Supreme Court applies common sense in interpreting Advance Payment Guarantees

Updated November 2011

In the case of Rainy Sky S.A. and others (Appellants) v Kookmin Bank (Respondent) [2011] UKSC 50, Buyers under six materially identical shipbuilding contracts (the Contracts) with a Korean shipyard (the Builder) were required, in the usual way, to make advance payments to the Builder. The Contracts provided that the Buyers were entitled to a refund of those advance payments in defined circumstances including the cancellation of the Contracts, events of default by the Builder and where the Builder became subject to certain insolvency proceedings.

The Builder, as called for by the Contract, had arranged for Advance Payment Guarantees (the Guarantees) issued by Kookmin Bank (the Bank) as security for the Builder’s obligations to refund the advance payments. The Contracts provided that the Guarantees were to be in a form acceptable to the Buyers’ financiers. The proposed wording for the Guarantees was supposed to have been annexed to the Contracts, but in fact was not.

The Shipyard became subject to an insolvency event in Korea, as a result of which the Buyers claimed a refund of the pre-delivery instalments. The Builder did not make payment, so the Buyers made a claim on the Guarantees. The Bank declined to pay, ultimately on the ground that on the true construction of the Guarantees, there was no obligation on the Bank to pay where the Buyers' right to claim a refund of the advance payments arose, not from termination of the Contracts but as a result of the Builder's insolvency. The problem lay with the wording of paragraphs 2 and 3 of the Guarantees which stated:

2. "Pursuant to the terms of the Contract, you are entitled, upon your rejection of the Vessel in accordance with the terms of the Contract, your termination, cancellation or rescission of the Contract or upon a Total Loss of the Vessel, to repayment of the pre-delivery instalments of the Contract Price paid by you prior to such termination or a Total Loss of the Vessel (as the case may be) ….".

3. "In consideration of your agreement to make the pre-delivery instalments under the Contract and for other good and valuable consideration (the receipt and adequacy of which is hereby acknowledged), we hereby, as primary obligor, irrevocably and unconditionally undertake to pay to you, your successors and assigns, on your first written demand, all such sums due to you under the Contract…".

The key issue for the court was the true meaning of paragraph 3. The Bank had promised to pay on demand “all such sums due to [the Buyers] under the Contract”. The question was what was meant by “such sums”. Only two possible meanings were suggested. The Buyers said that the expression “such sums” referred back to the “predelivery instalments” in the first line. They said that the purpose of the Guarantees was to guarantee the refund of pre-delivery instalments and that the promise was therefore to refund pre-delivery instalments. By contrast, the Bank said that the expression “such sums” was a reference back to the sums referred to in paragraph 2, namely the repayment of the pre-delivery instalments paid prior to a termination of the Contract. On the Buyers’ analysis the Guarantees guaranteed pre-delivery instalments which were repayable under Article XII.3 in the case of any insolvency event, whereas on the Bank’s analysis it did not.

Giving judgment for the Supreme Court (which was unanimous), Lord Clarke was strongly influenced by the commercial purpose of the Guarantees, which was to provide security for the Buyers' financiers in the event that the Builder became obliged to refund the advance payments. He agreed with the Judge of first instance and Sir Simon Tuckey (the dissenting judge in the Court of Appeal) that the Bank's interpretation defied common sense since the insolvency of the Builder was the very situation for which the security of an advance payment guarantee was most likely to be needed.

A difficulty both sides faced was trying to explain the purpose of paragraph 2. The Buyers’ argument was that it was merely a preamble to paragraph 3 and was not intended to limit the scope of the Bank’s obligations. The Bank (with some force) argued that paragraph 2 had to have some purpose, namely to identify the scope of paragraph 3. The problem for the Bank was that its construction of the Guarantee (ie that it had to pay in every situation apart from insolvency) was contrary to common sense and it could identify no explanation for why the parties would have agreed to limit the Bank’s obligations in this way.

Lord Clarke reviewed the law on the interpretation of contracts. In his view, it was not necessary (as the Court of Appeal had suggested) to conclude that the natural meaning of the words would produce a result that was so extreme as to suggest that it was unintended, before being able to take into account the commercial purpose of the agreement.

He summarised the correct approach where the wording was ambiguous as:

“Where a term of a contract is open to more than one interpretation, it is generally appropriate to adopt the interpretation which is most consistent with business common sense."

He agreed that paragraph 3 of the Guarantees was unclear and in those circumstances he preferred the Buyers’ construction as the one that was most consistent with the commercial purpose of the Guarantees.

Although this dispute arose out of the particular ambiguous wording of these Guarantees, the judgment of the Supreme Court is a welcome clarification of the circumstances in which the English courts will take into account the commercial purpose of documents when faced with wording that is unclear.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at November 2011. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.

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