¹⁷ After discussing the principle that the (p. 17) purpose of contractual interpretation is to discover the objective intention of the parties, rather than their subjective intentions, their Honours continued:¹⁸

1.19  This approach to contract formation has been criticized by David McLauchlan. There is a continuing debate about whether the creation of a contract is a purely objective exercise—based on how a reasonable person would view the actions of the parties—or whether the court is more concerned with how a reasonable person in the position of the promisee would view what the promisor has said and done.²⁰ But, whatever the outcome of this debate about how a contract is created,²¹ it is clear that, when it comes to interpreting the contract, this is done objectively—by reference to a reasonable person having the background knowledge which would reasonably have been available to the parties.²²

1.20  Why does the law treat the interpretation of contracts in this objective fashion? There are four main reasons.

1.21  In the first place, establishing the subjective common intention of parties to a complex contract can be difficult, if not impossible, to achieve. Even if we can establish the subjective intentions of each of the parties, it is difficult to know which parts of their (frequently opposing) individual intentions were held in common. Indeed, if each party separately intends to contract on a particular basis, but the parties do not communicate with each other, they have not reached an agreement and they do not have a common intention.²³ Establishing subjective common intention can only be achieved by objective methods.

(p. 18) 1.22  Secondly, many of the issues from which disputes arise will simply not have been considered by the parties when they were drafting the contract.²⁴ And, in order to get the deal done, the parties may have agreed on the words to be used without necessarily agreeing what they mean. One practical way round these problems is to ask what a reasonable person would have understood the parties to have intended from what they have said and done.

1.23  Lord Wilberforce put the point this way in Prenn v Simmonds:²⁵

1.24  Thirdly, and particularly importantly, the objective process is considered to promote certainty²⁶ and to save time and costs. This is an important theme of contractual interpretation, and appears throughout this book. If the meaning of a contract can only be established by examining the subjective intentions of the parties, the outcome is difficult to predict; and to establish it will involve considerable delay and expense. But if its meaning can be established from its external manifestation— normally the written agreement—it is easier to predict the outcome, and the time and cost of establishing it should be reduced.

1.25  A fourth reason is that the objective approach protects third parties, such as assignees. They are not parties to the discussions between the parties and could be prejudiced by interpreting a provision differently from how it appears in the document.²⁷ Again, this is a theme which recurs throughout this book.

1.26  Not everyone is happy with this approach. There are those who consider that it carries the search for objectivity too far. Lord Nicholls is one of those. In ‘My Kingdom for a Horse: The Meaning of Words’, an article in the Law Quarterly Review in 2005,²⁸ he asked:(p. 19)

Why should it be thought [that] evidence of the parties’ actual intentions … can never assist in determining the objective purpose of a contractual provision or the objective meaning of the words the parties have used?

1.27  The point was taken further by David McLauchlan in ‘Contract Interpretation: What Is It About?’, an article in the Sydney Law Review in 2009:²⁹

[it] would [be] perverse to exclude evidence that potentially could have allowed [one party to the contract] to get away with repudiating the parties’ actual common understanding at the time of the contract …

1.28  Even more tellingly, Lord Nicholls has asked: ‘Why should the judge have to guess when he can know?’³⁰

1.29  These are powerful arguments.³¹ They mirror what Lord Bingham said in a different context:³² ‘You need not gaze into the crystal ball when you can read the book.’ But the problem with this argument is that it proves too much. Taken to its logical conclusion it would destroy the objective principle altogether. In relation to any contract, it may be the case that evidence of the parties’ subjective intentions would enable the court to get a better understanding of what the parties actually intended. But that would simply replace objectivity with subjectivity. The dangers of this approach are those which have already been discussed: uncertainty, cost, and delay; and potential prejudice to third parties. As is so often the case in English law, pragmatism wins out over theory. Absolute justice gives way to a practical method of enforcing people’s bargains more quickly and with a greater degree of certainty than would otherwise be possible.

1.30  One reason why the interpretation of contracts is of such importance in practice is that English law generally recognizes the principle of freedom of contract, and therefore that what the parties have agreed is of paramount importance.

