UK: Corporate Governance – ABI and NAPF Launch Best Practice Statement On Executive Contracts and Severances

Last Updated: 5 February 2003

In December 2002 the ABI and NAPF jointly published a best practice statement on contracts and severance pay. Boards and remuneration committees of listed companies will need to bear this in mind when preparing their Directors’ Remuneration Reports, determining their remuneration policy, negotiating service contracts with newly recruited directors, and agreeing compensation for departing executives.

The statement will have increasing importance in light of the new statutory vote on the remuneration report introduced by the Directors’ Remuneration Report Regulations 2002 (for further information see separate briefings dated August 2002 and December 2002).

The statement forms part of the ABI Guidelines on remuneration, also covering principles and guidelines for the structure of remuneration and guidelines for share incentive schemes – these are covered in a separate briefing available on request. The Guidelines themselves can be accessed from the ABI website www.abi.org.uk.

The statement is a response to growing criticism in the media and elsewhere of "rewards for failure" where executive directors receive large payments on departure from the company. This has occurred because, by the time poor performance is evident and the writing is on the wall, it is too late to rewrite the rules and the executive’s entitlement to compensation is set in stone – in his service contract. In the absence of proof of gross misconduct such as fraud or dishonesty, the circumstances in which a director can be summarily dismissed without compensation are usually very limited. In theory it has always been open to companies to broaden the circumstances in which a director can contractually be dismissed with no or limited compensation, but in practice they have rarely done so. Shareholder pressure may mean that this is now an option companies will need to consider more carefully.

Emphasis on negotiating appropriate contracts at the start of employment

The main thrust of the ABI/NAPF statement is that remuneration committees must focus very carefully at the outset – that is, when the service contract is first entered into – on the potential cost of termination. Remuneration and nomination committees should work together to design service contracts which do not commit companies to payment for failure, and should develop a clear considered policy on service contracts which is included in the remuneration report. They should bear in mind – and avoid – the serious risk to the company’s reputation if it is obliged to make and disclose large payments to executives who have failed to perform.

This will clearly require remuneration committees to devise means of measuring performance, and the statement provides that the objectives set for the executive director should be clear and where possible made public – the more transparent the objectives, the easier it should be to determine whether the director has failed to perform and therefore to prevent payment for failure.

Bonuses

Executives’ claims for compensation on termination often include sizeable amounts for bonus that would have been awarded during the contractual notice period. The ABI/NAPF statement notes that these claims can be limited by imposing clear performance conditions on the payment of bonuses in the first place, and by specifying that a proportion of the bonus is for retaining the executive and falls away in the event of severance. This should be expressly provided in the bonus scheme rules or in the service contract, even where the bonus is expressed to be discretionary. Where a company states what factors it will consider in exercising its discretion (which is advisable in terms of producing evidence to refute any discrimination claims), it will only lawfully be able to consider these factors and no others – therefore it should consider stating that longevity is a relevant factor and/or providing expressly that no bonus will be payable where the executive’s employment has been terminated or (possibly) where notice of termination has been given, prior to the end of the bonus year or the bonus payment date. (Note however that there is a potential, as yet untested, argument that even this may fallfoul of the Unfair Contract Terms Act 1977.)

Length of contract

The guidelines state that the one year period provided for under the Combined Code should not be seen as a floor, and remuneration committees should be prepared where appropriate to consider shorter periods. Equally, change of controlclauses giving rise to an entitlement exceeding one year’s remuneration should not normally be included. Only in exceptional circumstances, such as where a new chief executive is being recruited to a troubled company, will a longer notice period (or more generous change of control clause) applying during an initial period possibly be appropriate.

Contract provisions regarding severance compensation

The statement suggests a number of ways to reduce the compensation companies will be contractually obliged to pay on severance:

• The statement supports the inclusion of a clause providing for phased payments, where the company continues to pay the departing executive on the usual basis for the outstanding term of the contract or, if earlier, until the executive finds new employment. Although this does not lead to reduced compensation for poor performers, it does mean that the company gets the benefit of any mitigation of loss (although of course a poor performer will usually take longer than others to find another job). This proposal seems to envisage a contractual provision enabling the company to give notice of termination and place the executive on garden leave until the earlier of his notice period and his finding alternative work. The statement suggests that in many cases executives will prefer to seek further employment rather than remain idle – in some cases this may be rather optimistic, but there is nothing to prevent the contract making continued payment conditional on the executive making reasonable efforts to find other employment (and, possibly, providing the company with proof of this).

(The statement says that this phased payment approach needs to be specifically provided for in the initial contract, and it is based on continuing the employment rather than terminating without notice. However, the same effect with regard to compensation can be achieved by including terms, either in a termination agreement or in the initial service contract, providing that in the event that the employment is terminated summarily, phased payments of damages become payable until what would have been the expiry of the notice period or, if earlier, until the director finds fresh employment.)

