The recent controversies over exit packages paid to former Chief Executives has called into question the duties and responsibilities of Board directors who approve exit packages for departing directors. In this article we focus on sometimes forgotten provisions of the Companies Acts that govern the payment of termination payments to Board members.
Section 186 of the Companies Act 1963 ("Section 186"), in conjunction with Section 189(3), provides that compensation for loss of office as director or, while director, of any other office in connection with the management of a company's affairs (except any bona fide payment by way of damages for breach of contract or by way of pension in respect of past services) is unlawful, unless it is pre-approved by the shareholders of the company in general meeting.
Failure to ensure compliance with Section 186 could leave Board members exposed, on a joint and several basis, to the company in respect of any payments made in breach of the section.
SECTION 186 OF THE COMPANIES ACT 1963
Section 186 provides as follows:-
"Approval of company necessary for payment by it to director for loss of office
It shall not be lawful for a company to make to any director of the company any payment by way of compensation for loss of office, or as consideration for or in connection with his retirement from office, without particulars relating to the proposed payment (including the amount thereof) being disclosed to the members of the company and the proposal being approved by the company in general meeting."
Section 189(3) of the Companies Act 1963 provides as follows:-
"It is hereby declared that references in sections 186, 187 and 188 to payments to any director of a company by way of compensation for loss of office, or as consideration for or in connection with his retirement from office, include payments to him by way of compensation for loss of office as director of the company or for the loss, while director of the company, or on or in connection with his ceasing to be a director of the company, of any other office in connection with the management of the company's affairs or of any office as director or otherwise in connection with the management of the affairs of any subsidiary company but do not include any bona fide payment by way of damages for breach of contract or by way of pension in respect of past services, and for the purposes of this subsection "pension" includes any superannuation allowance, superannuation gratuity or similar payment."
These sections, when read together, relate to any payments of compensation for loss (including retirement):
- of office as Director, or
- while a Director or on or in connection with ceasing to be a Director, of any other office in connection with the management of the company's affairs.
- In other words, Section 189(3) brings under the ambit of Section 186 payments by way of compensation for loss of a management office (e.g. the post of CEO or Finance Director) where the individual losing that office is also a director of the company.
Section 186 exists to protect members of a company from the company's directors. The section recognises an inherent conflict of interest where directors propose making a payment as compensation for loss of office to one of their number. The legislature has ordained that, so obvious and significant is this conflict of interest, mere disclosure to the members is an insufficient means of addressing it. Section 186 excludes from the directors' powers the power to decide whether or not to make such a payment, and confers that power instead on the members/shareholders acting by majority in general meeting. In the absence of approval of the members in general meeting, any payment made in breach of Section 186 is unlawful and liable to recovery.
CASE LAW FROM AROUND THE WORLD
Somewhat surprisingly, and particularly in circumstances where this provision has existed on the statute books for over 50 years, there is no decided authority on Section 186 in Ireland. The High Court recently came close to delivering the first judgment on the section in the proceedings taken by a non-executive director of Independent News and Media (INM), Paul Connolly, over a termination payment paid to INM's former chief executive1. In that case, which was heard over three days in July 2012, the Plaintiff sought a declaration that the termination payment paid was unlawful on the grounds that it had not been approved in advance by INM's shareholders at a general meeting. The case settled immediately prior to judgment, depriving us of the benefit of some much needed judicial clarity on the scope of this wide-ranging statutory provision.
However, similar statutory provisions have been considered in other common law jurisdictions, including the UK, Australia, New Zealand and Singapore.
