31 October 2022

Settlement Agreements For Employers – A Complete Guide

Waterfront Solicitors LLP


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Many employers use settlement agreements regularly, whilst others may be new to them and wondering how they can be helpful when managing a workforce. Our specialist employment & HR lawyers...
UK Employment and HR
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Many employers use settlement agreements regularly, whilst others may be new to them and wondering how they can be helpful when managing a workforce. Our specialist employment & HR lawyers advise clients of all sizes and we have years of experience which we can share with you to help you get the outcome you want. We hope that this guide answers all the most commonly asked questions and we look forward to hearing from you if we can assist further.

  1. What is a settlement agreement?
  2. Why might an employer want to use a settlement agreement?
  3. What are the advantages of a settlement agreement?
  4. What are the disadvantages of a settlement agreement?
  5. How much could it cost?
  6. How much should I offer the employee?
  7. What does "without prejudice and subject to contract" mean?
  8. What are "protected conversations"?
  9. Can I pay the severance package tax-free?
  10. How long will it take?
  11. What are my options if the employee does not comply with the terms of the settlement agreement?
  12. What happens when I come to Waterfront for advice?
  1. What is a settlement agreement?

Essentially, it's a written contract between an employee and employer (they used to be called compromise agreements until 2013 when the government changed their name).

In most cases, the agreement will set out the terms on which the employment relationship will come to an end, although they are sometimes used after employment has ended too.

The key terms will be that the employee is paid a sum of money and in return, they agree to waive their right to claim anything further from the business.

There will also be non-financial terms such as confidentiality and an agreement that the parties will not bad-mouth each other. The idea is that a line is drawn under the relationship and everyone moves on.

A settlement agreement can be a really useful and beneficial tool for a business. If you are considering a redundancy, if you have concerns about an employee's suitability or if they have raised complaints then you should be thinking about a settlement agreement as one of the options available to you. In many cases, it won't be the right option, but it's nearly always worth considering.

  1. Why might an employer want to use a settlement agreement?

There are probably three main scenarios in which a business might want to use a settlement agreement.

  1. A redundancy situation. If you want to shortcut the usual redundancy consultation process and just agree on exit terms with your employee, then you will need a settlement agreement. This is particularly common with senior employees but we see it at all levels. Alternatively, it may be that you want to offer an enhanced redundancy package to support your employee as they move on, but you want the finality which a settlement agreement offers, in particular, the reassurance that the individual will not seek to claim more from you.
  2. Where you have performance or conduct concerns. Managing performance can be time-consuming and an unattractive prospect for all involved, so a mutual agreement to end the relationship can work well for both employer and employee. Even if you are considering dismissing an employee for their underperformance or misconduct, that dismissal will come with the risk of an unfair dismissal claim (if they have at least two years' continuous service with you) or potentially another type of claim, such as discrimination. A settlement agreement gives you the comfort that no such claim will follow.
  3. Where an employee has raised a grievance or some allegations of wrongdoing. In addition to investigating and resolving their complaint – or as an alternative – it can make sense to talk about settlement. Often the employee will prefer to move on from the business rather than work with you to resolve matters.
  1. What are the advantages of a settlement agreement?

There are numerous benefits for an employer. As set out above, you get the finality of knowing that the relationship is over and you are not going to face any (further) legal challenges from the employee, so you can focus on your business and remaining workforce.

In addition, you can agree on non-financial terms which benefit and protect your business. Here is a non-exhaustive list:

  • A handover of the work carried out by the employee.
  • The return of company property.
  • A requirement that the employee keeps your company's affairs and the severance package confidential.
  • A prohibition on the employee bad-mouthing you and your people, which can be a risk, particularly on social media or websites such as Glassdoor.
  • The addition – or re-affirmation – of post-termination restrictions which prevent (for a defined period) the departing employee from carrying out competitive activities such as soliciting the business of your clients.
  • A reasonable assistance clause provides that the employee will give evidence after they have left you in any court proceedings or regulatory investigation in the event that their witness evidence might be useful.
  • A tax indemnity which sets out that the employee will bear the cost if the tax-free status of a payment is challenged by the tax authorities.
  • An agreed announcement – both internal and to clients – about the employee's departure.
  1. What are the disadvantages of a settlement agreement?

Because the employee has to take legal advice in order for a waiver of their claims to be legally binding, you may find that they are more aware of their legal rights and options than before. This can mean that the employee or their lawyer negotiates hard or even walks away from discussions to bring a claim. However, this is a risk you need to balance when deciding if making an offer is the right option for you.

Sometimes employers will ask us "Why am I insisting that my employee takes legal advice on their right to sue me (and why I am paying for it too)?" That's a valid question but, as set out above, there can be huge advantages to using a settlement agreement and, in the right cases, we recommend them to employers regularly.

It's also possible that offering a settlement agreement will have the effect of showing your hand or your intentions to the employee. For example, in some cases, your offer might be interpreted as evidence that you no longer want to work with that person. Nevertheless, this risk is usually manageable and acceptable, particularly if the offer is put in the right way.

  1. How much could it cost?

There are really three costs you need to account for:

  1. The cost of the severance package you want to agree. This will include elements that the employee is entitled to anyway when their employment ends, such as holiday and notice pay, but also an ex-gratia or compensatory payment for entering into the agreement and waiving their legal rights. The amount of this "ex-gratia" sum is discussed below.
  2. The cost of the employee taking legal advice. The law protects employees by saying that the waiver of an employee's (potentially valuable) statutory rights is valid only if they have taken independent legal advice before signing. For this reason, it is customary for the employer to pay for, or at least contribute towards the employee's legal advice. £500 plus VAT is common but it can be more depending on the relevant background and the complexity of the situation.
  3. Your own legal fees. Unless you are experienced in this area, it pays to take advice on your options and have a specialist draw up the required paperwork. An experienced employment solicitor will also be really helpful in any negotiations which take place.

