Deciphering Ambiguities in Contracts: The ‘Oh, of course!’ Principle

First published on Bar and Bench here

Contract law confines itself to the enforcement of voluntarily created obligations. It does not create rights and duties between the parties; instead the parties themselves create rights and duties which the law then enforces. Parties enjoy the freedom to choose terms advantageous to their interest while entering into a contract.

Ambiguities in contracts and ways to resolve them

The terms of the contract are relevant in understanding the true intentions of the parties. While contracts are typically professionally drafted, they may contain some ambiguities. These ambiguities do not arise from a lack of due diligence or clarity on the part of the drafters, but rather, from the impossibility of anticipating and articulating every conceivable scenario and contingency that may occur.

Take for instance a situation where the parties wrote in their contract that a company’s code of conduct bans harassment based on gender, race and religion. It doesn’t explicitly mention newer recognised forms of harassment, such as those based on sexual orientation or gender identity, but the intention is cover all form of harassment. Or if an agreement grants rights to publish a book in print and digital formats, and doesn’t specify rights for future formats that didn’t exist at the time of the contract, but the intent is to cover all formats.

As a result, parties often write only those terms in the contract which can convey their true intentions. However, due to lack of explicit words, the language used by the parties will often have more than one potential meaning and this leads to ambiguities. In order to resolve these ambiguities, we must determine the intention of the parties by referring to the language used in the contract.

Lord Hoffman in the case of Investors Compensation Scheme profoundly explained that the ambiguity in a contract can be resolved by understanding the terms of the contract from the point of view of the reasonable person, one who has all the background knowledge. Similarly, in the case of The Moorcock, it was observed that commercial contracts must be implied in such a way as both the parties, who are businessmen, must have intended at all events while entering into the contract.

It means that the explicit terms of the contract provides the foundation and it is often the implied terms that fill in the gaps by understanding the contract from the lens of the prudent businessmen. The Moorcock case was again relied upon in the case of Shirlaw v. Southern Foundries, wherein MacKinnon LJ evolved the “The Officious Bystander Test”.

The Officious Bystander Test or “Oh, of course!”

Language used by the parties will often have more than one potential meaning. Owing to the ambiguities, the parties in commercial transactions try to render that meaning to the transactions that are advantageous to themselves. It is quite common not to state all obvious details in a contract. For instance, in a contract between two parties, it is unnecessary to specify that the contract does not involve any other parties. Including such obvious details would unnecessarily increase the length of the contract. The obviousness of such details forms the basis of officious bystander test.

The officious bystander test is a legal principle that is used to determine the existence of an implied provision in the agreement. This test suggests that if any provision of the agreement is left to be implied, without there being an express provision, then such provision is something so obvious that it goes without saying.

According to this test, only such provisions of the agreement can be implied by the courts which were so obvious that if a third party had suggested such provisions to the contracting parties at the time of making an agreement, then such parties would have responded with a resounding “Oh, of course!” This principle is used to fill in gaps in contracts where the terms are not explicitly stated but are so obvious that they go without saying.

The case of Shirlaw v. Southern Foundries is the key authority for the officious bystander test. In this case, Shirlaw entered into an agreement with the Southern Foundries through which he was appointed as a Managing Director of the company for the duration of 10 years.

The Articles of Association (AoA) of the company suggested that the management can remove any person from the position of directorship subject to any agreement entered by the company. However, during the period of 10 years, the company was taken over and new owners altered the AoA . The new AoA suggested that the management can remove any person from the position of directorship at any time, thereby deleting the words “subject to the Agreement entered by the Company”.

Consequently, the new owners removed Shirlaw for his position without assigning any reason before the expiry of his 10-year tenure. Shirlaw sued the company for the wrongful damages arguing that there is an implied term in his agreement that the company will not remove him for the duration of 10 years.

The Court applied the officious bystander test and observed what would have happened if the agreement had been drafted and any third person reading the draft had suggested incorporating an express provision that the company would not exercise its rights to remove Shirlaw from the position of directorship. In this case, both Shirlaw and the company would have said that – “Of course that is implied.” Shirlaw would have certainly said that “obviously the company must not have, or create, the power to remove me at any moment from the Board and so disqualify me from that post”. The Court of Appeal applied the officious bystander test and ruled in favour of Shirlaw.

We can understand the said test with the help of examples:

Example 1: Assume there is a simple 15-year lease contract between two parties, which includes a 5-year lock-in period but does not mention anything about termination. To resolve this ambiguity, the court can apply the officious bystander test. If a bystander suggested adding a clause that allows either party to terminate the contract after the lock-in period, the contracting parties would likely respond that it is obvious that both parties can terminate the contract after the lock-in period.

Example 2: Assume there is a power purchase agreement for establishing natural gas-based power stations. According to the agreement, “fuel” refers to natural gas. If a dispute arises over whether “fuel” also includes Regasified Liquefied Natural Gas (RLNG), given that RLNG has the same physical composition as natural gas, courts can resolve this ambiguity by applying the officious bystander test. If a bystander suggested to include a clause that “natural gas”; does not include RLNG, the contracting parties would likely respond that it is obvious RLNG is not included, as it is more expensive and not domestically available.

Applicability of the officious bystander test in India

Courts in India have also applied the officious bystander test to understand the true intentions of the parties at the time of entering into the contract. The Supreme Court in the cases of Transmission Corporation of Andhra Pradesh Limited & others v. G M R Vemagiri Power Generation Ltd & another and Enercon (India) Ltd & Ors v. Enercon GMBH and Ors applied the said test in order to give business efficacy to the contract and to supply missing lines in case of obvious omissions.

Thus, the said test has been instrumental in cases of ambiguity in contract within India. However, the courts have applied the test considering the business common sense and intention of the parties to contract, since, as per the courts, the test requires ‘oh, of course’ from both the parties.

Conclusion

In the ever-evolving world of commerce, contracts are paramount instruments, yet ambiguities are inevitable. The officious bystander test serves as a crucial tool in contract law, helping courts infer implied terms based on the obvious intentions of the contracting parties. The test can help to clarify terms and reduce litigation. By ensuring that not every conceivable term needs to be expressly stated, it facilitates smoother commercial transactions and reinforces the underlying principles of freedom and fairness in contract law. By applying this test, courts can ensure that justice is served and the true intentions of the contracting parties are honoured.