Contractual discretion

Rationality in exercise of discretion – Watson and others v Watchfinder.co.uk Limited [2017] EWHC 1275

The question

What limits apply when an option is subject to the board's consent?

The facts

Watchfinder (WF) entered into a services agreement with another Adoreum Partners (AP) and granted options over its own shares to three of AP's directors.  The option agreement provided: “The option may only be exercised with the consent of a majority of the board of directors of the Company.”

When the directors attempted to exercise their share options, WF refused to issue the shares, on the basis that its board of directors did not consent.  The directors claimed for specific performance.  WF argued that the option gave the board an unconditional right to reject any exercise of the share options.

The decision

The Court held that the clause in the option agreement could not be interpreted as an unconditional right to reject any exercise of the options.  Otherwise the options, which were part of the overall deal, would be worthless – this was against commercial common sense.   

The provision could not be disregarded entirely and, although unusual, it must have been intended to impose some form of restriction on the options.

The Court held that, as a matter of construction or implication, the board had a duty to exercise its discretion over the option in a way which was not arbitrary, capricious or irrational in the public law sense (see Braganza v BP Shipping [2015] 1 WLR 1661).  This must involve a proper process, taking into account the relevant matters and not irrelevant matters, and without reaching a decision no reasonable board could have reached. 

In this instance, there had been no proper exercise of discretion.  There had been barely any considered exercise of discretion – there were no discussions, relevant matters had not been considered, the board wrongly thought it had an absolute veto, and the decision was arbitrary.

Why is this important?

This case shows the reluctance of the Court to allow an absolute discretion, particularly where this would result in an uncommercial outcome, as well as the importance the Court places on proper process and how any contractual discretion is exercised.

Any practical tips?

Clearly identify provisions in an agreement where discretion may be exercised (e.g. discretion, election, consent, etc.) and state whether this will be sole/absolute, reasonable, etc.  Even “absolute” contractual discretion is subject to proper process (considering relevant matters and disregarding irrelevant matters) and must not be not arbitrary, capricious or irrational.  Consider stating what process will be followed and what matters will be taken into account. 

At the point discretion is being exercised, ensure the decision makers know what they must do, that contractual/proper processes are followed and record a (rational or reasonable!) basis for the decision.