In Portsmouth City Council v Ensign Highways Ltd [2015] EWHC 1969 (TCC), the High Court implied a term imposing limits on a party's contractual discretion, holding that the party exercising the discretion was required to "act honestly and on proper grounds and not in a manner that is arbitrary, irrational or capricious", but the court declined to construe an express good faith clause as having application to the whole contract.

Facts

In July 2004 the claimant, Portsmouth City Council ('PCC'), entered into a 25 year agreement with the defendant ("Ensign") for the rehabilitation, maintenance and operation of PCC's highway network ("the Agreement"). 

Clause 24 set out that if Ensign failed to perform any of its obligations or remedy breaches within a specified period, PCC could award Service Points against it.  The Service Points were to be "calculated" by reference to Schedule 17 to the Agreement.

Schedule 17 contained a table which set out a large number of "Default Events" for which Service Points could be awarded and, against each Default Event, a "Maximum Event Value", where if the Maximum Event Value was greater than 1, the number of Service Points awarded would depend on PCC's view of the gravity of the breach.

PCC assessed and awarded Service Points on a monthly basis and, initially, both parties appeared content with the process. 

In 2012 PCC came to the view that the Agreement had become unaffordable.  PCC embarked on a strategy of awarding Ensign large amounts of Service Points to force it to accede to PCC's commercial demands in a renegotiation.  This involved, amongst other things, awarding the maximum amount of Service Points for every default, refusing to communicate with Ensign in relation to breaches, finding breaches which Ensign might find hard to remedy and storing up Service Points over several months so that Ensign could be "ambushed" with a large award of Service Points at one fell swoop.

PCC sought various declarations from the court as to whether it:

  • had discretion as to the amount of Service Points to award for a breach and, if so, whether there was an implied term that PCC was to act honestly, on proper grounds and not in a manner that was arbitrary, irrational or capricious; or
  • was under any obligation to act in good faith in respect of awarding Service Points.

Was there an implied term not to act arbitrarily, irrationally or capriciously?

Ensign argued that implied into Clause 24 was a requirement that PCC not exercise its discretion to award Service Points in a manner that was "arbitrary, irrational or capricious".  PCC resisted this argument relying on the Court of Appeal decision in Mid Essex Hospital Services NHS Trust v Compass Group [2013] EWCA Civ 200.

The facts in Mid Essex were in many respects similar to those in the instant case.  In that case, the contractor was subject to various performance criteria, which, if not met, allowed the NHS trust to award service failure points, which, in sufficient quantity, resulted in payment deductions.  The contractor considered that the service failure points being awarded were excessive and in breach of the contract.

In Mid Essex, the Court of Appeal concluded that a term limiting a discretion should be implied only if the contract would not make sense without it.  However, the court emphasised the distinction between a discretion that involved making an assessment or choosing from a range of options taking into account the interests of both parties and a discretion whether or not to exercise an absolute contractual right.  Only in the former case would there be an implied term limiting the exercise of discretion.  As it happened, in Mid Essex, the court concluded that no discretion existed as to whether the Trust could award service failure points as the contract provided clear rules as to how these should be determined.  Rather, the only discretion the Trust had was the extent to which it would enforce its contractual right to award the points.  No implied term limiting the award of service failure points was therefore necessary.

By contrast, in this case, rather than having to decide whether to exercise an express contractual right, PCC needed to consider the severity of a particular breach and award the appropriate amount of points.  The decision to award 3 or 4 points for a given Default Event involved an element of judgement rather than mere calculation.  Prima facie, therefore, this case could be distinguished from Mid Essex.

PCC, appreciating this distinction, argued that, correctly interpreted, the Service Points set out in Schedule 17 were fixed amounts and did not call for any evaluation.  However, the court did not agree, holding that they were, in fact, the maximum in a range rather than mandatory values. 

Accordingly, the court decided that a term should be implied into Clause 24 such that: 

"When assessing the number of Service Points to be awarded [PCC] is to act honestly and on proper grounds and not in a manner that is arbitrary, irrational or capricious".

Did PCC have to act in good faith?

Ensign also argued that PCC was under an obligation to act in good faith when determining the number of Service Points to award. 

Clause 44.1.1 of the Agreement imposed an express good faith obligation on PCC and Ensign in relation to how PCC discharged its statutory duty to deliver the best value to the taxpayer.  Ensign argued that this good faith obligation should be applicable to the Agreement as a whole.  In support of this proposition Ensign likened the long-term nature of the project to the kind of 'relational contract' seen in the High Court case of Yam Seng Pte Ltd v International Trade Corporation [2013] 1 All ER (Comm) 1321, which is generally recognised as being a watershed in the doctrine of good faith in English contract law.

PCC disagreed, placing heavy reliance on the decision in Mid Essex, where the contract had also included clauses that imposed mutual good faith obligations in particular situations.  In that case, the court had held the obligation was confined to those situations rather than being an overarching feature of the contract.

Ultimately, the court agreed with PCC's argument.  In particular:

  • there was nothing in the language of Clause 44 to suggest any wider application;
  • the existence of other clauses in the contract imposing a good faith obligation indicated that the parties had considered in which situations a good faith duty should apply and had provided accordingly; and
  • all the contractual clauses were adequately drafted such that there was no necessity to imply a good faith term for them to work. 

Having concluded that Clause 44.1.1 did not apply to the Agreement as a whole, the court considered whether it might apply specifically to Clause 24.  The court decided that it did not.  In the court's view, no part of the clause that required good faith specifically in order to work.  The court therefore rejected the argument that PCC was under an obligation of good faith in relation to Clause 24.

Comment

This case serves as a useful reminder of the implied limits on a party's exercise of any discretion afforded it under a contract.  The precise formulation of what the duty is varies across the authorities but the formulation adopted by the court most closely resembles the duty identified in the Court of Appeal decision in Socimer International Bank Ltd (in liquidation) v Standard Bank London Ltd [2008] EWCA Civ, to act "honestly, in good faith and not arbitrarily, capriciously, perversely or irrationally" save for the reference to good faith.

The case also echoes the exercise of judicial restraint in Mid Essex to avoid construing express good faith obligations more widely than their literal drafting.  Although good faith remains a developing area of English law, it is clear that that unless a contract falls within the limited categories identified the Yam Seng decision, the parties wishing to impose such a duty they should do so expressly.