Earlier this month, the Department of Trade and Industry (DTI) published a consultative document on severance payments to departing directors of quoted companies. In "Rewards for Failure" – Directors’ Remuneration – Contracts, Performance and Severance, the DTI states that it considers that shareholders are justified in their concerns about directors leaving ailing companies with large payoffs.
The consultation paper is seeking views on whether further measures are needed to ensure that compensation reflects performance when directors’ contracts are terminated and, if so, the form that such measures might take. The consultation paper makes it clear that any action taken (whether through best practice, legislative reform or some other means), will not apply to private companies or companies listed on AIM. However, it may be appropriate for all such companies to keep themselves informed of developments in the sphere of corporate governance, since it is likely that changes leading to greater transparency and shareholder protection will eventually filter through to all companies.
Background to the consultation
The consultation paper comes in the wake of the Directors’ Remuneration Report Regulations (SI 2002/1986) (the "Regulations") which came into force in August 2002. The Regulations introduced new requirements for companies quoted on the Official List of the UKLA or which are officially listed in another EEA state, or admitted to dealing on either the New York stock exchange or Nasdaq. Such companies must include a detailed report on their directors’ remuneration (including details of their remuneration policies) in their annual reports in respect of financial years ending on or after 31 December 2002. The Regulations also introduced the concept of an advisory vote for shareholders on the remuneration report. For a detailed discussion of the changes introduced by the Regulations and their likely practical effect, please refer to our previous employment bulletin dated 12 December 2002.Following on from these changes, in December 2002, two of the UK’s largest institutional shareholders, the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF) issued a joint statement entitled Best Practice on Executive Contracts and Severance setting out what they considered to be best practice guidance in relation to directors’ pay and severance arrangements (the "ABI/NAPF Guidance"). The Regulations and the ABI/NAPF Guidance have together encouraged much closer public scrutiny of directors’ remuneration and severance packages and have led to a number of high profile near-revolts by shareholders in recent weeks and, in one instance, the highly publicised rejection by the shareholders of GlaxoSmithKline of its resolution to approve the company’s remuneration report. Whilst the resolution to approve the report was only advisory, it is clear from the company’s subsequent public statement that it will be consulting with leading shareholders in the coming months on the issue, that it considers it cannot simply ignore the very clear message that it has received from its shareholders.
The consultation paper makes it clear that the Government fully supports the concept of substantial reward in return for high levels of success. Furthermore, the Government has confirmed that, in its view, setting levels of directors’ remuneration should remain a matter for companies and their shareholders. The paper explains that the Government believes its role is to create the corporate governance framework to enable shareholders to receive full and accurate information and to have the appropriate mechanisms available to them to be able to hold directors to account effectively on the issue of their pay.
The consultation paper sets out a range of options for reform, but states that these are not exhaustive and that any other options proposed will be carefully considered. The suggestions for reform essentially consist of two options:
(i) changes to "best practice" guidance; and
(ii) legislative reform.
"Best practice" reform options
Three "best practice" reform options are identified in the paper:
- reducing the best practice for notice periods from what has become the present "industry standard" of one year, which in turn should reduce the amount of severance payments;
- modifying the approach to liquidated damages clauses in contracts of employment by, for instance, introducing a recommended cap on the level of damages payable on termination based on, for example, six months’ salary (this is considered by the ABI and NAPF to be generally unpopular with institutional shareholders as the level of liquidated damages cannot usually be varied to reflect underperformance); and
- using "phased" payments on termination which would be subject to mitigation and would only be payable in their entirety if the director did not find alternative employment before the end of the "phased" period (this approach has already been recommended by the ABI and NAPF).
These options were discussed in detail in the ABI/NAPF Guidance which is itself appended to the consultation paper. For our comments on the proposals set out in the ABI/NAPF Guidance, including some of the practical steps which companies should consider taking please refer to our previous employment bulletin dated 5 February 2003. The DTI is also seeking views on how improvements in best practice should be promoted and suggests further institutional shareholder guidance or Combined Code amendments as two possible alternatives.
Legislative reform options
The DTI has also put forward some suggestions for legislative reform, which are largely based on the recommendations set out in the Final Report published by the Company Law Review Steering Group in July 2001. It does not support the approach suggested in the MP Archie Norman’s recent Private Member’s Bill, Company Directors Performance and Compensation, published on 11 December 2002 and now withdrawn. The Bill suggested that the Companies Act 1985 (the "Companies Act") should be amended to require compensation paid to a director on loss of office to be "fair and reasonable", irrespective of what was stated in his or her contract. The Courts were to be charged with the task of working out what this meant. The Government indicated that it would not favour such an approach, believing that it would give rise to increased disputes and litigation. Furthermore, the consultation paper states that the Government believes that there would be practical and legal difficulties in seeking to override or rewrite contracts of employment already in existence in such a way.
The consultation paper is seeking other suggestions for possible legislation which would require company boards to take underperformance into account in determining severance payments, whilst minimising the risk of litigation. By way of example, it seeks views on its proposed amendment of section 319 of the Companies Act so that "rolling contracts" of employment would be subject to the same statutory limits as fixed-term contracts. This would mean that a director could not be employed under such a contract for a period in excess of the statutory period for fixed terms (currently five years, although the paper states that this itself is a potential area of reform, on which views are also sought) without the company obtaining shareholder approval. It is difficult, however, to see how this would have an impact on levels of severance payments. It is also unclear how much impact this will have on quoted companies where, in most cases, contracts will be terminable on one year’s notice or less in accordance with the recommendations in the Combined Code.
