Article

by Roger Fayers

It is rare for a point of construction of an advance payment bond to reach the United Kingdom's highest court. Recently, however, the difficulties and dangers in drafting provisions in such a bond to reflect adequate security for default under a shipbuilding contract were forcefully exposed in the decision of the Supreme Court in the case of Rainy Sky SA and Others v Kookmin Bank1.

The judgment may be of interest to readers for two reasons. First, it restates the approach of courts in the United Kingdom to the construction of bonds, indeed of any contract. Second, it may tempt lawyers from civil law jurisdictions and other systems of law to reveal in subsequent articles in DCInsight the differences from, or perhaps the similarities to, this approach.

Shipbuilder's contract/bank's bond

The case arose out of a commonplace contract. Six companies (of which the claimant, Rainy Sky SA, was the first) placed an order with shipbuilders Jinse Shipbuilding Co Ltd for the construction of six vessels. The price of each vessel was $33.30m payable in five equal instalments of $6.66m, due at specified points of time with the final instalment payable on delivery.

By Article X.8 of each contract it was a condition precedent to payment by the purchasers of the first instalment that the builder would deliver to each of them a refund guarantee relating to the first and subsequent instalment in a form acceptable to their financiers. To meet this requirement, the respondent (Kookmin Bank ("the bank")) issued six materially identical advance payment bonds, one to each of the purchasers. Each bond provided that it was governed by English law and that all disputes arising out of it were to be determined by the commercial court.

Each of the six purchasers duly paid the first instalment, and Rainy Sky also paid the second instalment due under its contract. The builder, however, experienced financial difficulties and became subject to a debt workout procedure under the Korean Corporate Restructuring Promotion Law of 2007.

The purchasers wrote to the builder notifying it that this development triggered Article XII.32 of the contracts and demanded an immediate payment of all the instalments paid, together with interest. The builder refused to make any refund on the ground that Article XII.3 had not been triggered.

This dispute between the purchasers and the builder was referred to arbitration pursuant to Article XIV.3 of the contracts. The purchasers also wrote to the bank demanding repayment under the bonds. The bank refused to pay.

Issues and the rival contentions

At issue was whether the bank was correct in arguing that, on their true construction, the bonds did not cover refunds to which the purchasers were entitled under Article XII.3 of the contract. The commercial court found against the bank and entered summary judgment in favour of the purchasers. But in the court of appeal the bank was successful.

What, then, were the relevant provisions that gave rise to such difference of view? By paragraph 3 of the bonds, in consideration of the purchasers' agreeing to make the pre-delivery instalments under their contracts, the bank promised to pay on demand "all such sums due under the Contract". Simple enough, it would seem. But the draftsman had inadvertently set a linguistic trap; he had used the same expression ("the pre-delivery instalments") both in paragraph 2 and in paragraph 3 of the bonds.

So what was meant by the bank's promise in paragraph 3 to pay "such sums"? Two possible quite contrasting meanings were suggested. Rainy Sky said - and the commercial court and one of the appeal judges had agreed - that the expression "such sums" referred back to the "pre-delivery instalments" that were mentioned in that paragraph. The reason for this, it said, was that the whole purpose of the bonds was to guarantee the refund of the pre-delivery instalments and that the bank's promise was therefore to refund pre-delivery instalments.

By contrast, the bank said (and two of the appeal judges had agreed) that the expression "such sums" was a reference back to the sums referred to in paragraph 2 of the bonds (i.e., of the pre delivery instalments paid prior either to a termination of the contract or to a total loss of the vessel, and the value of any supplies delivered to the yard)

Just which of these interpretations was the correct one was significant. On Rainy Sky's analysis, the bonds covered the amount of the two pre-delivery instalments it had made and which, under Article XII.3 of the contract, were repayable to it in the event of the builder's insolvency, whereas on the bank's analysis it did not.

The correct approach

The court's first task was to determine the correct approach to be made to the construction of the bonds. Neither party disputed that recent court decisions pointed the way. The ultimate aim of interpreting a provision in a contract, especially a commercial contract, was to determine what the parties meant by the language used. This involved ascertaining what a reasonable person would have understood the parties to have meant.

Further, the relevant "reasonable person" in this context was one who had all the background knowledge that would reasonably have been available to the parties in the situation in which they were at the time of the contract3. What divided them, and what had divided the courts below, was the role to be played by considerations of business common sense in determining what the parties meant.

