Long-term contracts: another vote for literal interpretation

Globe Motors Inc (Globe) and TRW Lucas Varity Electric Steering Ltd (TRW) entered into an exclusive supply agreement (the agreement) under which TRW agreed to buy certain motors from Globe. The agreement was of a long-term nature but was, in the words of the court, poorly drafted.

The agreement defined the products which Globe was to supply exclusively, these included: certain specified products, including a so-called Gen1 motor, as well as any further products added by mutual agreement. In addition, there was a process by which changes to the requirements or specifications relating to a specified product could be made, which was known as the engineering changes process. A product which evolved through the engineering changes process would be a product subject to the terms of the agreement.

TRW was asked by a customer to consider alternative designs for the Gen1 motor. The proposed alternative motor (the Gen2 motor) was not one of the products specified in the agreement. TRW engaged a third party to develop and supply the Gen2 motor. Globe argued that under the agreement it had an exclusive right to supply the Gen2 motor.

It was common ground that if the Gen2 motor had been developed by Globe from the Gen1 motor through the engineering changes process, it would have been a product subject to the agreement. The critical issue for the court was whether the High Court had erred in concluding that TRW was obliged to use the engineering changes process to give Globe the opportunity to develop the Gen2 motor.

The court accepted that, when considering long-term contracts, a flexible approach is likely to best match the parties’ reasonable expectations. The court should therefore seek to construe the agreement to enable the flexibility to meet changing circumstances. For that reason, it rejected TRW’s more pedantic arguments on interpretation.

However, there were limits to the court’s flexibility on questions of interpretation. It was not possible to construe the agreement as obliging TRW to propose engineering changes to Globe. In preferring that construction, the High Court had sought to achieve a commercially sensible result, however, the judge had not explained why the language of the agreement permitted that conclusion.

The court found that the starting point was the language of the agreement and referred to the statement by the House of Lords in Total Gas Marketing Ltd v Arco British Ltd that the first principle of construction is loyalty to the contractual text viewed against its relevant contextual background ([1998] UKHL 22; www.practicallaw.com/1-100-8504). The court also referred to the emphasis placed by the Supreme Court in Arnold v Britton on the need to focus on the meaning of the words in their documentary, factual and commercial contexts ([2015] UKSC 36; www.practicallaw.com/9-616-5783). The fact that a contractual arrangement has worked out badly, or was disastrous for one of the parties, is not a reason to depart from the natural language.

The court found that, in reality, Globe was seeking to achieve by construction of the agreement what it might possibly have achieved by arguing for an implied term. Globe apparently did not pursue the argument for an implied term because it was statute-barred. The court emphasised that the construction of contracts and the implication of terms are different processes governed by different rules; implication being an altogether more ambitious process. However, one manifestation of the flexible approach is that the court may be more willing to imply an obligation to co-operate or a duty to act in good faith into certain long-term contracts. In this case, the court found that the long-term nature of the agreement and the flexibility of approach which it required might have "given considerable force to" an argument that TRW had an implied obligation to give Globe the opportunity to produce a Gen2 motor.

It was not necessary for the court to consider whether the agreement had been effectively varied. Nevertheless, the court decided to deal with the issue because of two inconsistent decisions on the topic: United Bank Limited v Asif, which supports the effectiveness of anti-oral variation clauses and World Online Telecom Ltd v I-Way, which does not ([2000] unreported; [2002] EWCA Civ 413). The court held that a term in a contract that purports to prevent the parties from varying the agreement other than in writing does not prevent the parties from varying the agreement orally or in any other informal manner.

This is another case for the literalists. While acknowledging that a flexible approach to interpretation is appropriate for long-term contracts, the court made it clear that there must be a basis for that flexibility in the words used and not just in the factual matrix. Here, the focus was on what the language of the agreement permitted. Contrast Lord Hoffmann’s approach in Chartbrook Ltd v Persimmon Homes Ltd, the high water mark for the purposive approach: "there is not, so to speak, a limit to the amount of red ink or verbal rearrangement or correction which the court is allowed" ([2009] UKHL 38; see News brief "The exclusionary rule: Hoffmann’s last word").

The clear message from Globe Motors is that it is primarily the responsibility of the parties to include clauses that anticipate the particular problems encountered with a long-term contract. The court will not rewrite or improve the parties’ written agreement because one of them has missed a trick or because subsequent events have shown that the natural meaning of the words has produced a bad bargain for one side. So far as possible, any intended flexibility should be reflected in the contract using broad, flexible terms and definitions, and not be left to creative interpretation.

More encouragingly for those who face the challenge of drafting a bargain that will run long into the future is the strong indication in the judgment that the flexibility of approach required when dealing with long-term contracts may assist a party in arguing for a term to be implied. However, that indication comes with a warning that the implication of contract terms is a different, more ambitious, undertaking.

Turning to the obiter comments on anti-oral variation clauses, the standard clause prohibiting amendment or variation unless in writing might now seem to be obsolete, but it still has some value. As the court recognised that parties intending to rely on informal communications to modify obligations under a written agreement will face a greater burden in proving that they mutually intended to agree a variation where they have previously agreed that variations will not be permissible.