Courts Move to Curb the Misuse of Contractual Powers

Recent judgments have demonstrated the Courts’ willingness to imply a duty to act honestly into a contract to prevent unscrupulous parties taking advantage of the powers afforded to them. Although this development does not go as far as to imply a general duty of good faith, it does require parties to exercise their contractual clout in a rational manner.

In contracts which control the provision of services it is common for parties to include service management regimes that enable the customer to obtain a discount or terminate the contract when the service provider breaches its obligations. Regimes such as this regularly involve an element of discretion, where the customer is able to decide how many “points” (or other measure) each breach by the service provider is worth.

In Portsmouth City Council v Ensign Highways Ltd, Ensign was contracted to provide highway maintenance services on behalf of the Council for a period of 20 years from 2004. Points were awarded by the Council when Ensign breached its obligations, with a greater number of points being awarded for the more serious breaches. If Ensign received 250 or more points within a 12 month period the Council was entitled to terminate the contract.

The arrangement proceeded smoothly until local authority funding cuts in 2012 rendered the contract unaffordable, and with a cost of £140 million for early termination the Council began looking at methods of excusing itself on the cheap. The Council adopted the strategy of awarding maximum points for every service breach regardless of its severity. Unsurprisingly Ensign complained, leading the Council to seek a declaration from the Courts as to its obligations when awarding service points.

The High Court did not, however, provide the Council with the reassurance it was hoping for, and found that the Council’s ability to award service points was subject to an implied term that the award would be made “honestly…on proper grounds and not in a manner that is arbitrary, irrational or capricious.” The Court ruled that applying the maximum value to all breaches did not satisfy this ‘rationality’ test, the application of which is now becoming more widespread.

Although service providers will no doubt welcome the decisions, the implied rationality term does rob the contracts to which it applies of a degree of certainty, and customers may now be overly tentative in asserting their contractual rights. This makes it all the more important for parties to agree a comprehensive regime in written terms in respect of penalties that leaves as little room for interpretation as possible.

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