Interpretation of Contracts

In most commercial litigation there will be an issue as to what a contract means. So the interpretation or construction of contracts is a subject that preoccupies clients, their lawyers and the courts. The legal rules on the interpretation of contracts are relatively well settled, but it is a subtle art in which judicial mood plays an important role. Lord Sumption, a powerful voice in the Supreme Court, gave a (non-judicial) speech recently in which he noted a change in judicial mood; he likened that change to military advances and retreats.

Lord Sumption suggested that an offensive had been led by the towering figure of Lord Hoffmann and that the Supreme Court has recently retreated from the advance positions seized by the Hoffmann offensive. The opposing forces in this war could perhaps be characterised as literal interpretation on the one hand and commercial interpretation on the other. That distinction does not do justice to Lord Sumption’s speech; the opposing forces are really (a) an approach which concentrates on the meaning of the words in the contract; and (b) an approach which modifies or contradicts the words used in pursuit of a commercially reasonable result. Nevertheless, it is a useful shorthand.

Lord Hoffmann was the dominant judicial figure of his day, and he gave the seminal judgments on the interpretation of contracts, most notably the decision in Investors Compensation Scheme Ltd v West Bromwich Building Society. The prominence of that judgment is such that in the leading textbook (Lewison on The Interpretation of Contracts), the five principles from the case are recited in the opening chapter after which the author states “the lazy reader may stop here".

Lord Sumption took particular issue with the fifth principle from ICS. The fifth principle was that the traditional adoption of the natural and ordinary meaning of the language is no more than a rebuttable presumption that people mean what they say in formal documents. If the background suggests that something has gone wrong with the words, the law may attribute a different intention to them.

The outcome of the commercial interpretation, Lord Sumption argues, is that the courts have put a greater emphasis on the background circumstances to a contract than the words used by the parties in the contract. He has at least three objections to that trend. First, the language of the parties’ agreement, read as a whole, is the only direct evidence of their intentions which is admissible. If it is not given sufficient weight, then we are simply leaving judges to reconstruct an ideal contract which one party wished it had made, but never actually did. Second, how can the courts fairly use the surrounding circumstances to modify a contract? Our legal system rigorously excludes the use of pre-contractual negotiations as evidence to help construe a contract. That in turn means that the court cannot consider any evidence of the sometimes complex give and take of the negotiations. An apparently harsh term may have been agreed in return for concessions elsewhere, but, since the motive behind the term is not admissible, the court cannot take that into account. Third, judges are not necessarily well placed to determine what commercial common sense requires. They tend to focus on fairness, but fairness often has nothing to do with commercial contracts. Commercial parties can be most unfair and entirely unreasonable, if they can get away with it.

This really raises a philosophical question as to the proper role of the court. Is it to respect the often ruthless nature of commercial reality and be faithful to the parties’ bargain? Or is it to impose a judge’s view of the fair and commercially reasonable result that the parties intended to achieve? The literal interpretation has the benefit of greater certainty; the commercial interpretation has the benefit of greater fairness.

We now know which Lord Sumption prefers. The law may not have changed, but the judicial mood has.

Gibson & Co.

July 2017

 
Mazarona Properties Limited v Financial Ombudsman Service

This case concerns the ability of the FCA to police the review process that it set up with so many banks in relation to the sale of interest rate hedging products (IRHPs). The decision suggests that the FCA (through the Financial Ombudsman) has no jurisdiction to consider what happened during the banks’ reviews. It will therefore worry the banks’ customers who might ask the question: how can we hope for a fair review if the FCA cannot police how that review is conducted?

Background

In October 2008 three associated companies (Mazarona) borrowed £6.4m from AIB. As part of that agreement, AIB was entitled to, and duly required, Mazarona to hedge against the risk of rising interest rates. Under the terms of the IRHP (a 2 year swap), AIB was a floating rate payer (3 month LIBOR on £6.4m) and Mazarona a fixed rate payer (4.66% on £6.4m). As interest rates crashed, so did any commercial benefit from the IRHP for Mazarona.

