Terminating the Employment Relationship and Structuring Severance Packages Jamie Flanagan Tina Giesbrecht March 11, 2005 Hands on support.
Introduction An individual s employment relationship is one of the most important relationships in that person s life. Over and above the financial benefits of the employment relationship, it provides a sense of identity and community. Just think how often you ask or are asked what do you do for a living? or where do you work?. Throughout Canada, courts of all levels are recognizing the importance of the employment relationship from a social perspective, not simply a contractual one. In particular, the Supreme Court of Canada in the last 10 years has rendered significant decisions in the employment law area which recognize the importance of the employment relationship. As an example, consider how often human resource professionals and employment law practitioners hear the term Wallace and it has been less than 8 years since the Supreme Court of Canada rendered its decision in Wallace v. United Grain Growers Ltd. With the increased recognition of the social and economic importance of the employment relationship, it is essential as employers to ensure that the most difficult aspect of the employment relationship, the termination of it, must be handled in the appropriate manner. Keep in mind the words of Mr. Justice Iacobocci from the Wallace decision who stated: The point at which the employment relationship ruptures is the time when the employee is most vulnerable and hence, most in need of protection. In recognition of this need, the law ought to encourage conduct that minimizes the damage and dislocation (both economic and personal) that result from dismissal. In this paper we will discuss the ways in which the employment relationship can be terminated focusing specifically on just cause terminations which require no notice or pay in lieu of notice and those terminations which are without just cause which trigger the obligation to give notice or pay in lieu of notice. Termination of Employment Generally speaking, the employment relationship can end (or terminate) in one of the following ways: by the resignation of the employee; at the conclusion of a term contract; by the retirement of the employee pursuant to a valid retirement policy; by the employer for cause, which is based on the misconduct or other fault of the employee; by the employer without cause (no fault) by providing advance notice of termination or pay in lieu; or by constructive dismissal in which the employer makes a fundamental change to the employment contract without the employee s consent. In a unionized workplace the terms of the collective agreement will apply and will limit the circumstances in which employment can be terminated, such that termination on a without cause basis may occur only in accordance with the terms of the collective agreement. This paper addresses termination of employment for cause and without cause in a non-union setting. It will also address practical issues to consider at the time of termination and structuring severance packages. Page 1
When Does an Employer Have Cause for Dismissal? Cause for dismissal can be established by the employer in two different types of circumstances. The first is where the employee engages in serious, unacceptable conduct which wholly undermines the employment relationship by destroying the underlying trust and showing that the employee is unsuitable for continued employment. Such conduct includes theft, assault, serious insubordination, and most, but not all, instances of dishonesty. Prior to dismissing the employee it is important to conduct a thorough investigation and give the employee an opportunity to respond to the allegations and provide any justification or other explanation. A decision to terminate for cause is one which carries significant potential liability, so the decision should usually be escalated to the highest level. When immediate dismissal for cause is contemplated, an employer must consider carefully whether the conduct is sufficient to entitle the employer to impose an immediate dismissal. The employer must be sure that the punishment fits the crime. There is a requirement that there be some proportionality between the severity of the employee s misconduct and the sanction imposed. The courts are considering all of the circumstances surrounding the employee s employment relationship and the misconduct at issue. Although there is no exhaustive list of the factors that need to be taken into consideration in determining the sanction of an immediate dismissal, some of the common factors are the following: the employment record of the employee the length of the employee s employment with the employer and the employee s work history is a significant factor. A long serving employee with an unblemished employment record will have to have been involved in severe misconduct in order to establish just cause; the type of business the nature of the misconduct must be judged in the context of the nature of the business. Some conduct may be less egregious in certain environments than in others. Compare a professional office with the shop floor of an industrial plant; the position of the employee employees in positions of trust have a much higher duty of fidelity; rules known and enforced knowledge of company rules and their strict enforcement will make it easier to sustain a just cause dismissal, rather than relying on inconsistent, lax or ignored rules; mitigating circumstances is the conduct out of character, is it related to a personal problem or disability that affected the employee s judgment. These may be taken into consideration; and the employee s conduct after discovery of the misconduct denial, lying or covering up the misconduct will attract different consequences than an immediate acknowledgement and confession. These are just some of the factors which an employer needs to keep in mind when determining whether the appropriate punishment for the misconduct is immediate dismissal. In all other for cause circumstances, which are usually referred to as performance based dismissals, the employer will have to be able to show: the expected standards of work performance or conduct were clearly communicated to the employee; the employee received adequate training and support; the standards expected of the employee were reasonable in the circumstances (for example, the employer did not act arbitrarily, discriminatorily or in bad faith in setting the standards for the employee); Page 2
