Good faith, acting reasonably, and absolute discretions

In recent years, the topic analysed by the Financial Markets Law Committee’s 37-page November 2022 paper, “Duties of Good Faith in Wholesale Financial Contracts”, has been coming up more often, which is why the FMLC has decided to examine what it all means.  Phrases like “good faith”, “acting reasonably”, and “absolute discretion” pop up all the time in debt finance documents, sometimes in critical places (for example, you will find “good faith” 12 times in the 2002 ISDA Master Agreement, including in the Close-out Amount definition). So what do they mean?

What does “good faith” mean? 

The FMLC paper notes how, even in civil law jurisdictions, the duty “eludes definition”, and that even in the USA, where the UCC does define it, its practical effects are limited because no obligation (good faith or anything else) can be implied which is inconsistent with a clearly expressed contractual right.  As a matter of English law, the FMLC concludes that the scope of any duty of good faith is narrow, and of limited application to wholesale financial markets contracts; and this has to be so, because if there were a pervading general duty of good faith, it would somewhat undermine the principle of freedom of contract (which accords paramount importance to express contractual terms) which forms part of the bedrock of English commercial contract law and is among the reasons that English law is internationally so popular for cross-border contracts.  The FMLC follows Lord Hodge in the 2021 UK Supreme Court judgment, Pakistan International Airline Corporation v Times Travel (UK) Ltd:

“in contrast to many civil law jurisdictions and some common law jurisdictions, English law has never recognised a general principle of good faith in contracting. Instead, English law has relied on piecemeal solutions in response to demonstrated problems of unfairness”. 

Should a contract contain a general duty of good faith? 

In negotiations, a party may sometimes suggest including a general obligation for the parties to “act in good faith”.  This is especially so if they are American, because, in the USA, any contractual obligation to which the Uniform Commercial Code applies is subject to “an obligation of good faith in its performance or enforcement”; “good faith” being defined as “honesty in fact in the conduct or transaction concerned”.  Usually, this would be rejected because, on the one hand, English commercial law has adequate protections to prevent discretions being exercised arbitrarily or capriciously, and it is important that the contract is drafted with bright lines so that the parties know where they stand, whilst on the other hand the phrase has no precise meaning, and it would be wrong in principle to include something vague in a finance document, where clarity is of the essence.

Contractual discretions 

The FMLC paper discusses the exercise of contractual discretion and, as all debt finance lawyers should know, this is very relevant to the question of what “reasonable” means in a contract.  Lawyers are used to phrases such as “in its reasonable opinion” or “acting reasonably” in contracts, and know that, by themselves, these only impose the Wednesbury standard of “not irrational”; and that if an objectively-reasonable outcome is required, then, as Robin Knowles J said in the 2018 National Power Corporation case, the parties need to be clear about this: 

“Given some of the authorities …, if contracting parties want objective criteria of reasonableness to apply, they may need to do more than just use the word “reasonable”.

The most well-known example of this is probably the 2002 ISDA Master Agreement definition of “Close-out Amount”, in relation to the calculation of which the determining party should:

“act in good faith and use commercially reasonable procedures in order to produce a commercially reasonable result”;

although, as derivatives lawyers will remember, even this gives the determining party a fair amount of latitude, as National Power Corporation itself showed.

All this was gone into by the Supreme Court in its 2015 judgment, Braganza v BP Shipping Ltd (and the duty to comply with the “Wednesbury reasonableness” standard is now often called the “Braganza” duty) where Lady Hale cited with approval Rix LJ in the 2008 CA judgment in Socimer International Bank Ltd v Standard Bank London Ltd:

“… a decision-maker’s discretion will 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.  The concern is that the discretion should not be abused…”;

and Lord Sumption in 2013’s Hayes v Willoughby Supreme Court judgment:

“Rationality is not the same as reasonableness.  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.”

Process as well as outcome? 

Lady Hale noted in Braganza that there is more to the Wednesbury requirement than simply not having an outcome which is positively irrational: the decision must be arrived at after taking into account all relevant matters and ignoring irrelevant matters.  In other words, the process must be proper.  However, in the context of financial contracts, where things may have to be done quickly, and the parties need to know where they stand, this was very much down-played by Snowden J in Lehman Brothers Finance AG v Klaus Tschira Stiftung GmbH in 2019:

“I accept that the ISDA Master Agreement should not be interpreted so as to require a court to conduct the type of analysis of the discretionary decision-making process by the Non-defaulting Party that would be appropriate in a public law context. In particular, I do not think that the court should readily become involved in a detailed assessment of whether the determining party took into account all relevant factors and ignored all irrelevant factors. That would encourage challenges to be made to the determination by the Non-defaulting Party which would cut across the desire for speed and commercial certainty of determination.”

Good faith and capriciousness

The FMLC notes that “it is unclear exactly what the concept of good faith means”, and that there is “significant overlap” between the requirements for good faith and an absence of irrationality.  One wonders whether they are not actually the same thing.  A decent illustration might be the 2017 judgment in BHL v Leumi ABL Limited.  In this case, a receivables finance agreement permitted the bank to charge an additional collection fee of up to 15% of amounts collected, which the customer expressly acknowledged was a fair and reasonable pre-estimate of the bank’s likely costs and expenses.  After the customer went into administration, the bank levied the maximum fee of 15%, without even considering what its actual costs and expenses were.  HHJ Waksman decided this was “wholly arbitrary, irrational, manifestly failed to take into account important relevant factors and cannot be supported”.  The FMLC seems to take this as evidence of lack of good faith, which it seems to view as being a duty “to make a genuine attempt to achieve” the contractual purpose, but would this not just as easily come within Lord Sumption’s specification of capriciousness?

Can the Wednesbury rationality requirement be excluded? 

The FMLC concludes that excluding a Wednesbury standard (so that a party could act capriciously) would be “extremely difficult” to achieve.  This may be right, although if the agreement was quite unequivocal on the point, doubtless it could be excluded, in the same way as a determined party can include effective blanket non-reliance wording so long as the wording is sufficiently clear.  However, simply adding “in its sole and absolute discretion” may not help: it did not displace the need for an honest and rational valuation in the 2012 CA judgment in WestLB v Nomura Bank International plc.  This is of course why any English law firm’s standard legal opinion has a qualification which explains that the exercise of any discretion may be subject to a Wednesbury reasonableness requirement, even if the document does not use the word “reasonable”.