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When is a decision a discretion? High Court guidance and impact for documentation and bonus disputes

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Gemson Felicity
Felicity Gemson

Senior PSL

London

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24 November 2014

In Brogden & anr v Investec Bank plc [2014] EWHC 2785 (Comm), 6 August 2014, the High Court ruled in favour of the employer in this high-profile bonus litigation. The most interesting aspect of the ruling is the judge's guidance on when a party can be regarded as exercising a contractual discretion which is fettered by implied terms. This has drafting implications and could also bolster the arguments of claimants looking to challenge bonus decisions.

Limitations on the exercise of contractual discretion

It is well established in case law that a contractual discretion that is conferred on one party to make decisions that affect both parties must be exercised honestly and in good faith, for the purposes for which it was conferred, and must not be exercised arbitrarily, capriciously or unreasonably (in the sense of irrationally) (Abu Dhabi National Tanker Co v Product Star Shipping Ltd (The "Product Star") [1993] 1 Lloyd's Rep 397). However, no such constraints apply if the discretion is whether or not to exercise an absolute contractual right (Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd (trading as Medirest) [2013] EWCA Civ 200).

In an employment context, these limitations on the exercise of contractual discretion are underpinned by an overarching duty also implied at common law for an employer not, without reasonable and proper cause, to conduct itself in a manner calculated and likely to destroy or seriously damage the relationship of trust and confidence between employer and employee (the "duty of mutual trust and confidence").

Bonus litigation trends: discretionary bonuses back in the spotlight?

These limitations on the use of discretion were first applied to bonuses in Clark v Nomura International plc [2000] IRLR 766, in which the High Court established that employers, when deciding whether to award discretionary bonuses, must not behave irrationally or perversely. This paved the way for a string of (mostly successful) claims challenging the non-payment of discretionary bonuses.

However, the tide turned in Commerzbank AG v Keen [2006] EWCA Civ 1536 when the High Court raised the bar for claimants to succeed by requiring them to demonstrate an "overwhelming case" of irrationality, before an employer could be required to justify its award decision. Cases on discretionary bonuses have since petered out and disputes have instead shifted to the contractual status of undocumented bonus promises and to the operation of specific arrangements.

The latest case, Brogden, indicates that cases challenging the employer's exercise of discretion could, however, continue notwithstanding the need for claimants to overcome the high evidential hurdle established in Commerzbank. This is because, in the light of guidance given by the High Court as to when a discretion arises, it will be relatively easy for claimants to argue that most bonus schemes have a discretionary element.

Brogden: the facts and arguments

Brogden and Reid worked as head and deputy head of equity derivatives at Investec. Their employment contracts provided for payment of a bonus calculated as a set percentage of the "Economic Value Added" (EVA) generated by the bank's equity derivative business. However, Investec calculated that the available bonus pool for 2010/2011 was zero so that they were not entitled to a bonus. They brought proceedings for damages for breach of contract to recover a combined GBP 6.3 million in unpaid bonuses.

There was lengthy argument as to how "EVA" should have been calculated. The claimants alleged that Investec had made assurances in pre-contractual negotiations that a more favourable formula would apply.

A central argument for the claimants was that to the extent that Investec had any discretion in relation to the calculation of EVA, it had a duty to exercise that discretion rationally and was in breach of that duty. Investec's counter-argument was that, although preparing accounts necessary to calculate the bonus pool involved questions of judgment about which reasonable people may differ, this did not involve the exercise of a discretion.

High Court confirms parameters for discretion

The Court rejected Investec's counter-argument, finding that the bonus clause gave the bank a discretion "in the relevant sense" to determine the EVA for the bonus pool; this determination involved numerous and substantial exercises of judgment and, as a result, was subject to implied requirements of good faith and rationality. However, as the method used by Investec to determine the EVA could not be regarded as irrational and there was no evidence of bad faith, the claimants had no right to any bonus for 2010/2011 and their claims were dismissed.

Leggatt J distilled a long line of previous case law authority into certain criteria which determine when a decision is to be properly regarded as an exercise of discretion (and therefore 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). He said that, unless there is clear language to the contrary, this is where the following factors are present:

  • a contract gives responsibility to one party for making an assessment or exercising judgment on a matter which materially affects the other party's interests;

  • the matter is one about which there is ample scope for reasonable differences of view; and

  • the decision is final and binding on the other party such that a court would not substitute its own judgment for that of the party who makes the decision

Managing risks in documentation

These broad parameters pointing to a discretion suggest that it will be difficult for a party to argue that it is not exercising contractual discretion where it can determine a matter which will affect the other's interests. Investec's counter-argument was a tenuous one and was, perhaps unsurprisingly, rejected. Provisions which refer a matter for final determination by a third party such as an expert would negate any argument that a party has exercised a discretion in breach of the implied constraints.

When reserving an absolute discretion for a party in documentation, agreeing a detailed formula for making a decision should reduce the possible areas of dispute. However, unless the formula is entirely objective, that party is likely to find it difficult to establish that it is exercising no discretion at all. This is particularly relevant in bonus pool and award decisions which inevitably involve some subjective assessment on the employer's part. Documentary evidence of bonus decisions and the reasons for them will help to manage the risk of successful claims.

The ruling suggests that parties could potentially contract out of the constraints on their discretion using clear language. However, such an exclusion is likely to prove very difficult to negotiate, and it remains to be seen whether the courts would be willing to uphold it on policy grounds. In addition, an employer who has operated a contractual right unreasonably in reliance on such an exclusion would still risk being found to have breached its duty of mutual trust and confidence.

More generally, this case highlights that it is important for documentation to define terminology used in bonus formulae (or in formulae determining payments to be made under commercial contracts) to reduce the scope for disputes. This dispute related to the interpretation of "EVA" but there are many abbreviations or acronyms that that may be understood in context within a particular industry, for example, "ROCE", "ROA", "ROE", "ROI" and "IRR" in the banking sector, which may not be fully understood or may be interpreted differently outside it.

Future trends in bonus litigation?

Bonus litigation will no doubt continue to be a risk area given the often large amounts at stake and the existence of commercially savvy and well-resourced claimants. This ruling will give claimants more ammunition to challenge discretionary bonus decisions, by giving them greater scope to point to discretionary terms, although the evidential hurdle of "irrationality" that they face is high.