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.
Legal and regulatory background
Directors’ service contracts must be drawn up with regard to both legal and regulatory provisions on pay. This means being aware not only of restrictions on directors’ involvement in decisions about their own contracts (see: Directors' service contracts: An introduction, under the heading of General principles of negotiation; source of instructions), but also of best practice guidelines for listed companies on pay levels and the make-up of the pay package. The UK Corporate Governance Code calls for a balanced package that pays no more than is necessary to attract, retain and motivate the top talent and avoids an ‘upward ratcheting’ in executive pay. ‘Balanced’ means having the right mix of fixed and variable (often performance-related) elements. (See: Design of directors' remuneration packages, an OUT-LAW guide.)
The company should bear several points in mind.
- Articles of association will often limit the amount the company can pay in directors’ fees. The service contract should therefore make clear that salary payable is inclusive of any fees or other remuneration to which the director may be entitled from the company or any group company. This will avoid argument over how much remuneration is referable to fees and enable the company to comply with any limits.
- Provisions regarding salary reviews – when they will take place, how they will be carried out – should be set out clearly to avoid future dispute. If a contractual right to an increase is not intended, there should be wording making this clear.
- The practice of increasing directors’ pay shortly before retirement and thereby significantly increasing their entitlement under a company’s final salary scheme carries risks. It could be deemed to be against the company’s best interests. The Corporate Governance Code provides that: ‘The remuneration committee should consider the pension consequences and associated costs to the company of basic salary increases and other changes in pensionable remuneration, especially for directors close to retirement.’
To avoid future dispute, both the employing company and an individual director need to ensure that bonus provisions are clear and fully understood. The key points to remember are listed below.
- The first major issue to determine is whether the director will have a clear-cut contractual entitlement to a bonus according to a particular formula or merely a right to be considered for a bonus by the board/remuneration committee. If the intent is the latter, very careful drafting will be needed.
- An employing company also needs to be aware that, even where a bonus scheme is discretionary, there will be constraints on the decisions that can be made. This follows the High Court case Clark v Nomura in which it was held that ‘even a simple discretion whether to award a bonus must not be exercised capriciously’ and an employer should not exercise its discretion in an ‘irrational or perverse way’ – ie a way in which ‘no reasonable employer would have exercised its discretion’. But this does not make it easy for an employee to challenge bonus decisions. (See the case of Commerzbank AG v Keene, described below.)
- Decisions regarding the level of discretionary bonus payments are prone to allegations of discrimination. A particularly high profile instance of this was the case of Bower v Schroder Securities Limited,
in which a senior investment banker was awarded £1.4m in compensation for what (in her words) was an ‘insultingly low’ award. (She received a bonus of £25,000 when comparable male colleagues were awarded £440,000 and £650,000.)
- Board/remuneration committees should also take into account Corporate Governance Code guidance in Schedule A, which underlines the link between pay and performance:
"The remuneration committee should consider whether the directors should be eligible for annual bonuses. If so, performance conditions should be relevant, stretching and designed to enhance shareholder value and to promote the long-term success of the company. Upper limits should be set and disclosed. There may be a case for part payment in shares to be held for a significant period."
- Additionally, board/remuneration committees should consider the Joint Statement, which says that:
"From the outset, boards should establish a clear policy to ensure any non-contractual payments are linked to performance. No director should be entitled to discretionary payments in the event of termination of their contract arising from poor corporate performance. Remuneration committees should consider retaining their discretion to reclaim bonuses if performance achievements are subsequently found to have been significantly mis-stated."
- This latter point mirrors the debate on bonuses in the banking sector and is likely to remain an important issue – despite the legal difficulties that can arise when attempts to claw back payments are made.
- If a service contract is to contain detailed provision about the calculation of the bonus, it will often be desirable to put this within a separate schedule. Such a schedule may specify:
– when the bonus is payable;
– whether the bonus is to be payable during part years when the director’s employment has begun/ended and, if so, how any pro rata bonus payment is to be calculated;
– who is to decide the final figure;
– whether the bonus will always be payable on termination or only in certain circumstances;
– how particular terms such as ‘net profits’, etc are to be defined;
– whether the bonus forms part of pensionable earnings (the Corporate Governance Code recommends that it should not);
– whether there will be express performance criteria (as stated above, the Code recommends that there should be performance conditions and that they should be designed to enhance shareholder value);
– whether there will, in accordance with Code guidelines, be provision for a limit on the amount of bonus payable.
