Everyone for him- or herself?

The English High Court has applied an objective standard of reasonableness in determining whether a party to a series of finance transactions had reasonably withheld its consent to the early termination of such transactions.

Historically, where a contract has given one party a discretion the exercise of which would affect both parties, unless the contract imposed a requirement of reasonableness in the exercise of that discretion, the English courts have opted to impose few restrictions on the party's decision-making powers under a contract, requiring only that a decision must be made, "honestly and in good faith," and that discretion not be exercised, "arbitrarily, capriciously or unreasonably”.[1]Given this minimal protection, contracting parties often seek to curtail the decision-making powers of their counterparty by imposing a requirement that the discretion holder "act reasonably" in exercising any such power.

Despite its popularity in all manner of contracts, and finance documents in particular, there had existed a degree of ambiguity as to what an obligation to "act reasonably" actually entails.  The extent of this obligation was the subject of the recently decided Barclays Bank plc v Unicredit Bank AG and others [2012] EWHC 3655 (Comm).

The Facts

The defendants were wholly owned German and Austrian subsidiaries of the Unicredit banking group (the "Defendants").  In connection with the synthetic securitisation of pools of loans held by them, the Defendants entered into three guarantee agreements with Barclays Bank plc ("Barclays") in April 2009 (the "Guarantees").  Barclays' principal return for assuming the risk of the loan portfolios' default was fees amounting to an aggregate of €24.8 million per annum.

The Guarantees set out a number of circumstances in which the Defendants could bring them to a premature end.  One such circumstance was where regulatory changes caused a Defendant to be subject to less favourable capital treatment with respect to a Guarantee, provided that the Defendant obtained Barclays' prior consent to the termination, "such consent to be determined by Barclays acting in a commercially reasonable manner."

Just 14 months after entering into the Guarantees, the Defendants requested that Barclays consent to their termination on the basis that regulatory changes meant the Defendants were no longer receiving capital relief by holding them.  Refusing the request outright in its first written communication, Barclays indicated in discussions that it would only be prepared to consent to the early termination if it were paid the discounted present value of five years' fees, being approximately €82 million.

Rejecting this request, the Defendants argued that it was not reasonable for Barclays to withhold its consent given the severity of the impact of the regulatory change on them.  The Defendants also stated that they considered Barclays' unreasonable refusal of consent to amount to a waiver of the consent requirement, and they thereof purported to terminate the Guarantees.  In subsequent communications, the Defendants indicated that they were not prepared to offer any sum in payment for Barclays' consent.

Barclays therefore applied to the court for an order that the Guarantees had not been validly terminated and remained in force.

The Issues

Mr Justice Popplewell was charged with determining whether Barclays' refusal to consent without receiving five years' fees was "commercially reasonable".  First considering the extent of a party's duty to act reasonably, he concluded as follows: 

(A)    in respect of the exercise of a party's general decision-making powers under a contract (i.e. where there is no qualification that the party needs to  act "reasonably"), provided that the discretion is exercised honestly and in good faith for the purposes for which it was conferred and that it is not capricious or arbitrary or, "so outrageous in its defiance of reason that it can properly be described as perverse," the courts will not intervene;

(B)    in the landlord and tenant situation (where a landlord is typically expressly required to act reasonably): 

(1)        a party's decision must be "objectively reasonable", such that a reasonable man in the circumstances could have arrived at it

(2)        the landlord is not, however, required to show that his decision is, "right or justifiable"; and

(3)        nor is the landlord required to take the commercial interests of his counterparty into consideration, unless the failure to do so would be so disproportionate as to be unreasonable;

(C)    previous case law has held that the standard of objective reasonableness may apply in commercial contracts, including finance documents[2]; and

(D)    as such, in a financing transaction where the parties have expressly elected to constrain a party's decision-making power by reference to reasonableness, the objective standard of reasonableness shall apply.

Had Barclays acted unreasonably?

Having concluded that an objective standard of reasonableness was required of Barclays, Mr Justice Popplewell considered whether Barclays had satisfied this in requiring five years' fees be paid in consideration for agreeing to the early termination.  He considered that it had, including on the following grounds:

First, evidence of negotiations suggested that at the time the Guarantees were entered into, Barclays had honestly believed (1) that it would be able to withhold consent until it was paid five years' fees and (2) that the Defendants had shared this understanding.  Illustrating his point, the judge observed that it would be a surprising result if the court held that no reasonable person could have exercised its discretion in a way in which Barclays honestly and reasonably believed, at the time the Guarantees were entered into, that both parties expected it to be exercised.

It should be noted that the judge did not believe that the existence of an entire agreement clause prevented him from considering evidence of the parties' pre-contractual intention in determining reasonableness, holding that this only operated to restrict the contractual terms.  He observed that an entire agreement clause would not preclude reliance on such communications to found an allegation of misrepresentation, nor restrict that material from consideration as to whether a commercially reasonable decision had been made.

Secondly, although via mechanisms other than a consent requirement, the majority of the termination provisions ensured that Barclays would receive five years' fees on termination, reflecting the parties' acceptance that this was Barclays' minimum expected return.  Barclays was assisted in this point by an anti-penalty clause which stated that five years' fees was a, "reasonable pre-estimate of loss."

Conclusions

This case provides useful guidance on the scope of a contracting party's responsibility to "act reasonably".  While acknowledging this will go beyond showing, "merely that the decision was made in good faith and was not arbitrary, capricious or irrational," it also makes clear the limited constraints that "acting reasonably" imposes.  Although the decision-making party must show that a reasonable man in the same circumstances could have arrived at the same decision, it is not required to show that its decision is "justifiable" or "right", nor that it has considered the impact of its decision on its counterparty's commercial interests.  This decision nips in the bud any suggestion of a commercial duty of care.

Parties will also be interested to note the court's reliance on pre-contractual negotiations in considering what constitutes a reasonable decision.  Regardless of the existence of an entire agreement clause, parties should be aware that any failure to correct a party's mistaken belief about how and when a decision can be exercised may well inform the court's judgment as to the reasonableness of that decision.

Lawyer Contacts

For further information, please contact your principal Firm representative or the lawyer listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com.

Edwin Borrini
London
+44.20.7039.5152
eborrini@jonesday.com

Luke D. Johnson
London
+44.20.7039.5268
ljohnson@jonesday.com

This Commentary is a publication of Jones Day. The contents are for general information purposes only and are intended to raise your awareness of certain issues (as at January 2013) under the laws of England and Wales. This Commentary is not comprehensive or a substitute for proper advice, which should always be taken for particular queries. It may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at its discretion. The mailing of this publication is not intended to create, and receipt of it does not constitute, a solicitor-client relationship.