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Severance of a director's service contract

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 . Where there is clear evidence of dishonesty or other serious...

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 options

Dismiss summarily for gross misconduct

Where there is clear evidence of dishonesty or other serious misconduct amounting to a repudiatory breach, the company is legally entitled to dismiss the culprit with immediate effect, without any requirement to serve notice or pay in lieu of notice. The need for clear evidence, however, cannot be over-emphasised: in the majority of cases, instant dismissal carries a significant risk of litigation; there may be a High Court claim for wrongful dismissal and, possibly, a statutory claim for unfair dismissal, as discussed below.

Serve notice and require director to work notice period

This option may not be in the best interests of the company (as noted in OUT-LAW's guide to Length of fixed terms and notice periods in directors' service contracts). Directors who are asked to serve their full notice can be demotivated and even hostile towards the company and the remaining directors. Their main focus will, understandably, be on finding another job rather than ensuring the long-term success of the business. The company will usually prefer to cut ties – and bring in someone else – as soon as possible.

Serve notice and put on garden leave

Garden leave provisions are becoming increasingly common. The main reasons for this are explained in our guide to Restrictive covenants in directors' service contracts. In summary: garden leave helps limit the threats to a business posed by a director’s departure to a rival and can provide more security than covenants. It also gives the company time and space to negotiate a severance package.

The director on garden leave will often approach the company to agree an earlier termination date so that they can take up their new position. Their entitlement to further payment will then cease.

Garden leave is also useful where cash flow makes a lump sum payment in lieu undesirable.

Steps should be taken to ensure the terms of the garden leave are consistent with the director’s contractual rights. The director should continue to receive all salary and benefits and should not be financially disadvantaged. An employing company should also ensure that there are very clear instructions about what a director can and cannot do while on garden leave. These should cover: contact with clients, employees or other business contacts; the steps the director is to take if contacted; the extent to which the director can be called upon to carry out particular tasks and provide assistance.

Terminate instantly under express payment in lieu provision

It is also increasingly common for service agreements to allow the company to terminate a director’s employment on making a payment in lieu of notice. This provides a mechanism to bring the director’s employment to an end instantly without being in breach of contract. Any restrictive covenants will continue to have effect insofar as they are enforceable. Further information about payment in lieu clauses appears in Payment in lieu clauses in directors' service contracts, an OUT-LAW guide.

Initiate a dialogue and negotiate a package

Frequently, the first instinct of the other directors/non-executive directors is to initiate a ‘cards on the table’ chat with a view to negotiating an appropriate package. This can work well, particularly if there is a good relationship between those who will have the discussion, the reasons for the departure are understood and the circumstances are not acrimonious – in other words, if the negotiations are likely to succeed.

But there are risks attached. Employment cases make clear that even where there is an agreement to talk off the record ‘without prejudice’, a party may still be able to rely on these discussions to support a legal claim. The risk is particularly acute where there has been no formal prior procedure. In these circumstances, the discussions and the absence of any formalities could be used in an unfair dismissal claim and/or negotiations for a significant sum in addition to contractual severance entitlements.

Legal and regulatory constraints

Sections 215 to 222 of the Companies Act 2006

The above sections preclude payments ‘of compensation for loss of office’ where particulars of the payment have not been approved by a company’s shareholders. Generally, though, this will not apply. Section 220(1) of the Act provides for express exclusions in relation to a payment made in good faith:

  • in discharge of an existing legal obligation (effectively defined as an obligation that was not entered into in connection with or in consequence of the event giving rise to the payment);
  • by way of damages for breach of such an obligation;
  • by way of settlement or compromise of any claim arising in connection with the termination of the person’s office or employment; or
  • by way of pension in respect of past services.

In addition, case law authority says that payments made to a departing director under express contractual provisions – for example, an express payment in lieu or golden parachute clause – are not covered by the requirement for shareholder approval. Sections 215 to 222 could be an issue, however, where a proposed payment to a director seems excessive in relation to their legal entitlements.

Code of directors’ duties

If there is evidence to suggest that proposed payments are excessive when set against an individual director’s legal entitlements, it’s possible that the code of directors’ duties has been breached and that the board’s decision to authorise the payments could be challenged. The argument could be advanced that directors, in agreeing particular payments for a departing executive, were acting other than in the best interests of the company.

If a payment is proposed that seems out of line with an individual director’s contractual entitlement and unfair dismissal rights, the company’s remuneration committee or full board ought to minute the reasons why. Such payments will need to be justified.

The UK Corporate Governance Code

The Code (provision D.1.4) says that:

"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. They should take a robust line on reducing compensation to reflect departing directors’ obligations to mitigate loss."

This provision can be useful when negotiating a package on behalf of a listed company. In particular, it can help endorse the point that payments must be closely linked to financial loss. If there is every reason to believe that a director with a 12 months’ notice period would find a position within six months following termination, the remuneration committee would probably find a package of more than six months hard to justify to shareholders.

