RSS feedsSome members of the Labour Party seem keen to give leader Tony Blair the push. But when boards of directors show their chief executives the door, corporate governance and legal issues must be handled carefully. Severance payments must not be seen as rewarding poor performance, though contractual agreements need to be honoured.
Large severance payments to departing chief executives have never been popular. Notable controversies in the past have included:
- a pay-off of almost £2m made to Bob Ayling, who was sacked as chief executive of British Airways in 2000;
- a £2.8m send-off in 2001 for Lord Simpson, ousted chief executive of Marconi, despite disastrous share price performance under his lead.
In June this year it was revealed that Scottish Power had paid almost £11m to four departing directors during the year. This included £5m to chief executive Ian Russell who was ousted at the beginning of the year, £2.3m being compensation with a £2.7m pension top-up in line with his contract. The company has said that future directors’ contracts would contain simpler and less expensive terms.
The investors’ view
The Association of British Insurers was not impressed by the Scottish Power payments and in August wrote to members of the FTSE-350 urging them to review executive pension arrangements. “We basically want any severance agreements to be linked to performance,” says an ABI spokesperson. Referring to the FTSE-350 letter, she adds: “It was really to urge them to go through old contracts and make sure they were up to date and in line with best practice. We didn’t want a similar situation to arise [like that of Scottish Power] where companies say to shareholders, we have to give these generous packages because it’s in the contract.”
Combined Code
Best practice guidance on remuneration issues is included in the Combined Code on Corporate Governance, which contains a section on “service contracts and compensation”. This states in paragraph B.1.5: “The remuneration committee should carefully consider what compensation commitments (including pension contributions and all other elements) their directors’ terms of appointment would entail in the event of early termination. The aim should be to avoid rewarding poor performance.”
ABI and NAPF statement
The ABI and the National Association of Pension Funds have added to the best practice canon by drawing up a joint statement on “best practice on executive contracts and severance”.
Their overall view is made clear in the statement’s introduction: “Institutional shareholders believe top executives of listed companies should be appropriately rewarded for the value they generate. However, they are also concerned to avoid situations where departing executives are rewarded for failure or under-performance. This is a matter of good governance, about which the ABI and NAPF have been concerned for many years.”
The two bodies believe it is “unacceptable” that failure can result in large payments to departing leaders and state: “Executives… should show leadership in aligning their financial interests with those of their shareholders.”
Basic principles
The joint statement contains a number of basic principles, including the following:
- Para 2.1: “The design of contracts should not commit companies to payment for failure. Shareholders expect boards to pay attention to minimising this risk when drawing up contracts. They should bear in mind that it may be in the interest of incoming executives and their personal advisers to exaggerate their potential loss on dismissal. Boards should resist consequent pressure to concede overly generous severance conditions.”
- Para 2.3: “Objectives set for executives by the Board should be clear. The more transparent the objectives, the easier it is to determine whether an executive has failed to perform and, therefore, to prevent payment for failure. Wherever possible, objectives against which performance will be measured should be made public.”
Contractual issues
The ABI and NAPF also refer specifically to a scenario where underperformance has led to a significant loss in share price, taking a tough line on what this should mean for executives’ severance pay, as follows:
- Para 3.7: “Companies should… consider including in contracts a safeguard for more extreme cases. For example, that compensation would not be payable in case of dismissal for financial failure such as a very significant fall of the share price relative to the sector.”
The two organisations also stress that remuneration committees should be clear as to the likely cost of severance at the time employment contracts are drawn up.
Calculating compensation
How are severance payments calculated? “The starting point is always the notice period in the contract of employment,” says Richard Baty, a partner in the employment department at lawyers Travers Smith. Given a situation where the board wants an under-performing chief executive out quickly, and therefore gives the individual no notice, then the CEO could have a claim for breach of contract. “The maximum value of that claim would be the amount he would have received had he worked the notice period,” Baty says. “That includes salary and the value of any benefits he might have got, such as pension contributions, the provision of a car, private health insurance etc.”
