Getting tough on fat cat failures

The Government has expressed a desire to link executive pay-offs to performance,
to put an end to the practice of payment for failure. But its consultation
paper is short on practical proposals, says Christopher Mordue

A listed company performs disastrously, its share price plummets, investors
lose millions, and thousands of employees are sacked. The senior directors lose
their jobs, but leave with huge severance payments. It’s a depressingly
familiar story.

Curbing such pay-offs and developing effective restraints on executive pay
is now a critical issue for UK business. Hot on the heels of recent
controversies comes the DTI Consultation Paper Rewards for failure – Directors’
Remuneration – Contracts, Performance and Severance. But will its proposals
make any real difference?

Although it floats a number of ideas, it is unlikely to result in any
dramatic legislative interventions along the lines of MP Archie Norman’s recent
Private Member’s Bill. This proposed that compensation on termination would be
required to be fair and reasonable in terms of the director’s performance,
regardless of the terms of their employment contract.

The effective linking of performance and severance pay requires a more
sophisticated approach to contractual termination payments as a whole. There
will undoubtedly be difficulties in negotiating these clauses and a risk that
‘market forces’ arguments will deter companies from pursuing these terms with

Equally, companies risk inflating remuneration packages to compensate for
harsher severance terms – so seeking to prevent rewards for failure could, in
turn, lead to excessive rewards for mediocrity or even success.

While legislation is acknowledged as the most effective form of restraint on
executive pay, there are huge obstacles to statutory regulation in this area.

Should legislation seek to override or rewrite contracts of employment?
Would it lead only to litigation? How could the law cater for all the complex
relationships between individual performance and the performance of the company
as a whole?

The consultation paper makes clear that the DTI regards remuneration
policies and practice as being an issue for remuneration committees and
shareholders, not the Government. The aim of the review is to strengthen the
corporate governance framework within which severance payments are determined,
ensuring they are linked to performance, rather than to regulate the level of
payments themselves.

Shorter fixed-term contracts

Nonetheless, some changes to company law are proposed to strengthen controls
over the length of executive director contracts. At present, the Companies Act
1985 prohibits fixed-term contracts lasting more than five years without
express prior shareholder approval.

These rules are easily avoided – contracts for fixed terms exceeding five
years are exempt as long as they can be terminated on notice. ‘Rolling
contracts’ are also exempt. Nor does the rule preclude increasing pay during
the contract to compensate for the shorter fixed term.

The Government proposes a new limit, under which the maximum fixed-term
contract would be 12 months without express shareholder approval. In the case
of new directors, a separate limit of three years for the initial fixed term
would apply. A further proposal would prevent companies and directors agreeing
covenants, separate to the contract of employment, which guarantee severance
pay exceeding the amount the executive could recover in terms of contractual
notice pay.

Restricted notice periods

The remaining proposals would see new guidelines or codes of practice, which

– Restrict notice periods to a maximum of 12 months and promote the use of
shorter periods

– Cap the level of liquidated damages (which fix in advance the amount of
compensation the executive will receive on termination – see below) to six
months’ salary

– Encourage severance payments to be paid in instalments, with the provision
that payments cease or are reduced when the executive obtains alternative

In practice, contractual notice periods are rather illusory when it comes to
removing a company director. The executive is generally dismissed with more or
less immediate effect. However, as salary and benefits for the notice period
are typically the most that the executive can receive as compensation for
wrongful dismissal, the notice period serves to set the executive’s expectation
of the amount of any negotiated settlement or the amount that they will receive
as a termination payment under the contract itself.

It is common for employers and directors to, in effect, agree the severance
payment at the outset of the contract – either in the form of a payment in lieu
of notice (PILON) or a liquidated damages clause.

There can be clear benefits to the company as well as the director in
including such clauses in the contract, but equally, there is a danger the director
will view these as a guaranteed cushion against the risk of dismissal. And
while shorter notice periods help to lower expectations, there is a risk
directors might seek to compensate for any reduction by negotiating higher
overall remuneration packages.

A PILON clause allows the company to bring the employment to an immediate
and lawful end by making the payment prescribed. The executive may have an
unfair dismissal claim with compensation capped at just over £50,000, but no
claim for wrongful dismissal as the contract itself is being complied with.

Further, the company still has the option of dismissing in breach of
contract by failing to give notice or pay the PILON – this would leave the
executive with a claim for damages which would be assessed on the basis of
actual loss. The executive would also be duty bound to minimise his losses.

However, companies need to be careful about including liquidated damages
clauses at all in executive contracts as they are significantly different.

Liquidated damages clauses (often used to protect against dismissal
following a company takeover) require a defined payment to be made as a
consequence of termination. If it is not paid, the executive can recover it as
a contractual debt without having to minimise his loss. Given that these
payments are contractually guaranteed, there is clear merit in capping the
amount of the payment at a level lower than that payable for the contractual
notice period.

Take care, also, over what is included in the PILON or liquidated damages
clause. For example, they could require payment of salary only, excluding
benefits and particularly expensive pension enhancements.