the employee failed to meet those standards; the employee was advised in writing that he or she failed to meet these standards, was told how to improve and was warned in writing that a failure to improve would result in termination for cause; the employee was given a reasonable period of time to improve his or her performance; the employee failed to achieve the required improvement; and there were no mitigating factors which make the employer s decision unfair (for example, the employee was suffering from an undiagnosed or undisclosed disability during the period performance was inadequate). If cause for dismissal exists, the employer can terminate employment. It is critical that an employer respond promptly when it becomes aware of the facts giving rise to cause, as a failure to do so may undermine the entitlement to terminate for cause on the basis that the employer condoned or otherwise accepted the employee s misconduct. It is also very important that there be a paper trail of the progressive discipline. An employer should not allege cause unless it has strong grounds for doing so, as if the employee sues for wrongful dismissal an allegation of cause which cannot be sustained may result in increased damages. As well, it is important to meet with the employee, inform him or her of the facts giving rise to the claim of cause and give an opportunity for the employee to provide an explanation or any information which should be considered. You should also be mindful of the fact that an employee terminated for cause may commence legal action, so it is important to collect and preserve any documentation which may be required to prove cause. How Can an Employer Terminate Employment Without Cause? If the employer wishes to terminate employment on a without cause basis, it has to provide written notice or pay in lieu. The rules regarding termination on a without cause basis are derived from three possible sources: the applicable employment standards legislation; the express terms of the written contract of employment, if there is one; and terms which may be implied into the contract of employment by common law. All of these sources must be considered when a without cause termination is planned. How Do I Give Notice of Termination? Notice of termination: must be given to the employee in writing; must be dated; must clearly and unequivocally set out the employee s last day of work; and for the purposes of the B.C. Employment Standards Act, may not be given during, or coincide with, any vacation, statutory leave, temporary lay-off, medical leave, strike or lockout. The notice is not effective if the employee works after the date the employment was supposed to end. The notice is also not effective if it contains any statements which suggest the employment may not end, such as We hope Page 3
that our business will pick up and your employment will not end. Further, notice probably will not be effective if it coincides with a period in which the employee is unable to work, such as a parental leave or, in some cases, a period of disability. How Much Notice is Required? The amount of notice is derived from one or more of three different sources: the amount required by the applicable employment standards legislation, which sets out the bare minimum amount for every employee based on length of service; the amount required by a valid, enforceable contract with the employee, if there is one; or the amount required by common law, which is based primarily on age, length of service and position. The minimum amount of notice or pay in lieu required by the B.C. Employment Standards Act is: 0, if the employee is employed three months or less; 1 week if the employee is employed between three and 12 months of consecutive employment; 2 weeks, after 12 months of consecutive employment; 3 weeks after 3 years; and and an additional one week per completed consecutive year of employment, to a maximum of eight weeks. The amount of notice required by the employment standards legislation is the floor or bare minimum. Unless there is an enforceable contract in place which stipulates the amount of notice required on termination, and the contract provides at least an amount equal to the statutory amount, additional notice requirements will be implied at common law. Common law notice requirements range between the statutory minimum and generally the upper limit of 24 months. In determining the amount of common law notice, courts consider the following factors: the employee s age; the employee s length of service; the employee s position; the employee s level of compensation; the availability of similar employment having regard to the employee s experience, qualifications and training; whether the employee was induced or enticed to leave secure employment to accept employment with the employer; and the timing and manner of termination. The older the employee, the longer the service, and the more specialized or unique the position, the longer the notice period will be. Page 4
How do I Terminate With Notice? The legal requirement is to provide advance notice of termination. Provided the amount of working notice meets the requirements of the employment standards legislation, the contract of employment or common law (depending on which is applicable), no severance need be paid. It is important that once notice is given, the employer cannot unilaterally alter any terms and conditions of employment without creating the risk the employee will claim a constructive dismissal has occurred, entitling him or her to quit and to sue for damages for the balance of the notice period. In considering whether to give working notice rather than pay in lieu, you should consider the following factors: whether there is any work the employee is required to finish; the degree of vulnerability of the employer if the disgruntled employee remains at work as an unhappy camper, considering the degree of involvement with co-workers, customers, clients or suppliers; whether the departure will be smoother if the employee is permitted