The object of construction

The primary object of construction is to determine the parties’ intention. Intention in this context means the parties' objectively determined intention, not the parties’ actual or subjective intentions. The objective intention is determined as manifested in the contract and the presumed intention found by examination of the surrounding circumstances.

The objective process of contractual construction involves the determination not of what the parties meant, but of what the parties’ agreement means: Bacchus Marsh Concentrated Milk Co Ltd v Joseph Nathan & Co Ltd (1919) 26 CLR 410 at 444.

Codelfa and the “true rule”

In Codelfa Construction Pty Ltd v State Rail Authority of NSW (1982) 149 CLR 337 at 352 (“Codelfa”) Mason J described what is commonly known as the ‘true rule’:

The true rule is that evidence of surrounding circumstances is admissible to assist in the interpretation of the contract if the language is ambiguous or susceptible of more than one meaning. But it is not admissible to contradict the language of the contract if it has a plain meaning.

Mason J explained the objective theory of contract in the following terms at 352:

We do not take into account the actual intentions of the parties and for the very good reason that an investigation of those matters would not only be time consuming but it would also be unrewarding as it would tend to give too much weight to these factors at the expense of the actual language of the written contract.

Ambiguity

Codelfa contains a gateway requirement of ambiguity in the words of a contract for it to apply. In Mount Bruce Mining Pty Ltd v Wright Prospecting Pty Ltd (2015) 256 CLR 104 at [48] the court held:

Ordinarily, this process of construction is possible by reference to the contract alone. Indeed, if an expression in a contract is unambiguous or susceptible of only one meaning, evidence of surrounding circumstances (events, circumstances and things external to the contract) cannot be adduced to contradict its plain meaning.

This raises the question of what is meant by ‘ambiguity’. Ambiguity means that the words of a contract are capable of more than one meaning. Where there is ambiguity, where the words as susceptible of more than one meaning, evidence of surrounding circumstances may be admissible to resolve that ambiguity.

The court’s task is to look at the words in context. In ICS v West Bromwich Building Society [1998] 1 WLR 896, 912-3 it was held:

The meaning of words is a matter of dictionaries and grammars; the meaning of the document is what the parties using those words against the relevant background would reasonably has been understood to mean.

The historical view of ambiguity has been where the face of the contract appears to conflict. For example, a clause that says “X will pay to Y” and X is defined differently in two clauses. The more contemporary view is that ambiguity may be apparent in light of surrounding circumstances.

However, the authorities make it clear that surrounding circumstances cannot be used to create the ambiguity. Any ambiguity must arise first from the text. Only then will the court look for the surrounding context and purpose.

The debate about ambiguity

Much intermediate appellant debate has transpired over whether ambiguity is a ‘gateway’ requirement for the ‘true rule’ in Codelfa to apply. The Victorian Court of Appeal in MBF Investments Pty Ltd v Nolan [2011] VSCA 114 at [195]-[204] viewed the Codelfa ambiguity threshold as history.

However the High Court in Western Export Services Inc v Jireh International Pty Ltd [2011] HCA 45, Gummow, Heydon and Bell JJ took the quick and unusual step of publishing written reasons in refusing an application for special leave. The matter concerned a point of contractual construction in a letter of agreement. The judges said at [2] – [6]:

The primary judge had referred to what he described as 'the summary of principles' in Franklins Pty Ltd v Metcash Trading Ltd (2009) 76 NSWLR 603 at 618 [19] and following. The applicant in this Court refers to that decision and to MBF Investments Pty Ltd v Nolan [2011] VSCA 114 at [195]-[204] as authority rejecting the requirement that it is essential to identify ambiguity in the language of the contract before the court may have regard to the surrounding circumstances and object of the transaction. The applicant also refers to statements in England said to be to the same effect, including that by Lord Steyn in R (Westminster City Council) v National Asylum Support Service [2002] 1 WLR 2956 at 2958-2959 [4]-[5]; [2002] 4 All ER 654 at 656-657.
Acceptance of the applicant's submission, clearly would require reconsideration by this Court of what was said in Codelfa Construction Pty Ltd v State Rail Authority of NSW [1982] HCA 24; (1982) 149 CLR 337 at 352 by Mason J, with the concurrence of Stephen J and Wilson J, to be the 'true rule' as to the admission of evidence of surrounding circumstances. Until this Court embarks upon that exercise and disapproves or revises what was said in Codelfa, intermediate appellate courts are bound to follow that precedent. The same is true of primary judges, notwithstanding what may appear to have been said by intermediate appellate courts.
The position of Codelfa, as a binding authority, was made clear in the joint reasons of five Justices in Royal Botanic Gardens and Domain Trust v South Sydney City Council [2002] HCA 5; (2002) 240 CLR 45 at 62-63 [39] and it should not have been necessary to reiterate the point here.
We do not read anything said in this Court in Pacific Carriers Ltd v BNP Paribas [2004] HCA 35; (2004) 218 CLR 451 at 461-462 [22]; Toll (FGCT) Pty Ltd v Alphapharm Pty Ltd [2004] HCA 52; (2004) 219 CLR 165 at 179 [40]; Wilkie v Gordian Runoff Ltd [2005] HCA 17; (2005) 221 CLR 522 at 528-529 [15] and International Air Transport Association v Ansett Australia Holdings Ltd [2008] HCA 3; (2008) 234 CLR 151 at 160 [8], 174 [53] as operating inconsistently with what was said by Mason J in the passage in Codelfa to which we have referred.
However, the result reached by the Court of Appeal in this case was correct. Further, even if, as the applicant contends, cl 3 in the Letter of Agreement should be construed as understood by a reasonable person in the position of the parties, with knowledge of the surrounding circumstances and the object of the transaction, the result would have been no different. Accordingly, special leave is refused with costs.

