"Golden parachute" clauses in directors' service contracts
This guide is based on UK law.
Purpose
Change of control provisions entitle directors to enhanced
severance packages in the event of companies being taken over or
merged. They are known colloquially as “golden parachute clauses”.
A fairly typical feature of directors’ service agreements in the
1980s, they became less common after the Cadbury, Greenbury and
Hampel reports led to closer scrutiny of executives’ contracts and
of provisions for termination payments.
The usual justification for change of control clauses was that
they provided security to directors who would not otherwise join or
remain. Over time, however, this has lost credibility.
The following arguments are likely to be made against change of
control provisions:
- directors’ contracts often include long notice periods; these
should be security enough. New owners of a company may lawfully
terminate a director’s employment without notice only if there are
grounds for summary dismissal;
- directors who are demoted after a takeover are protected by
law: they can resign, claim constructive dismissal and seek damages
consistent with their loss.
Enforceability
Code of directors’ duties
To be justified, change of control provisions must be consistent
with the code of directors’ duties. The code obliges directors
to:
- promote the success of the company;
- act within their powers and use them for a proper purpose;
- avoid putting themselves in a position where their personal
interests conflict with their duties as a director.
If the provision for payment seems to be excessive and out of
proportion with the benefit to the company, it can be challenged as
a breach of these duties. The same applies if there is any evidence
to suggest that the provision’s primary purpose was to act as a
“poisoned pill” to deter a potential takeover bidder.
If the board and the remuneration committee believe that change
of control provisions are necessary, it is advisable for them to
minute the reasons why. They should be confident they can justify
them as being consistent with the company’s best interests;
disclosure is likely to be necessary within the directors’
remuneration report.
City Code on Takeovers and Mergers (the “Code”)
Expert advice should be sought by any public company that wishes
to consider amending directors’ service agreements in light of a
possible takeover.
The City Code on Takeovers and Mergers provides that companies
that are the targets of bona fide offers, or that expect to be so
imminently, must not enter into a contract “otherwise than in the
ordinary course of business” unless they have obtained the prior
approval of shareholders in general meeting. It also says that:
“The Panel [on Takeovers and Mergers] will
regard amending or entering into a service contract with, or
creating or varying the terms of employment of, a director as
entering into a contract ‘otherwise than in the ordinary course of
business’ ... if the new or amended contract or terms constitute an
abnormal increase in the emoluments or a significant improvement in
the terms of service. This will not prevent any increase or
improvement which results from a genuine promotion or new
appointment but the Panel must be consulted in advance in such
cases.”
The Code applies to all offers for public companies and, thanks
to the Companies Act 2006, now has a statutory basis. No public
company can ignore its provisions.
Liquidated damages clauses and penalty clauses
Where advance provision is made for the damages payable to one
party as a result of a breach of contract by the other, the courts
will categorise the position in one of two ways. Liquidated damages
clauses are those where the pre-estimate of loss is seen as being
genuine; penalty clauses are those where it is not and where the
sum stipulated is “extravagant and unconscionable in comparison
with the likely level of loss”. The former are, in principle,
enforceable; the latter are void.
If a change of control clause is to be regarded as advance
provision for damages it will be necessary to demonstrate that it
was framed on the basis of a genuine pre-estimate of loss. This
will require evidence that proper consideration was given to an
individual director’s likely circumstances on termination and
proper account was taken of their duty to mitigate their loss by
seeking alternative employment.
There are those who say that change of control clauses should
not be regarded as advance provision for damages payable as a
result of a breach but as an express contractual provision under
which the company/director is entitled to terminate the contract
lawfully. While there is case law that supports this argument, the
position is by no means certain. If a remuneration committee does
decide that a change of control provision may be appropriate, it
remains advisable for it to try to ensure that the amount of the
proposed payment is a genuine pre-estimate of loss. This is also in
a director’s individual interests: it helps ensure that the change
of control provision can, in due course, be relied upon.
