By: Daniel Wise
So said Gordon Brown in the immediate aftermath of the economic crisis that shook the City in October of last year. This sentiment has been echoed by the Treasury Committee’s report published on 15 May which stated that “bonus driven remuneration structures led to a lethal combination of reckless and excessive risk taking.” As the recession begins to deepen in the UK, unemployment continues to rise and city financiers lick their wounds following a record low bonus round this year, a web of employment law issues arise out of employer reaction to this paradigm shift in the financial markets.
Primary among these are issues as to the legality of City employers’ attempts to slash bonus awards or recoup payments already received, and how to shape the bonus elements of remuneration structures in senior level service contracts to reflect changes in the expectations of both employers and employees in an environment that has grown intolerant of the fat cat/big bonus City culture.
Bonus Litigation
Hundreds of staff members at Dresdner Kleinwort have lodged claims to recover tens of millions of pounds in unpaid bonuses resulting from the decision of its new owner, Commerzbank, to slash compensation payouts. A raft of similar claims are expected against other financial institutions as employers come under increased commercial pressure to reduce or eliminate bonus payments, particularly in circumstances where organisations are now effectively Government run.
Depending on the specific employer bonus structure, the legal ramifications of trimming such bonus payments may be significant. Many employers will have established contractual obligations to certain levels of bonus payment in recent years, either through custom and practice, or as a part of negotiated service agreements to attract particular stars in the financial community. For example, many banks in recent years have introduced a “Golden Hello” scheme to new joiners, guaranteeing a minimum level of bonus for all or a portion of their first bonus year, regardless of performance during that period. These payments are designed to compensate new recruits for the bonus they have lost leaving their previous employer midway through a bonus year. A refusal to honour such a contractual provision will almost certainly be unlawful.
Another common trend that has developed in the City in recent years has been to link bonuses to performance targets, creating an irreducible contractual entitlement once these personal performance targets are hit, irrespective of the bank’s overall performance. These targets are often short term, and often paid out in lump sum cash awards. Despite the current climate and the potential difficulties banks are now facing, if such bonuses are not paid in circumstances where performance targets have been hit, again the employee is likely to have a strong claim for the recovery of this sum.
Thus where banks have bowed to commercial pressure to reduce bonuses as a result of a disastrous bonus year and a pessimistic financial forecast for 2009, the Courts may well rule against them, given the case law in recent years in favour of an employee’s contractual entitlement to certain levels of bonus payment irrespective of the economic climate and/or the strength of the particular bank’s financial position.
When addressing the restructure of bonus schemes for future years, many UK employment lawyers caution against changing too much too quickly, although in the current economic climate many financial institutions will have no choice. For example, adoption of the recent FSA Code’s principles and replacing what was previously a contractual bonus structure with deferred bonus scheme, may cause wholesale team moves to competing institutions along with a raft of constructive unfair dismissal claims from departing employees arising out of the bank’s breach of its implied duty of trust and confidence. However, the financial landscape will also be a major factor in assessing the commercial risk of these claims being brought. If either the majority of other banks are unwilling to take on new recruits or are adopting similar schemes for their employees, there will be little practicable risk of this legal consequence.
Repaying a Bonus
The clarion call through both the press and in political circles for high-profile, senior-level executives to repay bonuses which have already been awarded also throws up some interesting issues for UK employment lawyers. One individual who bowed to public pressure and repaid a substantial bonus is Michael Fingleton, chief executive of Irish Nationwide, who in March of this year voluntarily returned his €1 million bonus awarded for 2008. In his statement to the press at the time. Mr. Fingleton was at pains to point out that the bonus was “a contractual and binding agreement... which [he] was legally entitled to receive….” His move came in response to both political and commercial pressure, rather than as a consequence of any legal obligation to do so. This is of course correct. In circumstances of this kind, particularly where payment of the bonus is pursuant to a contractual entitlement, any employer’s remedies against senior executives to compel repayment are limited, unless specific contractual provision has been made for this within the service agreement. In circumstances of alleged regulatory breach by a financial institution, employers are in a much weaker position in the UK than in the US, where the Sarbanes-Oxley Act of 2002 requires certain levels of senior executives to repay incentive based remuneration in specific instances of securities law breaches.
