Strategy & Operations » Leadership & Management » How to get rid of the CEO

Some 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

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

  • 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

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

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

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

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

“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.”