For years, courts and commentators have debated the circumstances under which extrinsic evidence should be admitted when interpreting contracts.
According to the "plain meaning" school of thought endorsed by acclaimed contract expert Samuel Williston, extrinsic evidence should be admitted to aid construction of a contract only if the document appeared ambiguous on its face. (See Samuel Williston, A TREATISE ON THE LAW OF CONTRACTS, Â§Â§ 610, 618 (3d. ed. 1961).)
By contrast, Williston's contemporary, Arthur Linton Corbin, advocated that even the most apparently plain and clear language should be interpreted in light of the circumstances that surrounded the inception of an agreement. (3 Arthur Linton Corbin, CORBIN ON CONTRACTS, Â§ 579 (1960).) Under this approach, any kind of relevant evidence, including extrinsic evidence, may be used to prove the interceding and surrounding circumstances that might shed light on the meaning each party knew the other would impute to the words.
As Corbin recognized, the plain meaning rule merely supplants the extrinsic evidence of the parties with that of the court. That is, the court is "making an interpretation on the sole basis of the extrinsic evidence of its own linguistic experience and education, of which it merely takes judicial notice." (Arthur Linton Corbin, The Interpretation of Words and the Parol Evidence Rule, 50 CORNELL L. Q. 161 at 189 (1965).) The Corbin approach advocates instead that language is malleable and the meaning of a word depends on its context.
Even Oliver Wendell Holmes, often thought of as a plain meaning champion, noted more than a century ago: "It is not true that in practice (and I know no reason why theory should disagree with the facts) a given word or even a given collocation of words has one meaning and no other. A word generally has several meanings, even in the dictionary." (Oliver Wendell Holmes, The Theory of Legal Interpretation, 12 HARV. L. REV. 417 at 417 (1899). See also, Towne v. Eisner, 245 U.S. 418 at 425 (1918): "A word is not a crystal, transparent and unchanged, it is the skin of a living thought and may vary greatly in color and content according to the circumstances and the time in which it is used.") (Holmes, J.).)
California Adopts Corbin
For many of the reasons noted above, in an opinion by Chief Justice Roger Traynor several decades ago, the California Supreme Court adopted the Corbin approach in Pacific Gas & Elec. Co. v. G.W. Thomas Drayage & Rigging Co., Inc. (69 Cal. 2d 33 (1968).) In this seminal case, the court rejected the notion that words have some absolute and universal meaning that is the same to all people. Because the trial court had refused to admit any extrinsic evidence on the ground that it would contradict the judge's initial impression of the "plain meaning of a contract," based solely on its "four corners," the supreme court reversed.
In doing so, it noted: "The test of admissibility of extrinsic evidence to explain the meaning of a written instrument is not whether it appears to the court to be plain and unambiguous on its face, but whether the offered evidence is relevant to prove a meaning to which the language of the instrument is reasonably susceptible." (69 Cal. 2d at 37.)
The court recognized that the apparent abstract clarity of words used in a written instrument does not preclude the possibility that the parties chose the language in it to express some different meaning in the circumstances of their agreement. The court further expressly stated that this possibility "is not limited to contracts whose terms have acquired a particular meaning by trade usage, but exists whenever the parties' understanding of the words used may have differed from the judge's understanding." (69 Cal. 2d at 39.)
Under PG&E not all the evidence must be admitted. However, the decision stressed the importance of considering all credible evidence offered to prove the parties' intention-including testimony regarding the circumstances surrounding making the agreement, the object, nature, and subject matter. This preliminary consideration allows a court to more realistically place itself in the parties' situation and more accurately ascertain their intent at the contract's inception.
The Two-Step Approach
Thus, PG&E establishes a two-step process that applies when extrinsic evidence is offered to aid in interpreting a contract. First, the court should provisionally admit all credible evidence offered to prove the parties' intent. In this preliminary step, the court should consider whether the language of the contract is fairly susceptible to either of the interpretations that are being advanced.
Second, if the court concludes that the language at issue is reasonably susceptible to either of the proposed interpretations, "extrinsic evidence relevant to prove either of such meanings is admissible." (69 Cal. 2d at 40.) In this step, the evidence must be considered in construing the contractual language to determine its meaning.
This two-step process sets up a delicate balance. Introducing extrinsic evidence preliminarily for purposes of evaluating the possible reasonable meanings of the contract limits the effect of the evidence until its viability in the interpretive process has been assessed. The evidence will not be formally admitted into evidence unless it is determined to support a reasonable meaning of contractual language. This balance safeguards the plain language of the contract while simultaneously avoiding an artificial and strained restriction to its four corners.
