Welcome to the third in our Executive Remuneration series. In this update, we provide guidance for companies managing the departure of a senior employee. There exists a myriad of issues to be considered in the context of a senior departure: internal and external communications, regulatory notifications, succession planning and PR issues to name but a few. This update focuses on important considerations around remuneration.
Reason(s) for Termination
It might sound obvious, but it will be important to understand the reason(s) for the employee’s departure. This is likely to have a significant bearing on the company’s potential liabilities, both from a contractual perspective and in terms of litigation risk. Where the employee has resigned, the position ought to be more straightforward. Where the company has decided to terminate, it will be necessary to identify the legal reason for the dismissal as this will inform the employee’s entitlements (including in relation to cash and equity based incentives) and will also be an important factor in the company’s negotiating position.
The Severance Package – A Balancing Act
With a senior level exit there will invariably be a strong desire to reach an amicable separation quickly and confidentially. One way to achieve this is to offer an extremely generous package which takes account of the employee’s contractual and statutory rights and includes an additional incentive. However, companies subject to one or more of the FCA/PRA remuneration codes will be cognisant of the need to ensure that severance packages (i) accurately reflect the employee’s performance (and do not have the effect of rewarding failure or misconduct) and (ii) align with the overarching principle of promoting sound and effective risk management. More generally, firms subject to the Senior Managers and Certification Regime (“SMCR”) will need to be mindful of the regulators’ desire that remuneration be used as a robust tool for conduct management. Similarly, companies subject to the UK Corporate Governance Code (the “Code”) need to look at severance pay through a similar lens, with an appropriate link to performance. It will also be appropriate for those fully listed companies to take a robust line on minimising termination pay to reflect the need for departing employees to mitigate their financial losses.
So, the approach to severance pay for senior employees is very much a ‘balancing act’. Companies, particularly those in the FS regulated sector or those subject to the Code need to tread a fine line between offering a package attractive enough to ensure a seamless separation process and ensuring that they can justify any termination package from a regulatory or Code perspective, having regard to the factors mentioned above.
One important aspect of the severance package will be the approach in relation to notice pay. It is relatively unusual for a departing employee to work out the entirety of their notice period. More common are situations where the departing employee works out part of their notice and then spends the remainder on garden leave. This often allows for a seamless transition, for example in relation to handing over responsibilities to the successor whilst at the same providing the company with comfort that the departing employee is restricted from working for a competitor.
In certain circumstances it will be appropriate to terminate the employment before the end of the notice period by making a payment in lieu of notice (“PILON”). This may be a preferable option where there has been a contentious environment leading up to the departure and the company favours a ‘clean break’ by bringing the relationship to an end as soon as possible. The PILON option may also have financial advantages. For example, immediate termination will preclude the employee from accruing more service and could therefore avoid potential payment ‘triggers’ under incentive compensation schemes. It is also typical that an employee’s service agreement will limit PILON to basic salary only, meaning that the company would save (often considerable) amounts in terms of the benefits otherwise payable during the notice period. Lastly, depending on how the PILON clause is drafted, it may also be possible for the employer to pay the contractual notice pay in monthly tranches (subject to mitigation and offset in respect of future earnings) rather than an expensive lump sum (see below).
PILONs for senior employees can be expensive. Generally, there is no scope to reduce the amount of the PILON if the company does not want to find itself in breach of contract. The Code (which applies to all premium listed companies and is followed by many others) states that companies “should be robust in reducing compensation to reflect departing directors’ obligations to mitigate”. One way to achieve this is for the service agreement to include the express right to pay the PILON in instalments with a right of set-off whereby any income that the employee receives from a new job is deducted from the instalments. This right of set off is complimented by a contractual duty on the employee to mitigate their losses (i.e. an obligation to take reasonable steps to secure alternative employment). This element of mitigation is likely to be attractive to institutional investors and regulators. However, it is important to note that treating a PILON in this manner cannot be implemented unilaterally by the company – an employee would need to agree to this. Ideally any such agreement would be included in the service agreement. Whilst it is theoretically possible to include such a mechanism in a settlement agreement, it is unlikely that a departing employee would agree to this. If the employee does not agree to this approach, it will normally be the case that the company has little option but to make a PILON equivalent to the salary that would otherwise have been payable for the entirety of the notice period. In some limited situations (for example where there has been serious underperformance falling short of summary dismissal territory) a company will terminate in breach and then seek to agree a mutually acceptable package afterwards. This is a risky strategy and can expose the company to reputational damage. It will also put in jeopardy any post-termination obligations such as non-competes or non-solicitation restrictions. However, the company may take a risk-managed view on such issues and argue that making a full PILON would be inappropriate having regard to their remuneration philosophy, for example in relation to rewarding failure. The employee will be cognisant that any litigation will be expensive and reputationally damaging for both parties. They will also be aware of their duty to mitigate losses in the context of a legal claim for damages. As such this strategy, whilst unusual, may be appropriate in some limited circumstances.
