In a judgment released earlier this month, the English Court of Appeal has allowed a director to claim unpaid wages and compensation for constructive unfair dismissal from a company despite there being no formal contract of employment between himself and the company.
Indeed, the only express agreement that had been reached was an informal and, in some respects, apparently incomplete verbal agreement, concluded between the director and his business partners before they set up the company and went into business together, that the director would work for the company and would be paid for his work, but the amount he would be paid was not agreed and the company would only pay him once it could afford to do so. The Court of Appeal found on the basis of these facts that an implied contract of employment existed between the company and the director.
Directors of companies are not automatically considered to be employees. A directorship is a position of office and directors only become employees if they have a contract of employment with the company. In most cases an employment contract or service contract will be negotiated and signed in the usual way.
Directors can also be shareholders of the company and they may agree to take money out of the company by way of shareholder dividends, rather than wages. As a result, they may feel that there is no need to put in place employment contracts even though the directors are working full-time or almost fulltime for the company and may be considered to have an employment relationship with the company.
The dangers of not formalising the position are highlighted in the case of Stack v Ajar-Tec Limited. Mr Stack, Mr Martin and Mr Keane set up a company in which they each owned 1/3 of the shares and they were each appointed a director of the company. The company was a start-up that was funded by shareholder loans. The three directors/shareholders were found to have agreed that Mr Stack would work for the company and would, eventually, be paid for his work but the agreement was never documented and detailed terms were never agreed as to what Mr Stack would be paid and when.
Nevertheless, the Employment Tribunal appears to have found from the evidence a clear understanding amongst the directors/ shareholders that Mr Stack was to be an employee of the company, and this was enough, in the Court of Appeal's view, from which to find an implied contract of employment between the company and Mr Stack.
Mr Martin was the principal motivator behind the company. He signed an employment contract and worked full time for the company from the date of incorporation.
Mr Stack acted more as a financier of the venture, although he spent up to 80% of his time working for the company. He had agreed with Mr Martin and Mr Keane that he would work for the company once it was incorporated but that he would not be paid any wages until the company could afford to pay him. He was provided with various draft employment contracts, but the terms were never signed or agreed.
Mr Stack's relationship with Mr Martin and Mr Keane deteriorated and his appointment as a director was terminated in August 2009 without him receiving any wages from the company. Mr Stack claimed constructive unfair dismissal and unpaid wages. The company denied that he was an employee, which if right, meant that Mr Stack's claims could not be brought. The claim has now been hotly contested over a period of nearly five years, resulting in two hearings before the Employment Tribunal, two hearings before the Employment Appeal Tribunal and two hearings before the Court of Appeal. It remains to be seen if there will be a further appeal to the Supreme Court.
The Employment Tribunal held that Mr Stack was an employee, the Employment Appeal Tribunal held that he was not an employee and the Court of Appeal agreed with the Employment Tribunal and said that he was an employee.
On one analysis, the Court of Appeal's judgment appears to stand as authority for the somewhat startling proposition that an informal arrangement can lead to legally binding obligations and afford a director the status of employee. It therefore appears to create a minefield for start-up companies. In particular, it creates some uncertainty as to the circumstances in which a director can be removed from office without that removal also being treated as a termination of the employment relationship, thus giving rise to an unfair dismissal claim unless a proper termination process is followed.
The contrary, and arguably the better, view is that this case is a triumph for fairness that turned very much on its particular facts – there was no dispute that Mr Stack had devoted a substantial amount of time and energy, not to mention capital and other resources, to the venture.
It was also clear that no party had honestly intended that Mr Stack would work for free. Whilst Mr Stack had a 1/3 shareholding in the company, Mr Martin also had a 1/3 shareholding and had always received a salary from the company. The company argued that Mr Stack had worked only to protect his investment in the company and not for further remuneration, but the Court of Appeal rejected this argument as nonsensical when contrasted against Mr Martin's position. The Court of Appeal held that Mr Stack was to be an employee of the company and remunerated for his services but, as one might expect from a financier of a start up venture, had agreed to defer any remuneration until the venture had begun to bear fruit.
However, there are some difficulties with the Court of Appeal's analysis. In particular, the Court of Appeal never convincingly dealt with the question of how the company could be bound by an agreement amongst individuals before incorporation. One possible answer is that the evidence showed that all parties, who became directors and shareholders of the company, continued to act in accordance with the agreement that appeared to have been reached pre-incorporation, but there is a slight awkwardness in the proposition that the company acted as if it regarded itself bound by an informal agreement that was reached before it existed.
Whatever the answer to that question, it is likely to be infrequent that there will be sufficient evidence of an informal, pre-incorporation agreement amongst business partners to support similar decisions in the future.
Nevertheless, the case illustrates the importance of documenting the basis upon which directors work for companies. The absence of a signed employment contract does not necessarily mean that there is no employment relationship and, consequently, no right for a director to claim unfair dismissal and other statutory rights afforded to employees.
It is apparent that not only did Mr Stack and the company disagree on his employment status, but so did the English courts, more than once. If there is no intention to pay a director for his or her work this should be clearly documented in the same way that an intention to pay the director should be documented. If the director is an employee, a fair process must be followed before his or her employment is terminated to avoid a claim for unfair dismissal and other statutory amounts that may be due.
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