Practical steps for employers to reduce the risk that discretionary benefits become contractual by custom and practice

It is tempting, when seeing the words ‘any bonus payment shall be at the company's absolute discretion’ in an employment contract to think that the employer's discretion will in fact be 'absolute'. As usual though, when the law is involved, things are not quite so straightforward.

When an employer exercises a discretion set out in a contract to determine a bonus, they must:

  1. act rationally – ie, an employer must not determine a bonus that no reasonable employer would have determined in all of the circumstances; and

  2. not take into account irrelevant factors or fail to take into account relevant factors in determining the bonus.

The second of these requirements reflect a recent decision of the UK Supreme Court: Braganza v BP Shipping. If an employer does not satisfy these requirements, there is a risk that an employee could successfully claim for a higher bonus from a court or tribunal, and even claim that the employer's conduct gave the employee grounds to claim they had been constructively dismissed.

Risky areas

Some examples of where employers might be held to fall short of the requirements are:

  1. If a contract states that a bonus payment is 'discretionary based on the individual's performance', basing the decision as to pay the bonus payment on factors other than individual performance (eg company-wide performance).

  2. A manager determining to pay a low bonus solely because of a personal dispute between the manager and the employee.

  3. Paying no bonus when the employee was in employment for the full year, performed at a level that would otherwise normally justify a bonus, but was not in employment at the time the bonus was paid (and the contract did not expressly state that no bonus would be payable in those circumstance).

The employer's obligations, however, only go so far. Where the employer can point to some plausible reason for a particular bonus award, and the language of the bonus scheme does not prevent the employer from having regard to that reason, it is in practice a high bar for an employee to establish that a bonus award is unlawful. That said, future legal challenges alleging that irrelevant factors have been considered (or relevant factors ignored) are to be expected.

Reducing risks

Some practical points to consider to help reduce risk in this area:

  1. Include in the employment contract that any bonus is at the employer's absolute discretion (as the practice of paying bonuses itself could otherwise create a complete contractual right to bonuses with no latitude at all for employer discretion).

  2. State expressly that the company can determine not to pay a bonus if the employee is no longer employed or under notice of termination (given by the other party) before the payment date.

  3. Where a bonus scheme describes how a bonus will be calculated, include in the scheme documentation that a bonus payment can still be varied or not paid in the company's absolute discretion, including without limitation for reasons such as personal performance, overall group or company performance, personal misconduct etc.

  4. If no or a very low bonus will be paid, consider documenting the reasons for this and providing the employee an opportunity to comment. Take care, however, that you do not indirectly create other legal risks (eg of a discrimination claim).

  5. Ensure that all communications about the bonus scheme are consistent with it only being a discretionary scheme.

Peter Frost is a partner and Paul Young a senior associate at Herbert Smith Freehills