Federal Labour Court declares common practice in target setting inadmissible as a tool for resolving deadlock when negotiating bonus targets

Due to a recent decision by Germany’s Federal Labour Court (Bundesarbeitsgericht) on 3 July 2024 (case 10 AZR 171/23) on bonus agreements, companies should review their existing agreements and practice of granting bonuses.

Target agreements as a tool for modern HR management

Target agreements are a common tool in modern HR management. They are used to create incentives for employees to realise certain targets faster and better, thereby contributing to the (financial) success of the company.

Legal basis

In practice, target agreements exist in many different forms. They can be based on a corresponding provision, in particular in an applicable collective agreement, a company agreement or a clause in an employment contract.

What targets are admissible?

Target agreements for an employee are often linked to the employee’s personal performance, the performance of a group of employees or the financial success of the employer or the employer’s group of companies. Mixed forms are also very common, for example target agreements that are partly linked to the achievement of personal targets and partly to the achievement of company-related targets.

Target agreements may be based on hard targets, i.e. targets whose achievement can be determined using objectively ascertainable key figures (sales, net profit, number of customers, number of complaints, etc.) or soft targets, whose achievement can only be assessed using value judgements (people management skills, employee satisfaction, customer satisfaction, etc.).

What purposes are conceivable?

It is also possible to enter into target agreements only for the purpose of enabling performance appraisal by the targets achieved, without this being directly linked to the employee’s pay. Such bare-bones target agreement systems primarily let employees participate in defining their work targets, triggering incentives and possible promotion opportunities via the appraisal.

However, if target agreements are directly linked to pay, as is often the case in practice, the (full) achievement or (depending on the details of the agreement) partial achievement of the agreed targets entitles the employee to variable compensation. It is conceivable that other conditions must also be met (such as the absence of agreed grounds for exclusion).

Distinguishing between target agreements and target setting

Target agreements must be distinguished from target setting. What both tools have in common is that they are used to set targets for a specific period (often the financial year).

However, in all other ways, target agreements and target setting are fundamentally different:

• In a target agreement, the targets are set jointly by the parties to the employment contract. If one party does not agree with the proposed or discussed targets and no agreement is reached, then no target agreement is entered into.
• By contrast, the targets in a target-setting system are set unilaterally by the employer – possibly after prior consultation or discussion with the employee – and do not require the employee’s consent to be effective. Accordingly, a target can also be effectively issued unilaterally by the employer against the employee’s will.

The main advantage of the target agreement tool over target setting is that the targets determined (jointly) by way of a target agreement are generally less likely to be called into question by the employee. There is also greater room for manoeuvre when it comes to the content of the targets.

One major disadvantage of using target agreements, on the other hand, is that much more effort is required compared to target setting. For each target agreement period, a new attempt must be made to reach a consensus on specific targets.

Target setting as a conflict resolution mechanism in the absence of mutual agreement on targets

The fact that effectively reaching a target agreement requires consensus on specific targets inevitably raises the question of what recourse is available if the parties fail to reach such a consensus, potentially after several rounds of discussions or negotiations. This may be the case, for example, if the employee does not agree with the targets proposed by the employer (because they are considered too ambitious and unachievable, for example) or the employer does not consider the targets proposed by the employee to be sufficiently relevant to the (financial) success of the company or does not consider them sufficiently ambitious.

Previously, in order to avoid such deadlock, it was often stipulated that if no agreement was reached within a certain period of time after the start of the talks or by a certain date (by 31 January of the year in question, for example), the employer would be entitled to unilaterally set the targets for the target agreement period in question at its own discretion. Such provisions have proven to be a suitable way to ensure the validity of certain targets for the target agreement period despite a lack of consensus. Such conflict resolution clauses used to read as follows, for example:

“If no consensus is reached on the targets for the relevant target agreement period in the target agreement meeting and/or within a period of two weeks after the target agreement meeting has taken place, or if the employee culpably prevents the target agreement meeting from taking place, the targets and their weighting for calculating the bonus will be determined unilaterally by the employer at its reasonable discretion.”

Decision of the Federal Labour Court on 3 July 2024

In a decision dated 3 July 2024 (case 10 AZR 171/23), the Federal Labour Court has now blocked, or at least significantly restricted, the use of the tool of target setting as a conflict resolution mechanism in the absence of a mutual agreement on targets in many practically relevant cases.

The decision was based on an employment contract provision agreed according to a standard form and therefore subject to section 307 onwards of the German Civil Code (BGB), according to which the employee had the option of receiving a variable bonus in addition to his fixed salary. The employment contract included the following clause:

“The determination of a bonus and the bonus amount depend on the achievement of targets, the three essential criteria for which are agreed between the employee and the company each year, for the first time at the end of the probationary period. If the three criteria are not agreed between the employee and the company, they will be set by the company at its reasonable discretion.”

