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The Danger of Interpreting a Contract in a Vacuum

Posted on February 3, 2015 | Posted in Lawyers' Issues

Your client tells you his story of a dispute with his business partner, gives you a 40-page agreement, refers you to three lines in, say, paragraph 42(1)(ii) of it, and asks whether the lines will be interpreted according to his interpretation of them. He has allotted 1/2 hour for your consultation and expects an answer within that time. Can you do it? Not if you heed the guidelines set out in Creston Moly Corp v. Sattva Capital Corp, 2014 SCC 53, 25 B.L.R. (5th) 1.




The case involved a dispute over the date to be used to set the price, and therefore the number, of shares to which one of the parties was entitled. The matter was arbitrated; the arbitrator interpreted the contract, made a decision, and set the price; one party wanted to appeal that decision. Under the BC Arbitration Act, the issues under appeal had to fall within specified conditions set out in that Act. Suffice to say that it is much easier to appeal if the issue in dispute revolves around a question of law rather than a question of fact.


The importance of differentiating between a question of law and a question of mixed fact and law is not limited to an appeal of an arbitration decision. If the issue relates to a matter of law in an appeal to an appellate court from a lower court, then the standard of review is correctness (i.e. was the original decision correct or not). If the issue relates to a question of fact or mixed fact and law, then the appellate court can overturn only if the trial decision contained a palpable and overriding error (i.e. the error is obvious and would have affected the outcome of the lower court ruling).


Historically, the determination of legal rights under a written contract was considered a question of law because, at the time that the rule was established, only a judge was assured to be literate and therefore capable of reading the contract. Times have changed.




The Court noted that the law had been shifting from the historical approach for two reasons: the adoption of the factual matrix method of interpreting a contract and the difference in appellate constraint between questions of law and questions of mixed fact and law as set out in Housen v. Nikolaisen, 2002 SCC 33, [2002] 2 S.C.R. 235.


As to the first reason, the Court noted that “the interpretation of contracts has evolved towards a practical, common-sense approach not dominated by technical rules of construction. The overriding concern is to determine “the intent of the parties and the scope of their understanding” … To do so, a decision-maker must read the contract as a whole, giving the words used their ordinary and grammatical meaning, consistent with the surrounding circumstances known to the parties at the time of formation of the contract. Consideration of the surrounding circumstances recognizes that ascertaining contractual intention can be difficult when looking at words on their own, because words alone do not have an immutable or absolute meaning … The meaning of words is often derived from a number of contextual factors, including the purpose of the agreement and the nature of the relationship created by the agreement.”


As to the second reason, the Court noted that “questions of law are questions about what the correct legal test is. Yet in contractual interpretation, the goal of the exercise is to ascertain the objective intent of the parties – a fact-specific goal – through the application of legal principles of interpretation. This appears closer to a question of mixed fact and law”


The Court abandoned the historical approach, explaining that doing so accorded with the central purpose of distinguishing between questions of law and those of mixed fact and law; that is, “to limit the intervention of appellate courts to cases where the results can be expected to have an impact beyond the parties to the particular dispute. It reflects the role of courts of appeal in ensuring the consistency of the law, rather than in providing a new forum for parties to continue their private litigation…The legal obligations arising from a contract are, in most cases, limited to the interest of the particular parties. Given that our legal system leaves broad scope to tribunals of first instance to resolve issues of limited application, this supports treating contractual interpretation as a question of mixed fact and law.”


This does not mean that every issue regarding a contract deals with mixed fact and law. A court can make legal errors, for example, by applying an incorrect principle; ignoring the rule that certain contracts must be in writing; failing to consider a required element of a legal test or a relevant factor; failing to deal with the capacity of the parties to contract; or failing to adhere to the rules regarding the formation of contracts. However, the Court warned that, since the goal of contractual interpretation is to ascertain the objective intentions of the parties and is inherently fact specific, “the circumstances in which a question of law can be extricated from the interpretation process will be rare.”


Parol Evidence


As already noted, surrounding circumstances must be considered in interpreting the terms of a contract. However, the court stated, “they must never be allowed to overwhelm the words of that agreement. The goal of examining such evidence is to deepen a decision-maker’s understanding of the mutual and objective intentions of the parties as expressed in the words of the contract. The interpretation of a written contractual provision must always be grounded in the text and read in light of the entire contract. While the surrounding circumstances are relied upon in the interpretive process, courts cannot use them to deviate from the text such that the court effectively creates a new agreement. … It should consist only of objective evidence of the background facts at the time of the execution of the contract, that is, knowledge that was or reasonably ought to have been within the knowledge of both parties at or before the date of contracting. … Whether something was or reasonably ought to have been within the common knowledge of the parties at the time of execution of the contract is a question of fact.”


How does the parol evidence rule fit into this model? It precludes admission of evidence outside the words of the written contract that would add to, subtract from, vary, or contradict a contract that has been wholly reduced to writing. It precludes evidence of the subjective intentions of the parties. Its primary purpose is to achieve finality and certainty in contractual obligations and secondarily to hamper a party’s ability to use fabricated or unreliable evidence to attack a written contract. It does not apply to preclude evidence of the surrounding circumstances. This evidence is consistent with the objectives of finality and certainty because it is used as an interpretive aid for determining the meaning of the written words chosen by the parties, not to change or overrule the meaning of those words. The surrounding circumstances are facts known, or that reasonably ought to have been known, to both parties at or before the date of contracting; therefore, the concern of unreliability does not arise.




So how does this affect the ordinary lawyer in the circumstances we set out at the start? You cannot interpret a contract in a vacuum. You certainly cannot interpret a random portion of it. You have to read the entire contract and understand what happened while the contract was being formed. Often, initial drafts of the agreement will give some context to the revisions. Can a lawyer do this in ½ hour, in an hour, or even in two? Probably not.


Image courtesy of Flikr, Creative Commons.
Jonathan Speigel


Written by Jonathan Speigel Jonathan Speigel, the founding partner of Speigel Nichols Fox LLP, leads the litigation and construction practices.


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