Case law: Court clarifies duties of party if agreement gives them power to exercise contractual discretion
Businesses entering into agreements giving them a discretion over the fees they charge (or any other matter) must be able to show they have not exercised that discretion capriciously, arbitrarily or irrationally – or the court may penalise them, a recent ruling makes clear.
This update was published in Legal Alert - March 2018
Legal Alert is a monthly checklist from Atom Content Marketing highlighting new and pending laws, regulations, codes of practice and rulings that could have an impact on your business.
A bank agreed to lend money to a business. The agreement gave the bank the right to collect the business's unpaid invoices as security for the loan. The agreement also gave the bank the right to charge ‘an additional collection fee at up to 15% of amounts collected’, constituting ‘a fair and reasonable pre-estimate of [the bank's] likely costs and expenses in providing such service’.
The bank collected £8.1 million on the invoices, and charged a 15% collection fee of £1.2 million. The business objected. It argued that the 15% provision did not say the bank could simply decide to charge a 15% collection fee, irrespective of how much it actually cost to collect the unpaid invoices. Instead, the correct interpretation of the wording in the agreement was that it entitled the bank to claim back a sum equivalent to the actual costs and expenses incurred in collecting on the invoices, subject to a maximum cap of 15%.
The business also argued that the 15% provision amounted to a 'penalty'. The law says that a contractual provision providing for payment of a fixed sum, by one party to the other in the event of a breach of a primary obligation in it, is unenforceable if it amounts to a penalty.
The legal test of whether a provision is a penalty is whether it imposes a financial consequence (ie, a secondary obligation) for the breach of a primary obligation under the agreement, which causes a detriment to the party committing the breach that is disproportionate to the other party's interest in the performance of that primary obligation. The business argued that this test was satisfied.
The bank argued that the agreement entitled it to charge any fee it wished, up to a maximum of 15%, and that it had always charged other businesses the full 15%. It counterclaimed for the balance of the 15% fee.
The High Court found that the wording of the provision, when interpreted in the context of what it called the 'target' of that provision, meant that the bank had a discretion to charge a collection fee based on estimated or actual costs, up to a cap of 15%.
On the issue of whether the provision for a collection fee amounted to a penalty, the Court found that:
- Paying the collection fee was a primary obligation, and not a secondary one (as the fee was not a sum payable instead of damages in the event of a breach, but a primary obligation of the agreement – a sum payable to the bank for collection of the unpaid invoices). The collection fee could not therefore be a penalty
- Even if payment of the collection fee was a secondary obligation, the fee was not a fixed sum but an amount determined by exercise of a discretion by the bank. Also, in any event, the bank had a legitimate interest in being compensated for costs and expenses
- The business was a large organisation, which had negotiated the agreement at arm's length
It therefore ruled that the collection fee did not amount to a penalty.
However, having decided that the bank had a discretion as to the amount to charge for the collection fee, the Court had to consider a further issue. The law requires that when a contractual provision gives one party a discretion whether or not to do something, the discretion must not be exercised in an 'arbitrary, capricious or irrational' way. There had to be a proper process, taking into account relevant points (and not irrelevant ones); and the party exercising the discretion should not arrive at a decision no reasonable decision-maker could have arrived at.
The Court found that the bank did not attempt to work out the actual costs of collecting the unpaid invoices; failed to consider whether it could sub-contract collection to third parties for a cheaper fee; and decided to collect the whole 15% too fast to have undertaken a proper process.
It therefore ruled that the bank had not properly exercised its discretion. It had either failed to exercise it at all, or its exercise of the discretion had been defective.
The Court said that a useful benchmark for the proper exercise of its discretion would be what it actually cost the bank to collect on the invoices. In the absence of records, it ruled that a salary-based hourly rate would result in a sum of £33,260. It said that the maximum the bank could charge had it exercised its discretion properly would be 4%. The business had therefore been overcharged by £735,000.
- Businesses entering into agreements giving them a discretion over the fees they charge (or any other matter) should ensure they can show they have not exercised that discretion capriciously, arbitrarily or irrationally – or they may find that the court interferes with the exercise of their discretion
Case ref: BHL v Leumi ABL Ltd  EWHC 1871
Disclaimer: This article from Atom Content Marketing is for general guidance only, for businesses in the United Kingdom governed by the laws of England. Atom Content Marketing, expert contributors and ICAEW (as distributor) disclaim all liability for any errors or omissions.
Copyright © Atom Content Marketing