Look for hidden payments and entitlements…
An employee’s service agreement may have a ‘golden parachute’ clause entitling them to a payment if their employment is terminated in relation to a change of control event, such as a merger or a takeover. The idea behind such a clause is that the employee is entitled to payment of a specified sum as a debt, without the need for proof of actual loss and without any deduction for mitigation – in other words, it is like a PILON clause without any provision for phased payments, etc mentioned above. For that reason, golden parachute clauses are unpopular with institutional shareholders (and if a takeover offer is imminent, would require shareholder approval under the Code). Sometimes, such clauses can be unenforceable on the basis that they amount to a penalty clause, but it will depend on the precise wording.
Most share option schemes state that the options are lost on termination of employment, unless the employee is a good leaver. They often contain a Micklefield clause, which provides that the company will not be liable to the employee for the loss of any rights under a share option scheme where the loss flows from the termination of their employment.
FCA/PRA regulated firms will generally be subject to one or more of their remuneration codes or, in the case of insurers, the Solvency II remuneration provisions. A detailed explanation of these issues is outside the scope of this update but in terms of general observations:
Regulated firms are required to ensure that payments on termination of employment do not reward failure or misconduct, but rather should reflect the performance achieved over time.
Does there need to be any downward adjustment? This would usually be done under any malus provisions in the share option scheme rules (under which unvested, deferred variable remuneration would be reduced). The reasons for applying malus should be fully documented and a decision taken by the remuneration committee after it has considered all the relevant issues.
It is best practice (including in listed companies generally, as well as FCA/PRA regulated ones) not to accelerate vesting of any share option payments and FCA/PRA regulated firms may be prevented from doing so under the applicable remuneration codes.
In many cases, reaching agreement over share options will be a key factor in agreeing a settlement with a departing employee.
The agreed position should be narrated in any settlement agreement.
One contentious area in the context of senior departures can be the entitlement to a discretionary bonus. In most situations, the contractual position will be clear – it is generally the case that discretionary bonuses are not payable in circumstances where the employee is under notice of termination (whether given or received) as at the payment date. However, in certain sectors discretionary bonuses make up a relatively large proportion of total compensation, and employees who leave partway through the bonus year will feel that they have ‘earned’ a bonus, notwithstanding any clear contractual language to the contrary. As such taking a firm stance on the non-payment of what is likely to be a significant sum is likely to hamper attempts to negotiate a swift and amicable separation. It is therefore commonplace (or at least not uncommon) for employers to exercise their discretion to pay a portion of any bonus in the context of a senior exit. Where the employer is subject to the Code and/or one or more of the FCA remuneration codes (or Solvency II) it will be necessary to have regard to the issues set out above, for example the need to promote effective risk management and align pay with performance. In circumstances where the exit has been precipitated by serious misconduct or under performance, it will be difficult to justify paying anything by way of discretionary bonus. Indeed in such circumstances the employer may need to consider whether any adjustment vis-à-vis previous years’ discretionary awards is necessary (e.g. the engagement of clawback provisions).
Transfer of shares
Where an employee holds shares, they may need to be dealt with. In private companies, they will usually be transferred or sold back to the company or to an employee benefit trust under the company’s articles of association or a shareholders agreement. The company’s articles of association or any other agreement relating to equity (e.g. an investment agreement) will often include good leaver/bad leaver provisions which will set out what happens to those shares, including mechanisms for determining the value of the shares. In the case of listed companies, and unless the shares were otherwise subject to a holding period under an employee share plan, it would be highly unusual to have provisions requiring an employee to transfer any shares which he or she held.
