Being discrete: when to worry about contractual discretion

Last week the Royal Swedish Academy of Sciences Nobel Prize for Economics went to Hart and Homstrom for their contribution to contract theory. Hart has considered so-called "incomplete contracts". These arise because it is not possible to specify every eventuality. This is where contractual discretion often comes in.

We tend to use the term "discretion" quite broadly in reference to contracts. A party may have a discretion over whether to exercise a right or as to how an obligation is performed. Such "discretions" are truly absolute. Many, however, are not. Terms which involve a party in determining - in its discretion - whether something has happened, deciding whether to consent to a settlement or performing a calculation must be exercised in a particular way. Otherwise, the decision may be vulnerable to challenge.

Where that party is exercising a "true" discretion under a contract, in the sense of making an assessment or choosing from a range of options and taking into account the interests of both parties, the exercise of that discretion is subject to a term implied, as a matter of contractual necessity, that the person exercising the discretion does so honestly and in good faith, and having regard to the provisions of the contract by which it is conferred. The discretion must not be exercised arbitrarily, capriciously or unreasonably and cannot be used as a form of leverage in the parties' broader commercial relationship. The more unlikely something is, the more cogent must be the evidence required to persuade the decision-maker that it has indeed happened.

Given that the basis of the obligation is an implied term, in principle it is possible to exclude the duty. In practice it is not straightforward, however, and requires clear wording. Even if the contract were to say "X acting in its sole discretion...", X would still have to adhere to the implied term.

Whilst the duty is difficult to exclude, it is much easier to satisfy. The practical point is to behave sensibly when exercising a contractual discretion, usually by keeping a record of how the decision was arrived at and making sure it is defensible. It is important not to act, or be seen to be acting, in an arbitrary way. So it is both the decision process as well as the outcome that need to be considered.