A court can imply terms into contracts to fill gaps in drafting in order to reflect the parties' intentions when the contract was entered into. It is established law that where a contract provides that one party has a discretion to make decisions which affect both parties, the court will imply a term to the effect that such discretion must be exercised rationally, honestly and in good faith for the purposes for which it was conferred.
The facts
In Brogden et al v Investec Bank Plc1, the claimants were former employees of Investec whose employment contracts had provided for payment of a bonus calculated as 30% of the Economic Value Added ("EVA") generated by Investec's equity derivative business. EVA is a measure used within Investec to assess the performance of business units and their contribution to the overall profitability of the bank, in accordance with a basic formula.
For the financial year of 2010 to 2011, the bank calculated the available bonus pool as nil, with the result that no bonus was payable to the claimants. The claimants, on the other hand, believed that they should have been paid bonuses of £3.6 million and £2.7 million. They subsequently resigned and took legal action against the bank seeking damages for breach of contract for failure to pay bonuses that they said that the bank was obliged to pay under their respective employment contracts.
The arguments
A variety of arguments were put forward by the claimants, including that the method of bonus calculation had been agreed orally. But these were all rejected by the Court and the decision ultimately came down to the question of whether a term should be implied into the contract required the bank to exercise its discretion in calculating the bonus pool rationally and in good faith and, if so, then whether, on the facts, the bank had so exercised its discretion.
The claimants argued that the bank had exercised a contractual discretion in calculating the bonus pool available and that therefore, following established law, the contract included an implied term that such discretion be exercised rationally. According to the claimants, the bank had failed to comply with its obligations under this implied term by acting in bad faith to deliberately manipulate and adjust the inputs to the EVA calculation in order to reduce the claimants' bonuses.
The bank, on the other hand, argued that although the preparation of accounts such as were necessary for the calculation of the bonus pool involved questions of judgment about which reasonable people might differ, it did not involve the exercise of contractual discretion. It said that since there was a set formula within the bank which was used regularly in the calculation of bonuses, various controls and constraints were placed on the bank's decision making with the result that it could not be said to be exercising a discretion. As there was no discretion, there was no implied term that the calculation had to be made rationally.
The High Court's decision
The Court accepted that the bank was exercising a discretion in calculating the available bonus pool, but held that its approach in making the calculation was rational and should stand. In the Court's opinion, the claimants failed to provide any evidence to support the allegation of bad faith.
In delivering its judgment, the Court gave guidance on the elements that must be present if a decision by one party under a contract is to be properly regarded as a contractual discretion:
(i) the contract must give responsibility to one party for marking an assessment or exercising a judgment on a matter which materially affects the other party's interests;
(ii) the matter must be one about which there is scope for reasonable differences of view; and
(iii) the decision must be final and binding on the other party, in the sense that a court will not substitute its own judgment for that of the party who makes the decision.
With regard to (ii), the Court made it clear that there can be scope for reasonable differences of view even where controls and constraints are placed on the party's decision-making, as was the case in relation to the bank's calculation of the bonus pool.
Observations
The case serves as a useful reminder that, when one party is given the power to exercise a discretion under a contract, such power will always be subject to the requirement that it is exercised rationally and in good faith, and any exercise of it will be open to allegations of irrationality. It is possible to exclude the implied obligation to act rationally by including unambiguous wording to such effect in the contract. However in practice this is likely to be very difficult to negotiate.
The obligation of rationality will not apply where the three elements of a discretion outlined in the Court's judgment are not present. However, it seems that avoiding the obligation on such grounds, as the bank attempted to do in this case, will be difficult. The Court made it clear that a contractual discretion will be present wherever there is scope for reasonable differences of view in reaching the decision (provided that the other elements are also present), even where there are constraints and controls placed on a party's decision-making.
Agreeing a clear, detailed mechanism according to which the decision is to be made could help to avoid disputes. Certainly in this case a clearer description in the claimants' employment contracts of how their bonuses were to be calculated would have been helpful. However, even where such mechanism is present, it may still be difficult for a party making the final decision to demonstrate that it is not exercising any discretion at all.
Footnote
1. [2014] EWCH 2785
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