some transitional period of time to make announcements and hand off responsibilities; and whether the employee possesses significant confidential information which must be secured. The Atkinson Rule and Restrictive Covenants Employers must also be conscious of the principle of law known as the Atkinson Rule and its implication to restrictive covenants. The Atkinson Rule evolved out of a decision from the House of Lords in 1910 General Billposting Company Ltd. v. Atkinson. The issue in that case was whether restrictive covenants were still binding on the employee if the employee s employment was wrongfully terminated. In the case, the employee had a contractual clause that stated if his employment was to be terminated without cause, he was to be provided with 12 months notice of termination. The contract also provided that for a period of 2 years after his employment ended, the employee would not compete in the same business. The employer terminated the contract without notice to Atkinson. Atkinson immediately started a competing business. The employer sought to enforce the restrictive covenant. The House of Lords decided that the employer had repudiated the employment contract and the employee was entitled to agree to the contract being put to an end. So if the employee accepts the repudiation, it releases the employee from all of his or her contractual obligations, including the restrictive covenants which were to continue after termination of employment. This principle has come to be known as the Atkinson Rule. It applies to situations where there has been an improper just cause termination. In circumstances where an employer wishes to terminate the employment of an employee for just cause, one of the considerations the employer may wish to consider in taking that approach is whether or not there are restrictive covenants in a written employment contract which the employer wishes to enforce after the employment relationship has ended. If that is more important to the employer, it may be preferable to treat the termination as a without cause termination so as to avoid the risk of the Atkinson Rule. In circumstances where an employer wishes to terminate the employment of an employee without cause, the employer still must be aware of the Atkinson Rule. If there is a specific contractual provision which states the amount of notice or pay in lieu of notice, the employer will be required to meet that contractual obligation to prevent from being found to be repudiating the contract. However, in circumstances where there is no express provision in the employment contract that states the amount of notice required, the employer must ensure that the notice or pay in lieu of notice is reasonable and consistent with its legal obligation in order to avoid an allegation of repudiation by the employee. In those circumstances, when severance agreements are reached, the Page 5
documentation should make it clear that the restrictive covenants continue in force. To avoid the uncertainty of what amount of notice is required, it is always preferable to have it set out in the contract. In circumstances where there is no written employment contract which the employer wishes to rely on, but rather the employer wishes to rely on fiduciary obligations that may be owed by the employee to the employer after the termination of the employment relationship, it appears that the Atkinson Rule may also apply to fiduciary obligations surviving termination of employment. If an employer wrongfully terminates the employment contract, the fiduciary obligations which would otherwise survive termination of employment may not survive. Suffice it to say that if the employee that is being terminated is a key employee or one in which the employer is vulnerable to, based on relationships with customers or confidential information, careful attention should be made in the decisions relating to the termination of the employment of that employee, whether it be for cause or not, to ensure restrictive covenants or fiduciary obligations continue to exist. Avoiding Wallace Damages Wallace Damages are an extension of the notice period which can be imposed if a Court finds that there has been bad faith conduct in the manner of dismissal or there is conduct that affects employment prospects. Employers have an obligation of good faith and fair dealing in the manner of dismissal and they should be candid, reasonable, honest and forthright with employees and refrain from engaging in conduct that is unfair. Intangible injuries such as mental distress or humiliation caused by bad faith conduct can warrant an extension to the notice period. Avoiding Liability 1. Employers should not rely on cause if there are no grounds/insufficient evidence. 2. Near Cause does not work. 3. Avoid advertising for employee s replacement prior to dismissal. 4. Be candid, reasonable, honest and forthright in reasons for dismissal. 5. Treat employee fairly in dismissal avoid embarrassment and humiliation. 6. Consider time of day, other employees who witness dismissal, determine appropriate security measures and arrangements for employee to clear out belongings. 7. Pay all wages and statutory minimums notice on time. 8. Do not threaten or intimidate. 9. Exercise special care during employee s absence due to illness and upon return. 10. Provide assistance to assist employee in becoming re employed - out placement, reference (if appropriate). 11. Do not spread rumours or negative statements about former employees. Structuring Severance Packages When the employment of an employee is terminated without cause and without notice, it triggers the obligation on the employer to provide payment in lieu of notice. This is commonly known as a severance payment. It must be understood from the outset that a severance payment is not a payment to reward the employee for the Page 6
