Global menu

Our global pages

Close

Awarding bonuses in financial institutions

  • United Kingdom
  • Other
  • Financial institutions

13-02-2018

Bonuses form a key part of a senior employee’s remuneration package in financial institutions (FIs). We consider here some of the legal and regulatory constraints which come into play when making variable pay awards.

In this article, the terms ‘variable pay’ and bonus are used interchangeably although the European Banking Authority (EBA) definition of variable pay encompasses more forms of pay than simply bonuses.

Bonuses: common law issues

Contractual bonuses

Bonuses can be contractual or discretionary; most commonly, employees have a contractual right to be paid a bonus but the amount is stated to be subject to the exercise of discretion (‘partial discretion’).

Where a bonus is wholly contractual, it is important that the rules of the bonus scheme are very carefully drafted so as to exclude the possibility of any ambiguity. The terms should state that pre-contractual discussions and other oral representations are not binding and that terms can only be agreed or varied in writing.

A contractual bonus will be enforceable by an employee without the need to consider whether the employer was acting irrationally or perversely (see below) when exercising its discretion. In Khatri v Cooperatieve Centrale Raiffisen-Boerenleennbank [2010] the Court of Appeal held that where Mr Khatri’s terms of employment set out a clear formula for calculating a performance-related bonus his employer could not unilaterally replace that scheme with a purely discretionary based scheme by giving him a letter containing new terms (which Mr Khatri refused to sign).

A clear statement to staff can also form a contractual obligation. In Attrill and others v Dresdner Kleinwort Ltd and Commerzbank AG [2010] the terms of a bonus scheme provided that employees would be considered for a discretionary annual bonus. Dresdner announced a guaranteed minimum bonus pool of EUR400 million to staff. Subsequently, Commerzbank (which took over Dresdner) advised staff that individual bonus awards now contained a material adverse change clause, the awards were provisional and bonuses had been reduced by 90%. The employees successfully argued that the announcement of the bonus pool was a contractually binding commitment from which Commerzbank could not resile. The terms were clear and unequivocal, sufficiently certain and the facts showed that there had been an intention to create legal relations.

Notice periods

Employers who want to avoid paying a bonus to an employee during a period of notice must state this clearly in the bonus scheme terms. In Rutherford v Seymour Price Ltd [2010] the High Court rejected an employer’s argument that a term should be implied into a bonus scheme that in order to be considered for an award under the bonus scheme Mr Rutherford had to be employed and not under notice at the date of payment.

Discretionary bonuses

The exercise of employer discretion has prompted most litigation.

An employer must take care not to make representations as to an expected level of bonus since this may give rise to a contractual entitlement despite any discretionary wording.

Further, there are limits to an employer’s exercise of its discretion when deciding quantum.

In Clark v BET [1997] Mr Clark was entitled to participate in a bonus scheme which would provide an award of up to 60% of basic salary. The High Court held that BET should not have made a nil award of bonus in light of Mr Clark’s good performance and more generous awards to comparators (and awards given to Mr Clark in previous years). The employer was under a duty not to act capriciously or in bad faith by not awarding a pay rise.

An employer should also note that:

  • simply using the word ‘discretionary’ may not suffice (Small v Boots Company plc [2008]) as all relevant circumstances will be taken into consideration in determining whether there are contractual elements
  • even if a scheme is stated to be discretionary, an implied right to a bonus may arise by way of custom and practice

When exercising discretion an employer must take care to:

  • reach a decision in good faith
  • not act capriciously, arbitrarily or irrationally (Clark v Nomura [2000])
  • not breach the implied term of trust and confidence (Attrill v Dresdner Kleinwort and Commerzbank [2010] and Transco plc v O’Brien [2002])

In Clark v Nomura [2000] the High Court held that an award of nil bonus when Mr Clark had earned substantial profits was plainly perverse and irrational. The decision to make that award was one which no reasonable employer would have reached when exercising its discretion. In Commerzbank v Keen [2006] the Court of Appeal clarified that the employer did not need to show it had acted reasonably but that the exercise of its discretion was not irrational or perverse – this is a high threshold.

Constructive Dismissal

What about an employee who would have been eligible for a discretionary bonus but claims constructive dismissal before the bonus is determined? In Horkulak v Cantor Fitzgerald [2004] the Court of Appeal held that an award of damages for constructive dismissal should be assessed on what the court decided would be a likely outcome of a fair and rational exercise of discretion in respect of a discretionary bonus.

An employee may also be able to argue that an implied term of the contract is that an employer cannot terminate the employee’s employment in order to avoid paying a bonus (Takacs v Barclays Services Limited [2006]).

Wednesbury ‘reasonableness’

The scope for challenging the exercise of discretion in the decision-making process may have widened as a result of the Supreme Court’s decision in Braganza v BP Shipping [2015]. In this case (unrelated to bonuses) the Supreme Court held that an employer’s decision not to pay death in service benefit to a deceased employee’s widow (because the employee had committed suicide) was ‘unreasonable’ in the Wednesbury sense (the public law concept of reasonableness which allows the Court to consider the process by which a decision was reached, not simply the outcome).

This decision was tested in Paturel v DB Services [2015] although Mr Paturel failed to persuade the Court on the facts in his case that an award of one per cent of profits was one that no reasonable employer would have reached.

Financial services firms and risk adjustment

FIs and listed companies have separate obligations to include performance adjustment provisions for variable pay (including bonus) schemes. In broad terms, variable remuneration includes payments which are not pre-determined, are discretionary and conditional on certain factors.