The Federal Labour Court held this provision to be invalid, with the consequence that the provision about the target was deleted without replacement and, in order to avoid possible liability for damages on the part of the employer, it remains the case that the targets must be set by mutual agreement between employer and employee.

In its decision, however, the Federal Labour Court first clarified that an agreement in standardised employment contracts which states that the employer is entitled to specify the targets for achieving performance-related pay by way of unilateral performance appraisal at its reasonable discretion, i.e. to set a target, is generally admissible.

However, if a clause contained in a standardised employment contract stipulates that the targets to be achieved are to be determined primarily by agreement (i.e. by way of a target agreement) and only secondarily by the employer specifying them unilaterally (i.e. by way of target setting), such a clause unreasonably disadvantages the employee within the meaning of section 307 of the German Civil Code and is therefore invalid. This is because such a clause could unilaterally undermine the order of priority agreed in the employment contract between target agreement and target setting by the employer without the employee being able to prevent this. For example, the employer could refuse or break off negotiations on drawing up a target agreement for no reason and then unilaterally carry out the necessary setting and weighting of the targets to be achieved by the employee. The clause thus deviates from the general principle that contracts and the obligations arising from them are binding on each party (pacta sunt servanda).

The legal consequence, according to the Federal Labour Court, was the deletion without replacement of the provision on the target setting, i.e. the sentence “If the three criteria are not agreed between the employee and the company, they will be set by the company at its reasonable discretion.”

The remaining provisions on variable pay and the drawing up of a target agreement, in particular the sentence “The determination of a bonus and the bonus amount depend on the achievement of targets, the three essential criteria for which are agreed between the employee and the company each year, for the first time at the end of the probationary period” remain effective and must be observed by the employer. The employer is then obliged to conduct negotiations with the employee in good time on entering into a target agreement and, if necessary, to actually enter into such an agreement. The employer can no longer rely on the fact that it had unilaterally set the targets and thus fulfilled its obligations under the employment contract, according to the Court.

Practical implications

The Federal Labour Court’s decision is not a persuasive one. This is because, contrary to the Court’s opinion, the target setting after a failed target agreement corresponds to what was contractually agreed, i.e. the contractual fidelity (pacta sunt servanda) is precisely honoured by the target setting and not, as the Court believes, breached. Secondly, the law in section 162 of the German Civil Code already provides for an express provision in the event that a contracting party frustrates the fulfilment of a condition. Therefore, instead of going to great lengths to justify the desired result, it would have been sufficient to examine whether the employer had, in bad faith, prevented the fulfilment of the condition of not reaching a target agreement.

Despite all the criticism, the decision still has a lot of practical relevance. Employers would therefore be well advised to take the decision into account when drafting incentive schemes in the future, in order to avoid the possibility of employees successfully asserting claims for damages due to incorrectly set targets. In practice, such claims for damages can often amount to 100% of the variable pay.

In practice, the Federal Labour Court seems to have achieved the opposite of what it intended. From the employer’s point of view, they should consider not linking variable pay in standardised employment contracts to the achievement of targets from a target agreement, but rather to immediately stipulating that the employer (exclusively) sets the targets to be achieved by the employee by means of target setting. This actually places employees in a worse position than before, as they will have no possibility of influencing the bonus targets.

It should be noted that the Federal Labour Court emphasises that the instrument of target setting is not generally inadmissible. On the contrary, direct target setting by the employer can still be effectively agreed in a standardised employment contract.

Corresponding provisions are also permissible and customisable – especially for top executives and board members – if the regulations on variable pay, in particular the provision on target setting as a conflict resolution mechanism if there is a failure to come to a target agreement, are not contained in a standardised employment contract (preformulated by the employer), but are negotiated individually. In the absence of a standardised contract, the considerations of the Federal Labour Court from its ruling of 3 July 2024 are unlikely to apply in this case. Although negotiating individually is not usually considered in practice for non-managerial employees due to the effort involved, it can be a viable option, particularly for employment contracts for top executives and service contracts for board members (especially managing directors). Individual negotiation may exist, for example, if the draft contract prepared by the company at the negotiation stage initially only provides for target setting by the company, but the employee or board member does not wish to agree to this and proposes that the employment contract should include a target agreement for performance-related pay. A compromise negotiated on an individual basis may then consist of the company agreeing to the requirement to enter into a target agreement, but enforcing the tool of corporate target setting as a conflict resolution mechanism.

If target setting is provided for in a collective agreement or a company agreement as a conflict resolution mechanism in the event that a target agreement is not reached, this will still be admissible, as provisions in collective agreements and company agreements, unlike clauses in standardised employment contracts, are not subject to a test of reasonableness under section 307 of the German Civil Code.

We are happy to support you in drafting and amending your incentive schemes in a legally compliant way. Please feel free to contact us.