Overview

Settlement agreements (previously known as compromise agreements) are legally binding contracts used to end employment on agreed terms that include the employee making binding promises not to sue the employer, in return for a payment.

The rules governing settlement agreements are contained in the Employment Rights Act 1996, especially section 203.

Employers and employees can try to reach a settlement (either before or after a tribunal claim has started) by:

  • negotiating directly and entering into the agreement, although the employee will need legal advice to make that agreement legally binding
  • agreeing to an Acas conciliated settlement
  • using a private mediator
  • using judicial mediation by an employment judge where tribunal proceedings have been issued.

Settlement agreements and the negotiations that precede them can be complicated and it is important to understand the rules.

COVID-19: avoiding claims is even more critical during the pandemic as cases will take longer to be heard. Internal grievance procedures and negotiating with employees can lead to earlier settlements, as even aggrieved employees may prefer to reach a conclusion with an employer rather than wait for hearings which may take many months or even years.

Brexit: the legislation and case law on negotiation and settlement is not derived from the EU, so these procedures are unlikely to be directly affected by Brexit. However, a handful of employees involved in employment law cases have raised arguments that the proceedings are a breach of Article 6 of the European Convention on Human Rights (ECHR), which includes the right to a fair trial. Theresa May’s government said it would remain in the ECHR, and if this continues to be government policy, the Article 6 right may remain.

For more information on the legal implications of Brexit, see our Brexit hub.

Most employment disputes and tribunal cases end with settlement agreements. These agreements can end a dispute with a departing employee quickly, obtain closure in a difficult situation and avoid an employment claim. They may also be used to shorten or avoid a protracted capability, disciplinary or redundancy process.

An agreement can be reached before a claim is even started or before the tribunal hearing stage. Once a settlement is concluded, any promise that an employee will not bring a tribunal claim will only be legally binding if it is incorporated into either of the following:

  • a settlement agreement which complies with all legal requirements
  • an Acas COT3 agreement.

Employers can conclude settlements agreements of any statutory claim including unfair dismissal and discrimination, although the employee will need legal advice to make this type of agreement binding. If the only claim is a contractual one, for example, for breach of contract with no unfair dismissal element, then a contractual settlement agreement may be binding.

Personal injury and pension claims are not normally covered as the right to claim for any personal injury which the employee did not know about before signing the agreement cannot be waived. Accrued pension rights cannot be waived either.

The precise details of each settlement agreement will vary, but some terms are essential legal requirements and the agreement will usually include a factual and legal description of the claim being settled.

For a settlement agreement to be effective over a statutory claims such as unfair dismissal or discrimination, the following conditions must be met:

  • The agreement must be in writing.
  • It must relate to the particular claim that has been, or might be, brought by the employee.
  • The employee must have received legal advice, and the employee’s adviser must be named in the agreement and must also be insured.

If the above conditions are not met, the employee would still be theoretically free to make some claims even if the organisation has made a settlement payment.

The agreement may still be valid to settle contractual claims (like breach of contract or wrongful dismissal).

To be legally binding a settlement agreement has to specifically state the claims that it is intended to cover. Although it is standard practice to put wording in agreements such as ‘full and final settlement of all claims’ this is not enough for potential employment claims. Without careful drafting, there is a risk the employee could bring new claims at a future date.

In addition to the legally required terms, settlement agreements should also detail the timing and amount of the termination payment and for any notice period payments, and how these will treated for tax purposes.

The agreed net salary, benefits, bonus and any outstanding expenses need to be calculated.

Outstanding untaken holiday will need to be paid and included in the agreement and this will be subject to tax.

Pension payments are usually made up to the termination date and membership of any pension scheme usually ceases on termination. If it is agreed that part of the settlement sum will be paid as pension, the tax treatment for this needs to be provided for in the settlement agreement.

Share schemes

There may also be outstanding commissions, stocks and share options under share schemes. Compensation for share allocation or options will depend on what is agreed, and the scheme rules. Most schemes differentiate between ‘good and bad leavers’ and the settlement agreement needs to take this into account. A good leaver will usually mean someone leaving employment amicably, for example, on grounds of retirement or disability. A bad leaver will usually mean leaving in circumstances justifying the dismissal of the employee.

There are usually many other clauses in settlement agreements ranging from the termination date to more complex matters. Some agreements mention the reason for termination which may simply be by mutual agreement.

Other provisions may include:

  • a confidentiality clause (see below)
  • a clause covering any personal injury claims which arose before the agreement (see above re unforeseen injury)
  • a warranty that the employee has not been offered a new job yet (because the employer may have been able to pay less compensation if the employee had another job)
  • restrictive covenants (see below)
  • a clause about returning company property such as laptops or mobiles within a set time period.

