Law Column: Discretionary clauses
Unfettered Discretion, Reasonableness and Good Faith
Contracts define the rights and obligations of the contracting parties and set out the standards upon which they are required to act. In some circumstances, contracts grant one party the right to make a decision on a specified matter using their discretion. These clauses, called discretionary clauses, often use terms such as “sole discretion,” “sole and absolute discretion” and “unfettered discretion.” Depending on the parties’ intention, as disclosed by their contract, these clauses are measured by different standards and impose different obligations, including obligations to act reasonably and in good faith. It’s important to understand what these standards are, and how they are applied.
Discretionary clauses can be divided into two categories: those that impose an objective standard, and those that impose a subjective standard. In determining the standard and scope of discretion provided by a clause in a contract, the courts look to the intention of the parties as disclosed by their contract. The courts are hesitant to allow a party to have absolute and unfettered discretion and, in the absence of explicit language, the courts often impose an objective standard of reasonableness. The courts have noted this interpretation imposes the least hardship in that it produces a result that is not unfair or unjust to either of the parties.
Generally, an objective standard of reasonableness will be imposed when a discretionary clause relates to matters that can be measured or assessed objectively, such as operative fitness, structural completion, mechanical utility or marketability. On the other hand, a subjective standard will generally be imposed when a clause relates to matters that are not easy to objectively measure. Such matters include those involving taste, sensibility, personal compatibility or judgment of the party with the discretionary power.
How much discretion is there?
In circumstances where a discretionary clause is measured by an objective standard, the party exercising discretion should not base its decision on a collateral purpose. If such discretionary clauses are to have purpose and substance, the discretion afforded by them must be exercised in a reasonable way, not arbitrarily or capriciously, but for good reason. Acting on a collateral purpose may very well give rise to a breach of contract.
In addition to this objective standard of reasonableness, and even where a discretionary clause could be measured using a subjective standard, the courts have, in some cases, imposed an obligation to act in good faith. While good faith can be a difficult concept to define, it’s often explained as requiring a party to act with regard to the interests of the other party (although one need not prefer the interests of the other party over their own), with proper motives and in a manner that is consistent with the reasonable expectations of the parties under the contract. A failure to act in good faith, like a failure to act reasonably, can give rise to a breach of contract.
When negotiating discretionary clauses, the parties should seek to add as much certainty and clarity as the situation allows. They should consider the appropriate standards upon which the exercise of discretion will be measured and incorporate those standards into the contract. Where this has not occurred or where there remains some uncertainty, advice should be sought as to one’s rights and responsibilities under the contract. It must be remembered that discretionary clauses often impose obligations of reasonableness and good faith and that the courts are hesitant to allow a party to have absolute and unfettered discretion. Caution is required in order to ensure that one is acting within the bounds of its contractual obligations.
This article is for information purposes only and may not be relied on for legal advice. Matthew Swanson and Grant Mayovsky are partners at the law firm of Borden Ladner Gervais LLP. They both practice in the area of commercial litigation with an emphasis on contract and construction disputes.