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16 February 202410 minute read

Equitable discretion: The entrepreneurial need for flexibility

Equitable discretion: The entrepreneurial need for flexibility

Following the introduction of the control of general terms and conditions into German labour law, employers' options for structuring their contracts have been severely restricted. General terms and conditions only become part of the employment contract if they’ve been effectively agreed and included in the contract; but individual agreements continue to take precedence. This has significantly restricted the employer's ability to reserve the right to unilaterally change or deviate from the service. So employers should pay particular attention to the remaining freedoms. We’d like to highlight the institute of equitable discretion, according to which one party can unilaterally determine the benefit if there’s any doubt based on equitable discretion. If the provision does not correspond to equitable discretion, it’s not binding for the other party, and it can demand that the provision be made by the court in a judgement.

Contrary to what is sometimes assumed, this determination of performance by one party does not represent a deviation from the statutory model, but corresponds exactly to it, if the limits of Section 315 German Civil Code (Bürgerliches Gesetzbuch – BGB) are observed.

Due to unforeseeable developments and the complexity of employment relationships, it’s particularly difficult to regulate them in detail in advance. So employers want to reserve certain freedoms in their employment contracts to be able to react adequately and flexibly to unforeseeable circumstances and developments. This is particularly relevant when exercising the right to issue instructions (eg for transfers) or when granting variable remuneration. If these aspects are linked to discretionary decisions, the employer is given the desired room for manoeuvre and can react better but must observe the limits of "equity." The discretionary decision is subject to full judicial review.


Content review and exercise review

The review of a discretionary decision is carried out in two steps: the content review and the exercise review. Firstly, it must be checked whether the contractual agreement on the right to determine performance is effective at all (content review). In the case of standard form employment contracts, this is done based on a review of the general terms and conditions in accordance with Sections 305 et seq. BGB.  Good faith (Section 242 BGB) or immorality (Section 138 BGB) can also lead to the invalidity of the agreement.

In the second step, the exercise control takes place. This is based on the standard of equity in Section 315 BGB, unless otherwise agreed.

Against this background, it seems possible to choose a different, more far-reaching standard for determining performance in the employment contract, such as "free discretion." But it’s highly questionable whether this standard can be effectively agreed in the employment contract, as this would deviate from the statutory guiding principle and would likely constitute an unreasonable disadvantage (Section 307 BGB) for the employee. In practice, it’s important to focus on "equitable discretion" to prevent a court from deeming the clause itself to be invalid.

In addition to the contractually regulated rights, there are also some legally regulated unilateral rights to determine performance, eg in the context of company pension schemes or personnel selection decisions. Particularly relevant here is the employer's right to issue instructions in accordance with Section 106 of the German Industrial Code (Gewerbeordnung – GewO), according to which the employer can unilaterally determine the content, place and time of work at its own equitable discretion. As the determination of performance is not based on a contractual agreement in this case, there’s no need to review the content and it’s only necessary to examine whether the determination of performance is fair in the specific case (exercise review).


Considering the interests of both parties

But when is a decision equitable and which point in time is decisive? The Federal Labour Court (Bundesarbeitsgericht – BAG) has established the following rule of thumb: "The limits of equitable discretion are observed if the employer has weighed up the essential circumstances of the individual case in its decision and has given appropriate consideration to the interests of both parties." The relevant time for the assessment of fairness is always the time at which the employer has to make the discretionary decision. The term is broadly defined, which creates the necessary flexibility for the employer, but provides little information as to when a decision corresponds to equitable discretion and when it does not. Over the years, the Federal Labour Court has developed criteria that must be observed when exercising discretion. Accordingly, the employer must determine its own interests and those of the employee to carefully weigh them up against each other in the next step, in particular taking into account the fundamental rights of the parties and the principle of equal treatment under labour law.


No obligation to justify the determination of performance

If the employer has specified the performance, there is no obligation for the employer to justify the decision or to explain the weighing criteria; the only thing that matters is the objective equity of the decision. However, as this decision is fully subject to judicial review and the employer bears both the burden of presentation and the burden of proof for the equity of the performance determination, the employer must present all the criteria for consideration and their weighting at the latest in the event of a judicial review. Otherwise, the court will declare the provision inequitable and invalid and make its own performance determination. To avoid conflict, it’s advisable to inform employees of the reasons for the decision at the outset so they can better understand the decision and assess whether the determination was made within the scope of equitable discretion.