The remuneration requirements for FIs are contained in the six remuneration codes (the Codes) in the FCA Handbook and the PRA Rulebook, subject to relaxed rules for staff who satisfy a ‘de minimis’ concession. Firms must also ensure that their variable pay arrangements are compliant with the EBA final guidelines on sound remuneration policies 2015.

The Codes are applied proportionately according to a firm’s size and other factors.

The principal requirements of all the Codes are:

  • At least 40% of a bonus must be deferred over a period of at least three years. At least 60% must be deferred for the most senior management (for firms subject to SYSC 19A and SYSC 19D only) or when an individual’s bonus is a particularly high amount.
  • At least 50% of a bonus must be made in shares, share-linked instruments or other equivalent non-cash instruments (or units of shares of the alternative investment fund for firms subject to SYSC 19B or units or shares of the UCITS, equivalent ownership interests in the UCITS, share-linked instruments relating to the UCITS concerned, or equivalent non-cash instruments with equally effective incentives). These shares or instruments should be subject to an appropriate retention period.
  • Guarantees should only be given in exceptional circumstances to new hires for the first year of service.
  • Senior management should adopt and periodically review the general principles of their firm’s remuneration policies and ensure their implementation as well as disclosure of details of their firm’s remuneration policies at least annually.
  • Variable remuneration must be risk-adjusted and performance must be assessed by reference to financial and non-financial factors and based on the performance of the individual, business unit concerned and the overall results of the firm.
  • Any variable remuneration, including a deferred portion, should be paid or vest only if it is sustainable according to the financial situation of the firm as a whole, and justified on the basis of the performance of the firm, the business unit and the individual concerned.
  • Under the Financial Services Act 2010 contractual provisions that breach the remuneration codes can be rendered void in certain circumstances.

Issues for financial services firms

When considering whether a decision to award a bonus is perverse or irrational, can a FI justify a low or nil bonus? A firm will still need to consider the terms of the scheme and abide by case law. Compliance with the relevant remuneration code in itself will not be sufficient to ensure that other legal requirements are satisfied.

When drafting the terms of a variable pay (or bonus) award an employer will need to ensure that a bonus scheme is robustly drafted so as to comply with regulatory requirements (e.g. on deferral, malus and clawback and bonus cap) whilst also reserving sufficient discretion to the employer to pay a nil or low bonus when appropriate. Recent press reports suggest that the failed facilities management and construction giant Carillion had relaxed the clawback conditions that applied to bonuses, removing ‘corporate failure’ as a clawback/malus event, thereby limiting the conditions under which variable pay could be clawed back. FIs would be in breach of the remuneration codes if they attempted such a change.

Regulated FIs must ensure that clawback provisions are expressly authorised by an employee to comply with section 15 Employment Rights Act 1996 (unlawful deductions from wages) as a bonus falls within the definition of ‘wages’ for these purposes.

Practical pointers

Drafting a bonus scheme

  • Ensure that the terms of any bonus scheme are clearly and unambiguously drafted and that no unintended oral/written representations are made as to possible quantum of award
  • Set out malus and clawback provisions in plain terms, identifying the triggers, clarifying how long performance adjustment applies for and how much is recoverable (and whether the sum should be gross or net of tax and any social security contributions1)
  • Consider whether an employee should complete a full year of service before being eligible to participate in the firm’s bonus scheme
  • Make sure that the employer’s discretion when deciding a bonus award is clear and, where appropriate, unfettered

Employment documentation

  • Ensure that all documentation referring to bonuses is consistent: policy/offer letters and contracts/ invitation letters/ plan rules/ award documents/ general communications/ intranet sites/ remuneration policy
  • State in employment documentation that a bonus will only be paid while the employee is employed and not serving notice, on garden leave or under suspension or investigation
  • State that the contractual terms override any prior discussions, agreements or arrangements and that any oral representations are not binding
  • Ensure that any clawback provisions are expressly authorised by the employee. Consent can be express or implied but beware the risk of an unlawful deduction from wages claim if there is no consent. Written consent is the safest option

Policies

  • Ensure that there is a clear policy on performance adjustment for employees and a more detailed policy for Compliance/ HR. The policy should set out guidelines as to what factors should be taken into account in assessing the level of reduction

Performance risk adjustment: malus and clawback

  • Implement a malus and clawback policy
  • Ensure that a proportionate approach is adopted when applying malus to no-fault scenarios
  • Apply malus and clawback rules consistently across the firm to minimise the risk of challenge
  • Ensure that clawback provisions are carefully drafted so as not to fall foul of the penalty doctrine
  • Consider whether performance adjustment applies to the class of employee under review

Making a bonus award

  • Maintain clear records when exercising discretion explaining the reasons for a bonus award (particularly when the award is expected to be low)
  • Consider all relevant matters and no irrelevant matters when exercising discretion and when deciding whether to apply clawback
  • Avoid making statements that could create a contractual expectation to a certain level of bonus

Suspension

  • On a suspension, immediately consider what impact there might be on the payment of bonuses/ vesting of share awards. Is there a right to suspend vesting pending the outcome of the investigation?
  • If there is no such provision, attempt to agree with an employee on suspension that determination of a bonus award be delayed until determination of the disciplinary outcome. Check the malus rules in any LTIP rules to see if they are of assistance
  • Freeze current year and deferred awards when an investigation is ongoing. Note the FCA’s guidance that variable remuneration should be frozen pending the conclusion of an internal or external investigation

1 HMRC has published guidance in the Employment Income Manual setting out its views on the availability of tax relief for ‘negative taxable earnings’. Where an employee must repay a bonus by way of clawback, the sum repaid constitutes negative taxable earnings and the individual may claim income tax relief (but not NICs) for the repayment

For more information contact

< Go back

Subscribe to e-briefings