UK: Basic Principles Applied By The Court Of Appeal In Contract Interpretation And Implied Terms

When parties to a contract dispute its terms, the court, when construing its meaning, will first look to the specific words the parties used to reach their agreement before looking at commercial common sense, or implied terms and will only consider several contracts together where they form a contemporaneous single composite transaction between the same parties.

In Kason Kek-Gardner Ltd v Process Components Limited, the Court of Appeal has once more reverted to basic principles when interpreting a contract and considering the need for implied terms.

The background

In Kason Kek-Gardner Ltd v Process Components Limited, a company in administration (K) entered into two asset sales agreements (the Sales Agreements), the first with Process Components Ltd (P) for the sale of two of its four business divisions and the second, 10 days later, with Kason Kek-Gardner Ltd (Kason) for the sale of the remaining two divisions. Each Sales Agreement included the sale of defined intellectual property rights (IPR).

P and Kason were new companies formed by former - but different - directors of K.

Following completion of the Sales Agreements, P and Kason entered into a licence agreement (the Licence Agreement) under which Kason acknowledged that P owned all the IPR that had formerly belonged to K, and P licensed Kason to use the IPR which Kason required to operate the two divisions it had acquired.

The Licence Agreement contained a confidentiality clause, and a termination clause which provided that a breach of the confidentiality obligation constituted a non-remedial material breach entitling the other party to give written notice of immediate termination.

Subsequently, the shareholders in Kason sold their shares to a competitor of P. As part of the share sale due diligence process, Kason disclosed a copy of the Licence Agreement to the purchaser. P considered that disclosure to be a breach of the confidentiality clause and terminated the Licence Agreement.

The issues

A dispute arose, amongst other things, as to:

• What IPR each party had, in fact, acquired under their respective Sales Agreements with K. Kason argued it had acquired from K all the necessary IPR rights to carry on its business, and so did not require any licence from P; and
• Dependent upon the determination of the above, whether the Licence Agreement had been validly terminated.

Ownership of the IPR

Kason argued that:

• As both Sales Agreements to P and itself were part of the same administration, they should be read together. The obvious effect of this was that P had acquired the IPR for the two divisions it had acquired and Kason had also acquired the IPR for two divisions;
• The administrators had an obligation to realise all of K's assets for the best price achievable. They, and P, knew that two of K's four business divisions were excluded from the sale to P and that selling the IPR to those excluded divisions to P would depreciate the value of the divisions sold to Kason; and
• Given the above, a reasonable reader of the Sales Agreement to P would have been surprised if the IPR transferred to P went beyond that which was necessary for the two divisions it had acquired. Had that been the intention, the Sales Agreement would have expressly provided so.

The Court of Appeal agreed that where there are contemporaneous contracts made between the same parties, which form part of a single composite transaction between the same parties, then the several documents can be read together. However, that was not the position here. The two Sales Agreements were entered into 10 days apart and between different parties. They were not a suite of documents that could be read together and the second Sale Agreement could not be used to interpret the first.

Although admissible background evidence can be considered when construing a document, such background is limited to facts known or reasonably available to all parties, not to just one of them. Declarations of subjective intention are not part of the admissible background. There was nothing in the admissible background or language of the Sale Agreement to P to conclude that the IPR was divided as Kason argued. Kason's reliance entirely on commercial common sense and background could not be used to devalue the importance of the actual words used. Kason had not acquired the relevant IPR for the divisions it had purchased.

Was the Licence Agreement properly terminated?

Kason argued that:

• The confidentiality clause was subject to an implied term which permitted it to be disclosed for reasonable business purposes; and
• Only a material breach, not any breach, of the confidentiality provision entitled termination, and that the disclosure that took place was not a material breach.

The Court of Appeal held that a term will not be implied into a detailed commercial contract unless:

• It is necessary either to give the contract business efficacy; or
• It is so obvious that it goes without saying.

It is not enough that it would have been sensible to have agreed the term, or that with hindsight, the terms actually agreed operate to the disadvantage of one of the parties.

However, and consistent with established precedent, if the term to be implied passed either of these two tests, and was therefore to be implied, the existence of an entire agreement clause would not defeat it.

The term that Kason sought to imply was far too wide as it sought to permit disclosure of the Licence Agreement to a competitor, not just its lawyers or its regulator (which it might be obliged to do by law). The 'necessity' required by the test is for the business efficacy of the contract; not some wider business purpose of a contracting party. The business purpose of the Licence Agreement was to enable Kason to operate the two acquired business divisions, not for its shareholders to sell their shares. A sale of the business was not a necessary business purpose of the Licence Agreement.

Neither was the term sought to be implied, one that was so obvious that it went without saying. It was not obvious that P would have consented to disclosure of the terms of the Licence Agreement to a competitor, and even if it had, the limits of the permission would have been carefully negotiated.

As to the material breach point, the clause specifically provided that breach of the confidentiality clause was a non-remediable material breach. The termination provisions in the Licence Agreement were not a blanket provision providing for termination for any breach. In such cases, the court may well read down the apparent width of the termination clause so as to confine it to repudiatory breaches. The confidentiality clause had been singled out for special treatment in the termination clause. Where a contract expressly provided for rights of termination, it did not matter whether the event on which the right became exercisable amounted to a repudiatory breach.

Kason was in breach of the confidentiality clause and on the wording of the termination clause, P had validly terminated the Licence Agreement.

What does this mean for those negotiating and drafting contracts?

There is no new law in this decision but it provides a clear reminder that the primary tool to interpretation of a contract is the objective meaning of the words that the parties (to the contract) use in the context of the factual background known, or reasonably available, to them at the time of the agreement. Parties need to be clear on what they intend to contract for and make sure that the words they use clearly reflect that intention. If that is achieved, it will be difficult for one party to try and escape from what subsequently turns out simply to be a bad bargain.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.