The Lehman v Exxonmobil (EMFS) case recently decided by Blair J in the Commercial Court has many interesting nuggets relating to the valuation of securities for the purposes of the calculation of loss. In the case itself, these arose out of the failure of Lehmans to honour repo agreements, but are also of more general application. This post will address just one of those valuable discussions, namely the difference between what is reasonable and what is rational in the context of the exercise of a contractual discretion.
Briefly, Lehman having defaulted and gone into administration, EMFS sought to exercise its contractual right to sell the securities it was holding under the repo. Times were hard and the market was in a state of “severe dislocation” when EMFS sought to sell. Some were sold and some were not. Where securities had neither been sold nor had at least two quotations been obtained, the contract provided that the default market value would be the non-defaulting party’s “reasonable opinion” of the amount which represented their fair market value.
This naturally creates scope for some argument in circumstances where the securities have not been sold. Did the exercise require an objectively reasonable fair market value to be ascertained, or merely the ascertainment of the opinion which EMFS, acting rationally, would have formed at the time in the course of carrying out a valuation exercise as required by the contract?
The judge held that the question turned on the effect to be given to a contractual discretion. The leading authority on the question was the decision of the Court of Appeal in Socimer International Bank v Standard Bank London where Rix LJ explored whether there were limitations on a decision-maker’s freedom to make a decision in circumstances where he held a contractual discretion. He said that there were such limitations, and they were:
“… honesty, good faith and genuineness, and the need for the absence of arbitrariness, capriciousness, perversity and irrationality. The concern is that the discretion should not be abused”.
In the later decision Fondazione Enasarco v Lehman Brothers Finance SA, David Richards J said that the decision-maker was not:
“… required to comply with some objective standard of care as in a claim for negligence, but, expressing it negatively, must not arrive at a determination which no reasonable non-defaulting party could come to. It is essentially a test of rationality….”
But what is meant by “rationality”? Is it the same as reasonableness? In the Supreme Court in Hayes v Willoughby (a case about criminal harassment), Lord Sumption described the concepts as follows:
“Rationality is a familiar concept in public law. It has also in recent years played an increasingly significant role in the law relating to contractual discretions, where the law’s object is also to limit the decision-maker to some relevant contractual purpose: see Ludgate Insurance Co Ltd v Citibank NA [1998] Lloyds Rep IR 221, para 35 and Socimer International Bank Ltd v Standard Bank Ltd [2008] Bus LR 1304, para 66. Rationality is not the same as reasonableness. Reasonableness is an external, objective standard applied to the outcome of a person’s thoughts or intentions. The question is whether a notional hypothetically reasonable person in his position would have engaged in the relevant conduct for the purpose of preventing or detecting crime. A test of rationality, by comparison, applies a minimum objective standard to the relevant person’s mental processes. It imports a requirement of good faith, a requirement that there should be some logical connection between the evidence and the ostensible reasons for the decision, and (which will usually amount to the same thing) an absence of arbitrariness, of capriciousness or of reasoning so outrageous in its defiance of logic as to be perverse.”
So when considering the non-defaulting party’s “reasonable opinion” of the amount which represented the fair market value of the securities, the court did not seek to establish their objectively reasonable fair market value, but applied a test of rationality to the discretionary decision.
In the particular case, matters did not end there because EMFS had not in fact conducted any valuation exercise at the time. So the court tweaked the test to one of ascribing to the securities the opinion of fair market value, which EMFS acting rationally would have formed had it conducted the contractual valuation exercise.
This case therefore illustrates the different approach the court will take to the interpretation of a clause requiring something to be “reasonable” and one which requires something to be reasonable in someone’s “opinion”.
