Brogden & Anor v Investec Bank Plc

This is an appeal against the order of Leggatt J. dismissing the appellants’ claim for breach of contract on the part of the respondent (“the Bank”) in failing to pay bonuses to which they say they are entitled.

In April 2007 the Bank recruited the appellants to set up a department or “desk” trading in equity-based derivatives. They had a record of successful trading in similar products at another financial institution in the City and were persuaded to transfer their services to the Bank by the promise of the payment, in addition to their salary, of very substantial guaranteed bonuses in the first year of their employment, followed in subsequent years by bonuses related to the profitability of the desk.

The first appellant entered into a contract of employment with the Bank which included the following terms:

“3.

Bonus

You will be entitled to a guaranteed bonus of £6,200,000 . . . payable in your first year of starting employment . . .

In your second financial year of operation starting on 1 April 2008, the bonus calculation will be based on an EVA formula calculated as 40% of EVA generated by the Equity Derivative business. . . .

In the third financial year starting on 1 April 2009 and thereafter the bonus calculation will be normalised based on a formula calculated as 30% of EVA generated by the Equity Derivative business. . . . ”

The second appellant entered into a contract with the Bank on the same terms, save that in his case the guaranteed bonus was £3,800,000.

The original plan was for the Structured Equity Derivative (“SED”) desk run by the appellants to trade with other financial institutions in complex financial products linked to the equity markets. By the beginning of 2008, however, the appellants had devised equity-based financial products suitable for being offered to the retail investment market though independent financial advisers. Broadly speaking, the basic form of the product was a fixed-period bond on which the yield depended on the performance of the stock market over the ensuing five years. If the market rose, the investor would recover the value of his original investment together with an additional sum by way of a performance payment. Typically, the performance payment represented a return of simple interest at the rate of 6% per annum over the life of the bond. If the market went down, the investor would recover only the amount of his original investment. Some products contained an option for the investor to cash in his holding before the bond reached maturity, a process known as “kick-out”, and some provided for return of only part of the original investment if the market had fallen beyond a certain level at the date of maturity. It is convenient to refer to all these financial products generically as investment bonds.

The issue of investment bonds by the SED desk was very successful and raised considerable sums of money, which were then available to the Bank for a fixed term (subject to kick-outs) for use in other areas of its business. To that extent it can be said that the SED desk was a source of term funding for the Bank. The acquisition of deposits that in due course had to be repaid did not itself represent a revenue stream, but it did represent the acquisition of funds that could be used to generate revenue.

The dispute in this case concerns the benefit that the Bank derived from the activities of the SED Desk and what is meant by the expression “EVA” in the appellants’ contracts of employment, by reference to which their bonuses were to be calculated in the second and subsequent years. The appellants say that the purpose of the bonus provisions was to give them an incentive to make the SED desk as profitable for the Bank as possible and to give them a share in the economic value they created. They maintain that in order to achieve that end it is necessary to ascertain how much the Bank benefited from their activities, which can best be calculated by reference to the cost it would have incurred if it had raised an amount equivalent to the investors’ deposits in the capital markets. The Bank says that its established practice was to account for each area of its activities individually, thereby enabling it to determine which were profitable and which not. The individual profit and loss accounts were then combined to produce a profit and loss account for its business as a whole. The Bank says that this practice was explained to the appellants before they entered into their contracts.

In order to explain the nature of the dispute between the parties it is necessary to say a little more about the way in which the business of offering investment bonds to the retail market was conducted within the Bank. The Central Treasury department controlled the deployment of funds throughout the Bank. Because the sale of bonds involved the SED desk raising term funds in the form of investors’ deposits, the Central Treasury would notionally credit the desk with interest on the sums raised. The rate the department was willing to “pay” for funds at any given time was initially determined by the Bank’s then head of its Capital Markets Division, Mr. Van Der Walt, and subsequently by a committee known as the ‘Product and Pricing Forum’. It reflected a number of factors, not least the Bank’s appetite for raising funds from that source. It is important to note, however, that the rate was usually, if not always, lower than the market rate.

The rate of interest with which the Central Treasury was willing to credit the SED desk set the parameters of the product that the desk could offer if it was to make a profit on its activities. For example, if it would receive 4% from the Central Treasury on funds obtained from the sale of products, it had to structure those products in such a way that the return to bondholders was less than 4%. The appellants showed themselves capable of meeting that demand, but the lower the interest rate the desk received from the Central Treasury, the harder it became to offer a product that would appeal to investors.