Of course, PG&E does not stand for the proposition that contracts can never be interpreted based solely on the plain language of the written instrument.Â The supreme court has also stated that, if possible, the intent of the parties is to be inferred solely from the written provisions of the contract. (AIU Ins. Co. v. Superior Court, 51 Cal. 3d 807 (1990).) Nonetheless, under PG&E if a party submits extrinsic evidence regarding the intent of the contracting parties, then that evidence must be at least provisionally considered.Â
Later Legal Refinements
In the decades since PG&E, a long line of California courts have willingly followed its extrinsic evidence rule. (See Fremont Indem. Co. v. Fremont Gen'l Corp., 148 Cal. App. 4th 97 (2007); Am. Alternative Ins. Corp. v. Superior Court, 135 Cal. App. 4th 1239 (2006); Lockheed Martin Corp. v. Continental Ins. Co., 134 Cal. App. 4th 187 (2005); S. Pac. Transp. Co. v. Santa Fe Pac. Pipelines, Inc., 74 Cal. App. 4th 1232 (1999); Morey v. Vannucci, 64 Cal. App. 4th 904 (1998); Curry v. Moody, 40 Cal. App. 4th 1547 (1995); Oakland-Alameda County Coliseum, Inc. v. Oakland Raiders, Ltd., 197 Cal. App. 3d 1049 (1988).)
But when appropriate, courts have properly excluded evidence that did not support an interpretation to which a contract was reasonably susceptible. (See Bionghi v. Metropolitan Water Dist., 70 Cal. App. 4th 1358 (1999) (refusing to admit extrinsic evidence offered where the evidence was an improper attempt to add to or vary the terms of contract); Equitable Life Assurance Soc'y v. Berry, 212 Cal. App. 3d 832 (1989) (after provisional consideration, the trial court properly struck or discounted extrinsic evidence when the policies were not "reasonably susceptible" to proposed interpretations.))
Indeed, when a trial court admits evidence that does not support an interpretation to which a contract is reasonably susceptible, its decision may be reversed on appeal. (See Curry, 40 Cal. App. 4th at 1553) (reversing the trial court's decision when, after considering all extrinsic evidence, the court of appeal determined that extrinsic evidence was not competent to establish the meaning urged.))
Nonetheless, a few courts have resisted the notion that extrinsic evidence should be even provisionally considered to construe a seemingly clear contract. For example, in ACL Technologies, Inc. v. Northbrook Property and Casualty Insurance Co., the court attempted to limit PG&E to circumstances involving a "special meaning." (17 Cal. App. 4th 1773 at 1794 (1993).) And ACL also interpreted subsequent California Supreme Court decisions to have abandoned PG&E's approach requiring preliminary consideration of all proffered competent extrinsic evidence.
In reaching this conclusion ACL focused on language in Bank of the West v. Superior Court (2 Cal. 4th 1254 (1992)) and AIU Insurance Co. v. Superior Court stating that the intent of the parties is to be ascertained, if possible, from the written provisions of a contract. ACL took this statement regarding one aspect of contract interpretation to signal a retreat from the clear direction provided by PG&E.
The Ninth Circuit has also cast a critical eye on PG&E. Notably, in Trident Center v. Connecticut General Life Insurance Company, the court bridled at the fact that it could not affirm a lower court's dismissal of a contract dispute based on the pleadings. The court complained openly: "As this case illustrates, even when the transaction is very sizable, even if it involves only sophisticated parties, even if it was negotiated with the aid of counsel, even if it results in contract language that is devoid of ambiguity, costly and protracted litigation cannot be avoided if one party has strong enough motive for challenging the contract. While this rule creates much business for lawyers and an occasional windfall to some clients, it leads only to frustration and delay for most litigants and clogs already overburdened courts." (847 F.2d at 56970.)
The Trident court also opined that the PG&E decision damages the entire legal system: "By giving credence to the idea that words are inadequate to express concepts, Pacific Gas undermines the basic principle that language provides a meaningful constraint on public and private conduct." (847 F.2d at 569.)
