In the last ten years the media has been awash with stories of directors leaving their positions in disgrace – but with large payouts. The perception that these directors are being ‘rewarded’ for failure is a commonly held view and the public, quite justifiably, questions the appropriateness of these remuneration packages. In this article we will look at where the law stands on these payments and the rights of both the companies and the directors.
Are companies free to pay departing directors as they see fit or are there any restrictions imposed by the law?
Under the Companies Act 1985 payments to directors in respect of compensation for loss of office required shareholder approval but approval of the shareholders was not required where the payment was intended to compensate for loss of employment.
Due to the considerable media interest, a number of enquiries took place into the extent to which companies should be free to pay off existing directors. Probably the most memorable and famous of all the reports was the ‘Higgs Report’. Following the ‘Higgs Report’ a combined code was produced and in 2006 a number of recommendations were given legislative effect in the Companies Act 2006.[1]
So what is the effect of the new Companies Act upon a company’s ability to make a payment to an exiting director?
The golden rule is that a company may only make a payment to an exiting director where it has shareholder approval allowing it to do so. There are three principal exceptions to this where the payment is made:
- in good faith to discharge an existing legal obligation;
- in good faith to compensate for loss caused by a breach of such an obligation;
- to settle a claim.
There are two other exceptions which should be mentioned simply for the sake of completeness. These are payments by way of pension in respect of past services and small payments which do not exceed £200.
What are the consequences if a payment is made unlawfully under the Companies Act?
An unlawful payment never vests. That means it never really becomes the property of the exiting director. It will always be recoverable at the insistence of the company and possibly other classes of persons including liquidators. It should also be noted that any director who authorises a payment is jointly and severably liable to indemnify the company.
So how does a company ensure that the payments are made lawfully where shareholder approval is not forthcoming?
Companies should always ensure that when the service agreement is drafted it includes a payment in lieu of notice provision, which gives the director a right to receive payment of the equivalent of his notice period in the event that the company elects to make a payment without notice. Drafting the service agreement in this way gives the executive a contractual right to payment. The payment in lieu of notice will therefore be a payment in respect of a pre-existing obligation and will fall within one of the exceptions.
If the payment cannot be said to be in discharge of an existing legal obligation then care has to be taken to ensure that the payment does no more than to reflect damages for breach of such an obligation. The implication which arises from the legislation, although there are no cases on this point yet, is that the whole amount of any unlawful payment would be recoverable and that courts would not be free to determine which part of the unlawful payment could legitimately be said to be damages for breach of contract or compensation in respect of a claim.
So it seems that the law imposes a number of serious restrictions on a company’s ability to make a payment to an existing director but has it gone too far?
The rationale behind the legislation is shareholder protection, not to ensure that directors get fair compensation. It could be said that the legislation has gone too far against the interests of the individual director and that they have in a sense suffered a double whammy in the last ten years. Not only has the legislation become tighter but notice periods have become shorter. Gone are the two-year notice periods which were quite common ten years ago.
On top of that it should be borne in mind that the ability of an Employment Tribunal to compensate higher earning executives properly when they are unfairly dismissed is severely limited. The cap on the compensation payment which tribunals can make in unfair dismissal cases is £65,300. This essentially means that in many cases tribunals simply don’t have the power to do justice to the director’s case and if the director wishes to get true and fair compensation for his dismissal he needs to be able to point to a contractual entitlement. His ability to get such a payment depends on whether or not he had the foresight and ability to influence the drafting of his service agreement to provide for a right to payment in the event that the company makes a payment in lieu of notice.
So in conclusion, what would you recommend to someone before they become a director?
If you are a director of a company or any other senior employee do take very seriously the drafting of your contract because it is the contract which will essentially determine the value which can be placed on your dismissal. In other words, as counterintuitive as is sounds, consider your exit before you sign on the dotted line.
[1] www.cipd.co.uk/nedresource/information/history.htm#higg