English High Court contrues contractual discretion in complex finance transaction

March 2013

The English High Court found that a contractual requirement for discretion to be exercised in a "commercially reasonable" manner was to be assessed against an objective standard of reasonableness.

Barclays Bank plc v UniCredit Bank AG (formerly Bayerische Hypo-Und Vereinsbank AG) & anr [2012] EWHC 3655 (Comm), 21 December 2012

A commercial party may still favour its own interests to the exclusion of its counterparty’s and be acting commercially reasonably. This is the first case to apply such an objective standard in the context of a complex finance transaction. Clauses requiring a party to exercise a conferred discretion reasonably are common in both capital markets and loan documentation (including Loan Market Association standard form facility agreements), and therefore this decision is of potentially wide application.

Between September and December 2008 Barclays Bank plc (Barclays) entered into three securitisation transactions with German and Austrian subsidiaries of UniCredit SpA (UniCredit). Each transaction was documented in a deed of guarantee (the Deeds of Guarantee).

Under the Deeds of Guarantee, in exchange for quarterly payments of premium (the Premium) and a quarterly fixed fee (the Fixed Fees) from UniCredit, Barclays would make quarterly payments to UniCredit in respect of the first losses suffered from credit defaults on a reference portfolio of obligations (the Credit Protection Payments). The Deeds of Guarantee thus transferred elements of the risk in the underlying portfolios from UniCredit to Barclays, which allowed UniCredit to benefit from risk weighted asset regulatory capital relief (RWA Relief) under Basel II, reducing its Tier One regulatory capital requirements.

The Premium paid to Barclays was determined such that, over the lifetime of the Deeds of Guarantee it would in aggregate exceed the sum of the Credit Protection Payments paid to UniCredit. However any surplus Premium above the value of the Credit Protection Payments paid was to be returned to UniCredit at predetermined intervals such that the payments of Premium and Credit Protection Payments would balance over the lifetime of the Deeds of Guarantee. Barclays was in effect receiving the Fixed Fee in exchange for entering into a transaction to allow UniCredit to reduce its Tier One regulatory capital requirements.

It was recognised that UniCredit would wish to terminate each Deed of Guarantee when the size of each reference portfolio was substantially reduced. Therefore each Deed of Guarantee contained a provision permitting UniCredit to terminate after a period equivalent to the weighted average life of the loans in each portfolio. In each Deed of Guarantee this period was at least five years. Barclays was therefore guaranteed to earn at least five years of Fixed Fees, subject to any other termination provisions. Two other termination provisions also guaranteed Barclays at least five years of Fixed Fees.

The Deeds of Guarantee also gave UniCredit the right to terminate at any time if:

“a Regulatory Change occurs in respect of [UniCredit], provided that [UniCredit] has obtained the prior consent from [Barclays], such consent to be determined by [Barclays] in a commercially reasonable manner”.

Regulatory Change was defined as occurring when UniCredit determined it would “be subject to less favourable regulatory capital treatment with respect to this Guarantee”. In June 2010 UniCredit sought Barclays’ consent to an early termination of the Deeds of Guarantee under this clause, as changes in the regulatory treatment of securitisation transactions meant that the Deeds of Guarantee no longer provided UniCredit with the RWA Relief they were designed to achieve. Barclays refused to consent to the early termination. UniCredit argued that it was not commercially reasonable for Barclays to refuse consent in light of the change in regulatory treatment of the Deeds of Guarantee.

The court found that Barclays had determined that it would not consent to the termination without payment of the balance of five years of the Fixed Fees, and that UniCredit understood this to be Barclays’ position. The key question for the court was therefore whether Barclays’ determination was commercially reasonable in light of the regulatory change.

Barclays argued that its obligation to determine whether to consent in a commercially reasonable manner should be interpreted as equivalent to the standard of reasonableness implied in the exercise of an ordinary contractual discretion. Previous English case law (Socimer International Bank Ltd v Standard Bank London Ltd [2008] Bus LR 1306) has found that implicit in any contractual discretion is a limitation that it be exercised honestly and in good faith, and not be exercised arbitrarily, capriciously or unreasonably. In this context, unreasonableness meant that no reasonable person could have exercised the contractual discretion in that way. On this basis Barclays argued that its refusal to consent, absent payment of the balance of five years of Fixed Fees, was commercially reasonable.