There may also be an agreed reference which is attached to the agreement (see below).

It is very important that settlement agreements deal with notice and garden leave correctly. Employees may be paid in lieu of notice (PILON) which will always be subject to tax and NIC.

Any contribution by the employer to the employee’s legal fees should also be set out.

Some employers pay external legal advisors to prepare settlement agreements for them, others produce draft agreements themselves, especially for less senior employees. Whatever the employer decides to do, the employee must have had advice from a relevant independent adviser on the agreement and how it affects their ability to bring a tribunal claim.

Because an employer wants a cast iron agreement, it will often pay for an employee to get advice on the agreement. This contribution towards legal fees is not a legal entitlement but is almost always offered by employers.

Settlement agreements signed without the employee getting independent legal advice will not be binding which means the employee can still make a claim to an employment tribunal.

The employee must be able to make an informed decision, so the advice should cover what the settlement agreement is, what the terms mean, which claims are being compromised and how payments are being taxed.

The adviser does not have to advise on whether the agreement is a 'good deal' although a solicitor advising employees may be negligent if they do not consider this issue at all (McWilliam v Glasgow City Council, 2007).

Contributions towards legal advice vary but may be around £500-£1,000 plus VAT – but it can be more or less than this. In one case, the EAT said an offer of £500+VAT might be enough to cover the basic terms and effect of the proposed agreement but was not realistic to advise fully on the merits of the employee’s claim and an appropriate award of compensation, as this would require more hours of the solicitor’s time (Solomon v University of Hertfordshire, 2019).

At the moment, employers can choose to restrict their financial contribution towards legal fees, and employees may only get basic advice, in line with the employer’s contribution, or the employee may choose to supplement the employer’s contribution themselves. Some lawyers have suggested setting a minimum fee to cover the advice on the settlement agreement itself plus an additional sum in relation to other matters such as confidentiality provisions.

Acas has a Code of Practice on settlement agreements and has also issued non-statutory guidance. Failure to follow the Code does not, in itself, make an employer liable to proceedings or automatically lead to an increase in any compensation awarded by an employment tribunal, but tribunals will take the code into account when considering cases.

The Code suggests employers provide a minimum period of 10 days for employees to consider a proposed settlement agreement and to receive independent advice, although the parties can agree a longer period.

Binding settlements can also be negotiated using an Acas representative (leading to a COT3 agreement, named after the form used). If the parties use early conciliation (see Tribunal claims Q&As) and successfully reach an agreement, the conciliator will send the form out to the parties containing the agreed terms for them to sign and date.

The COT3 form may include:

  • the sum of money to be paid
  • when payment will be made
  • what claims are settled by the agreement
  • confidentiality terms.

A settlement achieved via Acas can be legally binding even if the COT3 form is not signed. In fact, a written agreement is not necessary at all for an Acas settlement to be binding.

If an Acas agreement is reached and one party tries to back out of the agreement before signing the forms, the other party may ask for a preliminary tribunal hearing to confirm whether or not an agreement was reached.

Whether termination payments are taxable is likely to be a very important aspect of negotiating a settlement agreement and depends upon the circumstances surrounding the payment. The general rule is that employers can pay the first £30,000 of any genuine compensation for loss of employment under the settlement agreement tax free, but this will not apply to all types of payment.

The rules for taxation of termination payments are complex. Changes to the rules have been made because of concerns that employers and employees were structuring settlement arrangements to include payments that would normally be taxable, to try and minimise the Income Tax and National Insurance due.

Employers should split a termination award into:

  • amounts treated as taxable earnings; and
  • amounts benefitting from the £30,000 income tax exemption.

Whether a termination payment is taxable or not depends on precisely what the payment is for. Usually every payment should be broken down into its constituent parts, not treated as a single lump sum.

National insurance

Termination payments which are genuine compensation for termination of the employment are currently free from National Insurance (NI). From 6 April 2019 employer’s NI is payable on termination payments above £30,000 and is collected as part of the employer’s standard weekly or monthly payroll returns and remittances to HMRC.

Taxable payments

Payments made for work undertaken before the employee’s departure are likely to be fully taxable, because these would normally be chargeable to income tax. All payments made for the period up to the point that the contract of employment ends (such as unpaid salary, wages and benefits accrued to date of termination) are contractual in nature and are generally also taxable together with:

  • Payment in lieu of holiday outstanding
  • Payments made if an employee works their notice or is placed on garden leave for the notice period are subject to tax.
  • Payment for new restrictive covenants (see above)
  • Any payments associated with a confidentiality clause.
  • Payments made to compensate for injury to feelings caused by the termination. Such payments are taxable unless the award is in relation to a psychiatric condition or other medically recognised condition.

