How settlement agreements work and when to use them

Our drafting masterclass series continues with a look at settlement agreements. We will consider how settlement agreements work and when to use them, key terms and common negotiation points.

Settlement agreements in an employment context are formal contracts between an employer and employee (or former employee) which prevent that employee from pursuing their employment rights against their employer.

Such agreements can be used to settle a threatened or actual claim, although it is more common for parties to rely on a COT3 agreement – an alternative short form of settlement agreement available through ACAS – where there is a live Tribunal claim as COT3s have the advantage of simplicity and become binding as soon as terms are verbally agreed rather than upon signature.

Often settlement agreements are used simply for the employer’s comfort where the employee has not asserted any employment rights and there is no live dispute, but the employer wishes to remove any potential for future litigation.

While settlement agreements are most commonly used to settle disputes on termination of employment, they can be put in place even when the employee remains employed but has brought some form of internal complaint, such as alleging discrimination.

A settlement agreement does not entirely eliminate the possibility that an employee will bring a claim against their employer, but dramatically reduces the probability of a claim and provides the employer with protection in the event a claim is filed.

The without prejudice rule and section 111A ERA

Settlement agreement negotiations are normally protected either by the without prejudice rule or under the provisions of section 111A of the ERA. Both of these rules prevent the existence and contents of negotiations from being disclosed in a Court or Tribunal.

Without prejudice protection will only apply in circumstances where there is an existing dispute between the parties such as a disputed disciplinary process or the threat of bringing a claim. Where there is an existing dispute the without prejudice rule steps in to protect conversations which are made in a genuine attempt to settle that dispute.

Provided the prerequisites for protection are in place, these rules mean that an employee cannot rely on the fact their employer has made a settlement offer as the foundation for bringing a Tribunal claim. Sometimes an employer will want to be able to rely on the offer in support of a costs application if the employee subsequently brings a Tribunal claim but is unsuccessful or is awarded less than the original offer made by the employer. In these circumstances, any offer should be marked: w ithout prejudice save as to costs .

It is also important for employer’s to protect their position when making settlement offers on a without prejudice basis to ensure that, if the financial sum is accepted, there is still scope to negotiate the written terms of the settlement agreement. For this reason, it is good practice to mark correspondence: w ithout prejudice and subject to contract to ensure that there is no binding contractual arrangement until all the terms are agreed and the settlement agreement signed.

Section 111A was inserted into the Employment Rights Act in 2013 in order to expand the circumstances in which settlement negotiations would be protected. While section 111A does not require there to be an existing dispute, it will only protect conversations where the employee’s recourse if dismissed would be a claim for unfair dismissal. If, for example, an employer needed to make redundancies for organisational reasons and wished to offer settlement agreements rather than going through the formal redundancy process, section 111A would protect such conversations.

If, however, a settlement offer were made in different circumstances, for example, where an employer wished to terminate the employment of an employee on long term sickness absence (but where there was no existing dispute) section 111A would not apply. 

This is because of the potential for a disability discrimination claim as well as an unfair dismissal claim in the event the employee’s employment is terminated. An employer in this situation would also not be able to rely on the without prejudice rule because there is no existing dispute. In a worst case scenario, an employee receiving an offer to terminate their employment in return for a settlement package in these circumstances could use the fact their employer had made an offer as the foundation of or part of a discrimination and/or constructive unfair dismissal claim.

An employer therefore needs to turn its mind to how and whether settlement discussions will be protected before making an opening offer. However, for drafting purposes it is good practice to label all correspondence and the agreement itself with both categories of protection: w ithout prejudice/ covered by section 111 of the Employment Rights Act 1996 .

Structuring payments

When making an offer of settlement an employer should consider the structure and tax implications of the payments it intends to make, and we will cover this more in our next article. The employee will have an interest in the payments being made in the most tax effective manner possible, and, for the employer, being able to maximise tax efficiency may assist with reaching an agreement.

Currently payments up to £30,000 paid as genuine compensation for the termination of employment may be paid free of tax. Any payments arising under the contract of employment, such as notice pay, are however taxable. Historically, it was common to try and wrap up taxable and non-taxable sums in single payments in order to present the entire sum as free of tax under a settlement agreement. The government has now legislated to prevent this kind of tax avoidance. Employers are now required to separate and tax sums paid for unspent periods of notice or ‘ post-employment notice pay’ (PENP) from ex- gratia sums which can be made tax free.

Coming next

Our next article in the Drafting Masterclass series will explore what are the key terms in settlement agreements and why they are needed.