But ‘avoiding rewarding poor performance’ and ‘taking a proper line to reflect mitigation’ are often difficult to reconcile. A director employed under a contract with a 12 months’ notice period is, in the absence of gross misconduct, entitled to 12 months’ notice irrespective of performance. If they have performed poorly, it may be more difficult for them to find another job and thereby mitigate their loss. In other words, it can be more difficult to negotiate a discount when a director hasn’t delivered.

Disclosure requirements

Full disclosure of amounts paid to departing directors is required in the directors’ remuneration report, which, as explained in our guide, Directors' service contracts: An introduction, will be put to an advisory vote by shareholders. So a board needs to bear in mind the likely reaction of investors before any deal is agreed.

Potential legal claims

Wrongful dismissal

A wrongful dismissal is a dismissal that breaches the terms of the contract. If, therefore, a director is entitled to 12 months’ notice but is dismissed instantly without notice, the company will be liable for damages; the director will be entitled to a payment equating to the loss of salary and benefits over the 12 months’ notice period.

Any damages will, however, be subject to a reduction for mitigation. A dismissed employee is legally required to take reasonable steps to find an alternative job. If they succeed and take up a new position during the notice period, any sum earned will reduce the amount of their loss pound for pound. If a court is not satisfied that an employee has complied with the obligation to mitigate, this will be reflected in its award for compensation.

Successful wrongful dismissal claims prevent the employer from relying on any provisions within the contract: if the employer is held to have breached the contract, it cannot enforce terms such as restrictive covenants, and these will consequently fall away. It is largely because of this that, where restrictive covenants exist, it is now standard practice to add a contractual payment in lieu provision allowing the company to terminate instantly without breaching the contract.

Unfair dismissal

Every person in Great Britain who has been employed for one year or more has a statutory right not to be unfairly dismissed. This right applies just as much to an employed director as to any other employee. Dismissal will only be found to be fair if:

  • it is made for a potentially fair reason, such as redundancy, poor performance or poor conduct;
  • before dismissing or serving notice, the employer followed the necessary fair procedure (see below);
  • it is reasonable to dismiss in all the circumstances of the case.

Until quite recently, unfair dismissal was not a significant factor in the majority of cases relating to the termination of directors’ contracts. This was because compensation for unfair dismissal was limited when set against a director’s contractual entitlement. The potential compensation recoverable for unfair dismissal has now, however, significantly increased. In addition to a basic award (which is still a limited amount, calculated in the same way as a statutory redundancy payment), an employee who has been unfairly dismissed is entitled to a compensatory award (dependent on their losses), the statutory maximum for which is now £65,300.

A further significant change took place in 2004. New statutory disciplinary and grievance procedures were introduced, requiring an employer to go through a minimum disciplinary procedure before dismissing someone. The procedure included:

  • calling the employee to attend a disciplinary hearing;
  • providing the employee with details of matters to be discussed before the hearing;
  • notifying the employee of the decision made after the hearing and providing the right to appeal.

If these minimum procedures were not followed, the dismissal was automatically deemed to be unfair and the compensation awarded could be subject to an uplift of between 10 and 50 per cent.

The good news for companies is that the statutory procedures were repealed with effect from 6 April 2009. In their place is a new Code of Practice on disciplinary and grievance procedures from the Advisory, Conciliation and Arbitration Service (ACAS). The Code sets out minimum standards for dealing with disciplinary matters, but there is no longer a requirement to follow a mandatory dispute resolution procedure in advance of dismissal and no automatic unfairness when the Code is not followed.

What does this mean in practice? The ACAS Code is not legally binding, but when deciding if a dismissal was fair or not, an employment tribunal will look at whether the Code was followed. If an employment tribunal decides that an employer failed to follow the Code and that was unreasonable, it may increase the compensation awarded by up to 25 per cent.

The appropriateness of unfair dismissal claims will, of course, vary. A director is not entitled to double recovery in relation to the same period of loss. This means, for example, that if a director is being paid in lieu of a 12-month notice period (either under an express clause or as a result of reaching agreement to make a payment in lieu) and they can mitigate their losses within the 12 months by finding another position, legal action will, from a practical point of view, be irrelevant. The director could seek to recover a basic award but this will be little more than a nominal sum. As regards the compensatory award, the director will not be able to demonstrate any losses: they will have been more than compensated by the payment in lieu.

If, on the other hand, a director’s actual losses are likely to exceed payments made under their contractual entitlements, an unfair dismissal claim becomes much more relevant. In these circumstances, an employing company that has failed to go through a fair procedure before giving notice could be in trouble. To avoid the risk of litigation, it will need to:

  • increase the proposed severance package by a sum that exceeds contractual entitlements and reflects the amount that could be paid in unfair dismissal compensation;
  • get the director to sign a compromise agreement that prohibits any claim.

Other

This section has dealt with the most likely actions when a company dismisses a director. It is important to remember, though, that others could arise – for example, the claim that a director’s dismissal was on discriminatory grounds.

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