Directors' remuneration packages
This guide is based on UK law.
Legal and regulatory background
Directors’ service contracts must be drawn up with regard to
both legal and regulatory provisions on pay. This means being aware
not only of restrictions on directors’ involvement in decisions
about their own contracts, but also of best practice guidelines for
listed companies on pay levels and the make-up of the pay package.
The Combined Code states that:
“Levels of remuneration should be sufficient
to attract, retain and motivate directors of the quality required
to run the company successfully, but a company should avoid paying
more than is necessary for this purpose. A significant proportion
of executive directors’ remuneration should be structured so as to
link rewards to corporate and individual performance.”
Basic salary
The company should bear in mind that:
- articles of association will often limit the amount the company
can pay in directors’ fees. The service contract should therefore
make clear that salary payable is inclusive of any fees or other
remuneration to which the director may be entitled from the company
or any group company. This will avoid argument over how much
remuneration is referable to fees and enable the company to comply
with any limits;
- provisions regarding salary reviews – when they will take
place, how they will be carried out – should be set out clearly to
avoid future dispute. If a contractual right to an increase is not
intended there should be wording making this clear;
- the practice of increasing directors’ pay shortly before
retirement and thereby significantly increasing their entitlement
under a company’s final salary scheme carries risks. It could be
deemed to be against the company’s best interests. The Combined
Code provides that:
“The remuneration committee should consider
the pension consequences and associated costs to the company of
basic salary increases and other changes in pensionable
remuneration, especially for directors close to retirement.”
Bonus
To avoid future dispute, both the employing company and an
individual director need to ensure that bonus provisions are clear
and fully understood. The key points to remember are listed
below.
- The first major issue to determine is whether the director will
have a clear cut contractual entitlement to a bonus according to a
particular formula or merely a right to be considered for a bonus
by the board/remuneration committee. If the intent is the latter,
very careful drafting will be needed.
- An employing company also needs to be aware that, even where a
bonus scheme is discretionary, there will be constraints on the
decisions that can be made. This follows the High Court case
Clark v Nomura in which it was held that “even a simple
discretion whether to award a bonus must not be exercised
capriciously” and an employer should not exercise its discretion in
an “irrational or perverse way” – i.e. a way in which “no
reasonable employer would have exercised its discretion”.
This does not make it straightforward for an employee to challenge
bonus decisions, however. In the 2006 case of Commerzbank AG v
Keene, in which a very high paid investment banker sought to
challenge the level of his bonus, the Court of Appeal indicated
that:
“It would require an overwhelming case to persuade the court to
find that the level of a discretionary bonus payment was irrational
or perverse in an area where so much must depend on the
discretionary judgment of the bank in fluctuating market and labour
conditions.”
While this decision concerns discretionary bonuses in the
investment banking sector, it is significant in relation to
discretionary bonuses generally. The ruling does make clear that
the courts are generally reluctant to review an employer’s decision
regarding the level of a discretionary bonus.
- Decisions regarding the level of discretionary bonus payments
are prone to allegations of discrimination. A particularly high
profile instance of this was the case of Bower v Schroder
Securities Limited in which another senior investment banker
was awarded £1.4m in compensation for (what she claimed was) an
“insultingly low” award. (She received a bonus of £25,000 when
comparable male colleagues were awarded bonuses of £440,000 and
£650,000.)
- Board/remuneration committees should also take into account
Combined Code guidance, which underlines the link between pay and
performance:
“The remuneration committee should consider whether the directors
should be eligible for annual bonuses. If so, performance
conditions should be relevant, stretching and designed to enhance
the business. Upper limits should be set and disclosed. There may
be a case for part payment in shares to be held for a significant
period.”
- If a service contract is to contain detailed provision about
the calculation of the bonus, it will often be desirable to put
this within a separate schedule. Such a schedule may specify:
1. when the bonus is payable;
2. whether the bonus is to be payable during part years when the
director’s employment has begun/ended and, if so, how any pro rata
bonus payment is to be calculated;
3. who is to decide the final figure;
4. whether the bonus will always be payable on termination or only
in certain circumstances;
5. how particular terms such as “net profits” etc. are to be
defined;
6. whether bonus forms part of pensionable earnings. (The Combined
Code recommends that it should not);
7. whether there will be express performance criteria. (As stated
above, the Combined Code recommends that there should be
performance conditions and that they should be designed to enhance
shareholder value);
8. whether there will, in accordance with Combined Code guidelines,
be provision for a limit on the amount of bonus payable.
- It may be sensible to have any detailed provision regarding
bonus, including calculations derived from net profits, reviewed
and approved by the company’s auditors, particularly if the service
contract will provide for reference to the auditors in the event of
dispute.
Pensions
The service agreement must clearly provide for:
- the director’s entitlement to pension, subject to the rules of
the scheme;
- the employing company’s entitlement to withdraw or amend the
rules or benefits of a particular pension scheme and/or to
terminate an individual’s participation within it at any time.
(Obviously, the director is likely to want assurance that, in the
event of this type of provision being relied on, equivalent
replacement benefits will be provided.)
It is also now of crucial importance that companies review
provisions to reflect the significant changes in tax treatment of
pension contributions, effective from April 2006.
Permanent health insurance
Permanent health insurance (PHI) is designed to secure income
for employees unable to work through sickness or injury. A PHI
policy will usually be taken out by a company for a number of
senior employees. The insurance provider will pay sums to the
company after the employee has been ill for a specified period;
payments will be made until the employee is able to return to work.
A typical provision within a director’s service contract may,
therefore, entitle a director to six months’ contractual sick pay
and, thereafter, sums from the company as received under its PHI
scheme.
While this is all very well in theory, in practice PHI can be a
troublesome benefit. There is often a gulf between employees’
perception of the scheme and the reality of it how it operates. A
PHI policy will usually only provide cover for someone while they
remain employed by the company. When an employee is dismissed
because of long-term absence through illness (or for any other
reason), their entitlement to PHI benefits automatically ceases.
The understanding of employees, however, is often that PHI protects
them against the impact of long-term illness and that they will
continue to receive benefits for as long as they are ill – whether
or not the employer chooses to dismiss them.
PHI entitlements have been the subject of a number of disputes.
The leading case is that of Aspden v Webbs Poultry and Meat
Group, in which it was held that an employee’s contract
contained an implied term that their employer would not dismiss
them while sick if dismissal would lead to loss of entitlement to
benefits under a PHI scheme.
The Aspden decision means that PHI provisions need very
careful drafting and demand expert help. A common solution is for
the contract to provide that:
- the employing company will not terminate where an individual is
absent through illness and is, or may become, entitled to PHI
benefits;
- the employing company will still be entitled to dismiss in
certain specified circumstances – for example, gross misconduct,
redundancy or where the individual ceases to be eligible for
benefits under the PHI scheme.
Employers must make it expressly clear that an employee’s
entitlement to PHI is subject to the rules of the particular
scheme. Failure to do so can be an expensive mistake: where the
contractual promise exceeds the real levels of cover under the
scheme the employer can find itself obliged to give benefits it
will not be able to recover.
Share options
Provision for share options should not be made in a service
agreement but rather in a separate side letter/agreement. This will
ensure that:
- the director’s entitlement to share options depends entirely
upon the provisions of the share option scheme;
- the director will not be entitled to seek compensation for loss
of share options as part of a wrongful dismissal claim.
