Limitation of contractual discretion and good faith considered by the Court of Appeal

A discretion conferred on one contracting party was not subject to an implied term not to exercise this power in an arbitrary, capricious or irrational manner. There is a distinction between a contractual discretion to exercise an absolute contractual right (where such a term should not be implied) and a discretion requiring the decision-maker to make an assessment, taking into account the interests of both contracting parties (where such a term should be implied). The Court of Appeal also addressed the interpretation of an express contractual obligation to co-operate in good faith.

In 2008 the parties entered into a suite of agreements (together, the Agreement) pursuant to which Medirest was to provide catering and cleaning services to Mid Essex Hospital Services NHS Trust (the Trust). When performance of certain of the services did not meet the service levels specified in the Agreement, the Trust relied on its contractual discretion, under clause 5.8 of the conditions to the Agreement (the Conditions), to award service failure points (SFPs) and levy payment deductions against the monthly contract price payable (Deductions) to Medirest, in accordance with the payment mechanism set out in the Agreement.

The Trust also had a right to terminate the Agreement if the number of SFPs awarded to Medirest exceeded a specified number in any six-month rolling period and, in July 2009, the Trust sent a notice of termination to Medirest stating that this had occurred. Medirest disagreed with both the Trust’s assessment of the number of SFPs and the amount of Deductions and purported to terminate the Agreement on the basis that the Trust had committed material breaches of the Agreement by awarding excessive SFPs and making excessive Deductions. The Trust later withdrew its July notice of termination following a revision of its monitoring information but issued a new termination notice in October 2009.

The parties subsequently agreed an effective termination date but each maintained that it had validly terminated the Agreement and had financial claims against the other. Medirest commenced proceedings against the Trust, claiming substantial damages for breach of contract. The Trust defended Medirest’s claim and made a counterclaim.

At first instance, Cranston J held, inter alia, that:

• the Trust’s conduct constituted a breach of the parties’ contractual obligation to "co-operate with each other in good faith" under clause 3.5 of the Conditions;

• the Trust’s power to make Deductions and to award SFPs under clause 5.8 of the Conditions was subject to an implied term that, in exercising this power, the Trust would not act in an arbitrary, capricious or irrational manner; and

• in breach of that implied term, the Trust had exercised its discretionary power under clause 5.8 of the Conditions in an arbitrary, capricious and irrational manner.

The Trust has now successfully appealed the first instance decision.

Limitation of contractual discretion?

A number of authorities have found that, where a contractual discretion has been conferred on one contractual party which will potentially impact upon the contractual rights and entitlements of another party, this discretion is subject to implicit limits. For example:

• where a former employee was entitled to a discretionary bonus under his contract of employment, the Court of Appeal held that there was an implied term, based on the common intention of the parties, that there would be "a genuine and rational, as opposed to an empty or irrational, exercise of discretion" (Horkulak v Cantor Fitzgerald International [2004] EWCA Civ 1287); and

• where a contract for the sale of assets between banks entrusted the task of valuation to one party, the Court of Appeal noted that the decision-maker’s discretion will be limited "as a matter of necessary implication" as the decisions would have an effect on both parties; accordingly, there is a "need for the absence of arbitrariness, capriciousness, perversity and irrationality" (Socimer International Bank Ltd v Standard Bank London Ltd [2008] EWCA Civ 116).

Jackson LJ, giving the leading judgment in the Court of Appeal, noted that in each of the above authorities (and other authorities relied upon by Cranston J at first instance) the implied term was intrinsic – "the contract would not make sense without it". Moreover, an essential feature of this line of authorities is that the discretion did not involve a simple decision whether to exercise an absolute contractual right; rather the discretion required the decision-maker to make an assessment or choose from a range of options, taking into account the interests of both parties.

However, Jackson LJ held that clause 5.8 did not confer on the Trust a discretion such as to give rise to an implied term not to exercise the discretion in an arbitrary, capricious or irrational manner. As regards the number of SFPs incurred by Medirest and the Deductions due, the Agreement contained precise rules for determining these issues; this calculation did not involve an exercise of discretion as there was only one right answer. Although once the correct figures had been established the Trust had a discretion to award the SFPs or levy the Deductions, Jackson LJ found that the discretion conferred by clause 5.8 was "very different" from the discretion which existed in the considered authorities as it simply permitted the Trust to decide whether to exercise an absolute contractual right. Whilst the implied term found in the considered authorities operated as a "necessary control mechanism" on an otherwise unfettered discretion, there was no need for any implied term to regulate the operation of clause 5.8 as any abuse (for example if the Trust made incorrect Deductions) would breach the express provisions of the clause. Indeed, the Trust had breached clause 5.8 by awarding excessive SFPs and making excessive Deductions.

Contrary to the judgment of Cranston J, the Court of Appeal held that, as a matter of contractual interpretation, clause 3.5 did not impose a general obligation on the parties to co-operate with each other in good faith. Rather, the obligation to co-operate in good faith was specifically focused upon the two purposes stated in the clause.

Beatson LJ emphasised the important role of context in determining the scope of an obligation to co-operate in good faith. Citing the recent decision in Yam Seng Pte Ltd v International Trade Corp Ltd [2013] EWHC 111 (QB), Beatson LJ noted Leggatt J’s emphasis in that case that "what good faith requires is sensitive to context", that the test of good faith is objective in the sense that it depends on whether, in the particular context, the conduct would be regarded as commercially unacceptable by reasonable and honest people and its content "is established through a process of construction of the contract". Beatson LJ thought that these considerations were also relevant to the interpretation of an express obligation to act in good faith. Accordingly, the scope of the obligation to co-operate in good faith in clause 3.5 had to be assessed in the light of the provisions of that clause, the Agreement’s other provisions and its overall context. As regards the second point, Beatson LJ noted that, when determining the scope of the parties’ obligations under clause 3.5, Cranston J gave insufficient weight to the other provisions of the contract (which included provisions dealing with excessive SFPs and Deductions). This failure to take sufficient account of the context of clause 3.5 resulted in the clause being construed too widely. In this regard, Beatson LJ cautioned that, where a contract makes such specific provision, care must be taken not to construe a general and potentially open-ended obligation (such as an obligation "to act in good faith") as covering the same ground as other, more specific, provisions, "lest it cut across those more specific provisions and any limitations in them".

Comment: Although the Court of Appeal’s decision on both the contractual discretion and good faith issues was ultimately a matter of interpretation of the Agreement, this case provides a welcome insight into how the court approaches these issues.

This case is also useful in emphasising the importance, when interpreting an express obligation of contracting parties to co-operate in good faith, of taking into account the context of such a clause. Also of note is Beatson LJ’s reference to the judgment of Leggatt J in Yam Seng Pte Ltd v International Trade Corp Ltd [2013] EWHC 111 (QB) (reported in the February 2013 Litigation Review). Although Beatson LJ does not develop the points made in Yam Seng concerning a general duty of good faith, it is interesting that no disagreement was expressed either.