Small businesses want to incentivise employees to work hard and create value for the company in the same way as larger businesses. One of the most common types of incentive offered to employees is a ‘discretionary’ bonus scheme, typically to be considered at year end and paid out in the first quarter of the following year. It is rare for smaller employers to put in place complex and detailed bonus schemes.
The key question with a discretionary bonus scheme is how that discretion needs to be exercised.
Discretionary bonus schemes will often say that a bonus is payable ‘entirely at the employer’s discretion’. In practice, however, labelling a bonus scheme as ‘discretionary’ will not prevent it from having some form of contractual effect. This was illustrated in a recent case, where the tribunal held that the word ‘discretionary’ may relate to a number of things such as:
- the decision to pay a bonus;
- how to calculate a bonus; or
- the amount of a bonus.
Courts and tribunals will not therefore rely entirely on the wording of the scheme but will consider a variety of factors when assessing the extent of an employer’s discretion.
Where an employer has paid bonuses under a discretionary scheme for several years, an employee may argue that they have an implied contractual right to receive a bonus by reason of custom and practice. Employers need to be aware that all relevant circumstances, including past practices, are likely to be considered when assessing an employee’s possible entitlement.
Qualifying for a bonus
Some discretionary bonus schemes provide that employees need to satisfy certain conditions to qualify for a bonus, such as individual performance targets. It follows that if an employee meets the specified conditions, the employer will pay a bonus but will have discretion as to the amount. Alternatively, an employer may wish to retain absolute discretion over whether to pay a bonus and the amount, in which case the documents referring to the scheme should be drafted clearly to reflect this.
Whether the employer’s discretion is partial or absolute, their discretion is affected by the legal duty not to act irrationally or perversely. The case of Clark v Nomura International plc established that an employer will be in breach of contract if it exercises its discretion in a way that no reasonable employer would have done. Employers therefore have to exercise their discretion in a way that is not capricious or in bad faith in order to ensure that they preserve the relationship of trust and confidence with employees.
The question often arises whether a departing employee is entitled to receive a bonus payment during their notice period. An employer may wish to stipulate that a bonus payment is conditional on an employee being in employment and not serving notice. Often, an employer will want an employee to stop working immediately and will reserve the right to make a payment in lieu of notice (PILON) in the contract of employment. A PILON clause should clearly specify whether or not an employee will be entitled to benefits and bonus payments in addition to their basic salary. Without a properly drafted PILON, an employee would be entitled to claim for loss of bonus if their employment is terminated in breach of contract (ie without notice).
In the recent case of Locke v Candy and Candy Limited Mr Locke was entitled to a discretionary bonus and a guaranteed bonus, but expressly subject to him being employed at the time. Mr Locke was dismissed and his employer paid him his basic salary in reliance on the PILON clause. Mr Locke argued that he should have received both his salary and bonus that would have been due if he had been employed during his notice period. The Court of Appeal found in favour of the employer as the bonus clause stipulated he had to be employed at the time. The case acts as an important reminder that employers should make it clear which payments fall due if a PILON clause is exercised.
Employers also need to remember that in exercising discretion under a contract of employment they should not take into account matters that could amount to discrimination under the Equality Act. Protected characteristics that might be relevant include sex, age and disability. The employer also needs to consider how bonuses are applied to part-time and fixed-term employees. A woman’s right to receive a bonus during maternity leave is one of the most complex areas of employment law and specific advice should be taken on this issue.
Small businesses must therefore exercise caution when exercising their discretion to pay a bonus and should be aware of the limitations outlined above. Clear drafting of contracts of employment and bonus schemes is essential and employers should ensure that discretionary schemes are operated fairly and consistently to avoid claims arising.