The ABI and NAPF have confirmed their opinion that legislation should be implemented only as a last resort. The ABI/NAPF Guidance itself urges companies to respond to the guidelines it sets out, warning that if companies do not rise to the challenge there is a real risk of legislation and greater regulation that may well damage Britain’s entrepreneurial spirit.
Comment
It is difficult to see how a tightening of best practice guidance will operate when faced with practical commercial realities and market forces. Shorter contractual notice periods or provisions agreed at the commencement of a contract of employment to limit severance packages in certain circumstances are likely to result in demands by executive directors for higher remuneration packages. These demands will be made as a result of the increased risks that directors will feel they are taking in joining a company in circumstances where they may receive a markedly reduced termination package in the event that the company does not perform. This is particularly likely in circumstances where they may be relinquishing a secure position.
For similar reasons it may become difficult to recruit top executive directors to companies during times of economic volatility or to those companies which are either suffering financial difficulties or which have a history of such difficulties. If such companies are to be permitted to offer enhanced packages in order to attract top executives to do the job, the executive may be reluctant to accept the package on the table in such circumstances, if he or she considers there is a risk either that shareholders may not subsequently approve the remuneration report or that the director may only receive a portion of what was agreed at the outset. The consultation paper recognises concerns, already stated by some companies, that the uncertainties presented by the situation or the introduction of prescriptive legislative rules may have the knock-on effect of increases to base salary or greater use being made of "golden hellos" – an upfront payment to the executive upon joining the company.
Whilst it is uncertain at this stage whether the Government will implement any of the reforms suggested in the consultation paper, it is clear from the effect that the Regulations have had and from the position being taken by the ABI and NAPF, that the level of directors’ severance payments will, in future, attract a great deal of publicity and attention. Consequently, Companies should take a great deal of care over the terms and conditions offered to a director at the outset of a relationship. Companies should, in particular, ensure that severance terms are clearly identified and that the company has the necessary degree of flexibility and latitude to be able to revisit the position regarding the director’s severance entitlements if the company (and/or the director) fails to reach performance targets. Companies should also be considering now, carrying out a review of their existing remuneration policies to determine whether they accord with what is regarded as acceptable in the ABI/NAPF Guidance (this is particularly in view of the considerable influence the ABI and NAPF appear to be having in this area). In situations where the current remuneration policies are likely to conflict seriously with the recommendations in the ABI/NAPF Guidance, companies would be well-advised to seek to negotiate changes to existing service agreements to provide them with the flexibility that best practice may soon require in relation to severance payments and to try to avoid the risk of potentially humiliating shareholder reprisals on this issue. In addition, performance targets themselves are likely to need even more careful consideration by the company’s remuneration committee and this will no doubt result in more work for the non-executive directors and a corresponding increase in their fees.
Shareholders will also expect companies to take a hard negotiating stance with directors leaving under a cloud, irrespective of whether the arguments being advanced regarding the director's performance would actually win the day in the court. At present, companies may often take the view that it is not worth risking the time and costs potentially involved in adopting such a strategy. In certain cases, this view may need to be revised.
There has in recent years been a move towards the greater use of executive share option schemes as part of remuneration packages and bonuses, linked to a combination of company and personal targets (where the bonus awards themselves are a combination of cash and restricted shares in the company). Clearly, this serves to align the interests of the director more closely with the interests of the company’s shareholders. The consultation paper includes a suggestion that a similar mechanism might be used for directors’ severance payments. The example given is to express a director’s compensation on termination in terms of a fixed number of shares, determined at the outset of the relationship by reference to the price prevailing at the commencement of the employment. Therefore, where the company was successful under the director’s leadership and management (and its share price was correspondingly high), and the director decided to leave employment, any severance "payment" would also be high. The converse would be true in the event that the director left at a time when the company (and the share price) was performing badly, resulting in a lower settlement figure. This has significant attractions, although it is not without its complications – the rules of share option or award schemes will require careful drafting and the rules of existing schemes may require amendment to permit the additional awards to be made on termination. In addition, if the level of severance is so closely linked to the company’s share price, this could serve to discourage entrepreneurial or acquisitive activities because of the perceived associated risks. Finally, of course, it will be rare that a company’s share price will be directly affected by the performance of a single director.
Whatever reforms are ultimately made (if any), increased uncertainty in the terms and conditions of directors’ employment, or attempts by companies to seek to amend terms already in existence without careful discussion and negotiation with the director concerned, is likely to lead to an increase in disputes and (in view of the high sums involved) High Court litigation. In this regard, companies would be well advised to seek to agree on the use of cheaper, swifter methods of dispute resolution, in particular, alternative dispute resolution or arbitration and, where possible, to seek to incorporate this into the employment contract itself.
The consultative document is available at www.dti.gov.uk/cld/condocs.htm.
The consultation period ends on 30 September 2004.
Article by Peter Frost, Paul Ellerman and Steven Wragg