Both in the boardroom and the courtroom, businesses and their counsel need a firm handle on the main principles of contractual interpretation:
- The words in the contract must be given their ordinary and grammatical meaning in a manner consistent with the surrounding circumstances known to the parties when the contract was formed,
- these surrounding circumstances include the commercial purpose of the contract (taking account of such aspects as the reason for the transaction and its market), since
- surrounding circumstances should include only objective evidence of the background facts at the time the contract was formed (information that was or should reasonably have been known to the parties at the time or before they entered into the contract).
The Alberta Court of Appeal applied these principles in a decision pronounced last month, Hole v. Hole, 2016 ABCA 34 (“Hole”). The background was a family dispute. The plaintiff agreed to transition out of a family business operated with the defendant which involved a certain “Project”, on payment of $1.6 million from the defendants. The parties signed a “letter of understanding” (“LOU”) and 8 days later signed a formal “Transition Agreement”.
The terms were unclear: while the LOU stated that the defendants “fully recognize” and “acknowledge” that the plaintiff’s share in the Project was $1.6 million, the final Transition Agreement provided that plaintiff’s payout was “payable…as funds are available…” The lawsuit arose because although paid $600,000, the plaintiff was seeking payment of the $1 million balance. The defendants contended that despite their acknowledgment in the LOU, they did not owe that sum.
The heart of the dispute was whether the LOU had contractual effect.
The Court of Appeal said it did and overturned the trial judge’s decision, chiefly because the trial judge accepted evidence regarding what occurred after the LOU was signed.
For example, the trial judge gave weight to correspondence from the individual defendants well after the LOU and Transition Agreement were signed, and agreed with the defendants that they were only to pay the remaining $1 million if it arose out of profits obtained after the Project and contingent on participation of the plaintiff in future projects.
On appeal, such evidence was ruled inadmissible as it arose after the agreement was signed so was not part of the ‘surrounding circumstances’ to be considered in contractual interpretation of the LOU. The Court of Appeal found that that the LOU was a valid contract linked to the Transition Agreement: “a reasonable person having knowledge of the admissible surrounding circumstances would have reasonably understood that the objective of the LOU was to defer payment of $1 million until the business of the respondents became financially stable, [but] that the signatories had agreed to pay and had a continuing obligation to pay $1 million plus interest […].”
The Court of Appeal stated that “courts should choose an interpretation which promotes a sensible commercial result and should discard an interpretation which defeats the intentions and objectives of the document, if construed fairly and broadly in the context of the surrounding circumstances”. In essence, the Court of Appeal found that it was not commercially reasonable to interpret the LOU in a way whereby the plaintiffs walked away with only a conditional payment, especially where 1) the parties knew the Project was substantially complete and 2) the LOU was signed mere days before the Transition Agreement was signed. The conclusion was that “the LOU was intended to create a legally enforceable obligation of the [defendants] to pay the [plaintiffs] $1 million, with interest, at a time that was dependant on the success and financial stability of the joint venture companies.”
The key takeaways?
First, parties should detail in their agreement what they consider the surrounding circumstances to be at the time they enter into an agreement, since those circumstances govern how the agreement is to be interpreted by courts or arbitrators.
Second, a letter of understanding will likely be found to have contractual effect if the surrounding circumstances at the time of its creation show the parties intended it to have such effect. This will especially be the case if the letter specifically references the agreement under negotiation and the agreement is executed a short time later.
Invitation for Discussion:
Our litigation lawyers are skilled at drafting and enforcement of transitional agreements like this. If you would like to discuss anything in this blog or any other business litigation matter, please contact one of our lawyers in the Business Litigation group at Linmac LLP.
Disclaimer:
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.