Where the employee is a statutory director, be aware of the need to obtain shareholder approval for severance payments! This is required for the majority of such payments (including payments for loss of office), unless a specific exemption applies. Exemptions exist for payments made in good faith, in discharge of an existing legal obligation, by way of damages for breaching a legal obligation, or settlement or compromise of any claim arising in connection with the termination of a person’s office or employment. As a result, provided any severance payment is in line with the company’s liability to the employee, there should be no need for shareholder approval. However if the company wanted to pay an additional amount beyond the employee’s legal entitlement (for example, to reward or thank the employee for past service where the departure is amicable, maybe to bring in a more experienced successor), shareholder approval would be required.
Technically, if a non-exempt payment is made without shareholder approval, it is held on trust for the company and the directors are liable to the company for the amount.
Listed companies and unlisted traded companies must also have a remuneration policy approved by shareholders every three years, and can only make payments (including loss of office payments) to directors in accordance with that policy. The remuneration policy must set out the principles that determine how payments for loss of office will be approached, including an indication as to how each component of the payment is calculated and whether, and if so how, the circumstances leading to loss of office and the director's performance are relevant to exercising any discretions. The package agreed with any departing employee must therefore fall within the parameters of the remuneration policy.
The GC100 and Investor Group guidance states that companies should carefully consider the drafting of their remuneration policy to ensure that they have sufficient flexibility to cover all sorts of leaver situation, as the remuneration committee can only exercise its discretion if allowed to do so under the policy.
Listed Companies – Notification Requirements
The Listing Rules oblige a listed company to notify a Regulatory Information Service (“RIS”) of the removal, retirement or resignation of a director "as soon as possible" and by no later than the end of the business day following the decision. Given the tight timescales here, it is important that, before you push the button to terminate, you have a clear strategy in terms of the steps that follow from that.
When a company notifies a RIS of a director's departure, it may not be possible to give details of the termination arrangements, but investors will expect the RIS announcement to give an explanation of how remuneration payments to the outgoing director have been or will be calculated. Fuller details can be supplied later in the annual remuneration report – see below.
Listed companies therefore have to manage the process of departures (and new hires) carefully to avoid required announcements at the wrong time (for example, when the departure has not been fully agreed). This is a delicate balancing act, since ideally when a departure is announced, the company will also want to confirm a replacement. Triggering public announcements at inopportune moments, and particularly before all the terms and conditions relating to the exit and the new appointment have been agreed should be avoided.
Annual Remuneration Report
All companies (listed and unlisted), except companies falling under the small companies regime, must disclose information about payments for loss of office. In the case of listed and unlisted traded companies, compensation must be disclosed in the annual remuneration report. Details must be given of any termination payments made above a de minimis limit set by the company, including the total amount of payment for loss of office paid broken down for each component, including treatment of outstanding incentive awards that vest on or following termination and details of how any discretion was exercised in respect of the payment.
Companies must also publish a statement on their website setting out what payments the directors have received or may receive in future for loss of office. Such a statement must be made available as soon as reasonably practicable after a person ceases to be a director and must include particulars of the payment, its amount and how it was calculated. This information may need to be mentioned in any subsequent remuneration report.
Determining the appropriate level of an employee severance package can be extremely difficult. There are added complexities for listed companies and for those in the financial services sector where a myriad of complicated remuneration codes (some of which may overlap) can apply. Organisations need to balance regulatory compliance (including compliance with the Code) with the need to come up with a package attractive enough to ensure a swift and amicable separation, whilst at the same time remaining cognisant of adverse PR and shareholder discontent around what might be considered to be an overly generous settlement package.
Points to remember:-
Determine the employee’s legal entitlements, and any payments that are discretionary (e.g. options and bonuses), and negotiate a severance package from there
Deal with any shares (if necessary)
Ascertain whether shareholder approval is required for any payments
Ensure payments are consistent with the remuneration policy (if applicable)
Payment for loss of office must be reported on in the annual remuneration report (if applicable)
Comply with applicable notification requirements, whether to the market and/or regulator(s) and ensure the process for announcing the departing employee and replacement are joined up
Well-timed internal and external comms are always advisable, as board level comings and goings can have huge PR implications and affect staff morale, investor relations and share price.
The fourth and final update in this series will be out in February and will cover remuneration considerations for FCA/PRA regulated firms from a cultural perspective.