Legal Briefing

An exercise in discretion

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Corporate and commercial | 01 October 2014

Contractual terms relating to the payment of bonuses by one party to another are ripe for dispute, particularly where those terms involve the exercise of discretion by the paying party. The proceedings brought by Andrew Brogden and Robert Reid against Investec Bank (Brogden & anor v Investec Bank Plc [2014]) are a further reminder of the necessity for absolute precision in the drafting of such terms. While the claim was resoundingly dismissed, the judgment contains a number of points of interest from the perspective of contractual interpretation, particularly with respect to the ‘types’ of discretion to which limitations/obligations will be implied. 


FACTS OF BROGDEN

Mr Brogden and Mr Reid (the claimants) were employed by Investec Bank (the bank) as, respectively, head and deputy head of a new structured equity derivatives division (the SED desk). Under the terms of their employment contracts (the contracts), the main part of their remuneration was expected to consist of a bonus. The bonus clause read as follows:

‘… the bonus calculation will be normalised based on a formula calculated as 30% of EVA generated by the [SED desk].’

It was common ground that ‘EVA’ meant ‘economic value added’ but the precise method of calculation of the EVA was not specified in the contracts.

A dispute arose between the claimants and the bank in relation to the payment of bonuses. According to the bank’s calculation, the EVA achieved by the SED desk for the financial year 2010/11 was nil and the claimants were therefore not entitled to any bonus. The claimants contended that, on a proper calculation of the EVA, the bonus pool was in fact over £8m.

The claimants claimed that, in addition to the contracts, there was an oral agreement that certain ‘ground rules’ would be applied in calculating the bonus pool. Further and alternatively, these ground rules could be identified by interpreting the bonus clause in accordance with ordinary legal principles. In particular, it was necessary to calculate the EVA using those methods that best measure objectively the profitability of the SED desk considered as a stand-alone entity. And finally, if the bank had discretion in relation to the calculation of the EVA, it had a duty to exercise that discretion rationally: it could not have been reasonably intended that the EVA should mean whatever the bank calculated it to be.

The bank denied that there was any oral agreement and asserted that the bank had an established method for calculating the EVA that was explained to the claimants prior to their entering into the contracts and that the words ‘EVA generated by the [SED desk]’ therefore meant the amount calculated as such EVA by the bank. Further, in light of that established method, there was in fact no discretion in the method of calculation of the EVA.

JUDGMENT

Leggatt J rejected the argument that there was an oral agreement in relation to bonus payments. Accordingly, the judgment hinged on the proper interpretation of the ‘elliptical’ bonus formula as set out in the contract.

Referring to the House of Lords’ decision in Chartbrook Ltd v Persimmon Homes Ltd [2009], Leggatt J highlighted that, while the law excludes from admissible background the previous negotiations of the parties:

‘… the law does not exclude the use of such evidence for the purpose of establishing that a fact that may be relevant as background was known to the parties’.

He found that the bank had communicated its method for calculating the EVA to the claimants in pre-contractual negotiations. On the basis of that finding and his opinion that it would be unreasonable for the parties to be obliged to construct a measure of their economic performance from first principles, Leggatt J held that the only sensible interpretation of EVA was ‘the figures calculated as “EVA” by the bank’.

Leggatt J did, however, accept that it could not reasonably be supposed that the bank had a completely free rein to calculate the EVA of the SED desk however it liked. The question, therefore, was what limitations were to be implied.

Leggatt J started his consideration of discretion with reference to:

‘… the well established principle that, in the absence of very clear language to the contrary, a contractual discretion must be exercised in good faith for the purpose for which it was conferred, and must not be exercised arbitrarily, capriciously or unreasonably (in the sense of irrationally).’

He went on to distinguish between three different uses of the term discretion: it can be used in a ‘weak’ sense to mean that ‘the standards that a decision-maker must apply cannot be applied mechanically and demand the use of judgement’; or ‘to indicate that a person has final authority to make a decision which cannot be reviewed or reversed by someone else’; and in a ‘strong’ sense ‘to indicate that the authority which imposes duties on someone does not control their decision of a particular issue’.

In accordance with the ‘well established principle’, a duty to act in good faith and rationally will be implied in the exercise of discretion in the strong sense. However, Leggatt J emphasised that that is not exclusive: such a duty has also been implied in cases of ‘weak’ discretion. In this regard specific reference was made to Abu Dhabi National Tanker Co v Product Star Shipping Ltd, (The Product Star) (No 2) [1993] and Socimer International Bank Ltd v Standard Bank London Ltd [2008]. InThe Product Star, a shipowner was not to obey the charterer’s order to proceed to a port if the owner considered it dangerous. In that case the expressly specified standard to be applied was whether the port was dangerous. However, the Court of Appeal held that the shipowners were in breach of contract because they had not honestly believed that the port in question was dangerous and such a conclusion would 
in any event have been unreasonable 
and capricious.

In Socimer International Bank, the contract gave one party (the seller) the right to liquidate or retain a portfolio of assets and provided that the value of the assets was to be determined by the seller. The Court of Appeal found that determining the value of the assets was not simply a matter of choice but a matter of judgement, where there can be a variety of different techniques used and differences of view about how those techniques should be applied. The Court of Appeal rejected the judge’s interpretation that the seller was bound to identify the true market value of the assets and interpreted the clause as one that gave the seller a discretion limited by constraints of good faith and rationality.

As Lord Justice Jackson noted in his judgment in Compass Group UK and Ireland Ltd (t/a Medirest) v Mid Essex Hospital Services NHS Trust [2013]:

‘An important feature of the above line of authorities is that in each case the discretion did not involve a simple decision whether or not to exercise an absolute contractual right. The discretion involved making an assessment or choosing from a range of options, taking into account the interests of both parties. In any contract under which one party is permitted to exercise such a discretion, there is an implied term.’

Leggatt J interpreted the reference to ‘taking into account the interests of both parties’ in this passage as meaning:

‘… that the decision is one which affects the interests of both parties, since in none of the cases was there any express requirement to take the interests of the other party into account.’

In Medirest the Court of Appeal held that there was an absolute formula for the calculation of penalty points under the contract in question which required no choice or assessment and there was therefore no implied obligation to act in good faith or to take the interests of both parties into account. Brogden is a useful reminder following Medirest that, even where a formula or standard may be specified, if the party applying that formula or standard is required to make an assessment or exercise 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 which is subject to the implied constraints that it must be taken 
in good faith, for proper purposes 
and not in an arbitrary, capricious or irrational manner.’

Leggatt J construed the bonus clause as conferring on the bank discretion that affected the claimants’ interests and about which there was scope for differences of view, and therefore involved the exercise of discretion in the ‘weak’ sense. He therefore held that the exercise of that discretion was subject to an implied duty of good faith. However, on the basis that the EVA had been calculated within the internal guidelines and polices of the bank and there was no evidence of bad faith, he held that the bank had fulfilled this duty.

CONCLUSION

While this was a victory for the bank, it appears that those drafting the contracts were perhaps lulled into a false sense of security by the existence of an established method for calculating EVA. By the simple insertion of that calculation into the contracts, these long, public and costly proceedings could have been avoided.

Given the breadth of what could have been construed as a ‘good faith’ calculation of the EVA in the absence of an established method, this case is a further reminder of the necessity for absolute precision in drafting. A reference to a formula or standard will not necessary avoid the implication of duty of good faith. Where possible a precise and absolute formula should be set out. If that is impossible, the limitations and obligations on the deciding party should be set out as fully as possible.