However, if a departing executive gets a job with equivalent remuneration quickly, that would4 be taken into account. “If you know they are going to walk into another job the next day, you might think twice before agreeing a settlement with them, which is the full value of his notice period,” says Baty. Given that this is unlikely to be the case, however, companies frequently end up agreeing a settlement for much, if not all, of the notice period.
“Every so often you see an employment contract that says ‘we can fire you without notice if you are not performing’, but that’s very rare,” he adds. “A decent lawyer would strike that out during contract negotiations because it means an employer can fire you on very subjective grounds.”
Unfair dismissal
When CEOs and other senior executives are sacked or encouraged to resign, the case almost always exists for a potential unfair dismissal claim.
“There is now a specific statutory procedure that employers have to go through when they terminate the employment of an employee, without which the dismissal will be unfair,” says Baty. “That is a problem if you want to get your chief executive out quickly, so a lot of companies will just ignore the procedure.
That means dismissals of executives are likely to be unfair.” Furthermore, Baty explains, executives’ dismissals nearly always are ‘unfair’ anyway in that they are for performance reasons, but the execs will never have been warned about their performance in the past.
Departing executives are, therefore, likely to be able to bring a claim for unfair dismissal at an employment tribunal and that claim can be for a sum up to around £60,000.
“An executive would not necessarily get that amount and it would depend how quickly they get or ought to get alternative work,” says Baty. “They can’t make no effort to find more work.” Nevertheless, the potential impact of an unfair dismissal claim should not be underestimated, particularly if the departing executive is unlikely to be able to obtain similar work again for whatever reason. Payment for any such claim would be on top of the notice period payments.
Potential discrimination
An executive who has been pushed out might also consider a claim for discrimination. In male-dominated company boards, for example, this might be an option for a departing female executive who feels she has been treated less favourably because she is a woman. “There is no cap on the compensation you can get for a discrimination claim,” says Baty. Claims could also be brought for discrimination on grounds of race, disability, sexual orientation or religion or belief.
From this October onwards, claims can also be brought on grounds of age discrimination. “This might really make a big difference,” says Baty. “Board directors often tend to be in their forties and fifties and the reason people want to get rid of them are because they have not been performing as well as they once did. But if they can argue that you sacked them because of their age, rather than their performance, you could face claims, which are potentially uncapped.
This could be significant if finding another job at board level on the same sort of package is very difficult for them. We have had a lot of queries from clients about the impact of age discrimination on what happens if someone gets removed from the board.
It also means that, unless these are agreed as part of any settlement, employers will need to be very careful about making announcements, such as saying someone is going because they ‘need new blood’ on the board. That could make it look like someone is being given the push because of their age rather than their performance.”
Taxation issues
The general rule is that severance payments are tax exempt in part. “The first £30,000 of the payment is tax free and no National Insurance is payable on any of it,” says Baty. “That’s great for the individual and for the company, too, because of the saving in employer’s National Insurance.”
However, it may be that the payment falls outside the tax exemption. The key determining factor is whether HM Revenue & Customs regards the payment as something the individual is entitled to under their employment contract. “If HMRC does, it’s treated like salary and taxed in the normal way,” warns Baty.
HMRC generally takes the view that if a contract contains a payment in lieu of notice clause, stating that the employer can terminate the contract lawfully and immediately by paying, say, salary or salary and benefits in lieu of the notice period, then any sum paid up to the value of the clause will be taxable. However, where any payments are made on top of the lieu of notice sum, then the first £30,000 will fall within the tax exemption.
Shareholder approval
If a company wants to pay someone more than they would be entitled to simply for payment in lieu of notice (as might happen if they think there is a case for an unfair dismissal or discrimination claim), then shareholder approval for the payment will probably be required under s312 of the Companies Act 1985.
“The aim of this is to stop company directors making over-generous payments out of company money to their mates when they leave,” says Baty.
Boards should also note that if they make such a payment without obtaining shareholder approval, not only is the executive who received it liable for the repayment, but those directors who authorised the payment are also personally liable.
“The government has indicated that when the new Companies Act is brought in, the scope of the old s312 will be narrowed so that shareholder approval will not be required for payments settling unfair dismissal and discrimination claims,” says Baty. “However, for the moment, we are stuck with the position where shareholder approval is likely to be required in those circumstances.”