In the English High Court decision of In Re Duomatic Limited2, a director (who was also a shareholder) threatened to sue the company if he was dismissed as a director and he was subsequently paid £4,000 to leave the company. There was no resolution of the members of the company authorising the payment. The company subsequently went into liquidation and the liquidator sought the repayment of the £4,000 paid to the director on the grounds, inter alia, that the sum was unauthorised. Buckley J. held that as the payment of £4,000 as compensation for loss of office had not been approved by the shareholders under Section 191 of the UK Companies Act 1948 (the then former equivalent section in the UK to Section 186), it was ultra vires. The Court held that the director who had received the payment and a fellow director were jointly and severally liable to repay the sum of £4,000 to the liquidator. In his judgment, Buckley J stated:
"It follows that the payment was an ultra vires payment, for it was a payment which the section says it was not lawful for the company to make. The directors responsible for making it are liable in respect of it on the grounds of misapplication of the Company's funds..."
More recently in Mercer –v- Heart of Midlothian Plc3 the Scottish Court of Session had to grapple with the unusual facts of a case brought by the former chairman of a football club who sought a declaration that he was Honorary Life President of the Club and therefore entitled to certain privileges which flowed from that post, including two seats in the directors box on match day. In defence to this claim, the Club asserted that the arrangement entered into with the former chairman by the Club's Board contravened Section 312 of the Companies Act 1985 (the then former equivalent section in the UK to Section 186)4. On the facts, the Court held that the arrangement entered into with the plaintiff by the Board of the Club did not contravene Section 312, as the privileges that were provided to him were essentially attached to his future position as Honorary Life President, rather that in connection with his retirement as Chairman of the Club and therefore did not fall within the scope of Section 312.
Significantly, the Court of Session confirmed that Section 312 required disclosure of proposed payments for loss of office to members and approval by the members in advance of the payments being made. Accordingly, the Court concluded that disclosure of the fact that a payment had been made to a Board director in the annual accounts of a company would not discharge the obligation imposed by the section to secure shareholder approval in advance of the payment being made.
In Gooding & Anor –v- Cater & Ors5 the Court had to consider whether a termination payment of £54,000 that had been paid to a retiring executive Board member was a bona fide payment by way of damages for breach of contract within the meaning of Section 316(3)6 of the UK Companies Acts 1985. The Court also had to consider whether, if it was not, the payment was within the scope of Section 312 and therefore required prior shareholder approval in general meeting. Interestingly the High Court held that Section 316(3) did not require an action for damages to have been instituted, and certainly did not require a judgment for damages to have been recovered, in order for the statutory carve out from Section 312 to apply. In this regard, the Court stated:
"it cannot be supposed that a bona fide settlement of a claim for damages is outside the exception in Section 316(3), and there is no sensible difference between a payment by way of settlement before a writ is issued and a payment by way of settlement after a writ is issued".
The Court further stated that the payment of damages for wrongful dismissal or of an agreed sum in settlement of a right to compensation for premature termination of a contract of employment is a payment to which a company is legally obliged to make, even if the amount to be paid is finally determined by negotiation rather than by the judgment of a Court and is thus outside the scope of Section 312.
The relevant statutory provision in New Zealand7 was considered by the Privy Council in Taupo Totara Timber Co Ltd –v- Rowe8. In that case, the respondent was managing director of a company and had a service agreement which provided that he was to serve as managing director of the company for 5 years. The agreement further provided that if during that period the company was taken over, the respondent would be entitled at any time within 12 months after the takeover to resign his office and receive a lump sum payment of five times his annual salary tax free. The company was taken over and the respondent duly gave notice of his resignation. The company refused to pay the lump sum and the respondent brought an action for its recovery. The New Zealand Court of Appeal held that he was entitled to recover the sum due. The Privy Council upheld the decision of the Court of Appeal.
The Privy Council held that the Board of Directors of the company was entitled to appoint the managing director on such terms as it thought fit and, in those circumstances, there was no requirement on the Board to seek shareholder approval of the managing director's contract of employment in advance of it being entered into, notwithstanding that it contained provisions for compensation for loss of office. The Privy Council drew a distinction between payments that a company has a pre-existing legal obligation to make and payments which it does not. The Privy Council concluded that it is only the latter payments that require prior shareholder approval.
