Substantive clauses and risk allocation - Defined terms and ...

Learning Outcomes

This article sets out how defined terms and interpretation operate in substantive risk allocation, including:

• How and why defined terms underpin risk allocation and contractual certainty in substantive clauses
• The distinction between interpretation and construction and application of the modern objective approach (ICS, Rainy Sky, Arnold v Britton, and Wood v Capita)
• Drafting techniques to minimise ambiguity: precise use of “means” versus “includes”, interpretation clauses, and order-of-precedence wording
• When courts favour business common sense versus the ordinary meaning of clear language
• Analysis of exclusion, limitation, and indemnity provisions, including the treatment of “indirect or consequential loss”, and predicting likely outcomes
• The effect of entire agreement clauses and the inadmissibility of pre-contract negotiations
• Managing definitions across main terms and schedules to ensure consistency in multi-document transactions
• Identifying and remedying common drafting defects: circular definitions, undefined cross-references, inconsistent capitalisation, timing/date traps, and problematic “and/or”

SQE2 Syllabus

For SQE2, you are required to understand how defined terms operate within the risk allocation and substantive provisions of commercial contracts, and apply principles of interpretation, with a focus on the following syllabus points:

• the purpose and use of defined terms within substantive provisions, especially risk allocation and exclusion/limitation clauses
• the key rules of contractual interpretation (including how ambiguity is resolved) and the distinction between interpretation and construction
• the modern authorities: Investors Compensation Scheme (ICS), Rainy Sky, Arnold v Britton, and Wood v Capita
• how contract drafter choices affect risk and legal certainty, including order-of-precedence and interpretation clauses
• how courts treat undefined expressions such as “indirect or consequential loss”, “material breach”, and “gross negligence”
• the consequences for parties where terms are unclear or not properly defined, and the limited role of contra proferentem in negotiated commercial contracts
• incorporation of schedules and external documents; entire agreement clauses; and the inadmissibility of pre-contract negotiations
• statutory overlays: Unfair Contract Terms Act 1977 reasonableness (B2B) and Consumer Rights Act 2015 fairness/transparency (B2C)
• recognition of and remedy for drafting and interpretation errors commonly examined in SQE2-style assessments.

Test Your Knowledge

Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, remember to look more closely at that area during your revision.

1. Why are defined terms included in contracts, and what are the risks if they are missing, circular, or inconsistent?
2. What is the difference between interpretation and construction in contract law?
3. How do courts ordinarily resolve ambiguity in substantive clauses containing risk allocation where terms are undefined?
4. What principle is applied when interpreting exclusion and limitation clauses in cases of ambiguity?

Introduction

Substantive clauses in commercial contracts set out core rights, obligations, and allocate risk between parties. Key to effective and enforceable drafting is the clear use of defined terms and a sound understanding of contractual interpretation. This article examines how using defined terms within substantive clauses manages legal risk, how interpretation rules are applied by courts, and the typical problems that can arise when definitions are omitted or unclear. SQE2 candidates must be able to draft, analyse, and interpret such contract provisions to identify potential disputes and support clients in legal negotiations or litigation.

Key Term: defined term
A word or phrase in a contract given a specific contractual meaning, usually by express definition, to ensure clarity and reduce repetition.

Key Term: interpretation
The process by which a court determines the meaning of contractual language, considering the contract as a whole and the surrounding admissible background.

Key Term: construction
The determination of the legal effect of contractual terms once their meaning has been interpreted, including how obligations, rights, and remedies operate.

Key Term: legal term of art
A word or phrase with a settled legal meaning (e.g., “warranty”, “condition”, “set-off”). Courts will presume this meaning unless the contract clearly provides otherwise.

Key Term: entire agreement clause
A clause stating that the written contract constitutes the whole agreement, aiming to exclude reliance on prior representations or collateral contracts.

Key Term: interpretation clause
A clause setting out general rules for how defined terms or contract language should be read, ensuring consistency for statutory references, plural/singular, or incorporation of schedules.

Defining Terms in Substantive Clauses

Substantive clauses determine the commercial and legal risks for each party. To ensure certainty, contract drafters commonly use defined terms for concepts that would otherwise be imprecise or repeated. Defined terms also avoid “elegant variation”—using different words for the same thing—which risks courts inferring different meanings.

Poor or missing definitions lead to ambiguity, which can shift risk unexpectedly between parties and cause disputes about the contract’s meaning.

Key Term: ambiguity
When a contract term is reasonably capable of more than one meaning, giving rise to potential uncertainty about parties' obligations or rights.

Key Term: circular definition
A definition that refers back to itself or depends on another defined term that in turn refers to the first, making the meaning unclear or incoherent.

