Settlement agreements: an employer's guide

Offering an employee a settlement agreement is a common way to resolve potential disputes, save time and potentially reduce costs by avoiding a disciplinary or other formal process, and provide a clean way for the parties to agree the termination of employment. It can also help reduce the risk of an an aggrieved employee misusing or taking confidential company information.

Settlement agreements are relatively standard documents because, to have legal effect in settling employment claims, they must comply with the statutory requirements legislation. However, there are areas where employers may vary what is included, typically whether to include post-employment restrictive covenants, arrangements for references and, for senior employees, what happens to any share options or other incentives.

We advise employers on settlement agreements and draft agreements for employers. We can also advise on any underlying employment law issues, such as redundancy.

How does a Settlement agreement protect the employer?

A settlement agreement records an agreement to terminate employment and, in return, the employee waives their right to bring most employment claims against the employer. One important exception is personal injury claims, which generally cannot be waived through a settlement agreement.

Settlement agreements can also be a useful way for employers to include post termination restrictions. However, care is needed when including any form of employment restrictive covenants, as restrictions that go further than reasonably necessary to protect legitimate business interests may be unenforceable.

HMRC tax free compensation payments to employees

HMRC can scrutinise termination payments and ask questions about their nature and how they have been taxed. Employers must operate PAYE correctly on payments that are taxable as earnings, and failure to do so can result in tax liabilities, interest and penalties.

In general, the first combined £30,000 of qualifying termination payments may be paid without income tax, subject to the statutory rules. However, payments such as salary, holiday pay and post-employment notice pay are generally taxable and are not covered by the £30,000 threshold.

Settlement agreement tax indemnity

We include a carefully drafted tax indemnity making it clear that the employee is responsible for any additional tax arising on payments made under the settlement agreement. However, a tax indemnity does not remove the employer’s obligation to operate PAYE correctly where required.

Nevertheless, it can create a contractual right for the employer to seek recovery from the employee of tax which the employer has been required to pay. Enforcing the indemnity may be difficult if the former employee cannot be traced or has limited means. In such cases, the employer may consider retaining an appropriate amount from the settlement payment, where legally and contractually appropriate.

Settlement agreement restrictive covenants

Employers may already have workable and enforceable non-compete and other post-termination restrictions in an employment contract or senior employee’s service agreement. In that case, unless the employee has breached the terms, it may not be necessary to repeat them in the settlement agreement.

Sometimes restrictive covenants were not included when an employee was more junior but are now required because their role has changed. They may also be out of date or potentially unenforceable.

A settlement agreement can provide an opportunity to review and, where appropriate, agree fresh restrictive covenants when an employee leaves.

Post-termination restrictions can cover a range of anti-competitive behaviour. Typical restrictions may prevent the employee from:

• Joining a competitor;
• Using the employer’s confidential information; or
• Poaching customers, clients and staff.

Protect employers property

Employers will usually arrange for company property such as documents, phones and computers to be returned. However, it is important to consider information stored on employee-owned devices, including memory sticks and home computers, as well as passwords and access credentials.

The settlement agreement should include an undertaking from the employee to return company information and permanently delete company information from employee-owned devices, subject to any legal or regulatory retention requirements. Such clauses can make it easier to enforce the employee’s obligations and provide additional protection for the employer.

Reputation management

It will not always be possible for an employee to remove all references to their employment from personal social media accounts. However, an employer may want agreed references to the employment to be removed or amended where appropriate.

Another consideration is the risk of a departing employee seeking to damage the employer’s reputation. A settlement agreement may include appropriate confidentiality and non-disparagement provisions, subject to their terms and any applicable statutory restrictions.

Employee references

An employer has no general legal obligation to provide an employee or former employee with a reference. However, the terms of a reference can form an important part of settlement negotiations.

Employers must ensure that any reference they provide is fair and accurate. To reduce the risk of claims, many employers provide simple, factual references.

Simple reference

Settlement agreements often include an agreed form of reference confirming:

• The employee worked there;
• The duration of employment; and
• The employee’s job title.

Amending the reference

Employers can reserve the right to amend an agreed reference if information subsequently comes to light which means that the reference would otherwise be inaccurate. This type of provision can help protect the former employer from being required to provide inaccurate information.

Share rights

Employees or directors may be required to transfer shares when their employment terminates. There can be additional tax and company law considerations where shares are linked to the employment relationship. Best practice is often to manage share transfers under a separate share sale agreement.

Options

Options will often lapse, to the extent they have not been exercised, when employment ends. The precise treatment depends on the terms of the relevant option agreement and, where applicable, the rules of the relevant tax-advantaged share option scheme. This means the position should be checked for unapproved options as well as EMI and CSOP options.