The working of the system in financial terms can be illustrated by a simplified example that was canvassed in the course of argument. Suppose the open market rate of interest is 6%, but the Product and Pricing Committee decide that the rate of interest on deposits to be credited to the SED desk is to be 4%. The SED desk knows that to register a profit in revenue terms it must produce a product on which the return is (say) 3%. The deposits are available to the Bank for use in its business, perhaps in the form of loans earning (say) 6%. On that basis the overall profit to the Bank is 3%, of which 1% is registered in the SED desk and 2% is registered in another activity centre. It is the distinction between the profit registered in the SED desk (1%) and the total profit realised by the Bank on the deposits (3%) that lies at the heart of the dispute.

The Bank was of the view that under the appellants’ contracts their bonuses were to be calculated by reference to the revenue generated within the activity centre represented by the SED desk. However, in the second and third financial years that produced bonuses far lower than the appellants thought properly reflected the value to the Bank of their operations. They considered that their bonuses ought to be calculated taking into account the full value to the Bank of having at its disposal the funds they had raised from investors. On each occasion the difference of opinion was resolved by the Bank’s agreeing to make a greater sum available for bonuses than that to which it considered the appellants were entitled. In the following year, however, the problem became more acute, because the profit and loss account for the SED desk showed a loss. The Bank therefore decided that no bonuses were payable. This time the dispute could not be resolved by agreement and the appellants decided to leave the Bank’s employment. They then brought the present proceedings to recover what they allege are the sums due to them by way of bonuses for the year in question.

Before the judge the appellants contended that before they entered into their respective contracts they had entered into an oral agreement with the Bank, in the person of Mr. Van Der Walt, that their bonuses would be calculated by reference to the total financial benefit accruing to the Bank from the activities of the SED desk, but the judge rejected that part of their case and there is no appeal against his decision. The critical issue below, therefore, and the one that is the subject of the present appeal, concerned the meaning of the expression “EVA generated by the Equity Derivative business” in the appellants’ contracts of employment. It was common ground that “EVA” meant “economic value added”, but the parties were in dispute about whether in its context it meant the overall economic value added to the Bank or the economic value added within the business of the SED desk. The judge held that the Bank had a discretion in relation to the manner in which it assessed EVA and that its decision could not be challenged unless it could be shown that it had acted irrationally or in bad faith. There were no grounds, in his view, for suggesting that the Bank had acted in bad faith and he was not persuaded that it had acted irrationally. He therefore dismissed the appellants’ claim.

Mr. Raymond Cox Q.C. for the appellants submitted that the judge was right to hold that the Bank had a discretion in relation to the manner in which it assessed EVA for the purposes of calculating the appellants’ bonuses, in particular because it had not previously been necessary for it to calculate EVA in respect of a deposit-raising desk. It was, therefore, an exercise for which there was no precedent. He contended that, since the purpose of paying the appellants a bonus was to reward them for the economic benefit they had generated for the Bank, it was irrational to calculate EVA by reference to the internal profit and loss account of the desk, rather than the overall commercial benefit that the Bank derived from having available for use in its business the funds raised by way of investors’ deposits. That, he submitted, was best measured by reference to what he termed the ‘institutional market rate’, i.e. the rate of interest which the Bank would have had to pay to raise an equivalent sum of money on the inter-bank lending market. In terms of the example mentioned above, that would involve crediting the SED desk with a profit of 3% rather than 1% on the funds it raised.

Mr. Cox drew our attention to the decision of the Supreme Court in Braganza v BP Shipping Ltd [2015] UKSC 17, [2015] 1 W.L.R. 1661 in support of the proposition that, in cases where a contract gives one party a discretion to act in a manner that will affect the interests of the other, the court will often imply a term that the discretion is not to be exercised arbitrarily, capriciously or irrationally in the Wednesbury sense. He did so in support of his argument that the Bank had a discretion in the choice of the criteria to be adopted for the purposes of calculating EVA for the SED desk and that it was irrational for it to adopt criteria which did not reflect the full economic benefit the Bank derived from the receipt of investors’ deposits. This was similar to, though not quite the same as, the submission that had been made to the judge that it was irrational for the Bank to adopt for the purposes of calculating EVA the rate of interest which the Product and Pricing Forum had determined should be credited to the SED desk in respect of deposits received from the sale of retail bonds. Mr. Cox also relied on certain documents generated within the Bank, in which it was recognised that profit and loss on liability-raising desks was determined by the internal rate of return that the Product and Pricing Forum decided should be placed on funds raised in that way. However, the document in question did not apply to the SED desk, which was viewed within the Bank as a trading desk.