employee s faithful service throughout the employment relationship. Rather, the legal basis for it is to put the employee in the same position the employee would have been had the employer provided the employee with working notice of termination of employment. In these circumstances, the amount of severance pay is determined by a combination of the employment standards legislation, the provisions of a written employment contract or the common law. With respect to the statutory termination pay which must be paid in lieu of notice pursuant to the employment standards legislation, that payment normally must be made within days after the termination of the employee s employment. The specific number of days is set out in the applicable statute. That payment is not subject to any deduction for mitigation income that the employee may earn in new employment during the statutory notice period. Also, the general consensus is that the statutory termination payment is subject to income tax deduction at marginal rates (rather than retiring allowance rates) and EI and CPP deductions (and corresponding remittances) must be made. Severance payments that are specifically set out in employment contracts must be paid according to the terms of the contract. Depending on the wording of the contract, the payment is normally not subject to deduction for income earned in mitigation and normally the amount over and above the statutory amount can be treated as a retiring allowance, which is subject to lower income tax withholding rates and no CPP or EI deductions. The common law claims for severance are the most common and uncertain. That is because every employment relationship is looked at on its own specific facts to determine what the employer s legal obligation is. The common law claim is based on a term being implied into the employment contract, which implied term states the employer will provide reasonable notice of the termination of the employee s employment. What is reasonable is the subject of much litigation. In respect of the common law notice, an employer can ask that the employee sign a release prior to payment of this amount. It is strongly recommended that an employee sign a full and final release in exchange for any pay in lieu of notice which is given. If working notice is given, then you cannot obtain a release unless the employee is provided some additional consideration (a benefit) at the end of the notice period in exchange for the release. If pay in lieu of notice is given, the employer must recognize that its legal obligation is to provide to the employee the same compensation and benefits as he or she would have received if working notice had been given. As a result, in structuring a severance proposal you should consider: whether the employee typically earns commissions, bonuses, or overtime, and if so what compensation for those items will be provided for the notice period; when benefits will end (note that long term disability and life insurance typically cease on the last day of active employment, while other health benefits can be continued for some period if you need information ask your broker or insurance carrier); whether the severance will be paid by lump sum or by salary continuance; whether counselling will be provided; how various monetary benefits will be treated, such as car allowance, stock options, employee purchase plan, or pension; return of company property, such as lap top, cell phone, company car, access cards, or work files; whether a reference will be provided, and if so, the terms of the reference; and Page 7
whether there are any particular factors you should consider in the timing and manner of termination, such as whether the employee has recently been absent from work for medical reasons, whether the timing of the termination will preclude the employee receiving a bonus, of whether the employee has a particular need for certain benefits. In a without cause situation, an employer should provide a letter to the employee which sets out the proposed terms on which employment will end, and should include the following, if applicable: confirmation of the last day of work; confirmation of the last day of employment, if different; confirmation of length of the statutory notice period and whether it will be satisfied by working notice, payment in lieu, or a combination, as well as confirmation of the date by which it will be paid; confirmation of the amount of accrued vacation pay and details of when and how it will be paid; confirmation of the date various benefits end; details of the right to convert group benefit coverage to an individual plan, typically available for life insurance and sometimes for long term disability, the period in which such conversion must occur and who to contact for information; the amount of any additional severance, whether a release must be signed, and details of how it will be paid (for example lump sum or salary continuance). This is often set out in a separate without prejudice letter; whether a reference will be provided; and the requirement to return company property. The more fair and comprehensive the termination letter and severance package, the more likely it is that the employee will accept it. As well, an employer should aim to provide a severance package which is as complete as possible in order to provide the employee with the information which he or she requires to make a decision about accepting the package and moving on to alternate employment. Understanding the Prince v. Eaton Nightmare Scenario Since the legal obligation on an employer is to provide working notice, when an employer terminates employment without cause and without notice, it creates a situation whereby the employer is at risk for potential claims that could be made for lost benefits during the notice period, particularly lost long term disability benefits. The Prince v. Eaton case illustrates the nightmare for employers for the liability for lost long term disability benefits. Generally speaking, most long term disability plans between the employer and the insurer do not provide coverage for employees after their employment has been terminated. Although employers should be able to obtain extended LTD coverage for the terminated employee during the statutory notice period, a normal extension of that coverage beyond the statutory notice period into the common law notice period is not available. As a result it creates a potential liability to the employer if the employee suffers a disability during the common law notice period, which would otherwise entitle the employee to participate in the LTD plan. The nightmare is that the employer may be required to fund all the benefits the employee has lost under that plan. This is a significant factor for employers to consider when making severance proposals. Even if there is no known health risk that the employee may suffer a disability during the notice period, if there is no settlement of the severance package, the employer remains at risk, even if the risk is slight, for what could be a significant financial claim. It is much better Page 8
