An effective bonus cap
The recent Court of Appeal case of GX Networks Limited v Greenland shows how important it is for employers to have effective capping arrangements in incentive plans and also to use them correctly.
Runaway sales, whether the result of successful marketing activity or just benign market conditions, can result in substantial amounts of commission being payable. This is often in excess of what is needed to reward an employee and sometimes what a business can afford in cash-flow terms or in terms of other budgets. Imposing, for example, a cap on any bonus payment can therefore be a prudent provision, particularly where cash is involved.
In this case, an employee achieved sales considerably in excess of what was expected when setting the relevant targets of a bonus scheme. The scheme provided for graduated payments according to achieved sales.
Although the bonus scheme was incorporated into the employment contract, the terms of the scheme anticipated that the employer might want to make changes to the scheme during the bonus year. Accordingly, the case focused on the scope of the flexibility to make such changes. The bonus scheme enabled changes to be made in two reported ways.
First, the targets could be adjusted by the employer until the final quarter to ensure that they remained "challenging but achievable". This is a relatively common provision in itself which should be included in all schemes. It gives the employer flexibility, for example, if a new business line is acquired within the year which makes revenues automatically double. Whether this was a provision that could have been used in this case to achieve what the employer wanted will never be known as the employer decided not to use this provision, fearing that it might be disincentivising to change targets mid-year as the employee might then not work so hard in the remainder of the year.
Instead, the employer took the second route provided for under the scheme and tried to invoke its capping provision. This said that the bonus could be capped at 100% of salary "by exception only [requiring] HR and Finance agreement". In fact, the employer as a concession increased the cap to 130% of salary, but the employee was not prepared to settle at this level as she felt she was entitled to an even greater amount.
The Court of Appeal decided that, although the wording was not absolutely clear, the proposed cap could only be invoked in exceptional circumstances and that even then an employer must apply its discretion fairly when taking such a decision.
In the present case, the Court could not see a reasonable employer invoking the cap. While the application of the formula produced a very large salary multiple for this particular employee, this did not seem “exceptional”. An unusual degree of business success and a large payout could not be equated with exceptional circumstances justifying the capping of this award - particularly where the contract already gave the employer the alternative of a discretion to change the targets and it had deliberately decided not to do so.
Examples of exceptional circumstances might include the employer's parlous financial position or the employee's misconduct - which could explain why the reference to the HR and Finance departments was made in the drafting - although neither were relevant here.
Points to note:
•Ensure there is a cap in the bonus plan. Many plans do not have caps, which leaves employers completely exposed.
•Any bonus scheme should expressly provide for the employer to be able to adjust targets to deal with changed circumstances.
•An employer should operate a formal review of targets within the year and ensure that if targets need to be changed (weighing up the disproportionate impact on morale this can have), this is properly communicated.
•Draft caps appropriately. For example, in the present case, it might have been better had the relevant rules had an additional provision like "a bonus cannot exceed 150% of sales unless the Board agrees”, which might (if set at the right level) be just as incentivising at the outset but could have led to a negotiation at the relevant time with the company having a stronger hand to play.
•“Exceptional circumstances” are indeed exceptional. Courts will be unlikely to say that expensive outcomes are exceptional per se.
This article first appeared in Law-Now, CMS Cameron McKenna's free online information service, and has been reproduced with their permission. For more information about Law-Now, please go to www.law-now.com