Payments for injury to feelings

Tax treatment for injury to feelings was has been a controversial issue for a long time. The legislation was amended from April 2018 to ensure that the payments for injury to feelings are subject to income tax and national insurance. This was a result of several decided cases, in particular Moorthy v. HRMC (CA 2018). HMRC require a review of the relevant medical records if the employee claims the injured feelings amount to a psychiatric injury or other recognised medical condition and the compensation therefore remains exempt from tax.

Payments in lieu of notice

All payments in lieu of an employee’s notice entitlement (PILONs) have also given rise to problems over the years. For terminations after 6 April 2018 all such payments are taxable and subject to NI. It does not matter whether there was a written PILON clause in the employment contract or not. The PILON will be treated as earnings rather than a 'termination payment' and will be fully taxed. The employer must work out the amount of basic pay that the employee would have received if they had worked their notice period, even if the employee leaves part way through their notice period. The PILON payment is treated as earnings and is not subject to the £30,000 income tax exemption.

Potentially exempt payments

The following sums which may form part of a termination payment are generally non-contractual and not taxable:

  • Compensatory and ex-gratia, non-contractual payments made for loss of office or up to the first £30,000.
  • Payment on account of a disability or injury.
  • Genuine statutory and contractual redundancy payments up to the £30,000 exemption, although some contractually based redundancy payments might be subject to income tax and NI.
  • Payments made direct into a registered pension scheme are not subject to tax up to the annual and lifetime allowances set for contributions to such pension schemes.
  • Contributions to the cost of special outplacement counselling are not taxable and are often paid directly by the employer and therefore do not count towards the £30,000 exemption.

Legal costs

Following the conclusion of a compromise or settlement agreement the employer often pays a contribution towards the employee’s legal costs direct to the employee’s solicitor under the terms of the agreement. Such costs will not be subject to income tax. The employer’s payment of the employee’s legal costs direct does not count towards the £30,000 exemption either, as long as it is only for advice in connection with termination of employment and there is a specific clause in the settlement agreement covering it. Employers uncertain on the tax position can get advance clearance on the payment from HMRC.

Tax indemnity

As some elements of compensation can be paid tax free, a tax indemnity should be given by the employee just in case. This makes the employee ultimately responsible for the payment of any tax and national insurance that HMRC decide should have been deducted.

Employers are under no legal obligation to provide job references once a settlement has been reached. Many employers only provide a factual reference setting out dates of employment and job title.

A departing employee may negotiate a more personal reference to be attached in an Appendix to a settlement agreement. Employers are then obliged to provide references to prospective employers in the agreed terms. A reference clause will also state that any oral references will be given in similarly favourable terms (see our References Q&As).

There may also be a mutually agreed internal and external wording of the announcement of the employee’s departure.

It has been common practice for settlement agreements to contain clauses preventing the employee from discussing the pay and terms of the settlement agreement with anyone other than their immediate family.

Confidentiality clauses, sometimes called non-disclosure agreements (NDAs), can also contain:

  • any time limits on the confidentiality
  • non-derogatory clauses.

The latter usually prevents both parties from making derogatory remarks or statements about the other. This includes statements to third parties including future employers.

It is completely usual for both parties to keep the fact and terms of the agreement secret and not to broadcast them on social media. However, if confidentiality clauses go too far then issues arise. Employees should be given reasonable time to think about the confidentiality clauses and obtain independent legal advice on them.

Whilst it is legitimate for employers to protect trade secrets, confidential information or their clients, settlement agreements should not contain clauses that cover up discriminatory treatment. Press reports have shown that some confidentiality clauses do attempt to limit the rights of individuals, for example, preventing them from making a complaint to the police. If employers try to gag former staff to conceal incidents of bullying and harassment in this way, the agreement is unlikely to be legally binding.

The government intends to introduce changes to settlement agreements particularly to tackle the issue of sexual harassment in the workplace. For the changes to confidentiality and NDAs please see the future developments question.

Possible reforms

In March 2019, the government launched a consultation examining the misuse of confidentiality clauses in employment matters and expressed an intention to introduce changes to settlement agreements to prevent matters such as harassment being kept secret. The Women and Equalities Committee also looked into the use of confidentiality clauses in 2019 and at the continued prevalence of sexual harassment in the workplace.