Mr. Jonathan Nash Q.C. submitted that the benefit derived by the Bank from receiving investors’ deposits could not be measured simply by reference to the institutional market rate and in any event was not what had been agreed. He took issue with the judge’s conclusion that the Bank enjoyed a discretion in relation to the way in which it assessed EVA for the purposes of calculating the appellants’ bonuses. He argued that, properly understood in the context of the commercial background and the discussions which preceded the contracts, EVA was to be calculated for these purposes by reference to the profit and loss of the SED desk as an independent activity. That was what the Bank had done, and because the desk had not made a profit in those terms during the year in question, no bonuses were payable.

It will be apparent that the dispute in this case turns, at least in part, on the meaning of the appellants’ contracts, since it is to the contracts that one must look to discover whether the Bank enjoyed any discretion in relation to the assessment of EVA. It was common ground, and in any event is apparent from the documents, that the new SED desk was intended at the outset to be a trading desk, buying and selling structured financial products on the inter-bank market. It was common ground that the expression “EVA” meant “economic value added”, but it is necessary to bear in mind that the contracts referred not just to EVA but to “EVA generated by the Equity Derivative business”. Standing alone, that expression might be thought to be rather opaque, but the judge found that there had been discussions between the appellants and the Bank about the Bank’s accounting practices which shed light on its meaning.

The judge made the following findings:

Against that background I think the judge was right to hold that the expression “EVA generated by the Equity Derivative business” meant the amount calculated as the EVA of the SED desk using the method normally used by the Bank to calculate the measure of performance known as EVA for each business unit. That is all the more so, given that the SED desk was intended to be a trading desk whose profit and loss would reflect essentially the same factors as other trading desks. (The diversification of its business into the sale of investment bonds in the retail market did not occur until some months after the desk had started trading.) However, I do not think that the judge was right to hold that the contracts gave the Bank a discretion in the established sense in relation to the manner in which EVA was calculated. Having been told that in the operation of its existing systems the Bank used the term “EVA” to mean revenue, minus costs, minus cost of capital, all calculated before tax, and that EVA for the new desk would be calculated in the same way as that for other business units, I think that the appellants had a right to have the EVA for the SED desk calculated in that way and that the Bank’s obligation was correspondingly limited.

I can well understand the appellants’ concern that the internal profit and loss account of the SED desk depended on the rate at which the Central Treasury department was willing to give it credit for deposits and was thus dependent, at least in part, on the Bank’s appetite for raising funds from that source. It must be borne in mind, however, that the desk had not been established to sell financial products of that kind to the retail market and that the contractual formula for calculating bonuses was appropriate for a trading desk of the kind intended. If the appellants did not think that they could generate enough profit from selling investment bonds, they were free to devise other kinds of products, and indeed were encouraged to do so. Moreover, although the manner of the calculation of EVA for the desk was apparent from the outset, no formal attempt was made following the development of its retail products to renegotiate the basis on which bonuses were to be paid. The appellants’ rights to bonuses therefore remained as they had been from the inception of their contracts, although the Bank, like any other employer, was entitled to make an ex gratia payment to increase the size of the bonus pool, as it did in the second and third years of the appellants’ contracts.

In those circumstances it is unnecessary, in my view, to consider the authorities relating to the limits that may be placed on the exercise of a contractual discretion, although the principles for which they stand were not controversial. They simply have no application in this case.

In his skeleton argument Mr. Cox also put forward a submission that where an employer has by positive action engendered in an employee a reasonable expectation that he will act in a particular way in the future, his failure to do so may be regarded as irrational, unless there are compelling reasons to justify it. He submitted that in relation to both the second and third financial years the Bank had increased the EVA of the SED desk after the year end to reflect better the value to the Bank of its activities. The appellants were therefore entitled to expect that approach to continue.

The judge rejected that submission and it was not pressed on us in oral argument as an independent ground of appeal. In my view it is based on a misunderstanding of the steps which the Bank took. In relation to each of those years a disagreement arose between the appellants and the Bank over the calculation of their bonus pool and in each case the Bank agreed to make available a larger sum of money than that to which the contractual formula gave rise. However, these were simply ex gratia increases in the size of the bonus pool. They were not capable of giving rise to any reasonable expectation on the part of the appellants that the Bank would act in the same way in succeeding years and did not create any obligation on it to do so. Nor can the Bank’s conduct in this respect be treated as supporting the appellants’ case that they were entitled to have their bonus pool calculated in a different way.

Accordingly, I have reached the conclusion, albeit for reasons slightly different from those of the judge, that the order below was correct and that the appeal should be dismissed.

I agree.