Wednesday, August 27, 2014

The Blue Paper and the Pink Paper: The Interpretation of Options

One of the most frequently encountered issues in the practice of commercial law is the construction of contractual notice requirements: a contract that confers on one of the parties the right to do something (eg exercise an option or a break clause) would ordinarily require that party to give notice to the other party. The consequences of failing to understand exactly what the notice requires and comply with it can be disastrous: for example, a tenant may lose the opportunity to exit an expensive lease in a falling market, an option-holder the opportunity to buy valuable property in a rising market and so on. The Court of Appeal has recently considered the principles governing the construction of clauses of this kind in Friends Life v Siemens.

The leading authority in this field is the classic speech of Lord Hoffmann in Mannai Investments. The facts of that case were beguilingly simple. A tenant with a 10-year lease of a property in Jermyn Street in London was allowed to exercise a break clause provided he gave notice to this effect to ‘expire on the third anniversary of the commencement date’ of the lease. The lease had been entered into on 13 January 1992. So the tenant should have given notice to expire on 13 January 1995. But it mistakenly gave notice to expire on 12 January 1995, confusing ‘first day of third year’ with ‘last day of second year’. Though what the tenant meant was obvious to the landlord (who was seeking to capitalise on the error), the judge and the Court of Appeal held that the notice was defective, particularly against the background principle that break clauses and notice requirements for options must be complied with strictly. In the House of Lords, allowing the appeal, Lord Hoffmann explained that the tenant had in fact complied strictly with the notice requirement because one does not confuse the ‘inherent’ meaning of words (if any) with the meaning the use of the words conveys to a reasonable person possessed of all the background knowledge the parties had.

Friends Life, at first sight, was a remarkably similar case. The tenant had taken a 25 year lease commencing in January 1999. It had one opportunity to exit this lease by exercising a break clause. Clause 19.2 provided that the tenant could exercise the break clause by:

giving the Landlord not more than 12 months’ and not less than six months’ written notice, which notice must be expressed to be given under section 24(2) of the Landlord and Tenant Act 1954.

On 28 September 2012, the tenant purported to exercise this break clause by serving a notice in the following form:

…WE HEREBY GIVE YOU NOTICE, for and on behalf of the Tenant, that the Tenant intends to terminate the Lease 23 August 2013 in accordance with clause 19 of the Lease.

This notice, as is evident, was ‘expressed to be given’ in accordance with clause 19 of the Lease, rather than (as clause 19 required) ‘under section 24(2) of the Landlord and Tenant Act 1954’. It is obvious that the tenant’s intention is plain, as it was in Mannai: the landlord could not have understood the notice to mean anything other than that the tenant was exercising the break clause.

In these circumstances, a layman might be surprised to learn that there is even a debate to be had about whether the notice is effective or not. The Court of Appeal held, however, that the tenant had made a fatal mistake, and it is submitted that that is clearly correct, and consistent with Mannai. In analysing cases of this kind, it is important to distinguish between: (a) a clause that requires the notice-giver to communicate a message bearing a certain meaning to the recipient; and (b) a clause that requires the notice-giver to comply with some condition that is independent of the meaning of words. In Mannai, Lord Hoffmann gave a well-known example that illustrates the difference:

If the clause had said that notice had to be on blue paper, it would have been no good serving a notice on pink paper, however clear it might have been that the tenant wanted to terminate the lease.

If the clause falls under category (a), the notice-giver can comply with it successfully even if it uses the ‘wrong’ words. In Mannai, the notice stated to expire on ‘January 13’ conveyed the meaning that it was to expire on ‘January 12’ because no reasonable representee could have thought in those circumstances that January 13 was the intended meaning. Notices of this kind are successful not because they ‘substantially comply’ with the contractual requirement: they comply with it fully and strictly. But this kind of reasoning is simply irrelevant if the clause in question falls under (b): the only way to comply with a requirement to send a notice on blue paper is to use blue paper. It is no good using pink paper even if the landlord knows that this was a mistake, and even if the message written on the pink paper was understood perfectly well by the landlord: the problem is the paper, not the message. Mannai and the cases that apply it, therefore, do not decide that ‘substantial’ compliance is enough: they decide that complete and exact compliance has been achieved even though the wrong words have been used.

In Friends Life, clause 19 required the tenant to give notice expressed to be under section 24(2) of the Landlord and Tenant Act 1954. This seems to be a clause under category (b) above: it does not relate to the meaning that the tenant must communicate to the landlord but to some form of words that the notice must use. At first blush, the conclusion that the notice is invalid seems obvious. But leading counsel for the tenant argued that clause 19 should be taken to have been complied with if the reason for the insertion of clause 19 has been complied with, that is, if the mischief clause 19 was intended to address has not been defeated because of the tenant’s mistake. Lewison LJ correctly rejects this argument in an instructive passage:

Attractively as that argument was advanced I cannot accept it. I accept, of course, that the purpose underlying a contractual provision may be highly relevant to what it means. But Mr Fancourt accepted that what the clause meant was that the notice had to say that it was being given under section 24 (2) of the Landlord and Tenant Act 1954. He did not contend that clause 19.2 should be interpreted in such a way that it meant no more than that the notice should satisfy the substantive provisions of section 24 (2). But compliance with the substantive provisions of section 24 (2) is not the same as complying with the formal requirements of clause 19.2. Moreover as Mr Wonnacott submitted since clause 19.2 required that the notice be “expressed” to be given under section 24 (2) it would not be enough to conclude that it conveyed that message implicitly. Here there was no compliance with the formal requirement of clause 19.2 that the notice be “expressed” in a particular way. There was quite simply no reference in the notice to section 24 (2) at all.

In other words, there is a difference between what clause 19 means, and why clause 19 was inserted: it is no good complying with the latter without complying with the former. The tenant’s obligation is to give notice in accordance with what clause 19 means, not to give notice that fulfils the reason for including clause 19 in the contract in the first place.

The importance of this case for the general law is that it highlights the value of a close analysis of whether a notice requirement relates to the meaning of words (thus governed by the Mannai rule) or to some form of words or condition independent of the meaning of words (thus governed by the pink paper example). Making a mistake about this can result in expensive litigation. As Lewison LJ says:

I do not accept that in the field of unilateral (or “if” contracts) there is any room for the notion of substantial compliance. As Diplock LJ said in United Dominions Trust the question is whether the relevant event has occurred. That question is to be answered “Yes” or “No”. It cannot be answered “Almost”. Either a purported exercise of an option satisfies both the formal and substantive provisions of the clause, or it does not. If it does not, then it is ineffective. In my judgment ours is such a case. I appreciate that that is a harsh result, but hard cases make bad law…The clear moral is: if you want to avoid expensive litigation, and the possible loss of a valuable right to break, you must pay close attention to all the requirements of the clause, including the formal requirements, and follow them precisely.

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