UniCredit argued that Barclays’ obligation to act in a commercially reasonable manner imported an objective standard of reasonableness in accordance with the standard applied in landlord and tenant cases (and which Porton Capital Technology Funds & ors v 3M UK Holdings Ltd & anr [2011] EWHC 2895 (Comm) had confirmed was applicable in commercial situations), namely that the decision is one which might be reached by a reasonable man in the circumstances. UniCredit argued that for Barclays to insist on the balance of five years of Fixed Fees was objectively unreasonable in light of the regulatory change.

Popplewell J found that where the parties had agreed to fetter the exercise of a discretion by express words, the court would presume it was the parties’ intention to achieve a greater restriction on the exercise of the discretion than if no such words had been used. Therefore, where parties have used express words to fetter the exercise of a discretion, the Socimer standard should not apply. Where commercial parties used the word “reasonable” they are likely to have intended it to mean reasonable in its ordinary, objective sense, rather than its specific public law sense. The use of “commercially” to qualify “reasonable” reinforced Popplewell J’s conclusions.

However, Popplewell J emphasised that reasonableness in this objective sense permits the decision maker to give primacy to his own commercial interests, even to the complete exclusion of the other party’s interests, provided the exercise of the discretion is one that could be reached by a reasonable man in the relevant circumstances. In the circumstances of the Deeds of Guarantee Barclays was entitled to give precedence to its interest in receiving the balance of five years of Fixed Fees over UniCredit’s interest in terminating the Deeds of Guarantee early. That a “Regulatory Change” had occurred obviating UniCredit’s original commercial driver for entering into the transactions did not mean that the only commercially reasonable decision Barclays could take was to consent to termination. The parties had clearly contemplated that Barclays could refuse to consent to termination following a Regulatory Change by giving Barclays discretion, and in exercising that discretion Barclays was “not obliged to carry out a balancing exercise between its interests and UniCredit’s interests”. Accordingly Popplewell J found that Barclays’ refusal of consent was commercially reasonable, a decision he felt was reinforced by the fact that other termination provisions in the Deed of Guarantee guaranteed Barclays at least five years’ Fixed Fees.

Comment

Although the Porton Capital case extended the objective standard applied in landlord and tenant cases to commercial agreements, this case is the first case to apply that standard in the context of a complex finance transaction. Clauses requiring a party to exercise a conferred discretion reasonably are very common.

For parties drafting or negotiating clauses that give one party discretion, the case provides additional clarity on the range of options available to limit the scope of that discretion as a matter of English law:

• leaving the discretion unfettered in the express terms of the contract will mean that it is subject to the Socimer standard that the discretion be exercised honestly and in good faith, and not arbitrarily, capriciously or unreasonably (ie a decision that no reasonable person in that position could have ever arrived at);
• requiring the discretion to be exercised reasonably will mean that the discretion must be exercised in the manner in which a reasonable man in the same circumstances would do; and
• requiring the discretion to be exercised in utmost good faith, imports an obligation “...to observe reasonable commercial standards of fair dealing … and also requiring faithfulness to the agreed common purpose and consistency with the justified expectations of [the other party]”.

In practice the difference between (a) and (b) is likely to be a question of degree rather than a stark line. With regards to commercial interests, (a) would allow you to ignore entirely your counterparty’s interests provided doing so was not arbitrary, capricious or done in bad faith, where as (b) would only allow you to ignore or discount your counterparty’s interests providing doing so was an objectively reasonable thing to do.

A further drafting point is that, whilst Popplewell J’s decision was reinforced by the use of “commercially” to qualify “reasonable”, it seems that he would have reached the same decision if only “reasonable” were including in the drafting. Therefore it is questionable whether “commercially reasonable” would import a different standard in commercial contracts to “reasonable”.

Finally, parties including similarly worded termination clauses in their contracts should be especially careful if their contract also includes a liquidated damages clause. In this case the Deeds of Guarantee contained a separate termination clause which provided for Barclays to recover the outstanding balance of five years of the Fixed Fees and described this sum as “a reasonable pre-estimate of loss”. Whilst Popplewell J recognised that this wording was likely included to avoid the clause being unenforceable as a penalty clause, he nevertheless derived support from it for his finding that Barclays’ insistence on the balance of five years of Fixed Fees was commercially reasonable.