When one party has the discretion to change or alter the terms of contract without taking the

consent of the other party/unilaterally which is binding on both the parties to the contract. Such
discretions are referred to as Contractual discretions.

When parties engage in contractual agreements, they will generally agree on the dispersion of
various powers within the arrangement. A contractual discretion is a legally constituted power of
decision, vested in one of the contracting parties, which they alone may exercise. A discretion will
arise when the rights and obligations of the parties are not fixed within the four corners of the
contract. Instead, it is stipulated that one or both parties should have a power of choice to make
decisions after the contract is formed.

Discretionary powers are an increasingly common feature of commercial contracts, as they are a
valuable asset to exchange when negotiating the agreement, an efficient way to provide flexibility
for unforeseeable future events and a way to achieve consensus ad idem at contract formation while
circumventing permanent agreement on all matters. For Example: A rent Agreement between
tenant and Landlord wherein the landlord has the power to deduct the security deposit in case any
damage is caused by tenant. Such right is considered as a contractual discretion as it is on the
discretion of landlord to cut the quantum of security money.

Basic examples of such discretionary powers include:

a) A discretion allowing one party to alter the interest rate part way through a finance or mortgage
contract;

b) A power to vary the charging or payment scheme in a contract of service;

c) A discretion to choose a port or place of delivery for goods in a charter party;

d) A power to vary operating rules for contractors or franchisees;

e) A discretion to approve assignment or subcontracting by the other party, or to consent to a

transfer of ownership.

f) determine that an employee is a “good leaver” under share plan;

g) claw back or reduce a bonus;

h) determine if an employee is unfit for work;

i) exercise a mobility clause; or

j) relax a contractual restriction (such as a restriction on outside interests).

When these powers are expressed in terms unconstrained by extrinsic advice, consent or input, their
remit and potential effects can be very broad and powerful. Hence, while the parties have bargained
for these unilateral powers, they may substantially alter the relative benefits and burdens of the
contract for each party – making them a very valuable asset. The rights affected by the exercise of a
discretion do not pre-exist the legal source of the discretion; they are derived from the same bargain
and instrument as the discretion itself.

Thus, as contract law governs voluntary, self-imposed obligations, the orthodox understanding is
that any protections or limitations to the exercise of the discretionary power can be expressly
provided for by the parties in their contract.
Where a contract confers a discretionary power on one party, the courts are applying a minimum
standard of decision making, limited by concepts of honesty, good faith, and genuineness, and the
need for absence of arbitrariness, capriciousness, perversity and irrationality. This has been called
the common law “mechanism to ensure good faith exercise of contractual discretions”. Due to the
increasing frequency of this limitation on the exercise of contractual discretions, it has come to be
considered a ‘default rule’.

The main framework of the rule developed in the United Kingdom over recent decades – a time of
quiet revolution in the courts’ construction of commercial contracts. The judiciary began to prioritise
the objectively reasonable interpretation that accorded with ‘commercial common sense’ over the
ordinary, natural meaning of the contract.

The nub of the issue is that if you have an absolute contractual right then, generally, your motivation
and any processes leading to its exercise are irrelevant. With a contractual discretion, however, the
court will imply, as a matter of necessity, a standard to which you must adhere, even where the
discretion is expressed to be absolute. The person exercising a contractual discretion must do so
honestly and in good faith, and having regard to the provisions of the contract by which it is
conferred. The discretion must not be exercised arbitrarily, capriciously or unreasonably. Where the
discretion involves determining whether something happened, the more unlikely that thing is to
have happened, the more cogent must be the evidence required to persuade the decision-maker
that it has indeed happened.

Absolute contractual rights are defined as the rights which are absolutely mentioned in the contract
between the parties which needs no discretion of the party to impose or implement such right on
the other party. For example: A contract between tenant and Landlord wherein in landlord has the
right to forfeit the security deposit in case tenant leave the house before 1 year of such agreement.
In such cases the court will not look into the matter of reasonableness or good faith.

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.
Development of the Default Rule – United Kingdom

1.1.1 Origin of the Rule

The locus classicus definition and justification of the rule is articulated by Leggatt LJ in Abu Dhabi
National Tanker Co v Product Star Shipping Co (“The Product Star”).1 This case concerned a charter
party, which conferred on the owner of the ship a power to determine whether the port from which
the charterer ordered the vessel was dangerous. In determining the scope of this power, Leggatt LJ
found:

The essential question always is whether the relevant power has been abused. Where A and B
contract with one another 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 must be conferred, it
must not be exercised arbitrarily, capriciously, or unreasonably. That entails a proper consideration
of the matter after making any necessary enquiries. To these principles, little is added by the
concept of fairness: it does no more than describe the result achieved by their application.

The United Kingdom Court of Appeal derived this limitation through construction, emphasising that
the limitation arises out of the provisions of the contract by which the power is conferred. However,
in subsequent Court of Appeal decisions where the rule was affirmed and applied, implication in fact
developed as the preferred mechanism to limit a discretions’ remit. Reference to the parties
‘reasonable expectations’ was the key force behind the imposition of the term. 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 that discretion”.

This approach is summarised by the influential judgment of Rix LJ in Socimer International Bank Ltd v
Standard Bank London Ltd. Socimer concerned the termination of a contract between two banks for
the forward sale of securities, where the seller was obliged to value the securities and give credit to
those belonging to the buyer. In rejecting the argument that this discretion was limited by a more
onerous objective standard of reasonableness, Rix LJ found.