Payments can be made in instalments and reduced in proportion to earnings
from alternative employment, or payments can cease once a new employment
package exceeds a certain level.

Duty to comply

It must be remembered that the duty to mitigate losses is a common law duty.
However, it can be made into a contractual duty by including a clause in the
contract that the executive is obliged to seek alternative work and report
regularly to the board on what steps they have actually taken in a contract. If
the duty is then not complied with, the instalments cease.

While these steps should lead to reduced severance payments they do so only
by limiting the overall amount of compensation for termination available under
the contract or as damages. They do nothing to expressly link severance pay to
individual or corporate performance.

This is where the DTI Consultation Paper is conspicuously thin on clear
proposals. Such a link between performance and severance pay can only be
achieved through clear terms in the employment contract. Courts do not reduce
damages to reflect performance.

One option would be to allow severance pay to be determined by the
remuneration committee. The contract would need to make clear that it could be
terminated by payment of such sum as the committee considered reasonable,
having regard to the executive’s performance and/or the company’s performance during
his/her tenure. Drafting in this way prevents a claim for wrongful dismissal
and making the payment brings the contract to a lawful end.

There are risks that the exercise of this discretion could be challenged on
the grounds of perversity if there is no clear rationale for the amount chosen
– though it is possible to reduce this risk by developing clear guidelines for
the remuneration committee.

An alternative approach would be to construct the severance payment along
the lines of a bonus scheme – the PILON would be calculated against pre-defined
performance measurements such as revenue, turnover, profit, share price or
market share.

Summary dismissal

A more drastic approach would aim to prevent compensation being paid at all.
In other words, disastrous performance would be grounds for summary dismissal.
It might be possible to achieve this by providing that the director will be
dismissed with immediate effect and without compensation if removed from office
at a shareholders’ meeting.

This might leave the executive with a claim for unfair dismissal but the
maximum exposure here would be the current cap on unfair dismissal compensation
of £53,500 plus basic award.

Alternatively, the contract itself could provide for immediate termination
without compensation if pre-defined performance targets have not been met or if
certain defined indicators of failure are present. Such clauses will, however,
prove difficult to negotiate and draft.

Christopher Mordue is an employment partner at Pinsents

Feedback on factors restricting fat cats

– "Factors and measurements that
link reward to performance vary greatly between organisations and sectors. It
should be left to employers and their shareholders to select those they see as
the most appropriate. Organisations should be free to pay the best salaries to
attract, keep and motivate the best people, but employers need to have
rational, justifiable and well-communicated reward polices in place.

Companies need to demonstrate how the reward package is linked
to organisational and personal performance, that it is affordable and that it
reflects appropriate market rates, individual skills and competencies.
Employers must be open and unambiguous in their pay decisions."

Charles Cotton, CIPD

– "Provided directors act in the best interests of the
company, and they are in any event under a legal obligation to do so, there
should be no reason for directors’ compensation payments to be other than fair
and reasonable. Companies have to get used to approving packages strictly
related to directors’ performance – this is wholly achievable within the
current framework."

Sarah Linton, Bryan Cave

"It is hard to see how the Government’s suggested changes
will have a significant impact unless boards and remuneration committees are
prepared to negotiate harder over notice periods and issues such as phased
payments. In reality, when trying to attract talent at board level, few may be
prepared to be so tough, given the risk of failing to make an appointment which
may in itself attract negative publicity."

Adam Turner, Lovells

The voluntary approach

The Association of British Insurers’
(ABI) and the National Association of Pension Funds’ (NAPF) Joint Statement of
Best Practice on Executive Contracts and Severance was issued in December 2002.

It affirms the principles set down in the combined code 1998
which came about as a result of the last series of corporate mishaps in the
late 1980s and early ’90s, and sets out principles of good corporate
governance. Compliance is voluntary, but companies subject to the code are
required to explain any non-compliance to shareholders in their annual report.

The ABI/NAPF statement defers to the code but while this
recommends a one-year notice period as a maximum, the statement goes further
and suggests shorter notice periods may be appropriate where other
‘remuneration conditions’ would lead to excessive severance payments. Some of
the main suggestions in the statement are:

– Payments in lieu of notice should be paid in monthly
instalments so these payments can be stopped as soon as the executive finds new

– Agreement at the outset on the amount of liquidated damages
that will be paid in the event of severance is discouraged, as are change of
control clauses (severance payments on change of control of the company) other
than in highly exceptional circumstances

– Clear performance conditions should be attached to variable
pay, and boards may wish to specify that a proportion of the bonus is for
retaining the executive and should fall away in the event of severance

– Every step should be taken to ensure the company receives the
full benefit of any duty upon the departing executive to mitigate their losses.

– Once statutory disciplinary procedures become implied into
all contracts of employment (currently this looks like early 2004) boards
should be prepared to use the procedure and contracts of employment should make
it clear that any executive dismissed in the wake of such proceedings would
receive a shorter notice period, based on statutory notice.

Mandy Perry, solicitor at Jones
Day Goulden

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