What rules or standards do courts apply when interpreting contracts?
Courts in different jurisdictions may employ unique standards when interpreting the meaning of contract terms. Common approaches include:
- Plain Meaning – The majority of jurisdictions interpret contract provisions based upon their “plain meaning.” That is, if a contract term is unambiguous, the court will apply the meaning commonly applied to the term or provision.
- Reasonable Person – Other jurisdictions interpret contract provisions based upon how a “reasonable person” in the applicable circumstances would interpret the contract. This is known as the “objective standard.”
- Subjective Intent – Some jurisdictions will look to any outside evidence to determine the subjective intent of the parties.
Some other common approaches to interpreting contract provisions are as follows:
- Express Terms – Afford the greatest weight to the contract’s express terms.
- Implied Terms – Look to implied terms originating from the course of dealing, course of performance, or trade usage.
- Specific Terms – Give greater weight to specific terms than general terms.
- Actively Negotiated Terms – Terms that are actually negotiated between the parties are given greater weight than standard terms or boilerplate.
- Totality of Circumstances – The court will take into consideration the overall circumstances of the agreement.
- Contract Purpose – The purpose of the contract, if ascertainable, should be considered in interpreting the intentions of the parties.
- All Writings – Interpret all parts of the contract as a whole (including when the contract consists of multiple writings).
- Context – Words are given their prevailing meaning in the context of the contract.
- Trade Terms & Course of Dealing – Specific trade terms are to be interpreted in accordance with their meaning in the trade. The parties’ intentions are interpreted consistently and in accordance with course of performance, dealing, and trade usage.
- Interpret Against Drafter – Ambiguous terms may be interpreted against the drafter.
Jurisdictions may employ any combination of these approaches when interpreting provisions or giving weight to conflicting terms.
• Discussion: Do you agree with this hierarchy of contractual interpretation? Why or why not?
• Practice Question: Ben and Jerry enter into a contract for the sale and purchase of goods. The contract is very short and is written in plain language. Soon after business dealings begin, Ben and Jerry argue of the extent of Ben’s obligation to supply all of the goods that Jerry needs. Jerry sues Ben for breach of contract for failing to meet his supply demands. Ben argues that the contract did not obligate him to meet this level of supply demand. In interpreting the terms of the contract, what are some of the rules that a court will employ?
What is the “Parol Evidence Rule”?
This rule or doctrine concerns the evidence that parties may introduce to the court interpreting the disputed contract. Specifically, it addresses the introduction into court of any evidence of the parties’ agreement that arose prior to the execution of the final agreement and is not included within the written document. This rule either allows or disallows a party from introducing that evidence to the court to modify or add terms to a contract. The purpose of this rule is to prevent confusion in the interpretation of the contract and fraud by any party against another.
• Prior Communications – The parol evidence rule primarily serves to exclude any evidence of prior negotiations (either before or contemporaneous with the signing of the contract) that has the effect of altering the express terms of the agreement. Information or communications contemporaneous with execution of the contract may be admissible in interpreting the contract, but are not admissible if they expressly contradict unambiguous, contract terms.
⁃ Example: You and I enter into a contract for the sale of goods. Later, we argue over the what goods are being sold under the contract. In a lawsuit over the matter, the parol evidence rule will cause the court not to consider our prior communications before we executed the contract if those communications contradict the contract.
• Final Agreement – For the parol evidence rule to apply, the contract must be the final agreement between the parties. This means the contract is an “integration”. If the party is determined to be a final expression of the parties’ agreement, the parol evidence rule is effective to limit what information outside of the writing the parties can introduce to the court in interpreting the agreement.
⁃ Example: In the above example, the court will determine whether the contract was meant to contain all of the terms of our agreement. If we specifically make reference to our prior communications in the contract, it would not be an integration. In determining whether the contract is the final agreement, the court will look to see if the contract includes an integration clause.
• Integration Clause – The best way to make certain that the contract is deemed a complete and final expression of the parties’ intent is to include an “integration clause.” An integration clause, also called a “merger clause,” is a provision in a contract that says that the contract is a complete and final understanding of all the terms of the agreement. In other words, these clauses state that the contract is intended to be a complete integration. Some merger clauses will specifically state that any outside information or communications contemporaneous with the execution of the contract or prior thereto should not be considered a part of the contract. Other, more specific clauses, will specifically reference outside information, documents, or communications and state whether the terms of those items are included in the final agreement. These clauses are usually conclusive unless a contract defense applies (such as fraud, duress, etc.).
⁃ Example: In the above examples, the court finds a clause that states, “This contract is the complete and final agreement of the parties”. In that case, the court will not review our prior email communications to determine what goods are included under the contract. The court will only look at the provisions of the contract itself.
An agreement may appear on its face as simply a partial understanding of the agreement between the parties. In such as case, the contract is not an integration.
• Discussion: Why do you think courts want to exclude prior communications that alter or contradict the terms of the contract? Can you think of any situations in which the court should certainly review prior communications, even if an integration clause is present?
• Practice Question: Clayton enters into an agreement with Samson to provide consulting services. Clayton and Samson later sue each other over the extent of services Clayton is obligated to perform for Samson. Clayton argues that the contract only calls for him to do so preliminary business analysis. Samson argues that Clayton was obligated to perform far more services. He says that prior communications indicate the extent of Clayton’s intended services. What do we need to know to determine whether the court will consider the prior communications in determining Clayton’s obligations under the contract?
What is a “complete integration” and “partial integration”?
