Contractual discretion and its limits

Commercial contracts often afford one party a discretion as to whether or how it exercises its rights or fulfils its obligations. For example, a contractual option may give the option holder the right, but not the obligation, to exercise that option (provided that any applicable conditions are met). In a variety of contexts, a party may require the consent of another to do certain things. Finally, under certain finance and derivatives contracts, one party is often tasked with valuing the underlying assets in certain circumstances (e.g. the close-out of a contract following an event of default).

In such instances, the following question arises: what are the limits, if any, on the exercise of such contractual right or discretion? The simple (if not the most practical) answer is that it is fundamentally a matter of construing the contractual provision in question. That said, there has been substantial judicial scrutiny of this issue in recent years, resulting in the development of a set of principles, which will be of assistance to commercial parties.

This article will survey this line of authorities, including the most recent developments in commercial and finance contexts, and also seek to give some practical points to consider, both before and after any dispute arises as to the proper exercise of the right or discretion in question.

In Abu Dhabi National Tanker Co v Product Star Shipping Ltd (The “Product Star”) [1993] 1 Lloyd’s LR 397, the discretion in question was the master or owner’s ability to refuse to proceed to any port which, in their discretion, was considered as dangerous. Leggatt LJ stated the following principle in relation to the exercise of a contractual discretion:

“Where A and B contract with each other to confer a discretion on A, that does not render B subject to A’s uninhibited whim. In my judgment, the authorities show that not only must the discretion be exercised honestly and in good faith, but, having regard to the provisions of the contract by which it is conferred, it must not be exercised arbitrarily, capriciously or unreasonably.”

It is important to note that the limitation applied even though there were no express limitations or qualifications on the exercise of such discretion. In a finance context, essentially the same limitation was held to apply in Socimer International Bank v Standard Bank London Ltd [2008] EWCA Civ 116, a case in which one party to an agreement for the forward sale of a portfolio of securities was tasked with its valuation.

The authorities are clear that such a limitation applies as a matter of necessary implication (Cantor Fitzgerald International v Horkulak [2004] EWCA Civ 1287). Therefore, the rationale for such a limitation is not grounded in some general doctrine of “good faith”, but rather that “it is presumed to be the reasonable expectation and therefore the common intention of the parties that there should be a genuine and rational, as opposed to an empty or irrational, exercise of discretion”.

Leaving aside for the moment the precise nature of the limitation and how it is applied by the Court (which will be addressed in the next section), when will any such a limitation be implied at all?

In this regard, the Court of Appeal has distinguished between:

1. the “exercise [of] an absolute contractual right” (an absolute contractual right); and
2. “making an assessment or choosing from a range of options, taking into account the interests of both parties”¹ (a contractual discretion).

There will be no limitation implied in respect of an absolute contractual right, whereas there will be (unless there are clear express terms to the contrary) in respect of a contractual discretion.

It is fundamentally a matter of construction of the particular contractual provision whether the party has an absolute contractual right or a mere contractual discretion. Therefore, the express terms will play a key role. If a contractual provision expressly limits or qualifies the way in which a party can exercise a right or perform its obligations (e.g. the requirement of (commercial) reasonableness or good faith), then it is highly likely to fall on the contractual discretion side of the line.

There are no hard and fast rules in this regard; the wording and the substance of the provision in question must be carefully examined to determine whether it confers an absolute contractual right or a mere contractual discretion. That said, and although not universal, it seems that where a party is entrusted with performing a quasi-adjudicative role in the context of conflicting interests of parties, the performance of that role will be subject to a limitation of the type described above.

Finally, being an implied term, the limitation may of course be excluded by contrary express terms. However, authorities suggest that although not utterly impossible, it would be extremely difficult to exclude. For example, in WestLB AG v Nomura Bank International Plc [2012] EWCA Civ 495, a fund was to be valued by the calculation agent “in its sole and absolute discretion” and the valuation was to be “final and binding…in the absence of manifest error”. However, this language did not exclude the implication of the limitation.

How are we to interpret the implied limitation on the exercise of a contractual discretion? What are the standards it imposes? The authorities set out the following principles, which apply in the absence of express words to the contrary.