Clear definitions ordinarily use “means” for an exhaustive definition and “includes” to extend beyond the ordinary meaning. Misusing those signals creates uncertainty. If a definition is intended to be closed, use “means” and list its elements; if you wish to avoid limiting the natural meaning, use “includes” with care (and consider adding “including without limitation” to avoid ejusdem generis issues).

Key Term: ejusdem generis
Where a list of specific items is followed by general words (e.g., “or other items”), the general words are interpreted as limited to the same kind as the specific items unless the contract makes clear otherwise.

Common Forms of Definitions

Definitions may be:

• Located in a dedicated section at the start or end of the contract
• Embedded within a clause if used only in that clause
• Incorporated by reference to other documents or agreements

Multi-document transactions often replicate defined terms across several contracts (e.g., SPA, services agreement, assignments). Consistency is important. If a document says “terms defined in the SPA have the same meaning here”, explicitly incorporate the SPA, identify priority conflicts, and confirm the definitions align with the second document’s context. If schedules carry operative obligations (e.g., “Excluded Losses” or “Services”), ensure they are expressly incorporated.

Definitions work best when:

• Capitalisation is consistent
• Cross-references resolve to existing clauses
• Each definition is used (avoid “ghost” definitions that are never applied)
• No definition smuggles in operative obligations (create obligations in the operative clause, not in a definition)

Interpretation of Defined Terms

When a dispute arises, courts interpret contracts according to established principles. The modern approach is objective: what would a reasonable person, with all relevant background knowledge known or reasonably available to both parties at the time of contracting, understand the words to mean?

This approach, originating in ICS v West Bromwich and developed in Rainy Sky, Arnold v Britton, and Wood v Capita, blends text and context. It respects the words chosen but allows business common sense to break ties where genuine ambiguity persists. It does not allow subjective, uncommunicated intentions or pre-contract negotiations.

• Clear language will be applied even if it produces a tough or uncommercial result (Arnold)
• Where there are two plausible meanings, the court may prefer the one consistent with business common sense (Rainy Sky), but not to re-write the deal
• Interpretation is iterative: read the clause, test it against the contract as a whole and admissible background, then revisit the text (Wood)

If a term is clearly defined, that meaning ordinarily prevails unless it leads to incoherence with the contract as a whole. Definitions sometimes include “unless the context otherwise requires”; this is used sparingly and is not a licence to vary a definition merely to improve a litigant’s case.

Courts will not usually consider pre-contract drafts or negotiations when interpreting a signed agreement. Entire agreement clauses support that position, although the general exclusion of negotiation evidence arises from the law of interpretation itself.

Technical, industry, and legal terms

• Technical terms are understood with expert evidence if disputed; drafters should define the term or reference a reputable standard
• Industry usage can inform meaning where proved (e.g., “exclusive operation” in aviation)
• Legal terms of art will default to their settled legal meaning unless displaced by the contract

Where a word is genuinely unclear, dictionary meanings can help, but context rules: definitions, structure, purpose, and the factual matrix shape meaning more than isolated lexicography.

Worked Example 1.1

A contract states: "Losses means any financial loss suffered by the Buyer." The substantive clause reads: "The Seller shall indemnify the Buyer for all Losses arising from a breach of this Agreement." Losses is not further explained and the Buyer claims for lost profits, while the Seller argues this is not included. How will a court interpret "Losses"?

Answer:
The court will look at the language of the definition and the surrounding contract. "Financial loss" is a broad phrase that can include lost profits unless a contrary intention is clear. If no exclusion appears elsewhere, the definition is likely to cover lost profits.

Worked Example 1.2

A limitation clause excludes “any indirect or consequential loss”. There is no definition of “consequential loss”. The customer claims wasted management time and lost profits as direct losses. How will a court assess “consequential loss”?

Answer:
In many commercial contexts, “consequential loss” is taken to mean losses falling within the second limb of Hadley v Baxendale (not arising naturally from the breach). Absent contrary definition, the court will likely treat ordinary lost profits that arise naturally as direct; profits dependent on special circumstances or further knock-on effects may be consequential. Parties often define “Indirect or Consequential Loss” expressly to avoid uncertainty.

Key Term: consequential loss
Typically refers to losses beyond the ordinary course, often aligned to the second limb of Hadley v Baxendale unless the contract defines it differently.

Contra Proferentem and Risk Clauses

Where a clause (often an exclusion or limitation clause) contains ambiguity, the courts may apply the contra proferentem principle—interpreting the provision against the party seeking to rely on it.

Key Term: contra proferentem
The legal rule that an ambiguous contractual term will be construed against the party who drafted or seeks to rely upon it.