• The liquidated damages approach, where the parties agree upfront how much the director will receive on severance as a lump sum, is not generally supported by the shareholder institutions on the basis that the amount cannot be varied to reflect under-performance (nor does it allow for mitigating earnings to be offset). Of course it would be possible to expressly provide that the specified amount of damages is smaller than otherwise if the company terminates for poor performance (or misconduct). However, this is not suggested by the shareholder institutions, who instead recommend that boards adopting liquidated damages clauses should provide that the amount of the damages be determined by arbitration (presumably the contract should make clear that factors such as performance should be taken into account by the arbitrator). The costs of arbitration would also need to be taken into account.

• If the contract is simply to include a notice period, damages for which would then be subject to the director’s duty to mitigate his loss, shareholders will expect reassurance that the board has taken steps to ensure he does so to the fullest extent possible – and therefore any termination agreement should reflect this duty fully. Again the institutions suggest that the board should consider providing for claims to go to arbitration rather than litigation.

• The statement notes that in due course a statutory disciplinary procedure will be implied into every contract of employment, including directors’ service contracts, pursuant to the Employment Act 2002. This is likely to come into force towards the autumn of 2003. Although not yet clear, the procedure is likely to apply to dismissals for poor performance as well as misconduct, and might also apply to redundancy dismissals. The shareholder institutions note that boards should be prepared to use the procedure if warranted and, if a director is dismissed following the use of such a procedure, the contract should provide for termination on a shorter notice period than otherwise. They suggest that an appropriate period would be the statutory minimum period of notice, which is between one and twelve weeks depending on length of service. This is quite a radical suggestion given the wide applicability of the procedure and the fact that the company could choose to invoke the procedure where the misconduct or poor performance is minor in nature (and where the dismissal would ultimately beunfair).

• Perhaps more palatable is the suggestion that contracts permit dismissal without notice in cases of serious financial failure – such as a very significant fall of the share price relative to the sector. However, would this be appropriate for all the directors of the failing company? – should all directors be responsible for such a failure or should an individual director be terminable with no or reduced notice only if he has failed to meet personal performance targets?

• Finally, the statement suggests that companies could provide for cash compensation on termination to be paid by reference to shares, with the amount of the shares set at the outset of the employment, thereby tying the compensation to the company’s fortunes. Remuneration committees adopting such an approach should satisfy themselves that it is workable and will yield advantages greater than the other approaches outlined above. The use of shareholding targets is seen as a more effective means of aligning the financial interests of executives with those of shareholders.

Of course the above suggestions deal only with the executive’s contractual entitlement. Executives dismissed for poor performance will often have valid unfair dismissal claims where the company has not been willing or able to give them targets and time to improve. The compensatory award for unfair dismissal will be capped at £53,500 from February 2003.

The Combined Code and the Higgs review

The Combined Code on corporate governance also touches on these issues. The Code states that remuneration committees should consider the advantages of providing explicitly in the initial contract what compensation commitments will apply on the termination of a director’semployment, save in the event of dismissal for misconduct. The Higgs Review of non-executive directors published earlier this week proposes that the Code be amended to include an additional comment that "in doing so, they should bear in mind the need to ensure that such provisions do not have the effect of rewarding poor performance which would not amount to misconduct or otherwise entitle the company to terminate the contract". This stipulation could be fulfilled by expressly providing that differing amounts of compensation are payable on dismissal for misconduct, poor performance and otherwise – or achieving the same effect by providing for differing notice periods for each type of dismissal. However structured, the contract could also provide for mitigating earnings to be offset.

Parliamentary initiative

Perhaps not surprisingly in view of the media attention given to this issue, the ABI/NAPF best practice statement and Higgs Report are not the only recent initiatives relating to "rewards for failure". Archie Norman MP has introduced a Private Member’s Bill "to amend the law in relation to payment of a company director by way of compensation for loss of office so as to require boards to take respective director’s performance into account in settling the amount of any such payment, notwithstanding anything in the contract". As the Bill has not yet been published, it is unclear exactly how it would work and whether it would cover private companies and unlisted public companies. If the proposal is to modify contract law to reduce a director’s contractual entitlement, the director might still be able to claim additional compensation for unfair dismissal. Would the law apply to current contracts or only new contracts entered into after the legislation came into force? How would boards determine that a director had performed poorly where no specific targets were set – to what extent would a director be deemed responsible for poor company performance? The Bill is due to receive its second reading in the House of Commons on 31 January 2003.

© Herbert Smith 2003

The content of this article does not constitute legal advice and should not be relied on as such. Specific advice should be sought about your specific circumstances.

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