Directors' service contracts: An introduction

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Directors' service contracts.

The general legal and regulatory framework

Directors and employers clearly do not start with a clean sheet of paper when negotiating a contract. There are several legislative, regulatory and other provisions that determine what is lawful and/or prudent, particularly in the case of a listed company. The following factors should be borne in mind.

Directors have, as OUT-LAW's guides on directors' duties make clear, a duty to promote the success of the company at all times. When negotiating and agreeing service contracts, they need to ensure that their conduct is consistent with this duty.

• The Companies Act imposes certain constraints on the length of notice periods and fixed terms.
• The Companies Act also requires listed companies to make full disclosure of directors’ rewards in a remuneration report on which shareholders have an advisory vote at the AGM. (Large votes against the report always mean bad publicity – see Investor activism in our guide, Remuneration issues: An introduction.)
• The UK Corporate Governance Code, which applies to all listed companies, imposes requirements regarding the source of instructions (see section 2, below), the length of notice periods and fixed terms, the make-up of the remuneration package and the negotiation of termination packages.
• The Institutional Investors’ Corporate Governance Statements set out details of the approach institutional investors expect companies to take in relation to the length of notice periods and fixed terms, the make-up of the remuneration package and severance packages.
• The ‘Joint Statement’ by the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF), issued on 18 February 2008, sets out guidelines on executive contracts and severance.

So listed companies are increasingly expected to comply with requirements over and above those laid down by statute – ie with the recommendations of the Corporate Governance Code – and to respect the views of institutional investors, whose stewardship role was emphasised by the 2009 Walker Report. (See our guides to Corporate governance and Remuneration issues.) Thus, notice periods shorter than 12 months are becoming common. (As our guide to Corporate governance makes clear, the Listing Rules require companies either to comply with the detailed provisions of the Code or explain, in the annual report, why they have not done so.)

The service contract between an employer and a director is both a legal agreement and an incentive tool: it’s also the focus of many corporate governance concerns, particularly on ‘rewards for failure’. The Joint Statement by the ABI and the NAPF concludes: ‘It is unacceptable that poor performance by senior executives, which detracts from the value of an enterprise and threatens the livelihood of employees, can result in excessive payments to departing directors. Boards have a responsibility to ensure that this does not occur.’

General principles of negotiation; source of instructions

There are two key legal and regulatory points.

A director should not be personally involved in their own service agreement and remuneration package.

This means that they should not be responsible for preparing or instructing the company’s lawyers in relation to their own contract and should not be involved in the company’s decision making about their own service agreement/remuneration.

There should be clarity about who has responsibility for negotiating service agreements and remuneration packages for directors.

As part of a ‘formal and transparent procedure’ for the development of executive remuneration policy and for the setting of the pay packages of individual directors, the Corporate Governance Code requires that (on a comply or explain basis):

• The board establishes a remuneration committee of at least three, or, in the case of a smaller company, defined as a company outside the FTSE 350, two members. (The company chairman may be a member if previously classed as ‘independent’; the other members should all be independent non-executive directors).
• Remuneration committees have delegated responsibility for setting remuneration for all executive directors and the chairman, and this extends to pension rights and any compensation payments. (See: Deciding remuneration packages, an OUT-LAW guide.)