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The exercise of contractual discretion in commercial contracts

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02/12/2014

In the 2013 case of Compass Group (trading as Medirest) v Mid Essex Hospital Services NHS Trust [1] the Court of Appeal was asked to consider the obligation of good faith in a commercial contract in the context of the exercise of a contractual discretion.

The case concerned a contract for the provision of hospital catering services pursuant to which the Trust was able to award itself service credits in the form of payment deductions for performance failures. There was also a clause which provided that “the Trust and the Contractor will co-operate with each other in good faith and will take all reasonable action as is necessary for the efficient transmission of information and instructions and to enable the Trust…to derive the full benefit of the Contract”. In assessing this clause, the Court of Appeal held that the Trust’s discretion to award itself payment deductions was not subject to an implied term that the discretion must be exercised in a non-arbitrary manner. Such a term could only be implied where the Trust was required to make an assessment or choose from a range of options taking into account the interests of both parties, rather than having to make a simple decision whether or not to exercise an absolute contractual right.

Some further light on the extent of the duty of good faith in the exercise of a contractual discretion has been shone by the High Court in Andrew Brogden and Robert Reid v Investec Bank PLC [2]. In this case, the claimants worked in a bank. Their employment contracts included a bonus clause and the amount of the bonus was referable to the “Economic Value Added” (EVA) generated by their part of the business. Their employer calculated the EVA as zero. The claimants disputed this and argued that to the extent that the employer had any discretion in relation to the calculation of the EVA, there was a duty to exercise that discretion rationally.

The High Court held that the employer’s discretion to determine the EVA was subject to an implied requirement of good faith and rationality. It explained that where a contract gives responsibility to one party for making an assessment or exercising a judgement on a matter which materially affects the other party’s interests and about which there is ample scope for reasonable differences of view, the decision is properly regarded as a discretion and that such discretion is subject to the implied constraints that it must be exercised in good faith, for proper purposes and not in an arbitrary, capricious or irrational manner.

(On the facts of the case, however, the employer had not exercised its discretion irrationally and there was no evidence of bad faith, so the claimants were unsuccessful.)

There are at least two lessons to draw from these cases. The first concerns the subtle distinction that exists between the situation where the discretion involves a decision as to whether or not to exercise a contractual right (the position in Compass) and the position where the discretion involves choosing from a range of options (the position in Brogden). The second is of the scope for legal argument that can arise where the wording of the contract invokes the exercise of a discretion rather than, as could presumably have been the case, a precise formula. Generally, the more precisely the mechanism for arriving at a decision is drawn, the less scope there should be for subsequent argument.

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[1] [2013] EWCA Civ 200
[2] [2014] EWHC 2785 (Comm)

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