Introduction to directors' service contracts
This guide is based on UK law.
Introduction
Directors’ remuneration has long been a political issue, with
media stories of “fat cats” and, more recently, “rewards for
failure” fuelling the debate.
The most notable legislative response has been the 2002
Directors’ Remuneration Report Regulations (“the
Regulations”), which require preparation of a directors’
remuneration report and far greater disclosure of directors’
remuneration packages from listed companies. Significantly, the
regulations entitle shareholders to an advisory vote on the
directors’ remuneration report.
In 2003, “no votes” at the annual general meetings of
GlaxoSmithKline (GSK) and WPP, and a string of other controversies
over executive pay and contracts, led the government to publish a
consultation document, “Rewards for Failure – Directors’
Remuneration, Contracts, Performance and Severance”.
Essentially, the document set out two options: revising practice
guidelines; more legislative change. Recent indications are of a
move away from the latter. On January 25, 2005, Patricia Hewitt,
the then trade and industry secretary, announced that the
government had decided against new provisions on directors’
remuneration in the Company Law Reform Bill, saying that research
by Deloitte, commissioned by the DTI, had shown that the
Regulations were having a “positive impact” on pay and severance
policies.
Companies, though, are by no means off the hook. Further
legislation at some time in the future cannot be ruled out. And new
guidelines are inevitable: Hewitt called on the Association of
British Insurers (ABI), the National Association of Pension Funds
(NAPF) and the Confederation of British Industry (CBI) to develop a
common set of best practice guidelines on directors’ contracts.
The service contract between a director and an employing
company, therefore, is more than a legal agreement and an incentive
tool. It is a window on corporate governance.
The general legal and regulatory framework
Directors and employers obviously do not have a clean slate 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 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 (see the section on Directors' duties);
- the Companies Act (revised in 2006) imposes certain constraints
on the length of notice periods/fixed terms;
- the Combined Code on Corporate Governance, which applies to all
listed companies subject to the Listing Rules, imposes requirements
regarding the source of instructions, the length of notice
periods/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/fixed
terms, the make-up of the remuneration package and severance
packages.
So listed companies are increasingly expected to comply with
requirements over and above those laid down by statute – i.e. with
the recommendations of the Combined Code – and to respect the views
of institutional investors. Thus, notice periods shorter than the
statutory minimum are becoming common. (The Listing Rules require
companies either to comply with the detailed provisions of the
Combined Code or explain, in the annual report, why they have not
done so; see our section on Corporate
Governance.)
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 regarding who has responsibility
for negotiating service agreements and remuneration packages for
directors
The Combined Code recommends:
- a formal and transparent procedure for developing policy on
executive remuneration and for fixing the remuneration packages of
individual directors – no director should be involved in deciding
their own remuneration;
- the board should establish a remuneration committee of at least
three, or, in the case of smaller companies, two members. The
company chairman may be a member (if previously classed as
“independent”); the other members should all be independent
non-executive directors (see our OUT-LAW guide The Combined Code on Corporate Governance: Board
committees);
- remuneration committees should have delegated responsibility
for setting remuneration for all executive directors and the
chairman, and this should extend to pension rights and any
compensation payments.
