A contractual decision maker may find themselves in breach of contract if they fail to exercise a contractual discretionary power fairly and in good faith. However, the law has not provided parties, especially their senior managers, with sufficiently clear guidance on how to do so. The recent Supreme Court decision of Braganza v BP Shipping Limited (18 March 2015)1 attempts to provide some guidance.

It is a well-established principle under English law that a party does not have an unfettered right to exercise a seemingly absolute discretionary power conferred on it by a contract. English law imposes implied restrictions, rooted in the general principles of good faith and fair dealing.

It is clear that a contractual discretion has to be exercised rationally, in good faith and consistently with its contractual purpose, avoiding arbitrariness, capriciousness and perversity. However, case law has not set out in precise terms what it means to say that a contractual discretion should be exercised rationally.

In this case, the Supreme Court sought to clarify the extent to which principles of judicial review of administrative action should be applied in the context of contractual decision making.

The factual background

Mr Braganza disappeared while working as the Chief Engineer on an oil tanker managed by BP. The BP internal investigators assessed six factors and formed the opinion that the most likely explanation for his disappearance was that he had committed suicide. Based on their report, the relevant manager decided that his widow was therefore not entitled to death benefits under his contract of employment, which provided that compensation would not be payable if “in the opinion of the Company or its insurers, the death…resulted from…the Officer’s wilful act, default or misconduct”.

The decision of the Supreme Court

The question for the Supreme Court was the proper test to apply when deciding whether the manager’s decision was reasonable.

In terms of the requirement of reasonableness in the contractual context, the Court recognised the distinction between:

  1. Reasonableness in the sense of taking reasonable care or fixing a reasonable time/price – which is subject to entirely objective criteria and where the decision maker becomes the court itself.
  2. That in the context of the contractual decision making function - where the decision remains that of the decision maker.

The Court considered that there is an obvious parallel between a decision making function of a contractual party and that of a public authority, in that in neither case is the court the primary decision maker. The standard of review adopted by the courts to the decisions of a contracting party should not be more demanding than the standard of review adopted in the judicial review of administrative action. The question is whether it should be any less demanding.

In judicial review, the decision making process is subject to the so called Wednesbury2 rationality test which has two limbs:

  1. Whether the decision maker has taken into account matters which they ought to take into account.
  2. If so, whether they have come to a conclusion so unreasonable that no reasonable authority could ever have come to it. This second limb may require that the decision maker should not exercise the discretion arbitrarily, capriciously, perversely or irrationally.

The Court recognised an understandable reluctance to apply the full rigour of the principles of judicial review of administrative action by a public authority in a contractual context and concluded that the precise extent to which the Wednesbury test applies to a contractual decision making process will depend on the contractual context concerned.

In this case, the Court held that the decision making manager should have considered whether the evidence was sufficiently cogent to overcome the inherent improbability that an employee has committed suicide. On the facts, the manager should not simply have accepted the view of an internal inquiry conducted for a different purpose. It was unreasonable in the Wednesbury sense to reach that decision without taking relevant matters into account.

Conclusion

Standard wordings in many insurance policies, particularly in the field of P&I mutual insurance, often confer discretionary powers on the insurers to determine the scope of their policy cover and issues in relation to claims. According to this decision, the exercise of such a discretionary power would be subject to the Wednesbury rationality test.

Although the standards required will depend on the contractual context, it is arguable that the decision making process of most properly advised management teams of large corporations, such as international insurers, would be expected to demonstrate high standards.

It is important to note that under the first limb of the Wednesbury test, it is imperative for the contractual decision maker to take into account matters that are relevant to the decision making process. Otherwise, they could still fail the rationality test, even if they have acted in good faith.