WHAT CAN BE GLEANED FROM THE EXISTING CASE LAW– WHAT PAYMENTS ARE CAUGHT BY SECTION 186?
If a payment, which would fall within the scope of Section 186, and does not fall within the two statutory carve outs prescribed in Section 189(3), is to be made lawfully, details of the proposed payment in question (including the amount of the proposed payment) must be disclosed to all members of the company and the proposal to make the payment must be approved by the members in general meeting after the relevant disclosure. The company should give its approval by passing an ordinary resolution of the members/shareholders. In the case of a private limited company, a written resolution passed in accordance with the articles of association will suffice. It is crucial that the approval of the company's members is obtained before the payment is made.
A distinction can be drawn between a termination payment that a company has a pre-existing legal obligation to make, for example because it is provided for in a contract of employment, and one that it does not. Prior shareholder approval is only required in respect of the latter. Indeed this approval is required before a severance or compromise agreement is entered into with the departing Board member in which the company becomes contractually bound to make the payment. In the absence of such approval, a contract obliging a company to pay an unlawful termination payment will be unenforceable.
The obligation to put the payment before the members of the company for approval rests, jointly and severally, on all of the Board directors, including the director who is to receive the payment if approved.
WHAT PAYMENTS ARE NOT CAUGHT BY SECTION 186?
Section 189(3) may be relied on to exclude certain payments from the ambit of Section 186, and specifically "any bona fide payment by way of damages for breach of contract or by way of pension in respect of past services".
The precise meaning of these exclusions has yet to be considered in this jurisdiction but the "damages exclusion" has been considered in the UK and, as set out above, does not require litigation to have been initiated or indeed, even threatened, in order for the statutory carve out to apply, thereby bringing payments that might otherwise be considered as within the scope of Section 186, outside of its scope.
However, it should be noted that the "damages exclusion" appears only to apply to compensation paid in compromise of a director's claim for damages for breach of his/her contract of employment. In other words, in order for a settlement payment paid to an executive director on removal, resignation or retirement to fall outside the scope of Section 186 that payment must be a bona fide settlement of a breach of contract claim, and accordingly, the quantum of such a payment is capped at the maximum amount the executive director could recover in a wrongful dismissals action (i.e. compensation for loss of remuneration during notice or on an unexpired fixed term if there is no notice clause). By way of example, if an executive director has a contractual entitlement to 12 months' notice, on termination a company is entitled to pay that director a lump sum in lieu of his notice entitlement without first having to seek the approval of the company's members to do so under Section 186. However, without shareholder approval, account cannot be taken of the quantum of compensation that the executive director might potentially recover in an unfair dismissals action under the Unfair Dismissals Acts 1977 to 2007.
So far as we are aware, there has, as yet, been no judicial consideration of the pensions carve out, however, it is likely that this carve out only applies to bona fide payments made to executive directors' pension arrangements to ensure the provision of pre-existing pension rights. If executive directors pension rights are enhanced in connection with their removal, resignation or retirement from office, the payments made to the pension arrangements of such directors to fund those enhanced pension rights are likely to require prior shareholder approval in accordance with Section 186.
WHAT ARE THE CONSEQUENCES OF A PAYMENT BEING MADE IN BREACH OF SECTION 186?
Unlike the current statutory equivalent provision in the UK9, Section 186 does not provide for the legal consequences of a payment being made in breach of the section.
If a payment was made to a retiring director in breach of Section 186, it would likely be contended in an action to recover that payment that a declaration should be made by the Court that the payment was made unlawfully and, as such, is held in trust by the director for the benefit of the company. Furthermore a claim for restitution would also likely be made out.
As confirmed In Re Duomatic, and outlined above, a separate cause of action could exist against the directors who approved the unlawful payment, in which case all directors would be liable on a joint and several basis for any award made by the Court in favour of the company. The potential for such a claim should be at the forefront of the minds of Board members who are asked to approve termination payments for retiring Board members, and should at least ensure that those members are vigilant in ensuring that the requirements of Section 186 are discharged where required.
