In Vector Gas Limited v Bay of Plenty Energy Limited(1) the Supreme Court considered the use of evidence of prior negotiations in contract interpretation. It was the court's first opportunity to consider the issue in detail since the House of Lords decision in Chartbrook Ltd v Persimmon Homes Ltd.(2)

Facts

The case concerned an interim agreement for the supply of gas by Vector Gas to Bay of Plenty Energy (BPE). 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.

Shortly before BPE issued proceedings, the parties agreed (through an exchange of correspondence between their solicitors) that Vector would continue to supply gas "based on the terms of the [existing] agreement" until determination of the proceedings or June 30 2006, whichever was earlier. This was agreed with the proviso that if BPE were unsuccessful, it would pay Vector on demand "for each [gigajoule] supplied, the difference between the price set out in the agreement and NZ$6.50 [a gigajoule], plus interest at the rate set out in the agreement".

BPE was unsuccessful. The issue was then whether the price of NZ$6.50 included the cost of transmitting the gas to the point at which it was taken up by BPE. Vector argued that the price excluded transmission costs, whereas BPE contended that such costs were included. The cost of transmitting the gas to BPE was NZ$1.86 a gigajoule. The difference between the price being inclusive or exclusive of transmission costs amounted to NZ$3 million plus interest.

The High Court agreed with Vector's interpretation. However, the Court of Appeal reversed the first instance decision, holding that the price was inclusive. Vector appealed to the Supreme Court. At each hearing the parties referred extensively to their negotiations in reaching the interim agreement.

Supreme Court decision

The full bench of the Supreme Court unanimously upheld Vector's appeal and found that the price excluded transmission costs. All of the judges were in some way influenced by the fact that the agreement was an interim agreement. The parties would have known that if they did not reach an interim agreement, the court would make an interim order. Such an order would have required BPE to give an undertaking to make good any loss that Vector might suffer if the latter won (ie, the difference between the price paid by BPE and the market rate). At the time of the agreement, the market rate was NZ$6.86 a gigajoule.

All five judges delivered separate judgments, setting out differing views on the potential use of prior negotiations and on their application to the circumstances of the case. As a result, their 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 in interpreting a contract.

Justices Blanchard and Gault both considered that the issue simply involved objectively ascertaining the parties' agreement from the correspondence. It was inappropriate to consider only the last two letters in the chain of correspondence, as to do so would give rise to ambiguity. When the correspondence was construed as a whole, in the context of an interim settlement to secure supply pending determination of a larger dispute, the objective meaning of the wording clearly excluded transmission and metering costs. The alternative interpretation (ie, that the price included transmission costs) would have produced an objectively absurd outcome - such a view would be at odds with the objective intention that the interim agreement should be a substitute for an interim injunction and an undertaking as to damages. It is well established that prior communications may be considered in order to establish the commercial or business object of a transaction and the subject matter of a contract. On the latter point Blanchard differed from Justice McGrath, considering that there could not sensibly be degrees of subject matter which would permit a court to conclude that the subject was gas supply, but not that the subject was supply of gas only. There was no need in this case to consider what other limits might apply to the use of evidence of negotiations in terms of the light that they might shed on the parties' objective intentions.

Justice Tipping's judgment began with a lengthy discussion of the legal principles, confirming that an objective approach is required - the court should seek to establish what a reasonable and informed third party would consider the parties to have intended. Tipping found that evidence of subjective intention and understanding is irrelevant and inadmissible, but extrinsic evidence is admissible if it establishes (i) a fact capable of demonstrating objectively the meaning that the parties intended, or (ii) an estoppel or special (ie, private dictionary) meaning. Without context, the ambiguous phrase at issue could bear either interpretation. When the context was considered, it was objectively apparent that the parties had agreed on what the price referred to during their negotiations.

McGrath began with an analysis of case law, which concluded that the admissibility of pre-contractual negotiations on questions of construction depends on relevance; thus, subjective intention and understanding are irrelevant, but objective facts may be relevant (with or without ambiguity). In addition, pre-contractual negotiations may be relevant to rectification or estoppel by convention. On the facts of the case - and in contrast to the views of Tipping, Blanchard and Gault - McGrath held that (i) the words used were unambiguous in their terms and included the cost of transmission in the price, and (ii) the pre-contractual material did not reveal the subject matter of the contract, other than that it concerned the supply of gas. Rectification had not been pleaded and could not now be raised. Although estoppel by convention should have been pleaded (but had not been), it was not unfair to consider estoppel by convention in this case, as the 'private dictionary' point had been argued. McGrath found that the parties had reached a common understanding that the price referred to gas energy only, not delivered gas. An estoppel prevented the parties from contending that the price included costs.

Justice Wilson stated that there are only three exceptions to the principle that words in a contract bear their ordinary meaning in context: ambiguity (ie, lack of clarity or conflict), commercial nonsense and estoppel by convention. These exceptions fix the proper limits of considering material extrinsic to a contract. Like McGrath, he found the words unambiguous in the context of the contract; he also held that rectification had not been pleaded and was unavailable. However, the literal meaning defied commercial common sense and could not have been intended. Estoppel by convention arose sufficiently from the pleading of a private dictionary meaning 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, although 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.

Comment

The issues arose from a contract concluded by an exchange of correspondence, not a formal document executed by the parties.

The judgments were influenced as much by differing views on what constituted the relevant contractual language as by differences regarding the applicable principles. The former issue directly influenced the various conclusions about whether the contractual terms were ambiguous and what the plain meaning was. In terms of principles, the major point of difference was whether to adopt a general rule excluding all evidence of pre-contractual communications, but subject to settled exceptions (which include rectification and estoppel). The alternative was to adopt a rule which would merely limit 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. Another point of difference related to a mixture of content and the application of the resulting rule (eg, the requirement for ambiguity and the scope of the subject-matter exception).

The reference in four of the judgments to estoppel, which allows unrestricted reference to negotiations, demonstrates its significance to issues of contractual construction.

None of the judges adopted a more restrictive view on the admissibility of prior communications than was expressed by the majority in Investors Compensation Scheme Ltd v West Bromwich Building Society.(3) The five judges ultimately differed on the basis on which they would modify the restrictions:

• Tipping would generally allow reference to pre-contractual negotiations in order to determine intent objectively;

• Wilson would do so only in the event of ambiguity or commercial absurdity;

• McGrath adopted the Chartbrook approach; and

• Blanchard and Gault preferred to leave the question open, with the former applying the subject-matter exception very liberally.

Overall, the case seems to signal an increasingly liberal approach to reference to negotiations.

Endnotes

(1) SC 65/2008 [2010] NZSC 5.

(2) [2009] 1 AC 110.

(3) [1998] 1 WLR 896 (HL).