Directors' service contracts: length of fixed terms and notice
periods
This guide is based on UK law.
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. (The equivalent provision under the Companies
Act 1985 applied to contracts of more than five years’
duration);
- a director’s contract must be available for inspection by
shareholders – under the Companies Act 1985, this applied only
where the contract was for a fixed term of 12 months or more or was
terminable on notice of 12 months or more.
Under the code of directors’ duties:
- 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 directors’ service
contracts with a notice period in excess of one year or with
provisions for pre-determined compensation on termination exceeding
one year’s salary and benefits, giving the reasons for such a
notice period/predetermined compensation;
- all directors’ contracts have to be available for shareholder
inspection.
The Combined 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.
(Two-year rolling contracts have come under fire from
shareholders – for example, at the AGMs of GSK and Tesco in
2003.)
Negotiation points
From the employing company's perspective
Notice periods/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 our
OUT-LAW guide to Terminating a director's
employment);
- 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 Combined Code advises, be best to
reflect this through an initial term followed by a shorter notice
period.
Long notice periods and fixed terms look increasingly
anachronistic. The Deloitte report for the DTI on the impact of the
Regulations concluded that there has 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.
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 seek to argue for a longer notice period on
the basis 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.