1.31  This was particularly apparent in the nineteenth century, when Sir George Jessel MR said, in Printing and Numerical Registering Company v Sampson:³³

1.32  Inroads were made into this principle in the twentieth century, to such an extent that Professor Atiyah was able to record what he described as ‘The Rise and Fall of Freedom of Contract’.³⁴

1.33  But, by the end of the twentieth century, the pendulum had swung back, with the courts being less inclined to override those contractual provisions which they did not like. So, in Photo Production v Securicor,³⁵ Lord Diplock was able to say:

1.34  This return to the principle of freedom of contract may have had much to do with the fact that Parliament had by now intervened to protect consumers, thereby leaving the courts free to give effect to freedom of contract where that legislation did not apply. In commercial transactions, the courts are now much more willing to accept that the parties should be the final determinant of what is good for them.

1.35  There are now few general exceptions to this basic principle of freedom of contract in commercial transactions. Perhaps the most important one in practice is the doctrine of penalties.

1.36  In England, the penalty doctrine is restricted to cases where there is a breach of contract.³⁶ It cannot be used to strike down the primary obligations of the parties under the contract—only the secondary obligations which arise on breach of those primary obligations. The logic of this distinction has sometimes been challenged. Why override the secondary obligations which arise on breach of primary obligations, but not the primary obligations themselves? Or, to put it the other way round, if the parties can agree their primary obligations, what is the logic of preventing them from agreeing the effect of breach of those obligations?

1.37  It is this which led the High Court of Australia in Andrews v Australia and New Zealand Banking Group³⁷ in 2012 to decide that the penalty doctrine could apply even where there was no breach of contract. The penalty doctrine in Australia can therefore strike down primary obligations as well as secondary ones.

(p. 21) 1.38  The United Kingdom Supreme Court considered this issue in Cavendish Square Holding v Makdessi; ParkingEye v Beavis³⁸ in 2015 and decided not to extend the penalty doctrine to primary obligations.³⁹ In England, the penalty doctrine deals, and has always dealt, with secondary obligations payable on breach, not with primary obligations; and it would not be appropriate to extend it.

1.39  It is therefore important to decide whether a particular provision of a contract is a primary or a secondary obligation. As a general principle, the expression ‘primary’ obligation is used to describe the terms of the contract; and a ‘secondary’ obligation describes the obligation which a party incurs under the general law for breaching a primary obligation—normally a liability to pay damages.⁴⁰ But, in the context of penalties, the distinction is drawn between two different types of contractual term. In this context, a secondary obligation is a contractual provision which provides what will happen if a party breaches another provision of the contract; and a primary obligation is any other provision of the contract.

1.40  Lords Neuberger and Sumption illustrated the difference in the Makdessi case:⁴¹

1.41  Whether a provision of a contract is a primary or secondary obligation is a question of categorization.⁴² It involves a two-stage process. First, the rights and duties of the parties under the provision are established. That is a matter of interpretation of the contract. Once the court has established what the provision means, the second stage is to determine whether it falls into the category of a primary or secondary obligation according to the legal rules concerned.

1.42  Whether a provision is a primary or secondary obligation is a question of substance, not of form. It does not matter how the parties themselves categorize the provision.⁴³ Once the court has established what the parties intend their rights and duties to be, the categorization of that provision depends on the application of the legal rule. However it is described, it will be a secondary obligation if it comes into effect on breach of the contract.

(p. 22) 1.43  Even if the provision concerned is a secondary obligation, the chance of it being struck down as a penalty has been substantially diminished as a result of the decision in the Makdessi case. The Supreme Court heard appeals from two separate Court of Appeal decisions. One case was a consumer transaction, the other a commercial one.

1.44  In the consumer case, a motorist had parked his car in a car park run by a company. The contract provided that the maximum permitted stay was two hours, that parking was free during that period, but that £85 would be charged to those who stayed longer. It was recognized that the amount of the payment was not a genuine pre-estimate of the loss which would have been recoverable by the company for breach of contract. On the basis of the existing law, that payment would therefore have been a penalty, and would not have been recoverable. All the company could have recovered would have been its actual loss.⁴⁴ But the Supreme Court decided that the payment was not a penalty because the company had a legitimate interest in charging the amount.⁴⁵ There is no longer a simple dichotomy between a provision which is a genuine pre-estimate of loss, and one which is penal.⁴⁶ The real question is whether it is penal, not whether it is a genuine pre-estimate of loss.⁴⁷ The innocent party may have a legitimate interest in having the contract performed which extends beyond the prospect of pecuniary compensation flowing directly from the breach.⁴⁸

1.45  Lords Neuberger and Sumption expressed the test in this way:⁴⁹

The true test is whether the impugned provision is a secondary obligation which imposes a detriment on the contract-breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation. The innocent party can have no proper interest in simply punishing the defaulter. His interest is in performance or in some appropriate alternative to performance.

