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.
Specifics of law and regulation
The Companies Act 2006 says that:
- Contracts of more than two years’ duration need to be approved by shareholders in general meeting. In the absence of such an approval, the term is void and the contract terminable on reasonable notice.
- A director’s contract (whatever its duration or notice period) must be available for inspection by shareholders.
Under the code of directors’ duties, contained in the 2006 Act:
- Where a contract provides for a particularly long term there is the risk of a challenge by shareholders on the grounds that, in agreeing to the provision, the directors failed to put the company’s interests first and consequently were in breach of the code of directors’ duties. (It is therefore advisable for any board/remuneration committee employing directors on long-term contracts to minute the reasons why.)
Under the Listing Rules:
- A listed company’s report to shareholders on directors’ remuneration must include details of any service contracts with a notice period of more than one year or with provisions for pre-determined compensation on termination that exceed one year’s salary and benefits, giving the reasons for such a notice period/pre-determined compensation.
The UK Corporate Governance Code says that:
- notice or contract periods should be set at one year or less;
- if it is necessary to offer longer notice or contract periods to new directors recruited from outside, such periods should reduce to one year or less after the initial period.
From the employing company’s perspective
Notice periods and fixed terms that exceed 12, perhaps even six, months may not be in the company’s best interests – irrespective of the seniority and importance of the director. There are several reasons why:
They are impractical: few companies want directors who have decided to leave continuing to work for them for a long period. They will usually agree to allow the director to go before their notice expires – or put them on ‘garden leave’ (but enforcing garden leave for more than six months can be difficult). (See: Restrictive covenants in directors' service contracts, an OUT-LAW guide.)
They have cost implications: the longer the notice period, the larger the potential pay-off if the company chooses to terminate the employment.
They can antagonise investors: institutional and other shareholders prefer shorter notice periods and fixed terms so as to limit the company’s exposure on termination.
The argument that lengthier periods are necessary to attract high-calibre people seldom holds water. Top-performing individuals do not need the security of long contracts: they can reasonably be expected to find
another position within six months and so mitigate their losses. If there are exceptional circumstances that justify a longer term, it may, as the Corporate Governance Code advises, be best to reflect this through an initial term followed by a shorter notice period.
Long notice periods and fixed terms look anachronistic. A 2005 Deloitte report for the government on the impact of the Directors’ Remuneration Report Regulations concluded that there had been ‘a rapid and
almost complete reduction in directors’ notice periods to one year or less’. The report included data showing that while 32 per cent of FTSE 100 directors had notice periods of two years in 2001, this had fallen to just one per cent by 2004.
In the Joint Statement, the ABI and NAPF say: ‘We believe that a oneyear notice period should not be seen as a floor, and we would strongly encourage boards to consider contracts with shorter notice periods. Compensation for risks run by senior executives is already implicit in the absolute level of remuneration, which mitigates the need for substantial contractual protection.’
From the director’s perspective
For a director, a lengthy notice period can be a double-edged sword. On the one hand, it provides financial security should things go wrong. On the other, it acts as a straitjacket: combined with a well-drafted garden leave provision, the notice period gives the company a hold on the director and can be used to limit their ability to move to an attractive position with another company.
Much will depend on personal circumstances. Where a director has concerns about their ability to secure another position quickly, perhaps because of their age or the economic climate, then it is in their interests to negotiate as lengthy a notice period as possible. Where a director is very confident about their position in the marketplace, and possibly sees their current job as a stepping stone to greater things elsewhere, a shorter notice period may be desirable.
In negotiations, the following are likely to be relevant.
Current notice: someone who has previously enjoyed the security of a six months’ notice period may reasonably expect the same from a new employer.
Risk: if the director is being recruited into a new sector, they may argue for a longer notice period on the grounds that it will be more difficult for them to secure another position swiftly. They may also want added security if the company has a reputation for hiring and firing directors, is in a particularly volatile marketplace or is otherwise unstable.
Reward: sometimes the director is lured by the promise of ‘jam tomorrow’. Where, for example, the company has plans to float on the Stock Exchange, the director will want to know they will be employed long enough to reap financial benefits.
From both perspectives
It is important that both the company and the individual director understand exactly what has been agreed in relation to the contract term.
They should, therefore:
- avoid jargon when negotiating/instructing lawyers – the meaning of terms such as ‘rolling’ or ‘evergreen’ contracts is often disputed between employment lawyers;
- be very precise about how the notice period/fixed term should work;
- make any provision as simple to understand and operate as possible;
- avoid complex arrangements whereby notice can only be served on particular dates/during particular periods, etc.