Making provision for a contractual term forcing repayment in these circumstances is now an issue that many UK banks are grappling with. The move to include such a term is not without its difficulties.
Firstly, the UK law on penalty clauses will cause such a contractual provision to be unenforceable if it provides for repayment of a bonus as a result of a breach of contract and the repayment is deemed to be a penalty. In determining this, a Court will consider whether the payment is a genuine pre-estimate of the loss suffered by the bank arising out of the breach or simply a penalty. If it is the latter, the clause will be unenforceable. However, case law on this subject suggests that where there is a bona fide attempt to pre-estimate loss, such a clause may be upheld, despite the fact that the figures differ from the actual loss caused.
Secondly, the purpose behind the clause must be to compensate the employer rather than to act as a deterrent. It is often the case in a financial context that breach by a senior executive could lead to substantial monetary losses, and in circumstances where such losses far exceed the amount required to be repaid by the director it will be easy for the employee to suggest the repayment was not to compensate the bank, but to act as a deterrent. Whilst it is possible to put together a sliding scale of repayment which is directly linked to loss flowing from the breach, persuading a senior executive to sign up to such a clause may well be an unsurpassable hurdle to any subsequent challenge.
Thirdly, proving that the breach occurred is often a practical difficulty in consequent litigation, particularly in the context of complex financial dealing structures where a Court is asked to determine the reasonableness of a decision arrived at based on complex assessments of commercial risk. This hurdle can often make such a clause unworkable.
An alternative approach to clauses of this kind is to avoid any linkage with a breach of contract by connecting a repayment obligation to external measures of some kind. These alternative contractual terms are commonly known as “no fault” repayment agreements. These provisions eliminate the risk of being struck down as a penalty clause, and can provide the employer with the ability to require repayment in various different circumstances, including when the bank itself has performed particularly badly in any given year. Whilst it is important that such clauses are drafted to ensure that sufficient clarity exists to allow them to be enforceable, other than this drafting hurdle such a clause can be relatively effective.
Employers generally have not previously used such clauses due to a concern that such a provision in a bank’s standard service agreement may deter strong senior executives from joining. However, depending on the mood of the general public going forward, both in the US and the UK, as well as an increased scarcity of positions at a senior level, banks may well find themselves in much stronger negotiating positions when drafting senior level service agreements.
Some of the suggested models for recovering all or a portion of a bonus already paid without linking this repayment request to contractual breach have been discussed in the context of clawback provisions which are also referred to in the FSA Code. The three common types of clause are as follows:
- Clawbacks due to over-estimated performance - Such a clause can be used when a bonus is linked directly to performance conditions or performance is one of the criteria taken into account when awarding a discretionary payment. The clawback provision will be operative where the performance criteria were initially thought to be satisfied but later turned out to have been overstated. This clause will be effective provided it is exercised objectively and reasonably.
- Clawbacks for negative developments - This provision is triggered by certain specified negative developments occurring within a set period after the bonus is paid. The negative development should be something which is not personally linked to the employee but rather an objective development such as the bank announcing a major loss.
- Clawbacks for unrecognised breach at the time of payments - This form of provision is not as safe legally given its close nexus to the penalty clause principle. However, case law suggests that such a clawback provision which becomes operative when an employer discovers serious breach by the employee (which occurred prior to payment of a bonus) may well be enforceable, and will not be struck down as an unenforceable penalty clause.
The extent to which some or all of these contractual measures will become commonplace will in a large part be shaped by global trends, and in particular the US’s reaction. Now that the world’s key financial centres are so closely aligned, it would be foolhardy to approach these sorts of issues as isolated domestic problems, and any reaction and/or solution will almost inevitably follow the tide of global opinion.
