How discretionary is a ‘discretionary’ bonus?

This is a topic that draws into particular focus at this point in the year, as bonuses are often paid around this time, after the close of the fiscal year. For some employees, especially those in the re/insurance sector, bonuses and other variable compensation (such as stock options) will form a substantial proportion of their annual remuneration. As such, this area is ripe for grievances and legal claims from employees who are disgruntled with their treatment and employers need to be particularly mindful of their obligations.

It will sometimes be the case that the mechanism for calculating an employee’s bonus entitlement will be set out explicitly in writing, either as part of their employment contract or in a separate bonus plan document or side letter. In this case, any failure by the employer to follow the express agreement between the parties will result in a right for the employee to claim damages for breach of contract. Of course, the correct interpretation of the contractual wording may be open to dispute, in which case the employer would be advised to seek legal advice before finalising the employee’s bonus allocation.

Often, though, the employee’s contract will state that the employer has discretion to set the bonus, either absolute (i.e. the payment of any bonus is completely at the employee’s discretion) or partial (i.e. the employee is entitled to be considered for an annual bonus, but the employer has discretion to determine its quantum). In such cases, it would seem that the employee would not have any basis to bring a claim if the employer chooses to exercise that discretion to award a bonus which is lower than the employee believes is justified. However, through the English case law in this area, some limitations on the exercise of the employer’s discretion have been developed.

The legal principles derived from those cases overlap, but can be summarised as duties on the employer:

• to exercise discretion honestly and in good faith;
• to not exercise discretion in an arbitrary, capricious or irrational way;
• to not exercise discretion in a manner that breaches the mutual ‘trust and confidence’ implied into all employment relationships.

The key case on the principle of ‘rationality’ in this context concerned an equities trader who had a contract which provided for a discretionary bonus based on his individual performance. He had earned profits in excess of £5+ million in the months before his dismissal and had also been responsible for a deal that would produce a further £15+ million. Despite this, he received no bonus, whereas all other traders received substantial bonuses (including one who made a loss). The Court held that a decision would be irrational if no reasonable employer would have decided to exercised its discretion in that way. On that basis, it found that the employer’s decision not to award the employee a bonus was plainly perverse and irrational.

In an attempt to avoid this result, bonus clauses will often provide that the employee is only entitled to receive a bonus where they are still employed and not under notice as at the bonus payment date. The case law generally supports the enforceability of this approach and so it would be prudent for employers to include this type of wording in their contracts.

However, the High Court suggested in the case of In Takacs v Barclays Services Jersey Ltd [2006] IRLR 877, that an employee may be able to succeed with a claim that there is an implied term preventing an employer from terminating an employee’s employment in order to avoid paying them a bonus. Although the case was settled without a final determination, this has cast some doubt on an employer’s ability to rely on a contractual right to terminate if their intent is to deprive the employee of an accrued bonus.

An employer’s discretion could also be restricted by virtue of its previous custom and practice. Even if a bonus is stated to be discretionary, if the employer has paid bonuses in a consistent manner over a period of years there is a risk that an employee may succeed with a claim that the right to a bonus has become an implied term of their contact.

This is a particular risk where the employer has recorded the basis for calculating bonuses in a written document, such as an incentive policy. While that written document may state that its terms are non-contractual and may be varied by the employer, if bonuses have been paid out consistently in accordance with its terms then there is risk that it may become part of the employment contract.

Employers with a written non-contractual bonus scheme would therefore be well-advised to take steps to protect its discretionary status, for example by regularly re-iterating the non-contractual nature of the scheme, periodically varying its terms, and applying a degree of judgement in determining individual allocations rather than rigidly following the written criteria.

The points discussed in this article are just a selection of the legal issues that impact an employer’s discretion in determining their employees’ bonuses. To discuss these issues in more detail please contact Bradley Houlston ([email protected]), the head of Appleby’s employment law practice.