So the High Court, albeit by two now retired judges, has confirmed Codelfa as binding authority.

The intention the court must ascertain

Mason J in Codelfa a 352 explained the intention a court must ascertain for the purpose of determining the correct construction:

Consequently when the issue is which of two or more possible meanings is to be given to a contractual provision we look, not to the actual intentions, aspirations or expectations of the parties before or at the time of the contract, except in so far as they are expressed in the contract, but to the objective framework of facts within which the contract came into existence, and to the parties’ presumed intention in this setting.(see also Wilson v Anderson (2002) 213 CLR 401 at 418 [8])

Reasonable intelligent bystander test

This objective approach to construction had led the court to apply a test involving a ‘reasonable intelligent bystander’ or, in the case of commercial agreements, the ‘reasonable business person’: Schenker & Co Aust Pty Ltd v Maplas Equipment and Services Pty Ltd [1990] VR 834 at 840.

The role of the objective person was described In Hospital Products Ltd v United States Surgical Corporation (1984) 156 CLR 41 by 62 Gibbs CJ:

The intelligent bystander must however be in the situation of the parties, for ‘what must be ascertained is what is to be taken as the intention which a reasonable person would have had if placed in the situation of the parties’: Reardon Smith Line v Hansen-Tangen [1976] 1 WLR 989 at 996.

In Toll (FGCT) Pty Ltd v Alphapharm Pty Ltd (2004) 219 CLR 165 at 179 (see also Pacific Carriers Ltd v BNP Paribas (2004) 218 CLR 451 at 462 [22]) the High Court said:

References to the common intention of the parties to a contract are to be understood as referring to what a reasonable person would understand by the language in which the parties have expressed their agreement. The meaning of the terms of a contractual document is to be determined by what a reasonable person would have understood them to mean.

When parties have consented to reducing their agreement to a particular form of words, courts focus on the words themselves and the circumstances in which the contract was formed. They will not have regard to the parties’ actual intentions. This objective approach places significant restriction on the evidence admissible in determining the question of construction.

Business common sense

When determining the parties’ expressed or presumed intention, Barwick CJ in Council of the Upper Hunter County District v Australian Chilling and Freezing Co Ltd (1968) 118 CLR 429 at 437 warned:

In the search for that intention, no narrow or pedantic approach is warranted, particularly in the case of commercial agreements.

In Cohen & Co v Ockerby & Co Ltd (1917) 24 CLR 288 at 300, Isaacs J said:

…expressions, and particularly any elliptical expressions, in a mercantile contract are to be read in no narrow spirit of construction, but as the Court would suppose two honest business men would understand the words they have actually used with reference to their subject matter and the surrounding circumstances.

Similarly, Lord Diplock said in Antaios Compania Naviera SA v Salen Rederierna AB [1985] AC 191 at 201:

If detailed semantic and syntactical analysis of words in a commercial contract is going to lead to a conclusion that flouts business commonsense, it must be made to yield to business commonsense.

In Vroon BV v Foster’s Brewing Group Ltd [1994] 2 VR 32 at 67, Ormiston J explained the rule of construction but warned that it had limits to its application:

I would accept that in commercial transactions the court should strive to give effect to the expressed arrangements and expectations of those engaged in business, notwithstanding that there are areas of uncertainty and notwithstanding that particular terms have been omitted or not fully worked out. Where one should draw the line is difficult to state and equally difficult to apply. The court’s desire to give effect to commercial bargains has in recent years been frequently reiterated but occasionally overstated.

Ormiston J observed that regard to business commonsense may not necessarily assist where the parties have omitted a series of significant terms in their contract: [1994] 2 VR 32 at 67. Further, the rule cannot be used to overcome the terms of an agreement merely because they appear to lack a commercial justification. However if the language of a term is open to two or more meanings, a court may construe the term so as to give it a meaning consistent with commercial commonsense: MFI Properties Ltd v BICC Group Pension Trust Ltd [1986] 1 All ER 974 at 976.

The construction of commercial contracts with regard to business commonsense serves a number of purposes. First, it enables business people to resolve their disputes without necessary recourse to lawyers. If lawyers were a necessity, it would obstruct business with delays and unnecessary costs. Second, business is assisted where business people are able to understand their contracts, assess any inherent risks, and decide as to the most economical means of providing for them: Schenker & Co (Aust) Pty Ltd v Maplas Equipment and Services Pty Ltd [1990] VR 834 at 848

Summary

Read the "true rule" in Codelfa carefully. It remains good law.
'Ambiguous' means "capable of more than one meaning". There is almost always a choice to be made regarding the construction of the words in the contract.
The process of construction should proceed by recourse to the words within the contract. The reasonable intelligent bystander test and business commonsense test may assist.
Ambiguity should not arise from the surrounding circumstances. The ambiguity should be resolved by recourse to the text, then its context and purpose.