Can your contract be challenged?

Sunday 8th November 2009

In the current economic climate parties to contracts are looking very closely at their agreements to see whether they reflect the original deal that they entered into. This is becoming increasingly common for those who have bought land for development at the height of the market on terms which perhaps now look less attractive.

The rapid decline in the property market has in many cases seen an alarming drop in the value of the land to be purchased between the date of contract exchange and the date of completion.   This has caused both the buyer and the seller to look very carefully at the terms of the agreement and whether it actually says what was meant at the time.  If a bad contract can successfully be challenged it can offer a very attractive way out of a contract that no longer makes economic sense.

The general rule is that a contract will mean what it says and a court will not alter the contract after the event unless there is a manifest error where the contract does not record what was intended by the parties. The court will, however, adopt an objective approach when construing contractual terms. The court will be prepared to look behind the contract in circumstances where it is clear that something has gone wrong with the language of that contract which when read literally produces an irrational or arbitrary result.

The House of Lords has confirmed that if, on a literal reading, the contract as drafted does not make sense it is prepared to look at the background to the contract negotiations and consider re-writing the agreement to make sure it does make sense. It will not look at evidence to assess what the intention of the contracting parties was, but it will look at that information to allow an objective assessment of what the contract term means.

In the words of the leading judgment there is no limit to the amount of red ink or correction which the court is allowed.  All that is required is that it must be clear that the text of the contract has gone wrong and does not produce a logical result.

In Chartbrook Limited –v- Persimmon Homes Limited the case related to the sale of land in Wandsworth by Chartbrook to the homebuilder Persimmon in 2001. The agreement included a payment obligation which allowed for an enhanced payment if the guaranteed residential unit value was exceeded (the Additional Residential Payment “ARP”). A dispute arose as to how the ARP was to be calculated. Chartbrook argued that on its interpretation they were owed an additional £4.4m.  Persimmon argued that the ARP was £897,000.

Clearly, the sums at stake were significant which explains why the matter was fought all the way up to the House of Lords.  The case is of broad significance because it provides clear guidance as to when a court will “rewrite” a contract.

The House of Lords stated that where it is clear from the text of the contract that something has gone wrong, a court can construe the contract in accordance with what a reasonable person would have understood the parties to have meant. In doing so, it can take into account relevant background information relating to the contractual negotiations.

The court concluded that there was a clear mistake on the face of the contract because the ARP clause was ambiguous which had to be resolved by looking at the purpose behind that clause.  It held that the Chartbrook interpretation would make other clauses arbitrary and irrational, while the Persimmon interpretation gave the ARP clause a “rational meaning”.

The court will not consider pre-contractual evidence when assessing what the parties’ intentions were. However, it will when considering the factual background to the contract or its “factual matrix” if it is clear that the language of the contract taken on its literal meaning produces an irrational result.

The ruling does not open the flood gates to allow parties to adduce evidence of the pre contractual negotiations to try and re-write the contract if there was a bad bargain.  It does reaffirm the position however that a court will look at the pre contractual background if a literal interpretation of that contract would produce an arbitrary and irrational result.

It can be expected that many more development agreements will be dusted down and very carefully scrutinised in the next few months to assess whether the terms should be amended by the court in the changing economic market.

It should not be seen as “open season” to rewrite bad contracts, but it does allow parties to review the contracts and the context leading up to them being executed, if the contract when read in the cold light of day produces an arbitrary result which seems illogical.

In the field of property development this can be particularly relevant if the period of time between the contract being executed and being completed has seen a significant change in land values which have an impact upon the price to be paid by the purchaser. Watch this space.