Ensuring a clean break

A compromise agreement can be an effective way to settle any claims raised by an employee and safeguard against the individual pursuing any future claims. However, care must be taken in the way the agreements are written as a recent case has demonstrated.

What is a compromise agreement? It is one of only two mechanisms by which an employee can waive his statutory employment-related claims. The other requires the involvement of the advisory service Acas, which many employers prefer to avoid.

A compromise agreement is valid only if it satisfies five conditions:

  • It is in writing
  • It relates to ‘particular complaints’ or ‘particular proceedings’
  • The employee has received advice on the terms and effect of the agreement from a relevant independent adviser (usually a soli-citor), who is identified in the agreement
  • There is a contract of insurance covering the risk of the employee bringing a claim against the adviser in respect of their advice
  • The agreement states that the conditions regulating compromise agreements under the relevant legislation are satisfied.

These conditions look simple enough, but many employers fail to ensure they are satisfied.

It is normal for the employer to draft the compromise agreement, and to include a blanket clause settling all possible claims. However, care must be taken to ensure that the second condition is met. In the recent case of Hinton v University of East London (UEL), the Court of Appeal held that this condition requires employers to identify the specific claims contemplated by the parties, by referring to either a general description of the legal claim (for example, unfair dismissal) or the relevant section of the legislation (for example, section 94 Employment Rights Act 1996).

As UEL learned to its cost, a failure to be specific may enable an employee to pursue a claim, notwithstanding the original intention of the parties to settle everything.

Claims that have not been raised (such as unforeseen future claims) cannot be settled in a compromise agreement. This was emphasised in the case of Lunt v Merseyside TEC Limited. The same case also highlighted a common drafting error in compromise agreements: a failure to deal properly with the fifth condition.

Employers often remember to state that ‘the conditions set out in s203 Employment Rights Act 1996 are satisfied’, but neglect the corresponding provisions in other legislation such as the sex, race and disability discrimination statutes. Such a simple error can be disastrous, because it will allow the employee to pursue a claim that the parties had intended to settle.

By taking care when drafting a compromise agreement, and ensuring that all the circumstances have been considered, much can be done to minimise the risk of future disputes between the parties.

Preventing legal claims

A compromise agreement will not be effective for waiving claims that have not been raised. However, these claims can largely be dealt with by following some simple rules:

  • Include a general waiver of claims (past, present and future) and address specifics
  • Itemise (for example, by referring to the relevant legislative section), and waive claims that have been raised by the employee (‘particular complaints’)
  • As far as possible, itemise all other possible employment-related claims (‘other complaints’) separately
  • Require the employee to warrant that they have informed their adviser of all complaints arising out of, or in connection with, their employment and its termination and, on this basis, the adviser has advised that they have no claims other than the particular complaints, which are itemised and waived; and the employee does not believe they have or may have any other complaints. These warranties should flush out any further claims that the employee might have, which can then be included in the list of particular complaints
  • If there are some claims the employee is unwilling to waive (most commonly, claims in respect of personal injuries and accrued pension rights), state expressly that these claims are not being settled
  • Require the employee to repay sums paid under the compromise agreement if they bring, or continue, any legal proceedings (except those that have been expressly excluded from the waiver of claims). This will act as an important deterrent
  • Ask the employee’s adviser for written confirmation that the third and fourth conditions for a valid compromise agreement are satisfied and that, based on the information disclosed to the adviser by the employee, they consider that the employee has no claims other than the particular complaints. There is no legal requirement for the adviser to give this confirmation, but it is common practice to do so.

References and announcements

An employer is not generally obliged to provide a reference, but any reference supplied must be true, accurate and fair. Given that compromise agreements tend to arise out of contentious circumstances, the parties may have different views of what is ‘true, accurate and fair’, and this can result in later disputes, including claims of victimisation.

To avoid this, it is good practice to agree the substantive terms of a written reference (including a reason for the employee’s departure) and include this in the compromise agreement. Be wary of agreeing to a reference that paints a misleadingly good impression of the employee; this can lead to claims by new employers who rely on the reference to their detriment.

Both the employer and employee may feel sensitive about how the employee’s departure is communicated, internally to staff and externally to customers and others. Again, disputes and uncomfortable situations can be avoided, by agreeing an announcement as part of the compromise agreement.

New restrictions

A compromise agreement, under which substantial compensation is often payable, presents a good opportunity for the employer to impose restrictions on the employee’s future conduct. These restrictions might be in the form of traditional post-termination covenants (for example, preventing the solicitation of clients or employees), which must be drafted carefully to ensure they are enforceable.

Alternatively, they might restrict the employee from: disclosing the circumstances of his departure (except in the terms provided by an agreed announcement or reference); disclosing the existence or terms of the compromise agreement; or making disparaging statements about the employer or its staff.

To avoid jeopardising the tax treatment of the compensation payment, the employer should either make such restrictions reciprocal, or assign a reasonable sum as consideration for them, from which deductions of income tax and National Insurance contributions (NICs) should be made.

Tax implications

Often, the first 30,000 paid to an employee in connection with the termination of his employment can be paid without deduction of income tax or NICs (with the excess being subject to income tax). However, this is not always the case, and it is easy to get the tax treatment wrong. Common pitfalls are:

  • New restrictions – employers should pay separate consideration for an employee’s agreement to enter into new restrictions. Failure to do so can threaten the tax-free status of some or all of the compensation payment
  • Payment in lieu of notice – employers often pay employees in lieu of some, or all, of their notice period. If the employment contract contains a clause allowing the employer to make such a payment, or if the employer always pays in lieu of notice, then the payment will be treated as a contractual payment (like salary, bonuses and holiday pay), and will be subject to tax and NICs. It should, therefore, be separated from the compensation payment
  • Penalties – an employer will often provide that the compensation payment is repayable if the employee breaches any terms of the compromise agreement. Such a penalty is likely to give rise to a tax charge on some, or all, of the compensation payment, unless repayment is required only if the employee brings claims in breach of the waiver of claims and the compensation sum fairly reflects the value of those claims. So if there is a contractual payment (which is taxable in any event) link it to the penalty clause instead
  • Early signature – signing a compromise agreement far in advance of the termination date can threaten the tax-free status of the compensation payment. Another reason to avoid early signature is that this will enable the employer to ensure that all complaints up to the date of termination are covered.

An employer may seek an indemnity from the employee in respect of further liability for tax and employees’ NICs. However, it is unwise to rely exclusively on an indemnity to correct tax irregularities, because an indemnity is only as valuable as the depth of the individual’s pockets and can itself give rise to further tax complications.

Last but not least, don’t forget to:

  • Provide for the return of all company property. List any items of special concern. If the employee will be keeping any property, the conditions of transfer (and tax implications) should be clear
  • Require the employee to complete any paperwork to formalise their resignation from directorships and other offices (for example, trusteeships)
  • Protect group companies and associated employers (as well as staff and clients) by referring to them in the agreement
  • Mark the agreement ‘Without Prejudice and Subject to Contract’ to help to avoid the employee relying on your settlement discussions if negotiations break down.
  • If you follow these tips, you should be well on the way to ensuring that your compromise agreement does what you intend: ensure a clean break between the parties.

Emma Sanderson and Andrew Yule are solicitors in the employment team of Withers LLP

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