If the government elected in December 2019 proceeds with reforms to NDAs and confidentiality clauses, some clauses in settlement agreements will become legally void. The reforms are intended to ensure that confidentiality clauses:

  • are not used to try to prevent disclosures to the police or to a regulated health, or care, or legal professional
  • are properly explained to employees, both within the agreement itself and in an additional written statement, so employees fully understand what they are signing
  • are transparent, specific and limited in scope
  • those limitations is clear to individuals signing NDAs because they have received independent legal advice.

Where employers do not clearly explain the limitations on confidentiality clauses then the individuals will be eligible for additional compensation in any later tribunal claim.

The Solicitors Regulation Authority, the Equality and Human Rights Commission and Acas are responsible for guidance on the second and third points above.

Whistleblowing

Special rules cover confidentiality clauses and whistleblowing. In summary, confidentiality clauses that prevent departing employees from making a protected disclosure (whistleblowing) are banned, even if the disclosures have previously been disclosed to anyone else.

Gagging clauses in settlement agreements in regulated sectors are simply ineffective. This rule arises under the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) regulations to protect whistleblowing in the public interest and ensure that those working in financial services feel able to speak out about bad practices.

Normally, settlement agreements will specify that they contain the full and entire terms agreed between the parties, including warranties and indemnities to cover something going wrong in the future.

The employee may be required to give warranties such as:

  • they have revealed all offers of other work
  • they have not committed an act of negligence or covered up gross misconduct during their employment
  • they have not done anything which would affect the employer’s decision to pay the agreed sum.

Many settlement agreements provide that the sums paid under the agreement are repayable if the employee breaches any terms.

There will also usually be an indemnity that the employee will reimburse the employer for the legal cost of proceedings and all losses arising from the mistaken payment of compensation. Repayment will only include the sums which the employee was not entitled to. For example, the employee may be able to keep all or part of a contractual notice payment but not additional compensation if an employer could prove that the employee denied they were starting a new job in a few weeks’ time.

Restrictive covenants may be used to restrict for a limited period where the employee can work after they leave. These may be entirely new provisions or re-affirm restrictive covenants from the original contract of employment. Employers may agree to a reduction or complete removal of some the restrictions.

Payment for new restrictive covenants may be needed to prevent an employee from acting in competition or approaching customers or employees once they have left the employer. These may be entered into on termination because the original contract did not contain these provisions, or they were unenforceable. To make these new promises binding there must be a ‘consideration’ paid, usually a small sum of around £500. This payment is fully taxable and liable to NI contributions.

Q&As

The employee’s adviser must be 'independent' and, therefore, must not act on behalf of the employer.

The independent adviser must have a current contract of insurance or covering the risk of a claim for any loss arising from the advice and the agreement must name the adviser.

The adviser can be:

  • a qualified lawyer (solicitor, barrister or legal executive)
  • a certified and authorised official, employee or member of an independent trade union
  • a certified and authorised advice centre worker.

The payment of the adviser’s legal costs in connection with the settlement of legal disputes are not liable to income tax.

Referring to an 'off the record' conversation is a fairly common expression used by employers and employees to describe discussions which took place when the employment relationship was coming to an end. However, the expression is technically inaccurate.

During negotiations, proposals and counter proposals are often made before an agreement is reached, and it is essential to be able to discuss matters without fear of jeopardising the employer’s legal position. The correct terminology for the conversations prior to a settlement agreement are either 'without prejudice' or ‘protected’ conversations. These are covered by two completely separate sets of rules, so depending on the situation surrounding the negotiations two different sets of rules may apply.

If the conversation meets the rules covering protected or without prejudice conversations, then the employee will not be able to refer to it in any later claim. Where possible, employers should try and ensure negotiations fall within both sets of rules. It is helpful to understand the differences between the two concepts otherwise employers may be exposed as a result of what they have said.

Since July 2013, employers can have special types of ‘protected’ conversations with employees regarding the termination of employment. In limited circumstances, employers can initiate, offer and discuss settlement agreements in a ‘protected conversation’ in the knowledge that they are protected from having the conversations held against them in any subsequent unfair dismissal claim.

However, they do not protect employers in all situations.

Claims not covered

The concept of protected conversations only applies to standard unfair dismissal claims. Conversations that relate to complaints of discrimination, automatically unfair dismissal, wrongful dismissal, breach of contract, whistleblowing, union membership, and health and safety, for example, are not protected.

In one case, an employee had claims for unfair (constructive) dismissal, and sex, pregnancy and maternity discrimination. An issue arose about whether an alleged protected conversation could be referred to. The EAT confirmed that the protection only applies if the employee brings ordinary unfair dismissal proceedings. It does not apply if the employee alleges there is an automatically unfair reason for dismissal such as pregnancy, or in discrimination cases. In such cases evidence of the negotiations will not be protected unless the ‘without prejudice’ rule applies (Harrison v Aryma Ltd, 2019).