It is plain from these authorities that a decision-maker's discretion will be limited, as a matter of
necessary implication, by concepts of honesty, good faith, and genuineness, and the need for the
absence of arbitrariness, capriciousness, perversity and irrationality. The concern is that the
discretion should not be abused. Reasonableness and unreasonableness are also concepts deployed
in this context, but only in a sense analogous to Wednesbury unreasonableness, not in the sense in
which that expression is used when speaking of the duty to take reasonable care, or when otherwise
deploying entirely objective criteria… Pursuant to the Wednesbury rationality test, the decision
remains that of the decision maker, whereas on entirely objective criteria of reasonableness the
decision maker becomes the court itself.

In 2014, the United Kingdom Supreme Court in Telefonica 02 UK v British Telecommunications,

considered whether British Telecommunications’ power to, “from time to time vary the charge” for
their service allowed them to introduce a new charging scheme based on different charging criteria
The Court found that:

1
Abu Dhabi National Tanker Co v Product Star Shipping Ltd (No 2) [1993] 1 Lloyd’s Rep 397 [‘The Product Star’].
As a general rule, the scope of a contractual discretion will depend on the nature of the discretion
and the construction of the language conferring it. But it is well established that in the absence of
very clear language to the contrary, a contractual discretion must be exercised in good faith and not
arbitrarily or capriciously...

In 2015, in Braganza, the United Kingdom Supreme Court posited the limitation clearly as an implied
term, reflecting the recent reversion to the separation of the concepts of interpretation and
implication. The Court found that, “the court will only imply a term that the decision-making process
be lawful and rational in the public law sense, that the decision is made rationally (as well as in good
faith) and consistently with its contractual purpose”. The Court found that the problem with
discretions is that they involve a clear conflict of interest, thus courts have sought to ensure that
they were not abused.

Overall, in the United Kingdom, it is considered that the threshold for intervention must be a high
one, with the circumstances in which a court will intervene being “extremely limited”. Provided
there was a genuine and rational exercise of the discretion, the party is not obliged to prefer the
interests of the other contracting party to the detriment of its own.

1.1.2 Importation of the Wednesbury Unreasonableness Standard

The case law above identifies that Wednesbury unreasonableness, an administrative law concept,
has been imported into this contractual context as an objective standard to test the subjective
considerations of whether the exercise of the discretion was in good faith and rational.

In administrative law, Parliament has given discretionary power to particular delegates under
statute. As a result, due to the fundamental separation of powers in the constitutional structure of
the United Kingdom and New Zealand, the Courts are reluctant to interfere with the substance of a
decision. Rather, their enquiry is usually limited to assessing the propriety of the decision-making
process. Courts have the jurisdiction to ensure the decision-making power is properly exercised, but
not to decide whether the proper decision has been made.

Similarly, in respect of contractual discretions, the fundamental common law rule is that the court
does not substitute its own decision for that of the holder of the contractual power. The courts are
committed to giving effect to the intention of the parties, therefore have seen their role as ensuring
a proper decision-making process, judged in light of the overall purpose and character of the
contractual deal, rather than commenting on the substance or effect of the decision. Hence,
analogies have been made with the judicial review of administrative powers.

Wednesbury unreasonableness is a standard applied in the judicial review of administrative law

decisions. In its original formulation, Wednesbury unreasonableness had two stages. First, the court
interprets the relevant statutory power and decides which matters must be taken into account by
the public decision-maker, and which must not. Second, the court determines whether these have
been considered. If the decision-maker has not “kept within the four corners of the matter which
they ought to consider”, the decision is ultra vires and invalid. Secondly, even when the authority
has taken into consideration all relevant factors, it is still possible to impugn the decision if, “they
have nevertheless come to a conclusion so unreasonable that no reasonable authority could have
ever come it”. This later phrase is what is traditionally imported to mean Wednesbury
unreasonableness.
However, recently the Supreme Court expanded the requirement of “rationality” or “Wednesbury
unreasonableness” to include both limbs in Braganza v BP Shipping Ltd & Anor. The case concerned
whether an employer had properly made his decision that an employee had committed suicide, as
opposed to being lost at sea, hence disentitling his widow to the death in service’ benefit. As
Braganza involved an employment contract, it was noted that this potentially attracted a greater
degree of scrutiny than ordinary commercial contracts, meaning that they likely afforded less
deference to the party exercising the contractual discretion due to the relative unequal bargaining
power. Nevertheless, both minority and majority judges agreed that the application of Wednesbury
unreasonableness to the exercise of contractual discretions was the correct approach. Therefore,
the opinion did not have to be objectively reasonable as measured against some external
benchmark.

However, increasing the previous standard of decision from solely the second limb, the majority in
Braganza found that the discretion was constrained by both limbs of the Wednesbury test. As
previously applied in this context, the final determination could not be so unreasonable – so
outrageous in the defiance of logic – that no reasonable person could have reached it. However,
secondly, the process of decision-making also had to be rational, taking into account relevant
considerations and disregarding those that were irrelevant. Thus, the Court recognised that the
Wednesbury unreasonableness obligations may include both obligations relating to how the decision
is arrived at, as well as the content of the decision itself. In the majority’s view, the employer’s
decision failed on the latter limb.

The limitation on the exercise of a contractual discretion

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.