The term integration determines the extent to which all provisions of the contract are included in the written document. It can either be completely integrated or partially integrated.
• Complete Integration – A complete integration is when the contract contains all of the facts or information regarding the parties’ agreement. If the court determines that a contract is a complete integration, the parol evidence rule limits all prior or contemporaneous outside evidence that contradicts, modifies, or supplements the contract. A complete integration will generally contain a strong integration clause specifically excluding any outside information not specifically mentioned in the terms of the agreement.
⁃ Example: I enter into a contract to supply you with goods. If the court is called upon to determine the extent of our duties, the court will look to see if the document demonstrates an intent to include all of out terms in the agreement. Including a clause in the contract stating that this is the full and complete understanding of the parties will generally make the document a complete integration. As such, the court will not consider any communications prior to or contemporaneous with the execution of the contract.
• Partial Integration – The written document may contain only part of the information constituting the agreement between the parties. If a court determines that a contract is a partial integration, it will allow certain outside evidence that serves to supplement or explain provisions of the contract. Even with a partial integration, the parol evidence rule restricts outside evidence of prior or contemporaneous communications that specifically contradict the terms of the written contract. Partial integrations generally do not contain integration clauses. Often, the agreement itself will make reference to outside communications to clarify certain provisions of the agreement.
⁃ Example: In the example above, the court determines if the contract is a complete or partial integration. In the agreement, if we make reference to prior communications or it is apparent that we intended for the agreement to include or incorporate prior communications, it is a partial integration. The court would consider any prior communications that appear to supplement or add to the written contract. The court will not consider communications that contradict the express terms of the contract.
• Discussion: Why do you think the court disallows the consideration of contemporaneous and prior communications of the contract is a complete integration? Should the court consider prior communications to fully understand the intent and agreement of the parties? Why or why not?
• Practice Question: Harold enters into a contract so supply Dana with manufacturing materials. The contract does not contain an integration clause. When a dispute arises between Harold and Dana regarding each party’s duties under the agreement, Dana wants the court to consider a chain of emails between her and Harold to explain the extent of their duties. Under what conditions will the court consider the chain of emails?
When does the parol evidence rule not bar the consideration of extrinsic evidence to a contract?
Extrinsic evidence or information prior to or contemporaneous with the formation of the contract cannot be introduced to contradict the contract. Nonetheless, it may be necessary to employ extrinsic evidence or information from outside of the contract for the following reasons:
• to aid in the interpretation of existing terms (for example, when an ambiguity exists),
• to show that a writing is or is not an integration,
• to establish that an integration is complete or partial,
• to establish subsequent agreements or modifications between the parties (i.e., those arising after the contract is completed), or
• to show that the terms of the contract were the product of illegality, fraud, duress, mistake, lack of consideration or other invalidating cause.
These exceptions exist to reduce misunderstanding and fraud between the parties and to promote judicial efficiency in the interpretation of agreements.
• Discussion: Do you agree with these rules for allowing prior communications in the interpretation of a contract? Why or why not?
• Practice Question: Alice enters into a contract with Hannah. They end up in court pursuant to an argument over the terms of the agreement. The contract contains and integration clause, so the court will not consider prior communications that contradict or add to the written agreement. Alice and Hannah are arguing over the type of goods described under the contract. Hannah argues that the description of the goods is ambiguous. Under what conditions will the court review prior communications between Alice and Hannah?
What is a “patent ambiguity” and “latent ambiguity”?
One important exception to the parol evidence rule is the use of extrinsic evidence to determine the meaning the parties attribute to certain terms or provisions. Generally, a court will give a term its common meaning or the meaning common in the context of the contract (such as a particular trade usage). Nonetheless, often a term or provision of the contract will be ambiguous. In such a case, ambiguities are broken into latent and patent ambiguities. Generally, outside evidence may be introduced to clear up an ambiguity that is obvious on the face of the document. This is known as a “patent” ambiguity. If a party claims that the contract contains an ambiguous term, but it is not obvious on the face of the contract, the party is claiming that a “latent” ambiguity exists. In such a case the party may be able to introduce outside evidence to show that an ambiguity exists. If the court determines that an ambiguity exists, it may consider extrinsic evidence to resolve the ambiguity. Many courts do not distinguish between patent and latent ambiguities. If an ambiguity exists, extrinsic evidence is allowed to the extent necessary to clear up the ambiguity. The parol evidence rule’s prohibition on the use of evidence to change or add to the contract remains intact.
• Example: You and I enter into a contract. When a dispute arises, we ask the court to resolve the dispute. When interpreting the terms of the contract the court will use established rules for interpreting the meaning of words and clauses. If the court determines that a word or clause is ambiguous when reading it (a patent ambiguity), it may allow outside information to explain the term. If the court does not read a term as ambiguous, it may allow me to introduce outside evidence to demonstrate that it is ambiguous. If I am successful in demonstrating an ambiguity, the court will then consider outside information to explain the ambiguous term.
• Discussion: Why do you think the court treats patent and latent ambiguities differently? Should the court consider all evidence and prior communications when determining the meaning or intent of the parties? Why or why not?
• Practice Question: Alice enters into a contract with Hannah. They end up in court pursuant to an argument over the terms of the agreement. The contract contains an integration clause, so the court will not consider prior communications that contradict or add to the written agreement. Alice are arguing over the type of goods described under the contract. Hannah argues that the description of the goods is ambiguous. Under what conditions will the court review prior communications between Alice and Hannah?