“Reasonableness”

The requirement of honesty and good faith seem clear enough; the party afforded the discretion (the decision-maker) must properly direct itself to the task in hand and should not exercise the discretion in question in furtherance of an ulterior motive. With respect to the requirement that the relevant discretion must not be exercised arbitrarily, capriciously, perversely or unreasonably, it seems settled that “reasonableness” in this context is not analogous to a duty to take reasonable care but to Wednesbury-reasonableness (i.e. in order for a decision to be impugned, it must be a decision which no rational decision-maker could have arrived at)².

However, this is not to say that the ambit of discretion will be wide in every case. In certain factual circumstances, it may well be that there are only very limited ways in which a party can exercise the discretion in question without falling foul of the rationality test. The more difficult and uncertain the exercise of the discretion in question, the wider the range of rational decisions will likely be. For example, this will likely be the case in the valuation of illiquid securities in difficult market conditions with little or no reliable pricing information³.

This means that, where there is a range of decisions that a party could have taken within the bounds of rationality and the original decisions falls within that range, the decision remains that of the decision-maker and the Court does not replace it with a decision which it (or anyone else, for that matter) would prefer.

Own interests

It seems that, at least in certain circumstances, the decision-maker may consult its own interests in exercising a discretion, as opposed to approaching the exercise with complete neutrality. For example, in Socimer, the non-defaulting party was forced to retain certain illiquid assets in difficult market conditions as a result of the counterparty’s default under a forward sale contract. Given the difficulties in valuing the assets in question in the prevailing circumstances and the fact that it never sought to retain the assets, it was held that the non-defaulting party was “entitled primarily to consult its own interests” in valuing the assets (subject to the requirements of honesty, good faith and rationality).

Similarly in WestLB v Nomura, noting that the commercial structure of the transaction was that Nomura, as issuer, was supposed to have no risk in the underlying assets, and the purpose of giving to such a party to the transaction a discretion to value is to enable it to protect itself from risk, it was held that Nomura was “entitled to have an entirely proper regard for any danger to itself from valuing too optimistically” (again, subject to the requirements of honesty, good faith and rationality). Also in Lehman Brothers International (Europe) (in administration) v ExxonMobil Financial Services B.V. [2016] EWHC 2699 (Comm), it was held that ExxonMobil, as the non-defaulting party valuing securities in the context of a close-out of a repo transaction under a 2000 Global Master Repurchase Agreement, was “entitled to have regard to its own commercial interests”.

However, it is suggested that caution must be exercised in this regard. In all of the cases above, the commercial rationale for giving the discretion as to valuation to one party was to protect itself from risk and the difficulty of the valuation in question were key factors in arriving at the conclusion that such a party may take its own interests into account. Although in many cases the very purpose of affording a discretion to one party might well be to protect that party from risk, it may not always be so. If not, it remains to be seen whether taking into account one’s own interest in exercising the discretion satisfies the test of honesty, good faith and rationality.

Process v outcome

The authorities have generally focussed on the end result of the exercise of a contractual discretion. However, in Braganza v BP Shipping Limited [2015] UKSC 17, the idea of the Court’s review of not only the outcome of a party’s exercise of a contractual discretion but also the process by which it exercised the discretion was raised. In that case, the Supreme Court did scrutinise not only the outcome but also the decision-making process. The Supreme Court expressly left open the question of the extent to which the Court’s review of the decision-making process would apply in all contractual contexts, particularly commercial contracts, stressing the importance of the employment context of Braganza itself.

The point was raised head-on in Lehman v ExxonMobil in the context of a US$ 250 million “repo financing extended by an oil major to an international investment bank” and it was decided that a review of the decision-making process in this context was not appropriate. Many will regard Lehman v ExxonMobil as a welcome decision for sophisticated commercial parties who, in most cases, may wish to avoid the uncertainties and expense of a full judicial review of the decision-making process pursuant to a contractual discretion.