to pay an additional month or two of severance to obtain a full and final release than to remain exposed to the potential liability to pay directly the lost LTD benefits. Salary Continuation or Lump Sum Payments A common form of severance package is a salary continuation package with a provision that the employee will be paid a lump sum payment (often 50%) of the balance of the salary continuance when the employee becomes employed. These types of proposals are mutually beneficial, in that if the employee finds alternate work soon, the fifty percent lump sum payment represents a higher win fall for the employee and represents a reduced exposure for the employer. If these types of arrangements are agreed upon by the employee, assuming they are properly drafted, they are a reasonable severance package and do not expose the employer to any additional claims. However, an employer cannot unilaterally impose a salary continuation severance package. A recent B.C. Supreme Court decision Tull v. Norske was a case where the employee refused to accept the employer s salary continuation proposal and sought to have the severance package paid out in a lump sum. The B.C. Supreme Court agreed and the employee was granted a lump sum payment for the notice period reflected in the salary continuation proposal. It is a significant decision, since the plaintiff was able to obtain the entire lump sum payment, without deduction of any future income the employee may earn in mitigation of the claim. Tax Treatment of Severance Packages In making severance proposals, an understanding of the tax consequences to the employee can assist in structuring the proposals in a tax-friendly manner to the employee, provided it is tax neutral to the employer. Advising employees of some of their options and providing flexibility is a useful strategy to make severance packages more attractive to employees. A severance payment is normally treated as a retiring allowance under the Income Tax Act as it represents a payment to the employee in respect of the loss of office or employment. As a retiring allowance, only income tax is deducted. The employer is not required to deduct CPP or EI premiums. The income tax is deducted at a flat rate depending on the total of the retiring allowance. If the retiring allowance is over $15,000.00, the flat rate is 30%. That is the highest rate applied. Prior to income tax being withheld, the employee is entitled to shelter portions of the retiring allowance from income tax by rollovers and contributions to the employee s RRSP. If the employee has years of service prior to 1996, the employee is entitled to contribute $2,000 per year of service prior to 1996 directly into the employee s RRSP, regardless of the contribution room available for the employee. In addition, over and above the retiring allowance rollover for years of service prior to 1996, an employee can contribute the retiring allowance directly to the employee s RRSP up to the unused contribution room available in the RRSP. In many situations, the employee elects to have the entire retiring allowance paid directly to his or her RRSP. The payment is then not subject to any tax withholdings at source. Since the severance payment/retiring allowance must be declared as income, the ability to have the RRSP deduction has significant tax advantages. The more the employee appreciates these advantages, the more favourable a severance proposal can be. Mitigation It is often not well understood by employees that their entitlement to a severance package could, if not resolved early, be subject to deduction for any income earned by the employee during what is found to be the reasonable notice period. If the employee obtains alternate employment shortly after the termination of employment, the employee s own efforts can significantly diminish the employee s claim against an employer. This is a factor that employees need to be aware of and understand particularly so that they can appreciate the win fall potential of a lump sum severance proposal being paid at the time of termination of employment. If the employee s job skills are Page 9
easily transferable and there is a demand in the market for the employee s skills, a lump sum severance proposal could represent a significant win fall for the employee if the employee obtains alternate employment quickly. It is important for the employee to understand this as often the employer lump sum proposal is discounted to reflect the potential for win fall for the employee. Another mitigation issue which the employee needs to understand is the statutory obligation to repay employment insurance benefits the employee receives during the notice period. If an employee does not accept a severance package and subsequently receives EI benefits, if and when a severance package is agreed upon or awarded, any EI benefits received by the employee during the notice period are deducted by the employer and remitted to Revenue Canada. Structuring severance packages are the most problematic when there is no written employment contract that specifically addresses what compensation an employee will be entitled to in the event the employee s employment is terminated without cause. The extent that these issues can be reduced to writing in an employee contract that will go a long way to avoid the uncertainty and risk that is inherent with proposing severance packages in the absence of a written employment contract. It is also advisable in circumstances where there is no written employment contract to seek legal advice prior to making the severance proposal, to ensure it is fair and reasonable and to ensure it is reasonably understood by the employee and that if accepted it will completely eliminate any future claims in anyway related to the employment relationship with the employee, including claims related to benefit plans, employment standards, or human rights legislation. Page 10