Discretionary bonuses: when can employers not pay?

The Co-Operative Insurance Society is reportedly in dispute with ten former employees for withholding their bonus payments due to difficult market conditions.

It appears that Co-Operative Insurance Society's (the Co-Operative) decision to withhold bonuses was on the basis that they were discretionary and it was therefore entitled not to make the payments due to heavy losses in the business last year. However, the Co-Operative is now facing a collective demand of more than £1m from disgruntled former employees who claim their performance entitles them to payments.

The Co-Operative's current predicament highlights two important lessons for businesses seeking to navigate the tough economy.

1.    Just because you call it a "discretionary" bonus, it doesn't mean you have no obligation to pay

The label applied to a bonus is not determinative. In the event of dispute, a Court will examine all the surrounding circumstances to satisfy itself as to the true nature of any bonus.

In summary, a bonus which is, or has become, a contractual entitlement must be paid in accordance with its terms and failure to do so will expose the employer to a claim for breach of contract. On the other hand, where a bonus is genuinely discretionary an employer may, if it has exercised its discretion properly, decide not to pay without exposing itself to liability.

Discretionary bonuses are not homogenous and come in all shapes and sizes. Some bonus schemes are discretionary in all respects i.e. whether any bonus is paid at all and if so, how much and how it is calculated. In other cases there may be a contractual entitlement to be considered for a discretionary bonus but no right to actually receive a certain amount of (or any) bonus.

Unhelpfully, a bonus may start off on a discretionary basis but become a contractual entitlement over time. For example, employers who regularly make payments of a certain amount (or calculated in the same manner) over a number of years can find such bonuses become implied into employees' contracts.

It is also incumbent on employers not to exercise any discretion in an unreasonable or capricious manner e.g. withholding payments from an individual whose circumstances mirror those of another who was given a bonus.

We recommend:

• Review any existing bonus scheme wording which may be regarded as "discretionary" to see if it could arguably be (or have become) a contractual entitlement. Consider what payments have been made in the last five years, have these varied or been different each time, were there any previous years when bonuses were not awarded? If so, this looks more like the exercise of a discretion.
• Where the intention is to maintain a discretionary bonus ensure there is a detailed bonus clause in employees' contracts or ancillary documents which makes this clear. The drafting should expressly state:
  • the reason for the bonus for example, to encourage loyalty or reward performance;
  • the elements which are at the employer's discretion;
  • that the employer may award a nil bonus in any year;
  • any factors which may be taken into account in exercising the discretion;
  • that receipt of a bonus in one year does not create any entitlement in future years; and
  • that the scheme may be amended or withdrawn without compensation at anytime.
• The Board or body considering the award of discretionary bonuses should keep detailed notes of its deliberations and conclusions. A company that can evidence real consideration of who gets what using quantative and transparent criteria will be much more likely to successfully withhold payments during difficult times.
• Even where a bonus is contractual it may be helpful to build in wording which enables the employer not to pay, in exceptional circumstances. Such wording will have to be very clearly and carefully drafted to prevent future disputes as to whether or not it has been triggered. For financial organisations one possibility may be to provide that a bonus will not be paid if the Prudential Regulation Authority opposes the payment (as they are reported to have done in the Co-operative's case). While such wording may face negotiation from individuals it could provide some vital "wriggle room" for an employer. Without such wording, employers could become liable for significant sums at times when their balance sheets can least afford it, as they will have an obligation to pay regardless of circumstances.
• While promising future bonuses may seem like a good way to incentivise and retain staff when a business is in trouble, proceed with caution - even oral discussions about bonuses can result in binding contracts being formed.

2.    If you inherit employees under TUPE, make sure you are covered where there is a pre-existing dispute

A basic principle of the Transfer of Undertakings (Protection of Employment) Regulations 2006 (TUPE) is that the new employer "stands in the shoes" of the old employer so they are bound by all the terms of the employment contract going forward and become liable for any pre-existing liabilities under such contract.

The Co-Operative's business was bought by Royal London in March 2013, at which point the bonus dispute was known and, presumably, factored into the terms of that acquisition. Technically, Royal London, as the new employer, would be responsible for existing employment-related liabilities such as this dispute, but it can be surmised that it secured suitable indemnity protection to make the Co-Operative responsible for any eventual costs stemming from the litigation.

This can be contrasted against the unhappy fate of Commerzbank who took on 102 bankers from Dresden Kleinwort in 2008/09. Presumably without any commercial protection in place, Commerzbank found itself liable for reportedly £44m worth of bonus payments that Dresden Kleinwort had previously promised to the employees.

We recommend:

• Proper due diligence is crucial to ensure that any financially significant potential liabilities are uncovered so that these can be factored into commercial negotiations in good time.
• Where liabilities are uncovered, contractual indemnity protection should be put in place to fully protect against claims arising from circumstances existing prior to the transaction and over which the buyer has no control.
• If an indemnity is negotiated to cover a pre-existing dispute consider what, if any, involvement the buyer will have in respect of the conduct of the claim itself. This should be dealt with in the commercial contract.
• Remember that any indemnity is only as good as the financial standing of the entity giving it. If this is uncertain or concerning an upfront price reduction may be more appropriate. Alternatively, a portion of the purchase price could be withheld prior to the outcome of any litigation and quantification of the liability.