This principle is weaker in negotiated commercial contracts between sophisticated parties, where courts emphasise ordinary meaning and context over presumptions. However, it remains relevant where language is genuinely ambiguous, particularly in standard terms or consumer contracts. In business-to-business contracts, exclusions and limitations must also satisfy the Unfair Contract Terms Act 1977 reasonableness test where applicable; in consumer contracts, the Consumer Rights Act 2015 requires fairness and transparency.

Worked Example 1.3

A service agreement defines "Liability" as "any and all claims, losses or damages except as set out herein," and then states, "The Supplier's Liability excludes indirect loss." The customer suffers loss of profit due to a breach. The Supplier claims this is excluded as "indirect loss," but the contract does not define indirect loss. What will the court do?

Answer:
The court will determine whether loss of profit is indirect or direct and whether the lack of definition creates ambiguity. Any lack of clarity will typically be resolved against the Supplier, the party seeking to rely upon the exclusion, but in a negotiated commercial contract the court may focus on ordinary meaning and context rather than applying a strong presumption.

Drafting Risk Allocation Clauses Using Defined Terms

Sound drafting of substantive clauses—particularly those allocating or limiting risk (such as indemnities, caps, and exclusions)—requires defined terms that are:

• Clear, detailed, and non-circular
• Consistent in their use throughout the contract
• Appropriately scoped to reflect the parties' intentions

Failure to define key risks and trigger events, such as “Force Majeure,” “Material Breach,” or “Gross Negligence,” can lead to radically different outcomes if a dispute arises. Expressions like “gross negligence” are widely used in international contracts but have no fixed, distinct meaning under English common law; if the distinction matters commercially, define it.

In indemnity drafting, specify:

• The event(s) that trigger the indemnity (e.g., third-party IP claims)
• The scope of recoverable losses (define “Losses” carefully and consider carving out taxes, fines, or “Excluded Losses”)
• Procedures (notice, defence control, mitigation)
• Interaction with caps/exclusions (e.g., indemnity carve-outs from the cap for fraud)

For limitation drafting, consider:

• A monetary cap (define the cap base and whether multiple claims aggregate)
• Excluded losses (define “Indirect or Consequential Loss”; consider listing specific exclusions like “loss of profits, revenue, goodwill” whether direct or indirect)
• Carve-outs (e.g., death/personal injury caused by negligence; fraud; deliberate default where agreed)

“Consequential loss”, “indirect loss” and “economic loss” vary with context; resist relying on bare labels. Use precise definitions and, where helpful, examples introduced by “including without limitation”.

Revision Tip

Ensure that every defined term is used consistently, without conflicting language or undefined cross-references. Always check for accidentally circular or embedded definitions before finalising a draft.

Role of Schedules and Interpretation Clauses

Sometimes parties use schedules to set out lists for defined terms (e.g., "Services" or "Excluded Losses"). An interpretation clause may also be used to clarify contract-wide conventions such as references to the singular including the plural, or that headings do not affect interpretation. Include a clause stating that schedules and attachments form part of the agreement.

Where several documents comprise one transaction, state whether one document is supplemental to another, which terms take precedence, and whether defined terms travel across documents. Use an order-of-precedence clause to resolve inconsistencies.

Key Term: order of precedence clause
A clause specifying which parts of a multi-part agreement prevail in case of inconsistency (e.g., special conditions override general conditions; main terms prevail over schedules).

Recitals can clarify commercial context and defined labels used later, but should not contain operative obligations. Interpretation clauses can specify that references to legislation include re-enactments and that “writing” includes email. Where timing matters, define “Business Day”, “Commencement Date”, and the effect of time zones to avoid midnight ambiguities.

Worked Example 1.4

The main agreement says “the Supplier shall deliver the Services described in Schedule 2,” while Schedule 2 says “Customer will provide data inputs weekly; Supplier delivers monthly summary reports.” A conflict arises: the main clause requires weekly deliverables; the schedule requires monthly. There is an order-of-precedence clause stating “If there is any inconsistency, the special conditions (Schedule 2) shall prevail.” How will the conflict be resolved?

Answer:
The order-of-precedence clause governs. The schedule’s monthly delivery requirement prevails over the main clause’s weekly wording. Clear priority wording avoids uncertainty in multi-document transactions.

Key Term: arbitration clause
A clause that commits disputes to arbitration. The presence of an expert decision-making mechanism can help render an otherwise uncertain obligation workable by supplying a procedural route to resolve disagreements.

An agreed dispute-resolution mechanism (arbitration or expert determination) does not cure every uncertainty, but it can help a court regard the contract as sufficiently certain by providing a commercial method for operating unclear provisions.

