Finance: The short goodbye

New attempts to cut the controversy surrounding directors' golden handshakes are made in the latest report on corporate governance chaired by Sir Ronnie Hampel. Ian Hunter asks whether the recommendations will be warmly welcomed.

The public and shareholders have, in recent years, been baffled by a stream of executives dismissed from ailing companies who have received substantial pay-offs, seemingly (at worst) as a reward for incompetence or, being charitable, their association with failure.

The disquiet caused by such pay-offs has increased calls for provisions to be included in executives' contracts of employment that provide the board of directors with the right to dismiss an executive without compensation when the hapless individual, in the board's view, has failed to perform his duties competently.

Such clauses have been vigorously resisted by executives and their legal advisers, who point out that executives are often used as scapegoats to explain the company's poor performance. A preliminary report by the Committee on Corporate Governance, chaired by Sir Ronnie Hampel, is proposing another way of dealing with the contentious issue of golden handshakes that aims to satisfy both parties' concerns.

In large part, the size of the golden handshake payments received by departing executives has been determined by the length of notice that they are entitled to receive under their contracts of employment. The starting point for calculating contractual damages on termination of employment is a sum equal to the value of the net salary and fringe benefits that the employee would have received during his notice period. Executives are under a duty to mitigate their loss by trying to find suitable alternative employment.

According to a survey published by Labour Research last year, more than 100 executives left with pay-offs in excess of pounds 100,000.

The Companies Act 1985 provides that directors may be granted a contract of employment with a life of five or more years only if the contract has first been approved by shareholders. In reality, contracts of such a length have not been the norm for many years.

The Cadbury and Greenbury reports which preceded the Hampel report also considered the issue of directors' pay. Both reports made proposals to regulate the size of directors' potential claims for compensation on the termination of employment.

One of the Cadbury report's recommendations was that no director should receive a service contract with a notice period in excess of three years without prior approval from shareholders. Cadbury also recommended a full disclosure of the total value of directors' financial packages, including individual figures for the chairman and the highest-paid UK director.

This report was followed in 1995 by the Greenbury report which, like the Cadbury report, shied away from recommending statutory control over directors' pay, but sought to strengthen directors' accountability. The report suggested that directors should set up remuneration committees consisting entirely of non-executive directors, who would be charged with determining the company's policy on executives' pay and compensation payments.

The committee also suggested that there was a strong case for reducing notice periods to one year or less, although longer periods would be acceptable in cases where a suitable explanation had been provided to shareholders.

The Hampel preliminary report has also covered a number of issues relating to directors. These include a recommendation that directors' contracts of employment make detailed provision at the outset for the payments the director would be entitled to if he were removed from office at any time, other than for misconduct. The report recommends that the director would be entitled to this payment regardless of whether he found other employment immediately following his dismissal by the company. The advantage with this arrangement, the report concludes, is that it would create certainty for both parties.

Mitigation is usually the most contentious element of any negotiations over compensation. The executive will usually argue that it will not be possible for him to find suitable alternative employment that offers the same or comparable benefits, within his notice period. The company, by contrast, will often argue that a highly qualified and experienced executive should find another position within a few months. The idea of an agreed, predetermined compensation payment has much to commend it. The skill lies in drafting a clause that is enforceable.

Liquidated damages clauses which provide for a payment to an executive on the termination of his employment, other than for gross misconduct, will only be enforceable if the payment represents a genuine pre-estimate of the executive's loss. If, for example, the executive is entitled to a three-year notice period and the damages payment due to him under the contract of employment provides for an amount equal to the value of his full salary and benefits for the whole three-year notice, such a clause may be vulnerable to attack on the basis that the payment does not represent a genuine pre-estimate of a loss - the argument being that the executive could seek alternative employment within a three-year period.

In these circumstances the company could argue that the clause constitutes a penalty and is therefore unenforceable.

There is a second consideration for executives agreeing to a liquidated damages clause. Normally, on dismissal, an employee may receive up to the first pounds 30,000 of any compensation payment tax free.

However, if the right to compensation is contractual it will be fully taxable. Some directors may take the view that a degree of certainty is worth the pounds 12,000 that they stand to lose on dismissal when such a clause is included in their contract of employment.

The recommendations made in the preliminary Hampel report, for the purposes of avoiding acrimonious litigation, are not new. It remains to be seen whether the recommendations will be enthusiastically adopted by both employers and employees in years to come.

The writer is an employment law specialist with the City law firm Bird & Bird.