The above amounts can add up but they have to be weighed against the alternatives, which could be the risk of a costly Employment Tribunal claim or just the continuation of a relationship which is expensive and not working well. In cases where someone is no longer right for the business, most decision-makers and HR professionals see the settlement agreement route as some short-term cost in return for a greater long-term gain.

  1. How much should I offer the employee?

The answer to this question can vary hugely from case to case – but it is likely to depend on your negotiating position and the alternatives available to both parties if an agreement isn't reached.

To demonstrate the point further, here are two examples.

First, let's say you are making redundancies and are confident you have followed a fair process, so the risk of a claim is low. If you want to offer some financial support simply as a gesture of goodwill as your employees leave then a relatively modest amount of a few weeks pay might be appropriate unless you want to be more generous than that.

A second and much different scenario would be where you are proposing exit terms but you don't have a fair reason for the employee's dismissal in the event that you are unable to reach an agreement. Where an employee has at least two years' continuous service, you need to identify one of five potentially fair reasons for a unilateral dismissal: capability (which includes both performance and ill health), conduct, redundancy, contravention of a legal obligation or some other substantial reason. If you do not have one of these options available to you then you would probably have to consider a compensatory payment of several months' pay.

Other factors could include industry norms, the seniority of the employee and the parties' appetite for an agreement or exit.

You should also bear in mind that you might be able to pay up to £30,000 to the employee without any deductions for income tax and national insurance contributions (see below). This tax exemption can be helpful in facilitating settlement because some of what you spend will go to the employee without the usual statutory deductions.

  1. What does "without prejudice and subject to contract" mean?

In the course of a dispute, it is common for the parties to attempt resolution by talking on a "without prejudice" basis. It means that the correspondence or a record of any conversations will not be seen by the Court or the Employment Tribunal, which means both sides can talk about making concessions without prejudicing their cases if talks fail and a judge is asked to decide the case instead.

In essence, it allows us to talk "off the record" so that whatever is discussed is not used as evidence against either party in the dispute.

If we are not discussing matters on a "without prejudice" basis, we are usually talking on an "open" basis.

"Subject to contract" means that whatever we discuss or agree in principle is subject to the parties formalising it in a written contract. It avoids the risk of the parties agreeing terms during the course of their discussions because even if a consensus is reached, it will not be binding until a contract – i.e. the settlement agreement – has been agreed and signed.

As an example, let's say you are taking disciplinary action against an employee and you are considering his dismissal. On an open basis your position is likely to be that you are entitled to dismiss him. However, on a without prejudice and subject to contract basis, you may want to offer him a severance package to see if his exit from the business can be agreed, instead of making a dismissal. There could be a number of advantages to this option (see question 3 above) and it would mean that the risk of claim is removed.

If you are unable to reach an agreement and go on to dismiss him then you would not want the concession you made and any following discussions to be seen by an Employment Tribunal in any subsequent claim. It could suggest that you did not feel able to dismiss him fairly. Accordingly, such offers are made on a without prejudice basis and/or subject to the protected conversations regime (see below).

  1. What are "protected conversations"?

The rules on protected conversations – found in section 111A of the Employment Rights Act 1996 – are effectively an extension of the rules relating to without prejudice discussions (see above).

For a discussion to be without prejudice there needs to be a pre-existing dispute which is often not the case when an employer wants to discuss exit terms with an employee. Section 111A applies in a similar way to the without prejudice regime by making settlement discussions off the record for the purposes of unfair dismissal claims, but even if there is no pre-existing dispute.

The protection does not apply to claims other than unfair dismissal (such as discrimination) or if there has been "improper behaviour", which could include an employer putting undue pressure on an employee to accept or saying that they will be dismissed if they don't.

  1. Can I pay the severance package tax-free?

It's important to take specialist advice on tax but in general terms:

  • pay, bonuses, notice pay and holiday pay are all taxable; and
  • non-contractual or ex-gratia compensation for loss of employment can be paid tax-free up to £30,000.

Statutory redundancy payments are also tax-free but count towards the £30,000 limit.

  1. How long will it take?

Like any agreement or contract, it depends on how long it takes to take for both parties to agree.

It's quite possible that a settlement agreement could be offered and agreed upon within a week, although it's important to note that best practice is to allow the employee at least 10 calendar days to think about your offer. Even if both parties want to conclude matters quickly, the employee has to take independent legal advice so it's unlikely to happen the same day or overnight given the need to arrange an appointment with a solicitor.

Sometimes settlement agreements can take several weeks or even months to conclude, but these cases are relatively rare. The idea is that the parties reach a mutual resolution as an alternative to the potentially more long-winded options available. In most situations, the parties and their advisers are all keen to see if an agreement can be reached promptly.

  1. What are my options if the employee does not comply with the terms of the settlement agreement?

You may have a viable claim for breach of contract. Depending on how the agreement is drafted you may also be able to not pay the agreed sums (or recoup them if you have already paid them) and look to the employee for the reimbursement of the losses caused to you by their actions.

  1. What happens when I come to Waterfront for advice?

We offer a free initial chat for all potential new clients, so please do give us a call in confidence to see how we can help. We're happy to talk you through your options and our costs on a no-obligation basis.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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