1.46  Lord Hodge described the test as being ‘whether the sum or remedy stipulated as a consequence of a breach of contract is exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract’.⁵⁰ Lords Mance⁵¹ and Toulson⁵² agreed with this formulation, Lord Mance adding ‘extravagant’ as an alternative. These pejorative adjectives (reminiscent, perhaps, of the time when equity varied by reference to the length of the Chancellor’s foot) are not easy to apply in practice, but they do emphasize how difficult it is now to set aside a provision as a penalty.

(p. 23) 1.47  Makdessi has very considerably raised the bar for a penalty claim. As Christopher Clarke LJ said in the Court of Appeal: ‘The law of penalties is a blatant interference with freedom of contract.’⁵³ The decision of the Supreme Court can be seen as a clear and deliberate response to that concern.⁵⁴

1.48  The extent to which this has fundamentally changed the law can be seen from the decision in the commercial case. In this case, a seller sold a controlling interest in his business to a buyer and entered into a restrictive covenant. The consideration for the sale included a large amount for goodwill, and much of it was payable on a deferred basis after completion. The contract contained a clause by which the seller would not be entitled to receive that further consideration if he was in breach of the restrictive covenant. The seller breached the restrictive covenant but claimed payment of the deferred consideration on the basis that the clause which prevented it being paid was a penalty. The amount of the deferred consideration was an extremely large sum—a multiple many times of the amount which would have been recoverable by the buyer for breach of the restrictive covenant. The Supreme Court nevertheless decided that the clause was not a penalty because the detriment to the seller was not out of all proportion to the buyer’s legitimate interest in enforcing the restrictive covenant.⁵⁵ The seller’s undertaking not to compete with the business after completion was an important term of the contract and was a key part of the value of the business being acquired.

1.49  One factor which the court considered to be of great importance was that this was a commercial transaction in which both parties were represented by lawyers. In a commercial transaction in which both parties are legally represented, it is up to the parties to determine what the contract should say, and the court will not intervene except in the most egregious of cases.

1.50  The test of whether a contractual provision is a penalty was reconsidered by the High Court of Australia in Paciocco v Australia and New Zealand Banking Group⁵⁶ in 2016. It has been seen that the penalty doctrine extends more widely in Australia than in England. But, in this case, High Court of Australia had to consider the test of whether a provision is a penalty. And here, the approach is very similar to that in the Makdessi case. French CJ and Keifel J⁵⁷ adopted the same approach as Lords Neuberger and Sumption in the Makdessi case—is the provision out of all (p. 24) proportion to the innocent party’s legitimate interest in enforcing the contract? Keane J⁵⁸ adopted the same approach as Lord Hodge in the Makdessi case—is the provision exorbitant or unconscionable when regard is had to the innocent party’s interest in the performance of the contract? Gageler J⁵⁹ considered that the question was whether the stipulation in issue was properly characterized as having no purpose other than to punish—also a theme that comes out very clearly in Makdessi. Although the types of provision to which the penalty doctrine can apply is broader in Australia than it is in England, the test of whether or not a provision is a penalty now looks to be the same in both jurisdictions.

1.51  In summary, the penalty doctrine has been curtailed very substantially in England. It only applies if the provision concerned is a secondary obligation and, even then, it will only be struck down if it is out of all proportion to the legitimate interest of the innocent party in the enforcement of the contract. Freedom of contract may have taken a fall in the twentieth century but, in the twenty-first century, it is alive and well and living in Westminster.

1.52  The principle that contractual interpretation is about establishing the objective common intention of the parties underlies all aspects of contractual interpretation. The other principles in this book are subsidiary to this basic principle, and need to be understood in the light of it. They are essentially ways of achieving this underlying purpose.