High Court implies public law limitations on a contractual discretion

High Court implies public law limitations on a contractual discretion

In a case which may surprise (and possibly alarm) lenders and their advisers, the recent decision of the High Court in Watson v Watchfinder.co.uk [2017] EWHC 1275 illustrates the potential pitfalls for commercial parties with a (seemingly absolute) discretion to grant or withhold consent to particular actions by their contractual counter-parties.

Here we look at this case and its implications for finance documents.

  1. Case background

Watchfinder is a well-known purchaser and seller of “pre-owned” luxury watches and has enjoyed enormous growth over the previous decade. It will be very familiar to those of us following the Tour de France coverage on ITV 4 for its extremely frequent sponsorship messages.

In December 2011 it entered into a services agreement with a company named Adoreum Partners, whose directors were the claimants in this case. Under the services agreement, Adoreum was to introduce new prospects to Watchfinder. Separately, the claimants entered into a share option agreement with Watchfinder which, as subsequently amended, conferred an entitlement on the claimants to subscribe for 5% of the issued share capital of Watchfinder for payment of £150,000. Clause 3.1 of the option agreement provided that “The Option may only be exercised with the consent of a majority of the board of directors of the Company”.   

After the above arrangements were concluded, the claimant introduced some potential investors to Watchfinder. One of these potential investors (Richemont) chose not to pursue the opportunity, but another (Beringea) did invest. Watchfinder elected to terminate the services agreement with Adoreum in 2014 and in March 2016 the claimants sought to exercise the share option. Watchfinder declined to issue any shares on the basis that the requisite board consent was not forthcoming. 

  1. High Court’s decision

The High Court set out the principles of construction in the Supreme Court case of Arnold v Britton [2015] AC 1619. They are very important so it is worth us repeating them here:

  1. Commercial common sense should not be invoked to undervalue the importance of the language used
  2. The less clear the centrally relevant words are, the more readily the court can properly depart from their meaning
  3. Commercial common sense should not be invoked retrospectively. The mere fact that a contractual arrangement has worked out badly, or even disastrously, for one of the parties is not a reason to depart form the natural language
  4. A court should be slow to reject the natural meaning as correct simply because it appears to have been very imprudent for one party to have agreed it
  5. Facts known only to one of the parties cannot be taken into account
  6. If an event occurs which had plainly not been intended by the parties, the court will give effect to what the parties would have intended if clear

And then the Court reminded us of when a term may be implied into a contract, referring to the Supreme Court case of Marks & Spencer plc v BNP Paribas [2016] AC 742, and in particular that a term may only be implied where, without the term, the “contract would lack commercial or practical coherence”.

Watchfinder argued that Clause 3.1 of the option agreement clearly conferred upon it an unconditional right of veto. The High Court rejected this argument, finding that this conclusion would render the option “meaningless” which could not possibly have been the parties’ intention.

Instead, following the decision of the Supreme Court in Braganza v BP Shipping [2015] 1 WLR 1661, the High Court determined that the right of veto was discretionary but, as a matter of construction or as an implied term, had to be exercised in a way which was not arbitrary, capricious or irrational in the public law sense. The High Court considered what criteria the Board should have regard to in considering the suitability of the claimants to become shareholders of Watchfinder, concluding that it should be on the basis of whether the claimants had made a real or significant contribution to the progress or growth of Watchfinder. The satisfaction of the duty would entail a proper process for the decision in question including consideration of material points and disregarding irrelevant matters in order to reach an outcome that was not unreasonable.  

Looking at the evidence, the High Court found that there was hardly any real exercise of the discretion at all. The exercise of the veto had been raised at the end of one board meeting but had been discussed extremely quickly and only very negatively by one particular director, the other directors merely indicating their agreement. Two of the directors present appeared to have no knowledge of Adoreum prior to the discussion. The High Court determined that the whole matter was dealt with very casually, there was no real discussion, it did not focus on the correct matters, and it proceeded on a mistaken view of what it was about and it was arbitrary.

Accordingly the Board had failed to comply with the “Braganza duty” and the Court proceeded as if the consent had been given.

  1. Implications for lenders and borrowers

This case is not a banking case but has important implications for lenders and borrowers. It is not unusual in loan documentation to find a long list of things that a borrower cannot do without the lender’s consent. Often the lender will be entitled to grant or withhold its consent in its sole and absolute discretion. This case indicates that having such a discretion does not necessarily give an unconditional right to a lender to grant or decline such consent. If the facts dictate that the Braganza duty applies, then the right has to be exercised in a way that is not arbitrary, capricious or irrational and, most importantly, the relevant party actually has a duty to undertake a decision-making process. In other words, it cannot simply react with a “computer says no” response.

Head of Banking & Finance, Jonathan Porteous, comments: “This is a case where, in our view, many applying the principles of construction set out in Arnold v Britton would have reached a different conclusion. The unconditional requirement for consent in the contract seemed clear enough. So the decision will raise alarm bells for lenders asked for consent by their borrowers. On these principles, an arbitrary or ill-considered rejection may be deemed to be no exercise of the discretion at all and a court may find that consent is thereby deemed to be given. Practical advice for lenders is never to exercise a discretion in an arbitrary, capricious or irrational manner, to give due consideration to the exercise of any such consent and to document that process”.

Contact our experts for further advice

Aslihan Ozbey, Jonathan Porteous

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