Typical Problems and Remedies

• Undefined or contradictory terms: Courts first seek the ordinary meaning in context; uncertainty invites dispute and expense
• Circular or reference-based definitions: Can render clauses unworkable; avoid defining A by reference to B where B depends on A
• Embedded obligations in definitions: Obscures meaning and risks inconsistency; create obligations in operative provisions
• Use of non-exhaustive language: “Includes” may expand obligations beyond intention; consider using examples with “including without limitation”
• Deleted provisions and negotiation drafts: Generally inadmissible; ensure the written contract reflects all intended terms
• Timing ambiguities: Clarify whether a deadline includes the stated day and define specific times with time zones; avoid “midnight” confusion by using 23:59 with a named jurisdiction’s time

Worked Example 1.5

A contract says "Material Breach has the meaning given in clause 9," but clause 9 contains no such definition. The Seller terminates for "Material Breach." Can they do so?

Answer:
The lack of definition creates ambiguity. The court will apply the ordinary and sensible meaning, but the lack of express definition could make enforcement risky, and the terminating party is at risk if the court finds no material breach occurred on usual understanding.

Worked Example 1.6

A contract states: “Subject to clause 2, the Supplier shall supply 10 crates of beer every month. Clause 2: In December the Supplier shall supply two crates of champagne.” What is supplied in December?

Answer:
As drafted, December supply is governed by clause 2 and clause 1 is disapplied. If both beer and champagne were intended in December, clause 2 should read “Without prejudice to clause 1, in December the Supplier shall supply two crates of champagne.”

Worked Example 1.7

An option clause states: “The Option expires at midnight on 31 December.” The parties are in different time zones. The grantee claims it exercised at 00:10 UK time on 1 January; the grantor says the option lapsed. What is the likely outcome?

Answer:
“Midnight” is ambiguous (start or end of the day; which jurisdiction). Absent a defined time zone and 23:59 specification, the court may interpret against the party asserting expiry. Drafting should specify 23:59 and a named time zone (e.g., “UK time”) to avoid this dispute.

Practical Measures to Reduce Risk

• Use a dedicated definitions section, placing all definitions in one part of the contract unless they apply only to a specific provision
• Keep definitions clear, non-circular, and free of operative obligations
• State that schedules form part of the agreement and include an order-of-precedence clause
• Avoid defining terms by reference to external documents not attached to the contract, or if necessary, expressly incorporate them and manage priority
• Use plain English, consistent terms, and active voice; avoid archaic jargon and “and/or” unless carefully used
• Clarify dates and times, distinguish between “date of agreement” and “Commencement Date”, and specify time zones
• Put all terms and amendments in writing; ensure entire agreement and variation clauses support the parties’ intention
• Avoid “elegant variation”—use the same word to mean the same thing throughout
• Consider statutory overlays: UCTA reasonableness for exclusions/limitations in B2B contracts; CRA fairness/transparency for consumer terms
• For technical subject matter, define key technical terms or reference an agreed standard; avoid loose industry jargon that evolves quickly

Exam Warning

If a defined term is used inconsistently, or if "means" and "includes" are used interchangeably without care, the contract may be construed unpredictably or the clause held void for uncertainty.

Key Point Checklist

This article has covered the following key knowledge points:

• Defined terms ensure precision, consistency, and manageable drafting in substantive clauses that allocate risk
• The modern approach to interpretation is objective, text-and-context based, guided by ICS, Rainy Sky, Arnold, and Wood
• Interpretation (meaning) precedes construction (legal effect); pre-contract negotiations are generally inadmissible
• Use interpretation clauses and order-of-precedence wording to harmonise main terms and schedules and to resolve inconsistencies
• Contra proferentem is weaker in negotiated commercial contracts but can still apply where wording is genuinely ambiguous, especially in standard terms or consumer contexts
• Undefined expressions like “indirect or consequential loss”, “gross negligence”, and “material breach” require careful drafting or definition; otherwise, courts default to ordinary meaning and context
• Entire agreement clauses limit recourse to pre-contract representations; variations should be in writing
• Dates/times and time zones must be specified to avoid deadline ambiguity; avoid “midnight”
• Avoid circular definitions, embedded obligations in definitions, and “and/or”; prefer clear scoping with examples (“including without limitation”)
• Statutory reasonableness (UCTA) and fairness/transparency (CRA) can control risk clauses and override unclear drafting

Key Terms and Concepts

• defined term
• ambiguity
• circular definition
• interpretation
• construction
• contra proferentem
• entire agreement clause
• interpretation clause
• order of precedence clause
• legal term of art
• ejusdem generis
• consequential loss
• arbitration clause