Contracts often give one party a discretion or power to exercise rights under the contract for their own purposes, without restriction. Often, they involve a party undertaking an assessment or having options open to it under the contract. For example:
- Where a party has the right to terminate a contract for material default, but material default is not defined and it requires an assessment of the default by the party seeking to terminate.
- Where a party has the right to alter the interest rate in a finance contract, and the contract does not contain any limitations on how that rate should be set.
The courts have long recognised that such powers can be abused. The common law has therefore developed a “default rule” which regulates the exercise of contractual discretions. This default rule provides that a party must not exercise a contractual discretion arbitrarily, capriciously, in bad faith, or unreasonably in the sense that no reasonable contracting party could have so acted. The threshold is a high one and the courts will not intervene lightly.
In this article, we examine how the United Kingdom Supreme Court has extended the default rule and a recent decision of our High Court which declined to follow the UK approach in respect of the contract in issue.
We set out details of the two approaches below. In summary:
- The United Kingdom Supreme Court has ruled that the test for reasonableness, when reviewing the exercise of contractual discretions, is the same test for reasonableness used in judicial review of decisions made by public bodies (often referred to as Wednesbury unreasonableness). This test requires an assessment of both the substance of a decision (which is what the default rule addresses), and the process by which a decision is made.
- The New Zealand High Court took the view that, for commercial contracts, the traditional default remains appropriate, such that the courts should only assess whether the substance of the decision is reasonable, and not the decision-maker’s process. The High Court acknowledged that the wider test adopted by the United Kingdom Supreme Court may be appropriate where a contract requires a party to have regard to the interests of the other party, such as those which are common in employment contracts and in the context of trusts.
The High Court also discussed, in obiter dicta, a revised approach to the judicial review of contractual discretions. While not binding in future cases, the proposed revised approach is a concept that commercial contracting parties should be aware of.
The extension of the default rule by the UK Supreme Court: Braganza v BP Shipping Ltd
In Braganza v BP Shipping Ltd,1 the UK Supreme Court ruled that the test for reasonableness, when reviewing the exercise of contractual discretions, is the same test for reasonableness used in judicial review of decisions made by public bodies. That test, sometimes referred to as Wednesbury unreasonableness, requires that:2
- the decision-maker must take account of all relevant considerations and exclude irrelevant considerations, and
- the decision-maker must not reach a decision which no rational decision-maker could have made.
The test requires an assessment of both the substance of a decision (which is what the default rule addresses), and the process by which a decision is made.
In applying this test, the Supreme Court expressly imported the public law concept of reasonableness into a private law contract (although we note that the particular facts of that case concerned an employment contract). For more details of that decision, see our update here.
Courts and commentators in various jurisdictions have subsequently debated the appropriateness of transplanting public law concepts (such as reasonableness) into a private law setting. There has also been debate as to how the default rule applies depending on the type of contract or the nature of the contracting parties in question: how should the default rule apply to a commercial contract, compared to an employment contract or contracts with a public context? Is an imbalance of power, or conflict of interest, necessary?
The New Zealand High Court recently considered these issues and examined Branganza in the decision of Woolley v Fonterra Co-Operative Group Limited.3
Woolley v Fonterra
Mr and Mrs Woolley owned and operated dairy farms in the Marlborough and Tasman regions, including the Glenmae farm. Over a number of years, there were various resource consent issues as well as concerns regarding the impact of the dairy operations on the environment. As a result of these issues, the Marlborough District Council successfully obtained enforcement orders in April 2014 in respect of the milking shed and effluent system at Glenmae.
Mr and Mrs Woolley had supply contracts with Fonterra for each of the farms. A provision in those contracts was that Fonterra could suspend milk collection in specified circumstances, including where environmental sustainability issues arose or where there was a failure to comply with resource consents.
In June 2014, Fonterra suspended milk collection from Glenmae and served a notice to that effect on Mr Woolley. Fonterra later refused to withdraw its suspension notice until further order of the Environment Court. It was concerned that Mr Woolley had not complied with existing orders of the Environment Court.
Mr Woolley took the view that he had complied with the enforcement orders given by the Environment Court, was therefore entitled to continue operations at Glenmae and that it was unreasonable for Fonterra to continue with its suspension of milk collection.
The farms were ultimately put into receivership as a result of the ongoing issues and Mr Woolley subsequently brought proceedings against Fonterra. The proceedings included an allegation that the decision to suspend milk collection and the process followed by Fonterra when exercising its contractual discretion was unreasonable in a public law sense, consistent with the UK Supreme Court decision in Braganza.
What test should apply to commercial contracts?
The High Court observed that: “There can be no doubt that Braganza has charted a new approach to the review of contractual discretions, but there has been no explicit endorsement in New Zealand of the United Kingdom Supreme Court’s approach, and — perhaps more crucially — it remains questionable whether it can be applied in more commercial contexts, as is evident from some decisions post-Braganza.”
The High Court held that Braganza should be confined to powers that require a party to have regard to the interests of the other party, such as those which are common in employment contracts and in the context of trusts.
In contrast, for commercial contracts (such as the supply contract in Woolley), the High Court considered that the traditional default rule is more appropriate, such that the courts can only assess whether the substance of the decision is reasonable, and not the decision-maker’s process: “The traditional elements of the default rule are sufficient, I find, to balance the risk of abuse of power with freedom of contract”.
Although not necessary to decide the case before it, the High Court also suggested that the default rule be replaced with a new, interpretive approach, which focusses on the purpose for which a contractual discretion is granted, as contemplated by the parties. Such a contractual discretion must, then, only be exercised for that purpose. The Court considered that this approach was flexible enough to apply to a wide range of contracts and contracting parties. Such an approach would also avoid the Court having to imply a term into the contract.
Overview of the High Court’s decision
The High Court concluded that Fonterra’s decision to suspend milk collection was not unreasonable:
- Fonterra’s power of suspension was already subject to limitations controlling its exercise, because it could only suspend collection on the grounds expressly set out in the supply contract.
- As this was a commercial contract, the traditional default rule was more appropriate (although the High Court concluded that Mr Woolley’s claim would still fail under the expanded Braganza approach).
- Taking into account all of the circumstances of the case, Fonterra’s decision to suspend milk collection was not substantively unreasonable.
Implications for commercial parties in New Zealand
The expanded approach adopted by the UK Supreme Court in Braganza has not been adopted in New Zealand in respect of commercial contracts and the default rule remains the relevant touchpoint in New Zealand when assessing the exercise of contractual discretions. As such, for the time being, commercial parties that enter into contracts should be aware that:
- The exercise of a contractual discretion, even if it is not subject to express restrictions, may be open to the court’s review.
- In a commercial contract, the courts will likely be concerned with the substance of the decision and whether it is unreasonable, in the sense that no rational contracting party could have made that decision.
It remains to be seen whether our judiciary will adopt the new, interpretive approach suggested by the High Court in Woolley. If that test is adopted, then it will be important for parties to be clear about the purpose(s) behind contractual discretions and to ensure that the exercise of a discretion aligns with the purpose(s).
If you have any questions about the matters raised in this article, please get in touch with the contacts listed, or your usual Bell Gully adviser.
1  UKSC 17.
2 Established by the decision in Associated Provincial Picture Houses Ltd v Wednesbury Corporation  1 KB 223.
3 Philip John Woolley v Fonterra Co-Operative Group Limited  NZHC 2690.