The concept of freedom of contract is often employed in commercial arrangements to allow parties to address unforeseen or ambiguous situations that may arise during the term of their contract. However, this broad freedom is not without limitations, and those exercising decision-making powers in a contractual context should be aware that there may be implied restrictions on what they can decide and the bases on which they can reach those decisions.

One recent case that explored the distinction between decision-making involving an exercise of absolute contractual rights and the exercise of a contractual discretion was Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd (t/a Medirest) [2013]. The case concerned the correct application of 'service failure points' under a catering supply agreement. The court held that there was only one answer to the calculation, and therefore, there was no need for an implied term to act rationally. However, in cases where an assessment or choosing from a range of options is involved, the decision-maker is required to act rationally, and an implied term to that effect will apply.

The legal standards to which parties will be held when making a decision under a contract and the circumstances in which these standards will apply can be complex. For example, an absolute contractual right, such as the right to terminate a contract, grants the decision-maker complete freedom to act. However, in a case where a contractual discretion is required, the decision-maker must exercise their discretion honestly and in good faith, with regard to the contract. They must not act arbitrarily, capriciously, irrationally or perversely, and the more unlikely the outcome of a decision, the stronger the evidence required to justify it.

It is important to note that an implied term to act rationally is extremely difficult to exclude, even by express terms, and may apply despite references to 'sole and absolute discretion' in a contract. The test for rationality derives from public law and the judicial review of a public authority's decision. Although some controversy exists regarding the extent to which this test should be deployed in a private law dispute, the modern approach derives from the Braganza case. The decision-maker should disregard matters which they ought not to take into account, and conversely, must not refuse or fail to take into account matters which they ought to take into account. The decision-maker must go through a proper process and evidence that process.

In conclusion, parties exercising decision-making powers under a contract should carefully consider the legal standards to which they will be held and the circumstances in which these standards will apply. They must take care to document their reasoning and follow a proper process. By doing so, they can avoid the uncommon pitfalls that can arise from the broad concept of freedom of contract.

Avoiding Contractual Pitfalls: The Importance of Contractual Decision-Making Powers

The concept of freedom of contract is commonly used in business agreements. However, it can lead to unexpected issues if not handled properly. Not all aspects of a contract can be defined in advance, so many companies include contractual decision-making powers to address this issue. But when it comes to making decisions, the decision-maker needs to be aware that there may be implied restrictions on what they can decide and the basis on which they can make their decision.

Previously, the key distinction was between decision-making involving an exercise of absolute contractual rights and the exercise of a contractual discretion. Absolute contractual rights allow the decision-maker to act as they choose, while the exercise of contractual discretion is subject to an implied term requiring the decision-maker to act rationally. The Court of Appeal explored this distinction in the case of Mid Essex Hospital Services NHS Trust v Compass Group UK and Ireland Ltd (t/a Medirest) [2013]. The court found that the implied term to act rationally operates as a necessary control mechanism in cases where there is no single answer or where there is a range of options to choose from.

In this blog post, we will discuss the legal standards that parties must adhere to when making a decision under a contract, and in what circumstances. We will also explore the importance of documenting the decision-making process and the outcome. We will then look at two alternative standards that have been introduced: the implied standard not to act vexatiously and the higher standard of objective reasonableness.

Absolute contractual rights: complete freedom to act

An example of an absolute contractual right is the right to terminate a contract. In TSG Building Services plc v South Anglia Housing Ltd [2013], the court noted that either party "for no, good or bad reason could terminate at any time." All that matters in such a case is whether the party has the right to terminate under the contract or as a matter of law. Other examples of absolute contractual rights include cases where the decision-maker has complete freedom to act, such as Shurbanova v Forex Capital Markets Ltd [2017], where the court found that there was no implied term to act rationally in reaching the decision to revoke trades carried out by Shurbanova.

Contractual discretion: duty to act rationally

Contractual discretion involves making an assessment or choosing from a range of options, taking into account the interests of both parties. Recent cases where the court has found there to be a contractual discretion include Braganza v BP Shipping Ltd [2015], Watson v Watchfinder.co.uk Ltd [2017], LBI EHF v Raiffeisen Bank International AG [2018], and Lehman Brothers Special Financing Inc v National Power Corporation [2018]. Where a contract includes a contractual discretion, the decision-maker must act honestly and in good faith, with regard to the contract. The discretion must not be exercised arbitrarily, capriciously, irrationally, or perversely.

More evidence required to support unlikely outcome

The more unlikely an outcome, the stronger the evidence required to persuade the decision-maker that it has indeed happened. In Braganza, the court had to determine whether a man had committed suicide in order to assess his wife's entitlement to death in service benefits. The act of committing suicide was viewed as particularly improbable as the man in question was a practising Catholic. The court required strong evidence to determine that he had indeed killed himself.

Both process and outcome important

Not only is the process important, but the outcome is as well. The outcome must not be so unreasonable that no reasonable person could have arrived at the same outcome. As the Court of Appeal noted in Socimer, the decision remains that of the decision-maker and is hence viewed from the decision-maker's perspective.

If you have not explicitly chosen objective reasonableness or can be certain that the decision-maker is exercising an absolute right, you may find yourself in a grey area. In such a situation, it is important to carefully consider the decision-making process and document the basis of any decision, much like a public authority anticipating a legal challenge. You should also avoid taking extreme positions without good reason.

While you should generally be able to act in your own commercial interest, you must be mindful of your contractual obligations and ensure that any decisions made are reasonable and fair to all parties involved. Ultimately, it is important to strike a balance between protecting your interests and ensuring that you are acting in good faith and in accordance with the terms of the contract.