Investors target high contractual payments to departing executives, but a tougher approach to severance pay may be better than shorter notice

Out-Law Analysis | 19 May 2015 | 12:37 pm | 6 min. read

FOCUS: Shareholders remain keen to avoid 'rewards for failure' for senior executives, as illustrated by Old Mutual's statement in February that notice periods should be less than 12 months. However, merely reducing notice periods below the current standard may not be the most effective approach.

Old Mutual, which owns around £5 billion worth of shares in UK listed companies, has said that it will use its vote on pay policy to reject "anachronistic" 12-month notice periods, other than in exceptional circumstances.

In February, Tesco was contractually unable to hold back large termination payments to its former chief executive and chief financial officer, based on their 12-month notice periods, even though investigations into the accounts were underway. That is likely to lead to trade bodies such as the National Association of Pension Funds (NAPF) and Investment Association (IA) considering whether their policies should also change. Those bodies already issue influential guidance on executive terms, including notice periods.

Old Mutual made it clear that it understood Tesco's obligations and decisions, and that, rather than criticising individual companies, it wanted to change a "structural flaw" in executive directors' terms generally.

Given the accounting failures that emerged following the executives' departures, Tesco suspended the agreed severance payments pending investigation but found that, legally, it was unable to maintain that suspension unless it could, in its own words, "establish a case of gross misconduct". It's no surprise, therefore, that investors have picked up on notice periods as part of their continued campaign against perceived 'rewards for failure'.

Generally under their employment contract, an executive would be entitled to claim damages based on the salary and benefits they would have earned during their contractual notice period if dismissed without notice or any payment in lieu of such notice, unless dismissed summarily for their own repudiatory breach – that is, for "gross misconduct". This is subject to the executive's duty to "mitigate their loss", for example by trying to secure other employment, the earnings from which can reduce the damages liability of their former employer.

Gross misconduct is not defined in statute, and its meaning to some extent will reflect the context of the particular post. There has been some debate as to whether presiding over poor corporate performance could be construed as gross misconduct. It may also be the case that the individual's contract of employment expressly refers to circumstances in which the employer will have the right to terminate without notice - for example, where a major scandal or financial misstatement occurs on the executive's watch.

So far, however, case law has not supported claims that arguably poor business direction, as opposed to something like financial irregularity, amounts to gross misconduct. So it may, in the absence of specific contractual provisions, be high risk for a listed company to dismiss a senior executive without notice or agreed damages, unless there was a clearer case of gross misconduct.

The standard notice period of 12 months for executive directors of listed companies gives them a strong hand in negotiations about their severance entitlements, as contractual terms generally cannot be changed unilaterally. Of course, these terms are agreed and approved by remuneration committees when recruiting a new executive. At that point, it is understandable that both sides will perhaps not focus on potential future conflicts and disappointments. Suggestions have been made that long notice periods justifiable on recruitment should automatically reduce over time, but they do not seem to have been widely applied in practice.

There is a history of both statutory and shareholder regulation of directors' notice periods. The Companies Act 2006 requires specific shareholder approval of any directors' service contract dated on or after 1 October 2007 that has a term of more than two years, defined to include any with a notice period of more than two years. The Act does, however, include an exemption from shareholder approval for payments to meet contractual liabilities.

Earlier service contracts only required such approval if the term was more than five years, under the Companies Act 1985. This difference reflects the even longer directors' notice periods that were common until 20 years ago, when investors campaigned for their reduction. As a result of investor views, what is now the UK Corporate Governance Code has aspired to, or required, notice periods of 12 months or less since 1995, with an allowance for longer notice if necessary on recruitment, as long as that period is subsequently reduced to the normal 12 months or less.

The reporting of the length of quoted company directors' notice periods first became mandatory from 2002, when directors' remuneration report requirements were revised at the same time as non-binding shareholder votes to approve them were introduced. The Corporate Governance Code had required the reporting of notice periods longer than one year since 1998, but the new regulations had legal force, and gave investors an annual opportunity for public opposition.

These statutory changes led to a rapid reduction in the percentage of FTSE 350 companies that still had two year directors' notice periods, from 27% in 2001 to 3.9% in 2004. But after that, one year's notice became the market standard followed by almost all quoted companies, making the reference in the Code to shorter notice an aspiration that investors seem not to have pursued vigorously – at least until now.

In Tesco's case the departing executives' basic contractual rights included a liquidated damages clause, although it is not clear if there was a liquidated damages clause in both the service agreement and the settlement agreement signed on termination, or just the latter. Usually, if a termination settlement includes damages for the notice period not worked, the agreement will include a warranty by the departing executive that there has been no gross misconduct, which effectively authorises non-payment or re-payment of damages if it is breached.

As a result, Tesco was legally required to pay a fixed sum set out in the settlement agreement to each departing executive unless it could legally establish a gross misconduct case, with all the difficulties that involves. While 'clawback' and 'malus' have been newsworthy for several years, these usually only apply to bonuses and long term incentive awards and in specified circumstances. For this reason, a warranty of no repudiatory breach would usually be the only mechanism to secure repayment of a settlement for salary and benefits due over the contractual notice period.

A formal requirement for phased payments and mitigation, also long recommended but not always adopted, would only help so much in these cases, not least because the circumstances would presumably make it considerably more difficult for the ex-director to mitigate losses successfully. Instead, contractual changes to the directors' service agreements could assist.

Contract drafters have a number of potential options here, from further defining 'gross misconduct' - bearing in mind that this could be seen as inflammatory and not helpful - to providing supplementary broad rights to dismiss on no or reduced notice where company or director performance requires without having to establish gross misconduct. Agreements could also set out different terms for a payout on termination without, or on reduced, notice in certain circumstances, which the Code first suggested in 1995.

It may then be worth thinking carefully about what length of notice period is appropriate, bearing in mind industry standards and the need to attract and retain the most qualified staff. But, as there are practical reasons for listed companies to want long notice periods for their leaders, whose basic pay over twelve, nine or even six months will usually be relatively substantial, it may not be possible to fix this issue just by reducing notice periods.

The difficulty with any true contractual innovation, however, is that even the most careful legal analysis cannot provide certainty as to how the courts will respond, especially in an area of law like this, in which settled case law is very important. How the law develops in respect of something truly novel may depend on what justice requires in the first case to test an innovation in a senior court, potentially holding all reasonable employers hostage to the unreasonable ones. For that reason, it might be helpful to try to use statutory provisions to underpin any innovation - and the 2013 amendments making directors' pay forfeit if inconsistent with the approved remuneration policy could well be used in that way. It would also be helpful if companies, investors and regulators could together agree on the best way for these issues to be addressed in directors' service agreements and in companies' directors' remuneration policies.

Whether more investors or, ultimately, the corporate watchdog the Financial Reporting Council follow Old Mutual's lead remains to be seen. But, with the Code, investors, investor bodies and statutory requirements all emphasising the need to link executive pay to a company's long-term success, and increasing  investor engagement, the long running saga of directors' notice periods and severance pay seems likely to engage company secretaries, remuneration committees and corporate counsel for some time to come.

Matthew Findley is a share plans and executive remuneration expert, and Steven Cochrane is an employment law specialist, at Pinsent Masons, the law firm behind Out-Law.com.