- It may be sensible to have any detailed provision regarding bonus, including calculations derived from net profits, reviewed and approved by the company’s auditors, particularly if the service
contract will provide for reference to the auditors in the event of dispute.
Commerzbank AG v Keene
The 2006 case of Commerzbank AG v Keene, in which a very high paid investment banker sought to challenge the level of his bonus, shows that the courts are generally reluctant to review an employer’s decision on the level of a discretionary award.
The Court of Appeal said that:
"It would require an overwhelming case to persuade the court to find that the level of a discretionary bonus payment was irrational or perverse in an area where so much must depend on the discretionary judgment of the bank in fluctuating market and labour conditions."
While this decision concerns discretionary bonuses in the investment banking sector, it is significant in relation to discretionary bonuses generally. Most companies, after all, operate in fluctuating market and labour conditions.
The service agreement must clearly provide for:
- the director’s entitlement to pension, subject to the rules of the scheme;
- the employing company’s entitlement to withdraw or amend the rules or benefits of a particular pension scheme and/or to terminate an individual’s participation in it at any time. (Obviously, the director is likely to want assurance that, in the event of this type of provision being relied on, equivalent replacement benefits will be provided.)
In addition, provisions must reflect the tax treatment of pension contributions, which changed significantly in April 2006. (See our series of guides on Pensions.)
The issue of pension entitlement as part of a severance package hit the headlines (for all the wrong reasons) when the government bailed out Royal Bank of Scotland in 2008–09. The £700,000 a year package for departing chief executive Sir Fred Goodwin was roundly condemned as a reward for failure. (Sir Fred eventually bowed to public and political pressure and agreed in June 2009 to hand around £200,000 back.)
The Joint Statement suggests the following in relation to pensions:
"Pension entitlement or contributions on severance can represent a large element of cost to shareholders. Remuneration committees should identify, review and disclose in the Remuneration Report any arrangements that guarantee pensions with limited or no abatement on severance or early retirement. These pension arrangements are no longer regarded as acceptable, except where they are generally available to all employees. Where opportunities arise, existing contracts should be amended. Such conditions should not be included in new contracts."
Permanent health insurance
Permanent health insurance (PHI) is designed to secure income for employees unable to work through sickness or injury. A PHI policy will usually be taken out by a company for a number of senior employees. The insurance provider will pay sums to the company after the employee has been ill for a specified period; payments will be made until the employee is able to return to work. A typical provision within a director’s service contract may, therefore, entitle a director to six months’ contractual sick pay and, thereafter, sums from the company as received under its PHI scheme.
While this is all very well in theory, in practice PHI can be a troublesome benefit. There is often a gulf between employees’ perception of the scheme and the reality of how it operates.
A PHI policy will usually only provide cover for someone while they remain employed by the company. When an employee is dismissed because of long-term absence through illness (or for any other reason), their entitlement to PHI benefits automatically ceases. The understanding of employees, however, is often that PHI protects them against the impact of long-term illness and that they will continue to receive benefits for as long as they are ill – whether or not the employer chooses to dismiss them.
PHI entitlements have been the subject of a number of disputes. The leading case is that of Aspden v Webbs Poultry and Meat Group, in which it was held that an employee’s contract contained an implied term that their employer would not dismiss them while sick if dismissal would lead to loss of entitlement to benefits under a PHI scheme.
The Aspden decision means that PHI provisions need very careful drafting and demand expert help. A common solution is for the contract to provide that:
- the employing company will not terminate where an individual is absent through illness and is, or may become, entitled to PHI benefits;
- the employing company will still be entitled to dismiss in certain specified circumstances – for example, gross misconduct, redundancy or where the individual ceases to be eligible for benefits under the PHI scheme.
Employers must make it expressly clear that an employee’s entitlement to PHI is subject to the rules of the particular scheme. Failure to do so can be an expensive mistake: where the contractual promise exceeds the real levels of cover under the scheme the employer can find itself obliged to give benefits it will not be able to recover.
Provision for share options should not be made in a service agreement but in a separate side letter/agreement. This will ensure that:
- the director’s entitlement to share options depends entirely upon the provisions of the share option scheme;
- the director will not be entitled to seek compensation for loss of share options as part of a wrongful dismissal claim.
For more about the issues raised by remuneration, see our series of guides on Remuneration of directors.