Five key factors to consider when entering into a settlement agreement

Many employers use settlement agreements to achieve a quick and confidential resolution when an employee is leaving a business. They are commonly used to record exit terms with the employee receiving a payment in return for waiving their statutory and common law rights. 

A settlement agreement can be an effective alternative to a longer formal process, such as a full redundancy or disciplinary procedure. It may be appropriate when there are ongoing issues with an employee, including around their performance conduct or where there is a breakdown in the relationship between the employer and employee. 

Although an employee cannot be forced to sign a settlement agreement, employers will typically offer a financial incentive to encourage agreement. 

Here we outline five key considerations for employers to review before making a settlement offer.

1. Identify whether a settlement agreement is appropriate

An employer may consider a settlement agreement when a workplace issue is becoming difficult to manage. 

Employers should, however, avoid relying on settlement agreements when there is no genuine dispute or issue to address. They should also not be used as a shortcut to avoid following proper processes and procedures, as doing so may weaken the employer’s position if the employee declines the offer. There is also a risk that the habitual use of settlement agreements may create an expectation from employees that they will always receive a payment to leave the business.

2. Ensure compliance with statutory requirements

There are specific statutory requirements under the Employment Rights Act 1996 that must be satisfied for a settlement agreement to waive an employee’s statutory employment rights:

• the agreement must be in writing and must relate to a specific complaint or set of proceedings, such as alleged misconduct or another employment issue;
• the employee must have received independent legal advice on the terms of the agreement, particularly, how it impacts their ability to pursue the statutory rights being waived; 
• the adviser giving the advice must be identified in the agreement and must have the relevant indemnity insurance relating to the advice; and
• the agreement must also confirm that the statutory conditions governing the settlement agreements in the relevant legislation have been met. 

3. Include post-termination restrictions

If an employee’s contract does not contain any post-termination restrictions, settlement agreements can include post-termination restrictions that will apply once the employee’s employment has ended. These restrictions are designed to protect the employer’s business interests. If post-termination restrictions are contained in the employee’s contract the settlement agreement is a good opportunity to remind the employee of their obligation to the company post-employment.

Common types of restrictions include:

• non-solicitation clauses preventing the employee from soliciting or approaching the employer’s customers, clients or suppliers; 
• non-competition clauses preventing the employee from working for or providing services to a competing business for a certain period; and 
• non-disclosure clauses prohibiting the employee from disclosing or using confidential information.

Any restrictive covenants included in a settlement agreement or employment contract must be reasonable to be enforceable. To be reasonable, the employer must show that the restriction protects a legitimate business interest and the restriction goes no further than is necessary. 

Post-termination restrictions should generally be between 3 and 6 months. Courts are likely to view excessively long time periods and broad geographical areas as unenforceable. It is therefore important to find the balance between providing enough protection for the employer but allowing the employee the opportunity to obtain new work. It is also important to note that the employer should pay additional consideration for any new restrictions introduced into the settlement agreement.

4. Define the scope of claims 

Settlement agreements typically provide payment or another incentive in return for the employee waiving their rights to bring claims. However, some claims cannot be carved out in a settlement agreement. These include:

• claims relating to accrued pension rights;
• personal injury claims of which the employee is not yet aware and could not reasonably be expected to the aware of; and 
• any claim for failure to collectively consult in a redundancy situation or in relation to obligations to inform and consult under TUPE. For more information on employers’ legal duties around collective redundancy consultation, please see our recent article here.

Employers should ensure that every claim being waived is properly described and clearly defined. Employers should also give careful consideration to any potential or unknown future claims and whether these should be set out in the agreement. 

5. Include a tax indemnity 

The employer is normally responsible for deducting the correct tax and employer’s National Insurance Contributions (NICs) from any termination payment provided in the settlement agreement and accounting to HMRC. Under current HMRC rules, the first £30,000 of a termination payment can be paid free of tax. If HMRC later takes the view that the exemption does not apply, it will typically pursue the employer rather than the employee. 

It is therefore important that the employer protects itself by ensuring it can recover any tax that later becomes payable. Any settlement agreement should therefore include an express tax indemnity confirming that the employee will be responsible for any additional tax liabilities and will indemnify the employer for any further payments required by HMRC.