In the recent case of Lehman Brothers International (Europe) (in administration) v Exxonmobil Financial Services BV [2016] EWHC 2699 (Comm), the High Court considered the law relating to the exercise of contractual discretion. The case is helpful in illustrating not only the approach the courts are likely to take in cases where a party has exercised a contractual discretion but also the approach the courts are likely to take in circumstances where a party did not in fact exercise its contractual discretion at the relevant time.


The case concerned a dispute between Lehman Brothers International (Europe)(in administration) (LB) and Exxonmobil Financial Services BV (EM) in relation to a sale and repurchase agreement pursuant to which EM lent US$250 million to LB and in return was provided with collateral in the form of equities and bonds from LB.

The agreement contained a "Default Valuation Notice" pursuant to which a "non-Defaulting Party" could ascribe a value to the securities in "the amount which, in the reasonable opinion of the non-Defaulting Party, represents their fair market value".

LB collapsed on 15 September 2008. EM sold most of the collateral by 17/18 September 2008. However, because of the severe dislocation present in the market at the time, some of the securities were not valued and sold by EM.

A dispute subsequently arose in relation to the balance of the account. EM asserted that there was a shortfall of approximately US$14 million owed to it by LB. LB asserted that EM owed it approximately US$9 million.


The case concerned a number of issues. For the purposes of this article, we consider the question the court faced in ascribing value to the securities which EM had not valued at the relevant time as it was entitled to under the contract.

In short, EM's case was that because the agreement gave it a contractual discretion to determine the "fair market value", the securities should be ascribed a value in accordance with the opinion which it (acting rationally) would have formed had it conducted the valuation exercise at the relevant time.

LB's primary case was that the securities should be ascribed their objectively reasonable fair market value.

Unsurprisingly, the two approaches being suggested by EM and LB respectively would lead to two very different outcomes.

Legal position

The leading authority on the issue of contractual discretion is Socimer International Bank Ltd v Standard Bank London Ltd [2008] EWCA Civ 116. Rix LJ had held in that case that where there was a contractual discretion, two potential questions arose. First, were there any limitations on the decision maker's freedom of decision? Second, what happened if the contractual discretion had not been exercised by the decision maker at the relevant time?

How to exercise the contractual discretion

On the first question, Rix LJ held that a decision maker's discretion would be limited, as a matter of necessary implication, by concepts of "honesty, good faith and genuineness, and the need for the absence of arbitrariness, capriciousness, perversity and irrationality."

In Fondazione Enasarco v Lehman Brothers Finance SA [2015] EWHC 1307 (Ch), David Richards J said the decision maker was not required to "comply with some objective standard of care". He said "expressing it negatively, [the test was that the decision maker] must not arrive at a determination which no reasonable non-defaulting party could come to."

Lord Sumption in Hayes v Willoughby [2013] UKSC 17 held that the test was one of rationality and not reasonableness. He held "reasonableness is an external objective standard applied to the outcome of a person's thoughts or intentions....A test of rationality, by comparison, applies a minimum objective standard to the relevant person's mental processes. It imports a requirement of good faith, a requirement that there should be some logical connection between the evidence and the ostensible reasons for the decision, and (which will usually amount to the same thing) an absence of arbitrariness, of capriciousness or of reasoning so outrageous in its defiance of logic as to be perverse."

On the facts of this case, Blair J held that contrary to LB's case, the court would not seek to establish an "objectively reasonable" fair market value for the securities. The court would apply a rationality test to any discretionary decision made by EM, since the application of an objective test would largely deprive a party of the benefit of the discretion which the contract had given it.

Blair J also rejected LB's arguments that, following the Supreme Court decision in Braganza v BP Shipping Ltd and Anor sub nom The British Unity [2015] UKSC 17 (Braganza), the decision-making process itself (and not just the outcome of the decision) should be subject to the kind of analysis which would be carried out in a public law context. It was not necessary for the court to decide whether EM had taken into account matters which it ought not to have taken into account or left out matters it should have taken into account. The Supreme Court had expressly left open the question as to the extent to which procedural judicial review objections could arise in commercial contracts, stressing the employment context of the Braganza case.

Absence of the exercise of a contractual discretion

As Blair J noted, in this case, EM had not in fact made any decision and the court was therefore concerned with the "counterfactual". He held that the correct test was what value EM would have ascribed to the securities (acting rationally and with regards to its own commercial interests and acting within the contract) had it conducted the valuation exercise at the time, not an "objective reasonableness" test.

Applying the correct test to the facts, Blair J, whilst acknowledging that only "tentative findings" were possible, agreed that as a matter of commercial sense EM would rationally have adopted the lowest legitimate valuations that were contractually permissible at the time.

Despite recognising that the valuation methodology advanced by LB's expert was "in principle a proper one", LB was unable to argue that the valuation methodology advanced by EM's expert was irrational. Blair J held that there was "nothing inherently unreasonable in the approach to valuation adopted by [EM's expert]". Tellingly, he noted that "[t]he striking thing about the case in this respect is that [LB] relied on the same approach [as EM's expert], until its case was amended to reflect [its own expert's] evidence". This, he held made LB's case "a difficult one" as it could not be heard to describe that approach as irrational.

Key Conclusions:

The key conclusions that can be derived from the case are as follows:

1. Even in circumstances where a party has failed to exercise a contractual discretion, a court will be prepared to retrospectively consider what a party would have done had it exercised its contractual discretion at the relevant time.

2. Where a party is given a contractual discretion to make a decision which involves its "reasonable opinion" it will be subject to a test of rationality rather than an objective reasonableness test.

3. The test for irrationality is a very high one. A party would have to demonstrate that the approach being advanced was "so outrageous in its defiance of logic as to be perverse" rather than merely advancing a more credible/reasonable alternative approach.

4. A party which has a contractual discretion but has failed to exercise it can factor in its own commercial interests when arguing how it would have exercised the discretion.

5. Where the exercise of a contractual discretion arises in the context of a commercial contract the court will focus on the rationality of the outcome of the decision rather than the decision-making process itself. The outcome of a decision may therefore be considered rational even if the process used to reach it is flawed.