There are no formal requirements for exercising the right to specify performance; it can be done by informal declaration to the other party. However, it should be noted that the right to specify performance can neither be made subject to certain conditions nor revoked.


No obligation to comply with unreasonable instructions

The performance provision is only binding for the other party if it corresponds to equitable discretion. Whether unreasonable instructions must be followed was a controversial issue for a long time. However, the BAG clarified in 2017 that the employee does not have to follow the instructions (and not even provisionally until a judgement to the contrary). Employees then have a right to refuse performance and can demand that the court makes the determination by judgement. However, the employee bears the risk of not complying with an instruction and possibly exposing themselves to sanctions under labour law if a court classifies the instruction as valid contrary to expectations.

At first glance, the court's authority to decide on the determination of performance appears to severely restrict the employer's room for manoeuvre. However, in reality it only sets the limits within which the employer can manoeuvre. The employer does not have to make the decision that the court considers to be "correct," but rather a decision that is justifiable within the scope of equitable discretion. So if the employer wants to ensure that the court does not make a decision on performance itself, it must be able to explain and defend its decision in court. No false restraint should be exercised here, as courts tend to take what they consider to be an inadequate explanation of the performance determination and its equity as a reason to uphold the claim and determine the performance themselves.


Equitable discretion when changing location

Disputes about the fairness of an instruction arise particularly frequently when the employer wishes to exercise its right to issue instructions to transfer an employee to another workplace. This is particularly the case if the work is to be carried out at a completely different location and it may even require the employee to relocate. The first question to ask is whether a specific place of work or even a relocation clause has been agreed in the employment contract. If there is no specific place of work, the employer can carry out the transfer on the basis of their right to issue instructions, as they can determine the content, place and time of the work performance at their reasonable discretion. Nevertheless, this determination must stand up to scrutiny, meaning that the employer cannot assign just any place of work. The BAG clarifies that the mutual interests must be weighed up according to constitutional and statutory value judgements, the general value principles of proportionality and reasonableness and customary practice and reasonableness, for which the circumstances of the individual case are always decisive.

Among other things, the advantages of an arrangement, the mutual needs and the distribution of risk between the parties, the asset and income situation or social aspects such as family obligations must be taken into account. The business concept on which the decision is based and the other reasons for the decision are also of particular importance for this consideration. However, in view of the subsequent disadvantages for the employee, the decision must under no circumstances appear to have been made arbitrarily or abusively.


Discretionary variable remuneration

Another frequent point of contention is the right to specify performance in the context of variable remuneration, where disputes arise not only over the amount of remuneration to be paid, but also over the setting of targets on the achievement of which the entitlement to payment depends.

In addition to bonus payments, this also applies to other special remuneration such as Christmas bonuses or gratuities. According to the case law of the Federal Labour Court, neither the type nor the amount of a bonus payment must be conclusively regulated in the employment contract; the employer can determine them themselves. In practice, the agreement of additional criteria is frequently encountered, which must be taken into account when making discretionary decisions, such as consideration of the company's success or the employee's individual performance.


Action for payment or action for information?

If a dispute arises over the amount of the special payment, the employee can bring an action for payment directly before the labour court. If the labour court also assumes that the employer's decision is unjust, it will determine the amount of the special payment to be paid by means of a ruling. In such cases, the employee will usually argue that they received a bonus of a certain amount in the previous year and that the performance was at least as good as in the previous year. If the employer does not substantiate this, it’s likely that the court will, in case of doubt, reassess the previous year's bonus. If, according to the agreement in the employment contract, non-public key figures of the company are to be used as the basis for calculating the bonus, the employee can also sue for this information to then file an action for payment in the next step.

In contrast to target agreements, targets are set unilaterally by the employer, who must observe the limits of equitable discretion. Cases in which the employer has not set any targets at all or has set incorrect targets are particularly in need of clarification in court. For example, setting targets that were unattainable from the outset is deemed to be incorrect. In these cases, courts of lower instances tend to consider the omitted or incorrect target setting to be unjust and set a separate target based on the targets from previous periods. Whether the BAG supports this approach has not yet been decided. However, it has expressly assumed that in such cases damages can be claimed in accordance with Section 280 BGB.

In practice, it’s essential to be able to properly explain the determination of the respective interests, their weighting and all other aspects that can be used to justify the discretionary decision to prevent a judicial determination of performance or a claim for damages.