In July 2012, the FCA and AIB agreed that AIB would review the sale of its IRHPs to certain non-sophisticated customers, like Mazarona. Two basic types of redress were identified. First, the refund of all payments made under the IRHP to a customer who would not have selected any such product; this was known as the “full tear up”. Second, a refund of the difference between the payments made under the IRHP actually sold and an alternative product which the customer would have selected if there had been no regulatory breach, the so-called “alternative product”.

In April 2014, AIB concluded its initial review, found that the IRHP had been mis-sold and offered redress on the alternative product basis for £387,615.22. That offer was rejected by Mazarona on 28 April 2014 who made a counter offer on the full tear up basis of £535,370.

AIB conducted a review of the redress that it had offered under the oversight of the “skilled person”. Apparently because of new information from Marazona on 28 April 2014, AIB withdrew its offer in December 2014 because it was satisfied that Mazarona would have entered into the IRHP actually executed even if there had been no regulatory breaches.

In January 2015, Mazarona complained to the Financial Ombudsman Service (FOS) about both (i) the withdrawal of AIB’s offer and (ii) the sale of the IRHP. FOS ultimately concluded that (i) she had no jurisdiction over AIB’s review of the redress it had offered (since the review was not “a regulated activity”) and (ii) Mazarona would have entered into the IRHP even if there had been no regulatory breach.

Analysis

These two findings are difficult to reconcile. If the FOS had no jurisdiction over the review process, then how can she have also made a finding about how Mazarona would have acted? Perhaps she reached that decision without considering any aspect of the review process.

In any event, Mazarona sought judicial review of both of the FOS decisions, but only obtained permission in relation to the finding on jurisdiction. The sole issue therefore that the judge was dealing with was “whether the Ombudsman was right to conclude that she could not consider what had happened in AIB’s review in her determination.” Having worked his way through the labyrinth of relevant definitions, Mr Justice Mitting concluded the Ombudsman had been right: she did lack jurisdiction to consider what had happened in the review. It is difficult to argue with the judge’s analysis of the relevant statutory provisions, but, if correct, the practical effect is that the FCA is not entitled to oversee the very review process that it set up. Unless and until there is a statutory amendment, the decision making of the banks and the skilled persons in the review process cannot be policed by the FCA.

Mr Justice Mitting refused permission to appeal. It is not yet clear whether Mazarona will apply to the Court of Appeal for permission to take the matter further.

Gibson & Co.

June 2017

 
Thomas v Triodos

In March 2017 the High Court considered the extent of the duty of care which a bank owes to a retail customer to whom commercial borrowing facilities had been extended. The transaction in this case involved switching borrowing from a variable rate to a fixed rate for a term of 10 years. The claim against the bank was upheld by HHJ Havelock.

In order to examine the significance of the decision it is first necessary to look at what duties a bank owes to a customer.

Recent case law on the sale of financial products has drawn a clear distinction between (1) the duty a bank owes when advice is given to purchase a product and (2) the duty a bank owes when information only is provided about a product. This distinction is often misunderstood by customers.

What is the difference?

In Rubenstein v HSBC Bank plc, it was held: “The key to the giving of advice is that the information is either accompanied by a comment or value judgment on the relevance of that information to the client’s investment decision or is itself the product of a process of selection involving a value judgment so that the information will tend to influence the decision of the recipient”.

Where a bank gives advice in circumstances where it may be concluded that it assumed responsibility for that advice then there is a duty to ensure that the advice is full and accurate. Full advice is advice that covers the available options and the pros and cons of any product being recommended and enables the customer to make an informed decision.

Where a bank is subject to a regulatory regime (for example under the Financial Services and Markets Act 2000 (FSMA) and the Conduct of Business Rules (COBS rules)) then the advisory duty may go further and require compliance with that regime.

Where a bank provides information to a customer on a product then the duty of care is of a lower standard. The duty is not to mislead or misstate information (see Hedley Byrne v Heller & Partners Ltd).

Background

The claimants, Mr and Mrs Thomas, were partners in an organic farming business. In 2006, the Thomases transferred their borrowing to the defendant bank and they entered into two loan agreements: one for £300,000 and another for £1.15m for fixed terms at variable interest rates of 1.25% and 1.75% respectively. In 2008, the claimants borrowed on a further two occasions.

