The price of failure

With the media and the Govt aiming boots at the fat cats, industry is going to have to radically improve self-regulation if it wants to avoid legislation. Richard Yeomans reports

The media, shareholders and the Government have become increasingly critical of 'golden parachutes' for directors who are perceived to have failed. Take the case of Bob Mendelsohn, the chief executive fired by Royal & SunAlliance in October 2002. He was entitled to two years' notice and received a payoff totalling £2.44m despite the insurer reporting a loss of £1.25bn prior to his departure. More recently, the GlaxoSmithKline board was humiliated when the shareholders very publicly voted against a clause in the chief executive's contract that entitles him to an estimated £22m if he is sacked. These types of cases have led to calls for radical reform and legislation in this area.

The issue of directors' payoffs is not a new one. 'The Cadbury Report' (1992), 'The Greenbury Report' (1995), 'The Hampell Report' (1998), the Listing Rules and the Combined Code (2000) (the codes) have all sought to impose an effective system of corporate governance. They have encouraged companies to limit notice periods to one year, appoint non-executive directors and a remuneration committee to monitor the terms and conditions of directors, and justify remuneration against objective performance measures.

However, the codes do not have the force of law. Instead, the system is based on transparency and accountability to shareholders, the idea being that companies will not, for example, agree notice periods exceeding one year for fear of shareholder reprisals, particularly from the institutional investors. This 'comply or explain' approach was introduced in 'The Cadbury Report', but many feel that it does not go far enough.

Part of the difficulty is that unless there is “gross” misconduct or incompetence, the director is usually entitled to their full notice period. This is partly due to the decision in Re City Equitable Fire Insurance Co (1925), which established that a director does not have to “exhibit a greater degree of skill than may reasonably be expected from a person of their knowledge and experience”. In other words, a director will satisfy this duty provided he does his 'incompetent best'.

A company will rarely want the director's performance, and the company's performance, to be examined in a public court hearing. The result is that companies invariably accept that the departing director is entitled to be paid out in respect of their full contractual notice period, subject only to their duty to mitigate, for example, to take reasonable steps to reduce their losses by finding new employment. This can lead to very large payments to seemingly undeserving directors.

Increasing discontent with the level of severance payments led the Association of British Insurers (ABI) and the National Association of Pension Funds (NAPF), both of which are leading institutional investors, to make a joint statement of best practice in December 2002.

The bodies recommend the following:

Notice periods should not exceed one year unless there are “exceptional circumstances”.

The payment of notice monies should be “phased” and should cease when and if the director finds new employment.

Companies should avoid “liquidated damages” clauses, such as agreeing at the outset of employment an amount to be paid on termination that is not subject to any duty to mitigate. These clauses can lead to “windfall payments” and can be particularly embarrassing for a company when the departing director walks straight into a new job.

Companies should consider calculating compensation by reference to shares with the number of shares being set at the outset of employment. The idea here is that the amount of compensation is linked to the performance of the company by reference to its share price.

Companies should set out the full cost of any pension enhancement agreed as part of a severance package. This is to deter companies from seeking to use hidden pension benefits to disguise the cost of the severance.

The ABI and the NAPF are not the only ones making recommendations. Archie Norman, Conservative MP and former chief executive officer (CEO) of Asda, tabled a draft bill last year that would have entitled companies to challenge their contractual obligations to failing directors. While Norman's proposal sounds simple, it would undermine the concept of upholding contracts and give the courts the unenviable task of deciding whether a director had 'failed', and what was a 'fair and reasonable' amount to pay a director who had failed. For these reasons, the bill was blocked by the Labour whips.

Norman's latest proposal is that boardroom payoffs should be capped at six months' salary for failing directors. Another option is to move from fixed notice periods to variable notice periods based on the director's performance. This would be particularly relevant where specific performance targets can be set at the time the employment contract is entered into. Perhaps the length of the notice period could be linked to the company's total shareholder return or earnings per share measured against a group of comparable companies. These types of performance measures are often used in share option schemes and other long-term incentive plans.

Some UK commentators have gone further and have advocated the US approach of 'employment at will', where senior executives can be dismissed without any notice at all. However, US executives generally work on the basis of high reward, high risk, so in return for job insecurity they receive far higher remuneration – Jack Welch, the former CEO of General Electric, reportedly earned $231m (£138.4m) in 2000. It seems unlikely the UK will want to pay that price for shortening notice periods.

Not surprisingly, the Confederation of British Industry (CBI) has defended boardroom payoffs on the basis that the notice period is a legal commitment that is open to shareholder scrutiny. The CBI has also emphasised the fact that companies must compete for executive talent in the global marketplace and that offering security of employment can be a necessary part of that process. However, the Government has indicated that the status quo is not an option.

Earlier this month, the Department of Trade and Industry (DTI) published a consultation paper entitled 'Rewards for Failure', which focuses on the issue of directors' payoffs. The paper contains many of the suggestions of the ABI, the NAPF and Norman, such as restricting notice periods to one year, capping the level of liquidated damages, encouraging the use of phased payments and enabling boards to override contractual notice periods to take account of underperformance. The DTI is consulting until 30 September on these ideas and about whether any changes should be introduced through further self-regulation or new legislation.

There is speculation that the increasing willingness of shareholders, such as those at GlaxoSmithKline, to challenge boardroom payoffs will be used by the Government to argue that radical legislation is not needed and that simply reinforcing best practice guidelines will be sufficient. This speculation is supported by the consultation paper, which states that shareholders are already holding companies more accountable and that one option is to defer any reform until more time has been given to see how shareholders react to the ABI and NAPF joint statement. In addition, the consultation paper warns that new legislation might entail a significant regulatory burden and could be costly and time-consuming.

It is likely that the Government will avoid radical legislation and will opt for further self-regulation. If so, while the size of golden parachutes may be reduced, many directors who are sacked in the future will still be able to look forward to a soft landing.

Richard Yeomans is an employment solicitor at Manches