How might private equity and venture capital be impacted if a court implies terms into a contract?

26 September 2017

A recent High Court judgment has provided an important lesson on the use of consent clauses in contracts, which will certainly have a bearing on the interpretation of provisions commonly found in private equity and venture capital documents. It's also a reminder for companies to be careful engaging fund raising advisors on terms where part of their success fee is 'discretionary'.

Watson & Ors v Ltd [2017] Ltd is a rapidly growing retailer specialising in pre-owned luxury watches, perhaps more familiarly known as this year's sponsor of the Tour de France TV coverage, with turnover increasing from £16m in 2013 to £60m in 2016 on the back of private equity investment.

Adoreum Partners was engaged by Ltd in 2010 to provide a variety of business development services, including the introduction of potential investors. In return, Adoreum Partners would be paid a monthly retainer and a bonus fee upon the successful introduction of an investor. In addition, a share option agreement was granted by Ltd to the partners of Adoreum, permitting them to acquire 5% of the shares in Ltd.

The share option agreement contained one condition:

"The Option may only be exercised with the consent of a majority of the board of directors of [ Ltd]"

Adoreum Partners introduced Beringea LLP to Ltd in 2013, and funds managed by Beringea LLP and a second investor, Piton Capital, subsequently invested US$10m in return for a 15% shareholding in the summer of 2014.

Having seen the impressive growth of Ltd and raising the exercise price, the partners of Adoreum attempted to exercise their share option in 2016 (priced at £150,000 for 5% of the shares).

The board of directors of Ltd voted against the exercise of the option and notified Adoreum Partners that the condition to exercise had not been satisfied. Taking the clause at face value, the board had decided it had an absolute discretion on whether to grant the shares or not.

The High Court ruled that this was not the case, as there was an implied duty to exercise the contractual discretion rationally. The case concluded that the board of Ltd had not complied with this duty, as they had without proper process jumped straight to the decision that they did not want the option to be exercised (perhaps understandably, with their shareholder interests in mind, to avoid unnecessarily diluting the share capital).

How is this relevant to private equity and venture capital?

Aside from the growth capital backdrop to the case, investment documents commonly contain discretionary or consent rights. For example:

  • Investor and Investor Director consent matters;
  • Good Leaver definitions, where often there is a limb allowing a Company (with Investor Consent) to categorise someone as a Good Leaver if they do not meet the other conditions;
  • Liquidation Preference determination rights. For example, in allowing an Investor to determine the value of non-cash consideration (such as shares) when applying an exit waterfall; and
  • Further investment tranches being subject to the prior consent of investment committees.

Often these clauses are negotiated, requiring the discretions to be exercised "reasonably" or a consent "not to be unreasonably withheld", but not always. The important lesson is that even if a discretionary clause has not been negotiated this way, and even if a clause grants a party the "sole" or "absolute" discretion to make a decision, there is now a growing base of case law suggesting the courts are willing to imply a duty of rationality on the party exercising these clauses.

This is not to say that investors' rights under the above standard clauses are definitely fettered. However, with the right fact patterns and a party suffering unfair detriment as a result of the exercise of a discretion, a court has the tools at its disposal, and has shown it is willing, to imply a duty to act rationally into contracts.

What is the duty of rationality and how do you comply?

It is an implied term that a contractual discretion must be exercised in good faith and not arbitrarily or capriciously. It is only possible to exclude with very clear language to the contrary ("absolute" or "sole discretion" does not go far enough), so the contract would need to expressly exclude this implied duty.

This does not mean that the party has to act "reasonably". For example, it does not require the party to make the same decision that a judge would make when assessing the same decision from an objective or neutral standpoint. However, it does mean:

  • A decision maker needs to follow a proper process for the decision in question;
  • All material considerations should be taken into account and irrelevant considerations should not be;
  • The discretion must be exercised in a manner consistent with any surrounding documents indicating how the decision should be made;
  • There should be evidence to support the decision (such as board meeting minutes). As the Ltd case demonstrated, it is difficult to introduce this evidence after the event; and
  • The party affected by the decision should, possibly, be given the right to make representations to the decision makers.


The case presents an interesting reminder that courts are willing to imply terms into contracts, so investors should tread carefully when exercising a discretionary contractual right that could result in a material detriment to a counterparty, and also be careful to ensure they are not leveraging certain contractual rights with an ulterior motive not linked to the particular decision in question.

Companies raising finance should also be careful to avoid 'discretionary' success fees (i.e. "pat-on-the back uplifts") when engaging corporate finance advisors. If a reward is truly discretionary, then it need not be documented in a contract. If investment is being made on the back of an introduction by a corporate finance advisor, investors should be sure to look out for these discretionary clauses in engagement letters and seek to address these clauses prior to investing, as they will also suffer the resulting dilution.

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