If there is any possibility of a claim other than unfair dismissal, then the employer should try and ensure that its conversations with the employee are ‘without prejudice’. This will require a dispute between employer and employee to have already arisen. Anything said during ‘without prejudice’ conversations will be protected in all types of legal claim not just unfair dismissal.

Improper behaviour

Protected conversations were introduced to enable parties to have frank discussions, even where a dispute had not actually arisen yet. Even the fact that a conversation took place should not be disclosed in any later claim (see Faithorn Farrell Timms LLP v Bailey, 2016) but any 'improper behaviour' from the employer will lead to this protection being lost. The Acas Code of Practice on settlement agreements provides examples of improper conduct, which includes behaviour such as harassment, violence, bullying, intimidation, offensive words, aggressive behaviour and putting undue pressure on the employee.

A judge will need to consider evidence and decide the facts surrounding allegations of improper behaviour to decide if pre-termination negotiations are to be kept secret rather than just relying on the lawyers’ submissions (Harrison v Aryma Ltd, 2019).

For example, if an employer says to an employee, ‘If you don’t accept the proposal today, then you will be dismissed anyway…’ this will count as improper behaviour. Anything said in the pre-termination negotiations can then be used by the employee in any subsequent tribunal claim.

Employers will often need to have two types of correspondence and meetings in parallel. So, conversations about day to day management matters will be discussed openly whereas the protected conversations will happen separately.

An organisation running settlement discussions must have a Plan B, because consensus on settlement may not happen. For example, a fair disciplinary procedure must be followed before a dismissal decision is taken.

A tribunal may be able to consider evidence of protected conversations to establish the effective date of dismissal or termination if this is in dispute (see Basra v BJSS Ltd, 2017).

It is never completely 'safe' to start discussing terms of settlement. Employers do need to initiate conversations in many situations, for example, where continuing to employ an individual is no longer prudent. The safest way to have these talks is to comply with all of the possible rules, so those governing ‘without prejudice’ conversations, 'protected conversations' and those happening under the Acas Code of Practice on settlement agreements.

If discussions between employers and employees to promote the settlement of a dispute are properly 'without prejudice' then they cannot be referred to in any subsequent hearings. However, managers in charge of settlement negotiations need to fully understand when the rule applies.

Ongoing dispute

The first issue to remember is that there must be an existing dispute for the without prejudice rule to apply - so a manager springing a surprise conversation on an underperforming employee would not be covered by this protection.

This differs from the protection afforded by protected conversations which do not require a pre-existing dispute in order for discussions to be kept out of later proceedings.

There is no need for litigation to have actually been threatened, but there must be a dispute before any ‘without prejudice’ protection can arise.

For example, in one case the employer and employee had different recollections concerning contractual terms. The employee said he could mention the discussions about the terms because when they occurred there was no dispute and, therefore, no ‘without prejudice’ privilege. The Court of Appeal said that if the parties were wrangling over the recollection of the terms of the employee’s contract, then that was a dispute. The discussions were genuinely ‘without prejudice’ and must not be referred to in the employee’s witness statement prepared for the tribunal hearing (Framlington Group v Barnetson, 2007).

Disciplinary and grievance hearings

It is always better to agree the status of a 'without prejudice' discussion in advance of the meeting. Problems often arise if employers start settlement discussions in the middle of a grievance or disciplinary hearing. If this happens, there is a risk of having the discussions referred to in front of a subsequent court or tribunal (see BNP Paribas v Mezzotero, 2004).

‘Without prejudice’ conversations must be in good faith and may take place in parallel to disciplinary and grievance hearings, but ideally separately from the hearing. Referring to, or merging, settlement negotiations with disciplinary or grievance hearings is highly risky.

In one case, the Court of Appeal confirmed that evidence of previous negotiations settling another dispute could be admitted in a subsequent tribunal hearing. There was no protection because the settlement negotiations had been referred to during the grievance hearing and the privilege had therefore been waived or abandoned. The University had also included documents attached to its tribunal forms which referred to the settlement discussions. This also meant the 'without prejudice' protection did not apply (see Brunel University v Webster, 2007).

Other points to consider:

  • labelling a document or discussion as ‘without prejudice’ is not conclusive. The content is crucial in defining its status – it must be an attempt to resolve a genuine dispute
  • the employer attempting to blackmail an employee in a document or discussion, or committing some other serious impropriety, will put that document or discussion outside the 'without prejudice' rule
  • ideally the employee should be given the opportunity to take legal advice before a ‘without prejudice’ discussion.

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