Use of Evidence of Prior Negotiatons in Contract Interpretation

Introduction

New Zealand's highest court, the Supreme Court, has recently considered the use of evidence of prior negotiations in contract interpretation. It was the Court's first chance to consider the issue in detail since the House of Lords decision in Chartbrook Ltd v Persimmon Homes Ltd [2009] 1 AC 110. The case concerned an interim agreement for supply of gas by Vector Gas to Bay of Plenty Energy. Vector and BPE reached the interim agreement after Vector gave notice to terminate the parties' existing contract for supply and BPE, disputing Vector's right to terminate, issued proceedings for specific performance.

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Facts

Shortly before BPE issued its proceedings the parties agreed, through an exchange of correspondence between solicitors, that Vector would continue to supply gas "based on the terms of the [existing] Agreement" pending determination of the proceedings or 30 June 2006, whichever was the earlier, provided that, in the event BPE were unsuccessful, it would pay Vector on demand "for each GJ supplied, the difference between the price set out in the Agreement and $6.50 per GJ, plus interest at the Rate set out in the Agreement".

BPE was unsuccessful. The issue then became whether the price of $6.50 included the cost of transmission of the gas to the point at which it was taken by BPE. BPE contended that the price was inclusive of transmission; Vector argued that it was exclusive. The cost of transmission of the gas to BPE was $1.86 per GJ; the difference between the price being inclusive or exclusive of transmission costs amounted to $3 million plus interest.

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The Lower Courts

The High Court adopted the interpretation advanced by Vector, namely that the price was exclusive of transmission costs. However, the Court of Appeal reversed the first instance decision, holding that the price was inclusive of transmission. Vector appealed to the Supreme Court. At each hearing, the parties referred extensively to their negotiations in reaching the interim agreement.

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The Supreme Court decision

The full Bench of the Supreme Court unanimously upheld Vector's appeal and found that the price was exclusive of the cost of transmission.  One way or another all of other Judges were influenced by the fact that the agreement was an interim one. The parties would have known that, if they did not reach an interim agreement, the court would have made an interim order.  Such an order would have required BPE to give an undertaking to make good any loss Vector might suffer if Vector won, i.e. the difference between the price paid by BPE and the market rate. At the time of the agreement the market rate was $6.86 per GJ. However, each of the five Judges delivered separate judgements setting out differing views on the potential use of prior negotiations and on their application to the circumstances of the case.

As a result, the unanimity was limited to the outcome in the present case, with the judges differing on a question of fundamental application (whether the relevant contractual language was ambiguous) and on the applicable principles for using extrinsic material to interpret a contract.

Blanchard and Gault JJ both considered that the issue simply involved the objective ascertainment of the parties' agreement from the correspondence.  It was not appropriate to consider only the last two letters in the chain of correspondence (which would give rise to ambiguity) as when the correspondence was construed as a whole in the factual context (an interim settlement to secure supply pending determination of a larger dispute), the objective meaning of the phrase clearly excluded transmission and metering costs.   The alternative interpretation (that the price included transmission costs) would have produced an objectively absurd outcome, at odds with the objective intention that the interim agreement was a substitute for an interim injunction and undertaking as to damages.  It is well-established that regard may be had to prior communications to establish the commercial or business object of a transition and the subject matter of the contract (as to which, in the view of Blanchard J, differing from McGrath J, there cannot sensibly be degrees which would permit a court to conclude that the subject is gas supply but not of gas only).  There is no need in this case to consider what other limits there might be on the use of evidence of negotiations for the light which they might shed on the objective intention of the parties.

Tipping J's judgment began with a lengthy discussion of the legal principles, confirming that what is required is an objective approach (what a reasonable and informed third party would consider the parties had intended).  Evidence of subjective intention and understanding is irrelevant and inadmissible but extrinsic evidence is admissible if either it establishes a fact capable of demonstrating objectively the meaning which the parties intended or it establishes an estoppel or special (private dictionary) meaning.  Without context, the phrase is ambiguous because it is capable of being inclusive or exclusive of transmission costs.  When regard is had to context, it was apparent, on an objective basis, that the parties had reached agreement during negotiations as to what the price referred to.

McGrath J commenced with a case law analysis which concluded with the view that the admissibility of pre-contractual negotiations on questions of construction depends on relevance - subjective intention and understanding is irrelevant but object facts may be relevant (with or without ambiguity).  In addition, pre-contractual negotiations may be relevant to rectification or estoppel by convention.  In application to the facts of the case, contrary to the views above, he held that the words used were unambiguous in their terms (and included the cost of transmission in the price) and that the pre-contractual material did not reveal the subject matter of the contract (other than it concerned gas supply).  Rectification had not been pleaded and could not now be raised.  While estoppel by convention should be pleaded (and had not been) it was not unfair to consider estoppel by convention in this case as the "private dictionary" point had been argued below.  He found that the parties had had a common understanding that the price referred to gas energy only, not delivered gas; an estoppel prevented the contention being advanced that the price included costs.

Wilson J stated that there were only 3 exceptions to the principle that words in a contract bear their ordinary meaning in context, namely ambiguity (lack of clarity or conflict), commercial nonsense and estoppel by convention, and that those exceptions fixed the proper limits of considering material extrinsic to a contract.  Like McGrath J, he found the words unambiguous in the context of the contract and that rectification had not been pleaded and was not available.  However the literal meaning defied commercial commonsense and cannot have been intended.  Estoppel by convention arose sufficiently from the "parties' private dictionary" pleading and enabled all correspondence to be examined without artificial division.  Viewed objectively in that light, all references to price were exclusive of transmission costs.  Accordingly, while the express reference to the terms of the prior agreement meant that the price literally included transmission costs, this was not intended because it made no commercial sense.  Alternatively an estoppel arose to preclude adoption of the literal meaning.

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Comment

It is important to bear in mind that the issues arose from a contract concluded by an exchange of correspondence, not a formal document executed by the parties.

The judgments were as much influenced by differing views as to what constituted the relevant contractual language, a matter which directly influenced the differing conclusions about whether the contractual terms were ambiguous (and what the plain meaning was) as differing views on the applicable principles.  The major point of difference in principle turns on whether one adopts a general rule excluding all evidence of pre-contractual communications but subject to settled exceptions (which include rectification and estoppel), or a rule which only limits the receipt of such evidence to what is relevant to an objective assessment of meaning (thereby rendering evidence of subjective intent and understanding irrelevant) or to rectification or estoppel.  The second area of difference related to a mixture of content and application of the resulting rule (such as the requirement for ambiguity and the scope of the 'subject matter' exception).

The potential importance of estoppel (which allows unrestricted reference to the negotiations) to issues of contractual construction is demonstrable from the reference to it in 4 of the judgments.

None of the judges adopted a more restrictive view on the admissibility of prior communications than the principles expressed by the majority in Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 896 (HL) and their differences ultimately turned on the basis on which they would modify those restrictions. One (Tipping J) would generally allow reference to pre-contractual negotiations in order to determine intent objectively, another (Wilson J) would do so only in the event of ambiguity or commercial absurdity, another (McGrath J) adopted the Chartbrook approach, while the remaining judges (Blanchard and Gault JJ) preferred to leave the question open for future consideration (with the former applying the subject matter exception very liberally).  Overall, an increasingly liberal approach to reference to negotiations seems signalled.

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