However, the California Supreme Court has never subscribed to such criticism of PG&E. Contrary to the suggestion in ACL, neither Bank of the West nor AIU gave any indication, express or implicit, that PG&E was dead. In fact, consistent with PG&E, AIU preliminarily considered, but ultimately declined to accept, extrinsic evidence determined not to "shed light on the meaning to be ascribed to the coverage provisions at issue." (51 Cal. 3d at 823, n.9.) Similarly, Bank of the West mentioned drafting history in passing, as background to its analysis. (2 Cal. 4th at 1262.)
Additionally and significantly, Bank of the West made clear its continued commitment to contracts in the context of the agreement as a whole, "and in the circumstances of that case." (2 Cal. 4th at 1265.) Thus, rather than impliedly overruling PG&E, the court apparently adopted PG&E's view that contracts should not be interpreted solely in the vacuum of their four corners, but rather in light of the circumstances in which they were conceived and drafted. Indeed, California's Civil Code also states that "a contract may be explained by reference to the circumstances under which it was made, and the matter to which it relates." (Cal. Civ. Code Â§ 1647.) Those "circumstances" can be shown only through extrinsic evidence of the very sort considered in PG&E. (69 Cal. 2d at 40.)
Moreover, ACL itself has received some rather harsh criticism. A mere six months after it was decided, a court of appeal renounced ACL's criticism of the use of extrinsic evidence to interpret policies. Reaffirming the importance of using industry publications as interpretive aids, the court noted, "it is difficult to characterize as 'objectively unreasonable' an interpretation which would result in coverage which is proffered and supported by insurance industry experts." (Prudential-LMI Comm. Ins. Co. v. Reliance Ins. Co., 22 Cal. App. 4th 1508 (1994); see also, Vandenberg v. Superior Court, 21 Cal. 4th 815 (1999) (relying on the insurance commentators' views regarding the meaning of the phrase "legally obligated to pay as damages."))
Some have argued that Nedlloyd Lines B.V. v. Superior Court (3 Cal 4th 459 (1992)) indicated that the California Supreme Court might be ready to retreat from the PG&E holding. However, Nedlloyd is extremely limited, addressing the propriety of considering extrinsic evidence in one narrow area. The Nedlloyd court simply held that in the international context, "a valid choice of law clause, which provides that a specified body of law 'governs' the 'agreement' between the parties, encompasses all causes of action arising from or related to that agreement, regardless of how they are characterized." (3 Cal. 4th at 470.)
Yet while Nedlloyd refused to import PG&E's extrinsic evidence rule into the highly specialized context of international choice of law provisions, it did nothing to retreat from PG&E's application to insurance policies and other contracts in general.
Indeed, even Justice Mosk, once one of PG&E's harshest critics, had by the time of Nedlloyd apparently seen PG&E's wisdom, pointing out in his dissent: "Even under circumstances in which the ambiguity arises more from context than language, extrinsic evidence is admissible to show the meaning the parties intended." (3 Cal. 4th at 493.)
The California Supreme Court recently specifically reaffirmed the vitality of PG&E in Dore v. Arnold Worldwide, Inc. (9 Cal. 4th 384 (2006).) There, the court noted that the phrase "at any time" was not patently ambiguous in the context of a letter stating when a new hire could be terminated. However, the court pointed out that this lack of patent ambiguity did not preclude the possibility that the letter containing this language, when considered as a whole, might be ambiguous. It then explicitly reaffirmed the viability of PG&E.
The court went on to provisionally consider the employee's proffered extrinsic evidence. Because the language-even viewed in light of the extrinsic evidence-was not "reasonably susceptible" to the interpretation urged by the party offering the extrinsic evidence, the court concluded that the letter "contained no ambiguity, patent or latent, in its termination provisions." (9 Cal. 4th at 393.) Accordingly, the extrinsic evidence was deemed inadmissible and the contract construed without it.
While Justice Baxter did not share the majority's enthusiasm, even he pointed out in his concurrence that the majority's opinion was a "general endorsement" of PG&E. Although Dore ultimately concluded that the proffered extrinsic evidence did not support a reasonable interpretation of the "at any time" language, it reached this conclusion only after provisionally considering the evidence. Accordingly, Dore followed precisely PG&E's two-step process.
Finally, even in the context of the statute of frauds, the California Supreme Court recently held that when ambiguous terms in a memorandum of understanding are disputed, extrinsic evidence cannot be used to supply the essential terms but it is admissible to explain them. (Sterling v. Taylor, 40 Cal. 4th 757 (2007).)
Cassandra S. Franklin is of counsel with Dickstein Shapiro's Insurance Coverage Practice in Los Angeles, where she concentrates on representing insureds in complex coverage disputes.