Lesson 14 of 25 · 6 min

Sole discretion, reasonable discretion, and the gap between them

One word in front of the noun decides who has to justify what, and most schedules use the word that requires nothing.

Agreements qualify discretion with a small number of recurring phrases, and the phrase is not decoration. It sets the standard the exercise is measured against, if it is ever measured at all.

Sole and absolute discretion is the widest. It permits the holder to act for its own reasons and does not require it to weigh the other party's position. Reasonable discretion, or commercially reasonable judgement, imports an external standard: the act must be one a comparable institution could have taken on comparable facts. Good faith sits between them, addressing the honesty of the exercise rather than its wisdom.

The gap between these standards is almost never visible on the day. Both lenders can cut the same row by the same amount on the same afternoon, and both shortfalls are due immediately. The standard governs a different question: what, if anything, must exist in writing behind the decision, and what can be examined afterwards. Under a reasonableness standard the institution's own process carries that weight — a committee memorandum, a market observation, a model output — and the paper has to exist before the act rather than be assembled after it.

Two details complicate the reading. Standards are often mixed within one agreement — sole discretion to determine collateral values, reasonable discretion in the manner of a sale. And the standard is separate from notice: a reasonableness qualifier says nothing about whether you hear about the act in advance, which is governed by its own clause, as Track 5 lesson 7 described.

Key terms

Sole and absolute discretion: A power exercisable for the holder's own reasons, with no obligation to weigh the borrower's interest or to state a basis.
Reasonable discretion: A power measured against what a comparable institution could have done on comparable facts. An external standard rather than an internal one.
Documented basis: The written rationale behind an exercise of discretion. Required in substance under a reasonableness standard, optional under an absolute one.

Worked example

Two agreements, one afternoon

Two borrowers, each with a $940,000 portfolio and a $520,000 balance. Both lenders cut the same row from 62 percent to 45 percent in the same week.

Lending value before, both: $582,800
Lending value after, both: $423,000
Shortfall demanded, both: $97,000
Borrower A, sole and absolute discretion: No stated basis required
Borrower B, reasonable discretion: A basis capable of being shown
Difference in cash due that week: $0

The phrase changed what could be examined later. It changed nothing about the $97,000 or the date it was due.

Check yourself

A $1,120,000 portfolio supports a $610,000 balance at a 58 percent advance rate. Under a clause granting sole and absolute discretion, the lender moves the row to 46 percent. What is the shortfall, and what does the phrase change about it?

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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.