In the current economic climate, employee bonuses are regularly hitting the headlines. This article provides a useful recap on some of the legal issues surrounding bonuses and looks at the more recent decisions in this area.

How much discretion do employers really have?

It depends. The first place to look is the contract of employment.

It used to be the case that simply referring to a scheme within a contract could mean that it became a contractual right. However, the courts have developed their approach and have held that the key issue which dictates the level of employer discretion is in the scheme’s wording, rather then whether the scheme is contained within a contractual document. In the case of Midland Bank Plc v McCann, the Employment Tribunal held that a performance related pay scheme was discretionary, even though its terms were contained in contractual documents.

If the bonus scheme is expressly specified to be discretionary in all respects, then the employer can retain a discretion over whether to award a bonus and if so, the amount to award. However, an employer's discretion is fettered by various terms and rules which the courts have sought to imply over the years.

The inclusion of the word “discretionary” in describing the terms of a bonus scheme is in itself not definitive. In Small and others v (1) Boots Company Plc (2) Boots UK Limited, the Employment Appeal Tribunal held that where a bonus scheme uses the word “discretionary”, the Tribunal must look at all aspects of the bonus scheme in order to determine whether or not it is, in fact, discretionary. For example, the employer may retain discretion in how to calculate the bonus, how much to award, or in deciding whether to pay one or not. Simply using the word “discretionary” in the bonus documentation does not automatically render all aspects of the bonus wholly discretionary. In Clark v BET plc, the fact that an employee had complied with the terms of the bonus scheme in order to be entitled to a bonus meant that the employer had no option but to award a bonus - however, the employer still retained discretion over the amount to be awarded.

Furthermore, even where a bonus is drafted so as to be at the employer’s discretion, an employee may nevertheless be able to argue that they have become contractually entitled to receive a bonus by reason of custom and practice. This was the case in Noble Enterprises v Lieberum where the bonus scheme in question gave the employer discretion regarding implementation of the scheme from year to year. However, once the bonus year began, the employer’s discretion became limited. In this case, the bonus scheme had operated for 5 years. In the sixth year, the employer had neglected to inform its employees before the start of the bonus year that it did not intend carrying on with the scheme. As a result, the employees had a reasonable expectation of receiving a bonus at the end of the year and the Tribunal held that it was not within the employer’s discretion to terminate the scheme once the bonus year had begun.

How should employers exercise the discretion?

An employer's discretion must be exercised in a proper manner. In Clark v Nomura International Plc, the court held that an employer must exercise its discretion to award a bonus in good faith. In this case, a senior equities trader had earned the company £6 million and had been responsible for securing a deal which would earn the company a further £16 million in the near future. The employee bonus scheme at Nomura was expressed to be discretionary, based on individual performance. For the period in question, the employee did not receive a bonus, despite the earnings he had secured. However, his colleagues, who had earned the company less money during the same period, were awarded a bonus. The court described the employer’s actions as being “plainly perverse and irrational”. It did not matter that the employee had left and had no future with the company as this was not a criterion for a payout - the court found that the proper test to apply was whether or not a reasonable employer would have exercised its discretion in the same way. Note, though, that there is no duty imposed on the employer to “act reasonably” - it must only demonstrate that it undertook a meaningful and rational assessment of the employee’s entitlement to a bonus payment.

In Clark, it's worth bearing in mind that the court emphasised that because of the wording of the bonus clause in question, the fact that the employee had left the company was not relevant. This point was reinforced in McCarthy v McCarthy & Stone PLC where the court held that where an employee had satisfied the performance conditions set out in the company’s employee share option scheme, the employer no longer had discretion as to whether or not to pay the bonus, even though the employee had subsequently been found to be guilty of misconduct and dismissed. There would have had to be an express cause to this effect for such a condition to apply.

What about employees who leave the company - do they have a right to a bonus?

When an employee has been dismissed in breach of contract, they may nevertheless be entitled to a bonus payment, not only in relation to any entitlement which has already accrued, but also looking forward to what they would have received had they remained an employee during their notice period. If, however, the employment contract contains a pay in lieu of notice (or “PILON”) clause and the company relies on that clause in terminating the employment, then the terms of the PILON will usually determine whether or not a bonus payment should be included in the employee’s notice payment.

In Locke v Candy & Candy Ltd, the employee had been promised a substantial bonus if he remained in employment at a specified date. Before the payment date, his employer purported to exercise its right to terminate under a PILON clause, meaning that he was not in employment at the right time to trigger the bonus. The employee brought a claim arguing that the PILON clause simply said he would receive pay in lieu - therefore (he argued) pay in lieu should include the bonus he would have received had his employment not been terminated. The court held that although the PILON clause in the contract was ambiguous as to precisely what payments the employee would be entitled to receive, the employee nevertheless had no entitlement to receive a guaranteed bonus, for the simple reason that the contract clearly stated he had to be in employment (which he was not). The legacy of this case will be that when drafting a bonus scheme, the scheme rules should be clearly articulated in order for employers to benefit from any discretion they wish to maintain, and must be drafted consistently with the provisions of a clear PILON clause.

In Reda v Flag, a Privy Council case, two senior executives were dismissed by their employer, who subsequently implemented an employee share scheme for senior executives shortly after their departure. Even though the employees’ contracts contained a provision allowing the employers to terminate their employment at any stage and for any reason during their employment, the employees argued that the termination of their contracts was ultra vires (ie. it was not a proper exercise of their employer's powers) as it was simply an attempt by the employers to avoid having to grant them stock options under the scheme which amounted to a breach of the implied duty of trust and confidence. However, the Court did not agree. The employers, the Court found, did have the authority to dismiss the executives under the terms of their employment contracts for any reason, even if they were motivated by a desire to remove their entitlement to share options. Reda therefore demonstrates that careful contract drafting is key, as (at least in the view of this court) an express contractual term will overrule an implied one. While not binding on the UK Courts (as the case was a Bermudan one), it will nevertheless be influential and provides useful ammunition to an employer wanting to argue the point.