Bonuses: Discretionary vs Contractual explained

Bonuses: To pay or not to pay? 

Podcast Transcript

In today's session, we're talking about whether to pay or not to pay in relation to bonuses. So we're discussing where bonuses are discretionary and where they're contractual and we're going to get to the bottom of why the distinction between the two is so important. 

Sometimes, obviously, an employer is not in a position to guarantee a bonus to its staff. Whether or not it can afford to pay or sees benefit in paying or for staff to receive a bonus will depend on a great number of factors, not least the performance of the business, the performance of the individual, and the company's own strategy for growth and retention. So for this reason, companies often seek to retain discretion over whether a bonus would be paid and if so, how much. This approach is obviously very appealing to many businesses because it means they can be more reactive to the needs of the business when deciding bonus payments and many contracts set out that a bonus is discretionary, but actually, this isn't necessarily always the case in practice, despite the wording of the contract. So in this session, we set out some key questions which you should be asking yourself if you're seeking to rely on the discretionary nature of a bonus. 

So firstly, Naomi, can you explain to us what is meant by a contractual bonus? 

Of course. If an employee can establish that a particular bonus entitlement is contractual, which means it's made pursuant to a binding promise, it's sufficiently certain and it's quantifiable, then they will be able to enforce it if they can show that any conditions for payments, which might be things like individual, team or company performance, have been met. If the bonus is contractual and the employer doesn't pay, the employee can bring a claim for breach of contract and the employer may have to pay the value of the bonus, as well as any costs incurred by the employee in bringing a claim which we’ll come on to discuss. Sometimes a bonus is said to be contractual in the employment contract. This makes finding a contractual right much more straightforward. However, more often than not, employment contracts state that any bonus is discretionary and Rose is going to explain that despite this wording, the bonus might still be contractual. When considering this question, the court will look to factors such as past payment of bonuses and any formulae that have been applied to calculate the amount. If this gives a pattern of bonus paying, which is sufficiently certain, formulaic, then it may give rise to a contractual right. So that explains a contractual bonus or non-discretionary bonus.

The next obvious question is … Rose please could you explain what a discretionary bonus is?

Yes, absolutely. So a genuinely discretionary bonus is one over which a company has some form of discretion over whether it's going to be paid or how much is going to be paid. The company is still at choice as to what those factors will be. Firstly, the company could retain discretion over whether a bonus is payable at all. It may be a decision that it's made year on year based on the profits of a company, and if they don't meet a particular level, then a bonus won't be paid at all. Alternatively, a company can retain its discretion as to how much is going to be paid or the parameters that are going to be used to calculate the payment. And sometimes a company would retain discretion over both whether a bonus is payable and how much is payable and on what basis. So it's clearly very appealing for businesses who perhaps don't have reliable cash flow year on year or who might be making large scale investment for expansion to keep the triggers for the payment of bonuses very flexible.

Furthermore, many businesses feel it's imperative to reassess how bonuses will be calculated year on year in order to ensure that bonuses are incentivising the right element within the business depending on what the current business needs dictate. They could be adapted, for example, to try and address dwindling sales figures or cultural issues within the company. The discretion could also attach to the timing or frequency of the payments, or whether any other conditions, such as minimum retention periods or claw back could be attached to it. So, Naomi, now understanding discretionary bonuses and with them allowing much more flexibility, surely there's an easy fix here.

Can we just refer to all bonuses as discretionary in the employment contract and consider ourselves covered?

Well, Rose, the short answer is no. Just because a bonus is said to be discretionary doesn't mean that it will be. A bonus entitlement may have developed contractual force because of past payments and/or the payment of bonuses to others. This comes back to the point about quantifiability and certainty of payment. So if an employee has been consistently rewarded with a bonus where certain KPIs are met (again this is usually about company and individual performance), where those KPIs are met again in future, that individual may have a contractual right to a bonus payment. And this is the case even if the bonus is expressed to be discretionary. Seeking to exercise discretion where the employee has a protected characteristic gives rise to another layer of risk. This is because it may open the door for an employee to claim that discretion has been exercised against them because of that protected characteristic. Obviously, this is going to be a very fact sensitive situation,. but let's take the example of an employee who has a disability just to illustrate the point. 

An employee with a disability

If an employee has a disability which impacts their performance and means that they cannot reach their KPIs, the company might decide in its discretion not to award that employee a bonus. However, if they didn't reach their KPIs because of that disability or something connected with it, they may have a claim for disability discrimination. With all of this in mind, we advise employers to be careful about exercising their discretion not to award a bonus to an employee, even if the scheme is said to be discretionary. This is because the employer payments and/or not paying could give rise to a claim for discrimination, as we've just discussed. Careful thought should go into assessing what is in the contract, what's happened historically, and what, if anything, an employee has been promised or has a reasonable expectation of receiving in terms of bonuses.

So, Rose, back to you for our final question.

If a bonus is genuinely discretionary, is an employer at absolute liberty to decide if and what to pay?

It's a very good question. If a bonus is genuinely discretionary because the conditions for contractual entitlement have not been met, this actually still isn't the end of the story. The employer may not always be able to withhold payment. There are limitations placed on the exercise of the employer's discretion with regard to bonus, and the duties can overlap and be summarised as 

• the duty to exercise their discretion honestly and in good faith, 
• the duty not to exercise discretion in an arbitrary, capricious or irrational way, and 
• the duty not to breach the implied term of trust and confidence that exists in employment contracts. 

Whether the employer has breached any of these duties is very contextually sensitive, and the law in this area is generally guided by previous case law, so it's all going to depend on the facts of the matter. But if a breach can be established, then the employer could be liable to make the payment of the full bonus to the employee, as well as covering their legal costs. 

Case Example (Braganza v BP Shipping)

A key case that has covered this point of needing to apply good faith when exercising discretion, though it doesn't relate specifically to bonuses, is the Braganza v BP Shipping case. It's a very sad case, but in very simple terms, if you're not familiar, a chief engineer on a BP oil tank disappeared from the ship whilst at sea. He had a death in service benefit which would have been paid to his family, but was subject to terms that it wouldn't be paid if he took his own life. When BP Shipping investigated, they actually concluded that Mr. Braganza had taken his own life and therefore didn't make a claim under the benefits scheme for the death in service benefit to his family. And Mr. Braganza’s widow appealed and said that BP hadn't reached its conclusion that Mr. Braganza had taken his own life in good faith, because it hadn't reached this decision based on rational reasoning. And it was found that a decision that an employee had committed suicide would not be rational or reasonable unless the employer had had it clearly in mind that suicide was such an improbability that cogent evidence would be required to form the positive opinion that it had taken place. Therefore, even with clear and careful contract drafting and a careful review of historical entitlements and any assurances or promises given, there will still be limits on how an employer can exercise its discretion. The discretionary bonus, therefore, certainly promises to offer a lot of flexibility, but in reality needs to be treated with a lot of caution.

Thanks so much for joining us. Listen out for our introduction to bonuses and benefits and our session on what to do in the event of a bonus dispute, both of which we will link below.

Thank you. 

You may be interested in our other podcast Bonus Disputes: What happens when things go wrong?