How Courts Interpret Ambiguous Contracts

Thursday, January 1, 2004 - 00:00

A court's objective in a case involving the interpretation of a contract is to ascertain what the parties intended. When a contract's provisions are clear, a court will enforce the contract as written, without any reference to evidence outside the contract, such as testimony about what the parties negotiated or intended the provisions to mean.1

But how will courts interpret an ambiguous contract? There is a general rule that a court will construe ambiguous contract terms against the drafter of the agreement. But this rule only applies where one contracting party is in a superior bargaining position, usually either as a result of greater experience or the assistance of counsel.2

More common is the situation where contracting parties have equal bargaining power and similar levels of sophistication, and both are represented by counsel. The general rule stated above will not apply in this circumstance. Rather, a court interpreting ambiguous contract terms will look outside the four corners of the contract to determine the parties' intent. Recent New York court decisions provide guidance on exactly where the court will focus its inquiry in such a situation: the parties' course of conduct during the contract negotiations and the contract term.

To understand a court's analysis where there is a dispute about the meaning of ambiguous contract terms in an arms-length transaction, it is helpful to use a hypothetical. Assume Party A enters a contract with Party B, whereby Party B is to provide advertising services to Party A in return for the payment of an "annual fee." Also assume that both parties are highly sophisticated and retain counsel to prepare or review their agreement.

Provision I of the contract states that Party B will be paid an "annual fee" of $100,000 per year for the work performed. In this provision, the "annual fee" is referred to as the "fixed fee." Provision II of the contract also refers to the annual fee as the "fixed fee" and states that the fixed fee is subject to increase only as set forth in Provision III. Provision II does not refer to any potential decrease in the fixed fee. But Provision III of the contract states that the fixed fee shall increase or decrease if the actual value of the services provided is above or below the fixed fee. Provision III's reference to a decrease is clearly in conflict with the language in Provisions I and II.

Further assume that over the course of ten years under the contract, the fixed fee paid was never less than $100,000 per year. Yet, during a number of those years, circumstances were such that, under Provision III of the contract, Party A could have argued that the fixed fee should have been decreased below $100,000, as the value of the services actually rendered during those years was below $100,000. Also, assume that Party A had employees monitoring its contract, received statements each year regarding the type and value of services rendered by Party B, and approved such statements before rendering payment of the fixed fee.

Despite all of this readily available information, Party A did not object to the fixed fee paid until the eleventh year of the contract. At this time, Party A decides to bring suit against Party B, claiming that it is entitled to a refund of the alleged overcharges it paid during those years under the contract when the value of actual services rendered was below $100,000.

It has often been held that in a litigation such as the hypothetical dispute between Party A and Party B described above, a court will look to the parties' negotiations, course of conduct, and the custom and practices of the relevant industry when interpreting the ambiguous contract terms. But recent case law emphasizes that the parties' course of performance during the contract term will be considered the most important evidence of the agreed intention of the parties where the meaning of the contract's terms are subject to dispute.3

These recent cases indicate that courts will reject a party's suggested interpretation of an ambiguous contract provision where that interpretation is contradicted by that party's conduct over the life of the contract. Under this principle, Party A in our hypothetical would likely be precluded from recovery because its conduct during the contract term was inconsistent with its claim that the fixed fee was subject to decrease below $100,000 per year if the value of the services actually provided was less than $100,000.

The recent case law is instructive for those involved with the negotiating and drafting of contracts. The negotiations during the drafting process, and the parties' course of conduct in the years to come under the contract, may be critical should litigation ensue. Records should be kept concerning the negotiations and the parties' communications both before the contract signing and during the contract term. Drafts of contracts are excellent evidence of the parties' intent and should be retained. Indeed, prior drafts of the agreement may expressly refute the claim or position later advanced by one of the parties.

Even with the best preventive measures, litigation may become inevitable. In that event, the first inquiry is, of course, whether the contract terms are ambiguous. If they are, the parties' actions during the contract period become a critical factor in the contract's interpretation. As such, it is important to conduct a thorough factual investigation regarding the parties' conduct during the contract term to determine the parties' likelihood of success on their claims or defenses. The recent case law demonstrates that a party is not likely to prevail on its interpretation of ambiguous contract language where its conduct is inconsistent with its proffered interpretation.

Where the parties have not engaged in any course of conduct during the contract term that is relevant to the proposed or pending litigation, the parties' conduct during contract negotiations and the customs of the pertinent industry will guide the court's analysis. Thus, as discussed with regard to the parties' course of conduct, it is equally imperative that there be a complete investigation regarding the negotiation process and the customs of the relevant line of business to determine the merits of the litigation. 1 See R/S Assoc. v. New York Job Devel. Auth., 98 N.Y.2D 29, 744 N.Y.S.2d 358 (2002) ("Unless the court finds ambiguity, the rules governing the interpretation of ambiguous contracts do not come into play"); ABS Partnership v. AirTran Airway, Inc., 765 N.Y.S.2d 616 (1st Dep't 2003).
2 See Herbil Holding Co. v. Commonwealth Land Title Ins., 183 A.D.2D 219, 590 N.Y.S.2d 512 (2d Dep't 1992) ("[A] contract must be construed most strongly against the party who prepared it, and favorably to a party who had no voice in the selection of its language").
3 See, e.g., Soberman v. Groff Studius Corp., 99 Civ. 1005 (DLC) 2000 U.S. Dist LEXIS 3958, *22-24 (S.D.N.Y. March 27, 2000); Simon & Son Upholstery Inc. v. 601 West Assocs., LLC, 702 N.Y.S.2d 256, 257 (1st Dep't 2000); Federal Ins. Co. v. American Ins. Co., 691 N.Y.S.2d 508, 512 (1st Dep't 1999).

Neal H. Klausner and Marc J. Rachman are Partners and Jennifer L. Schatzman is an Associate with Davis & Gilbert LLP.

Please e-mail the authors at nklausner@dglaw.com, mrachman@dglaw.com and jschatzman@dglaw.com with questions about this article.