However, this is not to encourage parties to pay no regard to the process adopted in exercising the discretion. In practice, a rational decision-making process carried out honestly and in good-faith is likely to lead to a robust and defensible outcome. Further, it would be surprising if the Court’s decision on the outcome were not coloured to an extent by the evidence of the process adopted, even where the latter is not formally under scrutiny.

Finally, of course parties are entirely free to expressly provide for the review of both the process and the outcome. For example, the 2002 ISDA Master Agreement provides that the “Close-out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”. The reference to “commercially reasonable procedures” means that the Court is able to scrutinise the process undertaken by the determining party.

What does the Court do if: (a) the Court has decided that the original exercise of a contractual discretion was contractually non-compliant; or (b) the discretion had to be exercised but, for whatever reason, the discretion was not exercised at the relevant time (and cannot now be exercised)?

Consistent with the principle set that the decision remains that of the decision-maker, the authorities are clear that the Court will ask a question of what contractually compliant decision the decision-maker would have made⁴.

First, this means that the Court will not simply provide its own preferred contractually compliant decision. To do so would largely deprive the decision-maker of the benefit of the discretion conferred upon it.

Second, it also means that the Court will not automatically accept the decision maker’s bare assertion that it would simply have exercised the discretion in the way that would have been most favourable to it; that is, the party afforded the discretion is not necessarily entitled to the benefit of the most favourable exercise of the discretion it could (rather than would in fact) (in a contractually compliant manner) have made⁵.

That said, it may well be that, on the evidence, the most favourable contractually compliant decision which the decision-maker could have made was what it in fact would have made. This is entirely credible in cases such as Socimer, WestLB v Nomura and Lehman v ExxonMobil where the decision-maker would have been entitled legitimately to consult its own interests. In such cases, however, the decision-maker shouldensure that it adduces factual evidence to support its “minimum obligation” case. Given the hypothetical nature of the exercise, this will most likely be in the form of a witness statement from the individual who was (or would have been) entrusted with making the relevant decision⁶. Without such evidence, there is a danger that the Court decides that it has no evidential basis to determine what the decision-maker would have done, or even the Court accepting other party’s evidence as to what it thinks the decision-maker would have done.

In conclusion, the exercise of contractual discretion has received substantial judicial scrutiny in recent years, with many cases reaching the appellate level. This has produced a number of helpful principles, which should assist parties in their exercise of a contractual discretion, in their scrutiny of the counterparty’s exercise of such discretion and in any disputes resulting from such an exercise.

The key practical points for commercial parties are as follows:

• Express terms. Much of the analysis above applies in the absence of further or contrary express terms in relation to the right or discretion in question. Clear express terms to the contrary may displace the above analysis so careful attention should be given in drafting and interpreting provisions conferring contractual rights or discretion.
• The decision maker. One should determine at the outset whether the contractual provision confers: a) an absolute contractual right; b) an absolute contractual obligation; or c) a contractual discretion. Under a), its exercise will be unfettered. Under b), there will be no right or discretion and the obligations must be performed strictly in accordance with the contract. Under c), there may be a range of options, the width of which will depend on the particular circumstances. In an extreme case, there might only be one (or a very narrow range of) rational decision(s), which will make the discretion largely illusory.
• Challenging the exercise of the right or discretion. Under a), the exercise cannot be challenged. Under b), the decision-maker will be in breach if it does not perform its obligations strictly in accordance with the contract. Under c), one should assess how wide the decision-maker’s discretion might be and whether its decision likely falls within it, in light of the contractual provision in question and factual circumstances. The more difficult the decision, the more likely it is that the decision-maker will be afforded a wide discretion. In such cases, it may be difficult to displace the original decision.
• Adduce the right evidence. Where there has been no (or no contractually compliant) exercise of discretion, the need to produce factual evidence as to what the decision-maker would have done has been mentioned above. In some cases, expert evidence may also be required to assist the Court in deciding what the range of contractually compliant outcomes is (i.e. what the decision-maker could have done). However, when adducing such evidence, it is important to ensure that the expert evidence addresses the right question: that is, what range of outcomes could the decision-maker have determined, acting honestly, in good faith and rationally. What the experts themselves would have done, or would prefer, is legally irrelevant and will be of little assistance to the Court⁷.