Decision-making under contracts - businesses do not have unlimited freedom
Business contracts have many functions - to define obligations, establish rights and remedies, specify procedures for how the parties interact, and many others. It's the language of the contract which determines the scope of these.
Another common feature of many contracts is to give one party the power during contract lifetime to decide a matter affecting the other. (Common examples are: an approval right for an assignment; the right to consent to proposed new uses of intellectual property; or the right to approve the management of a fund. There are countless other examples).
Under English law, you might expect that it would be the written language alone which determines how a business exercises these powers. But that is not the case. Where the power constitutes a so-called "genuine discretion" under the contract, the exercise of the power is subject to an implied contract term - ie a binding provision which does not appear anywhere on the face of the document, but which is read into the contract.
According to authoritative caselaw, the implied term requires that the decision-making power must be exercised in good faith and "not in a way which is capricious, arbitrary or irrational". This is an inroad into the traditional English law notion of 'freedom of contract'. And it means that the contract's language cannot always be taken literally.
The implied term is not synonymous with what business lawyers refer to as "reasonableness". In fact, the origins of the implied term lie in the public law concept of decision-making rationality (as distinct from reasonableness - a distinction which can be painfully confusing, and is often missed).
When examining 'rationality', the court's role is not to 'second-guess' the content of a decision which a commercial organisation has made, or substitute its own decision on the same issue. Rather, the questions that the court has to address are whether the decision genuinely relates to the subject-matter of the contract and whether both the decision-making process and the outcome of the decision-making fulfil a set of minimal objective criteria.
The widening impact of these principles
These legal principles are not even new (they originate in English court decisions in the finance sector which are over 10 years old, and have been elucidated many times since). What is new is the way that the application of the principles is gathering pace and having an increasingly wide impact across sectors and industries.
This is apparent from ever-more detailed and closely reasoned decisions of High Courts and the Court of Appeal on the issue. And in 2015 the English Supreme Court invoked the implied term in Braganza v BP Shipping, and explored in detail how it should operate (BP Shipping were held to be in breach). That ruling has increased the level of awareness of these principles still further.
Recent illustrations of where the implied term has been applied
Here are five recent examples of court decisions (including one from September 2017) where an affected party challenged a decision of the other for breaching the implied contract term:
- Refusal by a company's Board of Directors to grant an option over company shares - implied term held to have been breached by the Board (Watson v Watchfinder - High Court, 2017)
- Payments made under a sales commission plan - implied term breached (Hill v Niksun, Court of Appeal 2016)
- Decision-making by the Board and Remuneration Committee in relation to a share plan - implied term breached (this was a preliminary finding of the Court (Simpkin v Berkeley, High Court 2016))
- Operation by a local authority of a contractual service level regime under a long-term road maintenance contract - Council's decision-making was found to be subject to the implied term (Portsmouth City Council v Ensign - High Court, 2015) [note, there was no finding by the Court of an actual breach, only that the Council's conduct was subject to the implied term]
- Charging of fees for taking over the collection of certain receivables under a receivables finance agreement - implied term held to have been breached by the way in which the fee was calculated (BHL v Bank Leumi, High Court, September 2017)
I expect many further decisions on these principles in the year ahead. These rulings will have an increasing, if unspectacular, impact on how decisions are made under signed contracts.
Distinguishing between a 'genuine discretion' and an absolute contractual right
Clients often ask - is there any way to avoid the impact of the implied term? Well, part of the answer is that the implied term only applies to the exercise of a "genuine discretion" under a contract, not to the exercise of an absolute contractual power or right. That's a crucial distinction, and is the topic of part 2 of this bulletin.
Take-away message - it's behaviour that matters.....
There are plenty of practical take-aways to be gleaned from the cases listed above, and from other cases which address these issues. Those lessons concern the machinery for decision-making in the context of particular agreement types.
But there is a wider take-away message, too, which is not confined to one agreement type. The law around decision-making in business-to-business contracts is changing, across all sectors and agreement types. To an ever-increasing extent, contract law is probing, not just how the written word should be interpreted, but the wider question of the behaviour of contracting parties during contract lifetime.