How are we to interpret the implied limitation on the exercise of a contractual discretion? What are the standards it imposes? The authorities set out the following principles, which apply in the absence of express words to the contrary.
The requirement of honesty and good faith seem clear enough; the party afforded the discretion (the decision-maker) must properly direct itself to the task in hand and should not exercise the discretion in question in furtherance of an ulterior motive. With respect to the requirement that the relevant discretion must not be exercised arbitrarily, capriciously, perversely or unreasonably, it seems settled that “reasonableness” in this context is not analogous to a duty to take reasonable care but to Wednesbury-reasonableness (i.e. in order for a decision to be impugned, it must be a decision which no rational decision-maker could have arrived at)2.
However, this is not to say that the ambit of discretion will be wide in every case. In certain factual circumstances, it may well be that there are only very limited ways in which a party can exercise the discretion in question without falling foul of the rationality test. The more difficult and uncertain the exercise of the discretion in question, the wider the range of rational decisions will likely be. For example, this will likely be the case in the valuation of illiquid securities in difficult market conditions with little or no reliable pricing information3.
This means that, where there is a range of decisions that a party could have taken within the bounds of rationality and the original decisions falls within that range, the decision remains that of the decision-maker and the Court does not replace it with a decision which it (or anyone else, for that matter) would prefer.
It seems that, at least in certain circumstances, the decision-maker may consult its own interests in exercising a discretion, as opposed to approaching the exercise with complete neutrality. For example, in Socimer, the non-defaulting party was forced to retain certain illiquid assets in difficult market conditions as a result of the counterparty’s default under a forward sale contract. Given the difficulties in valuing the assets in question in the prevailing circumstances and the fact that it never sought to retain the assets, it was held that the non-defaulting party was “entitled primarily to consult its own interests” in valuing the assets (subject to the requirements of honesty, good faith and rationality).
Similarly in WestLB v Nomura, noting that the commercial structure of the transaction was that Nomura, as issuer, was supposed to have no risk in the underlying assets, and the purpose of giving to such a party to the transaction a discretion to value is to enable it to protect itself from risk, it was held that Nomura was “entitled to have an entirely proper regard for any danger to itself from valuing too optimistically” (again, subject to the requirements of honesty, good faith and rationality). Also in Lehman Brothers International (Europe) (in administration) v ExxonMobil Financial Services B.V.  EWHC 2699 (Comm), it was held that ExxonMobil, as the non-defaulting party valuing securities in the context of a close-out of a repo transaction under a 2000 Global Master Repurchase Agreement, was “entitled to have regard to its own commercial interests”.
However, it is suggested that caution must be exercised in this regard. In all of the cases above, the commercial rationale for giving the discretion as to valuation to one party was to protect itself from risk and the difficulty of the valuation in question were key factors in arriving at the conclusion that such a party may take its own interests into account. Although in many cases the very purpose of affording a discretion to one party might well be to protect that party from risk, it may not always be so. If not, it remains to be seen whether taking into account one’s own interest in exercising the discretion satisfies the test of honesty, good faith and rationality.
Process v outcome
The authorities have generally focussed on the end result of the exercise of a contractual discretion. However, in Braganza v BP Shipping Limited  UKSC 17, the idea of the Court’s review of not only the outcome of a party’s exercise of a contractual discretion but also the process by which it exercised the discretion was raised. In that case, the Supreme Court did scrutinise not only the outcome but also the decision-making process. The Supreme Court expressly left open the question of the extent to which the Court’s review of the decision-making process would apply in all contractual contexts, particularly commercial contracts, stressing the importance of the employment context of Braganza itself.
The point was raised head-on in Lehman v ExxonMobil in the context of a US$ 250 million “repo financing extended by an oil major to an international investment bank” and it was decided that a review of the decision-making process in this context was not appropriate. Many will regard Lehman v ExxonMobil as a welcome decision for sophisticated commercial parties who, in most cases, may wish to avoid the uncertainties and expense of a full judicial review of the decision-making process pursuant to a contractual discretion.
However, this is not to encourage parties to pay no regard to the process adopted in exercising the discretion. In practice, a rational decision-making process carried out honestly and in good-faith is likely to lead to a robust and defensible outcome. Further, it would be surprising if the Court’s decision on the outcome were not coloured to an extent by the evidence of the process adopted, even where the latter is not formally under scrutiny.
Finally, of course parties are entirely free to expressly provide for the review of both the process and the outcome. For example, the 2002 ISDA Master Agreement provides that the “Close-out Amount will be determined by the Determining Party (or its agent), which will act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”. The reference to “commercially reasonable procedures” means that the Court is able to scrutinise the process undertaken by the determining party.