The Thomases became concerned about the cost of servicing their debt if the interest rates rose. They asked the bank about fixing the rate on some or all of their borrowing.

The Thomases claimed in a telephone conversation the bank had been told that they were thinking about fixing the rate on all their borrowing for ten years. The bank provided some information in writing and some information over the telephone to the claimants.

The Thomases also questioned whether the maximum likely charge for redeeming borrowing would be £10,000 to £20,000 and this was not corrected by the bank. The claimants subsequently fixed two of their loans to fixed rate loans.

The bank referred to the Business Banking Code (BBC) in its literature and in the letters to the Thomases confirming the fixes.

In 2008 the Thomases had second thoughts about their decision to fix the interest rates and started to enquire about what the cost would be if they were to re-fix. The bank told the Thomases that the penalty would be £96,205.47, which was subsequently amended by the bank to £54,691.59. The Thomases could not afford this cost.

The Thomases went on to issue proceedings against the bank. They maintained that they were not blaming the bank for the interest rates falling but they did blame the bank for not explaining the financial consequences which would flow if they tried to get out of the fixed rate before the 10 year fixed rate had expired. They said that the bank had misrepresented what the financial consequences would be.

Decision

  1. The Thomases’ claim succeeded.
  2. The relationship was not an advisory one and no advice was given.
  3. Fixed rate lending, which is the subject matter of this case, is not a regulated activity under the Financial Services and Markets Act 2000. Even if it was, the Thomases were in business as a farming partnership and therefore it is doubtful whether they would qualify as private persons under the COBS Rules so they would not have the benefit of the protection afforded by the Rules.
  4. There was no dispute that the bank owed the Thomases a duty not to mislead of misstate when providing information.
  5. The crucial point in this case is that HHJ Havelock went on to consider whether there was any and, if so, what scope for imposing a more extensive, intermediate, duty than the duty not to mislead or misstate when a bank provides information to a customer. In doing so he considered a number of conflicting first instance court decisions which tackle the issue.
  6. HHJ Havelock agreed with Judge Moulder inThornbridge Ltd v Barclays Bank that an intermediate duty could exist outside of an advisory relationship and this was not precluded by the decision in Green & Rowley v Royal Bank of Scotland. The existence of a duty of care, and the level of the duty, would depend on the particular facts of the case and whether, as a matter of policy, it is thought appropriate to impose such a duty in the circumstances.
  7. The significant feature of this case is that the bank had advertised to the claimants that it subscribed to the Business Banking Code. The BBC does not have contractual force between a bank and a customer, but it provides a benchmark as to how banks should behave. The fairness commitment in the BBC included a promise, directed to the customer, that if the bank was asked about a product, it would give the customer a balanced view of the product in plain English, with an explanation of its financial implications. There were no disclaimers, basis clauses or exclusions in the terms and conditions which applied between the Thomases and the bank which would lead to the conclusion that the bank was not willing to assume responsibility for honouring that promise.
  8. When the Thomases inquired about fixing the rate, the bank owed them a duty not to misstate. However, the duty of care which the bank owed went further - to explain the financial implications of fixing the rate. It was a duty owed only in response to the Thomases inquiries because that is what the bank had signed up to in the BBC. It was not a duty to volunteer information if not asked.
  9. The Thomases were entitled to an explanation in plain English as what fixing the rate entailed and the consequences. The essential components were: (1) that the rate could be fixed for a period (whether in months or years, and whether any minimum or maximum length of time); (2) where the available fixed rates could be found (e.g. on the internet); (3) what those rates represented (the forward cost of money); (4) the effective rate that would be payable (i.e. the current swap ask rate for the period of the fix plus the banks margin, if any); and (5) the financial consequences of terminating the fixed rate before the end of the period.


Conclusion

This is a brave decision by HHJ Havelock. Traditionally there has been a clear distinction between the duty a bank owes when (1) advice is given to purchase a product and (2) when information only is provided about a product. This decision has blurred that distinction and introduced a new “intermediate duty” to explain a product to a customer, which is higher than the duty imposed not to mislead or misstate when providing information to a customer. This decision will almost certainly be subject to further judicial scrutiny even if the decision is not subject to an appeal itself.

April 2017
Gibson & Co.