In the nature of things, a court will likely become involved only where the meaning of the provision is disputed because there is some ambiguity. If the wording is unambiguous, then either it would not be involved at all or, if it did become involved, there will be no alternative but to give effect to that meaning. Ambiguity, however, can involve that there is more than one potential meaning. So how then is the judge to choose between them?

One course would be for him to look at the alternative meanings and decide which of them is the most natural and, having done this, to give effect to that meaning unless he thinks it would produce a result so extreme (absurd) as to suggest that it cannot have been intended. This was the line taken by two of the appeal judges below.

Another course is for the judge to say "I don't need to pick the natural meaning and then stick with that unless I think it flouts common sense. What I should do is to accept that the provision is capable of two meanings. If one of them obviously flouts common sense, then I should opt for the other. If I think neither meaning flouts common sense, then it's more appropriate that I adopt the one that is the more, rather than the less, commercial construction because that is more likely to be the one that the parties intended." The Supreme Court took this latter course.

Application to the facts

Since two constructions of paragraph 3 of the bonds were possible, it became necessary to look at the considerations that favoured one commercial view over the other. Clearly at the root of this case lies poor draftsmanship. The draftsman had merely to add the words such as "mentioned in this paragraph" or "mentioned in paragraph 2" and all would have been clear. So the court was left to sort out the muddle.

Suffice to say that after analyzing the provisions of the bonds and the contracts, the court found against the bank. On the basis that paragraph 3 was capable of more than one construction, it was not necessary to conclude that a particular construction of it would produce an absurd or irrational result before choosing which of those meanings seemed most likely to achieve the commercial purpose of the bonds. The purchasers' construction accorded more with commercial sense, because it gave them security on the happening of the event (i.e., the insolvency of the builder), which would most likely require that there be a first-class security.

The court added that it would similarly have found against the bank in another way. Had it been necessary to do so, it would have gone so far as to say that the limited scope of the bonds contended for by the bank (i.e., excluding repayments in the event of the builder's insolvency) would flout commercial sense and so would have been rejected. In the result, judgment was given for the purchasers in the amount of $46.62m[4] together with interest.

Principles of common law construction

I should conclude with a few general remarks on the principles adopted by the courts in the United Kingdom to the construction of contracts. This approach, that the concluding document stands alone as the contract, has often been criticized as too narrow and unfair. After all, if the true intention of the parties can be ascertained by looking at certain material, why should a court be prevented from doing so?

A partial answer to this is that at least there has been some change: "The time has long passed when agreements were isolated from the matrix of facts in which they were set and interpreted purely on linguistic considerations5."

Nevertheless, it remains the case that the approach of our courts is a stricter one than in civil and some other jurisdictions. It is still one that favours commercial certainty over absolute justice.

Another kind of evidence excluded is evidence of what happened after the contract was made. So too is evidence of the parties' negotiations. Whatever meaning a particular clause might have been suggested in the course of negotiations, there is nothing to show that the parties actually agreed to it as part of their contract. One or other may have changed their mind - so the safe course is to interpret only what they eventually agreed on.

Our law, it may be said, places theoretical obstacles in the way of practical justice. In favour of such obstructions, however, is the advantage we see in greater certainty. If what a commercial man's contract means involves an inquiry into his subjective intentions, he will never know where he stands.

Nor must it be forgotten that many contracts are relied upon by third parties who must take them at their face value and cannot know what may have transpired outside them. In this way, therefore, does our law, in the words of Lord Devlin, "strive to give effect in a reasonable way to what it believes to be the bargain [the parties] really intended to make6."

Roger Fayers' e-mail is r.fayers@ntlworld.com

1 [2011] UKSC 50.

2 Article XII.3: BUILDER'S DEFAULT OF THE CONTRA CT PROVIDED - "If the Builder shall apply for or consent to the appointment of a receiver, trustee or liquidator, shall be adjudicated insolvent ... take advantage of any insolvency law ... the Buyer may by notice in writing to the Builder require the Builder to refund immediately to the Buyer the full amount of all sums paid by the Buyer to the Builder on account of the Vessel and interest thereon."

3 See e.g., Investors Compensation Scheme Ltd v West Bromwich Building Society [1998] 1 WLR 749 and Chartbrook Ltd v Persimmon Homes Ltd [2009] AC 1101.

4 The amount comprises the first pre-payments of $6.660m made by five of the purchasers and the first and second pre-payment of $13.32m made by Rainy Sky.

5 Per Lord Wilberforce in Prenn v Simmonds [1971] 1 WLR 1381, 1385.

6 See generally Lord Devlin, Samples of Lawmaking 52 et seq.