PROPOSED REFORM OF SECTION 186 – COMPANIES BILL 2012
On the enactment of the Companies Bill 2012, which is expected to occur later this year, Sections 186 and 189(3) of the Companies Act 1963 will be consigned to history and will be replaced by Sections 252 and 255 of the new Companies Act.
The Companies Bill 2012 recasts the current restriction in Section 186 in markedly more precise terms. Section 252 of the Companies Bill 2012 ("Section 252"), in conjunction with Section 255 (5), provides that it shall not be lawful for a company to make a payment by way of compensation for loss of office (including a management office) to a director unless the following conditions are satisfied:
- the particulars relating to the proposed payment (including the amount of it) are disclosed to the members of the company; and
- the proposal is approved by resolution of the company in general meeting.
- The section goes on to provide that in addition to the statutory carve outs from Section 252 provided for in Section 255 (discussed below), a payment made bona fide in discharge of an existing legal obligation does not fall within this section. Section 255 defines an "existing legal obligation" as one that was not entered into in connection with or in consequence of the event giving rise to the payment for loss of office in question. This definition would appear to capture severance or compromise agreements entered into with retiring Board members at the time of termination, which provide for non-pre-existing termination payments and render such agreements unenforceable unless the terms thereof have been pre-approved by the members in general meeting. This statutory carve out does not currently exist in the Companies Acts and its introduction is likely to owe its origin to the case law referred to above in which a distinction has been drawn between a termination payment that a company has a pre-existing legal obligation to make, and one that it does not. As outlined above, case law from the UK and New Zealand confirms that prior shareholder approval is only required in respect of the latter.
Section 255 also repeats the existing provisions of Section 189(3), in that it provides that Section 252 does not apply to any bona fide payments by way of damages for breach of contract or pension in respect of past services.
As regards the consequences of a payment being made in breach of Section 252, Section 233(3) of the Companies Bill 2012 provides that where a company makes a payment to a director in breach of Section 252, that director shall be liable:
- to account to the company for any gain which he or she makes directly or indirectly from the payment;
- to indemnify the company for any loss or damage resulting from the payment; or
- to do both of those things as the circumstances may require.
This provision provides a welcome clarification on the legal consequences of a payment being made in breach of that section and removes any ambiguity that might currently exist due to the fact that Section 186 does not expressly provide for the legal consequences of a payment being made in breach of that section.
It is essential that all Board members are aware of the stringent requirements of Section 186. Failure to ensure that payments by way of compensation for loss of office are approved in advance by the members of a company could leave the Board members who approved the payment exposed, on a joint and several basis, to a legal claim for recovery of the payment unlawfully made. Accordingly, it is incumbent on all Board members to be aware of their statutory obligations and to ensure they are discharged when such payments are proposed to be made by a company.
For that reason, we recommend that legal advice should be taken at an early stage when a Board becomes aware that a Board member is departing, and where it is proposed to make a termination payment to him or her on departure. The Board must ensure that all attendant obligations relating to the departure, including under Section 186, are discharged, and be assured that no unforeseen legal liabilities will have been created by their approval of a termination payment for a departing Board member.
1 Connolly v Independent News & Media Plc [2012/4106 P]
2  2 Ch 365
3  S.L.T.945 Court of Session (Outer House
4 This section has since been repealed and the present provision relating to compensation for loss of office in the UK is contained in Section 215 of the (UK) Companies Act 2006.
5 English High Court, Unreported Decision of 13 March 1989.
6 This section is a former UK equivalent section to Section 189(3) of the Companies Act 1963.
7 Section 191 of the (New Zealand) Companies Act 1955.
8  3 AR ER 123,  A.C. 537
9 Section 215 of the (UK) Companies Act 2006.
This article contains a general summary of developments and is not a complete or definitive statement of the law. Specific legal advice should be obtained where appropriate.