DTI consults on "Reward for Failure"

On 3 June, the Trade and Industry Secretary Patricia Hewitt launched a new consultation exercise examining Directors' severance compensation. This concentrates on directors' contracts, performance and severance payments.

In particular, the consultation document, "Rewards For Failure", seeks views on whether - and if so what – further measures are needed to ensure that compensation reflects performance when directors' contracts are terminated. The document explores a range of options for the enhancement of best practice and/or legislative change.

This consultation is a response to concerns over directors who leave companies that have performed poorly, but who still receive substantial compensation payouts. Although the consultation document focuses on listed companies, the options for changes to the Companies Act on directors' contracts would apply as much to private and un-listed public companies as to listed ones.

Summary of Key Questions for Consultation:-

Q1 Views are sought on whether, and if so how, best practice on compensation and severance could be further extended to limit the total amount paid by:

a) restricting notice periods (and therefore severance) to less than 1 year;

b) capping the level of liquidated damages.

Q2 Views are sought on whether, and if so how, best practice could be further extended to encourage the operation of phased payments in order to restrict the level of any severance or compensation payment.

Q3 Views are sought on how improvements in best practice might be most effectively promulgated (eg. Institutional shareholder guidance, Combined Code amendments).

Q4 Views are sought on other best practice options which would have the effect of limiting severance payments in cases where a company has performed poorly.

Q5 Would it be possible, and if so in what ways, to legislate for contracts to include provisions which require the board to take into account underperformance in determining severance payments and which would avoid the potential for litigation?

Q6 Should companies legislation provide that the statutory period for a director's contract would be limited to one year duration, or three years on first appointment, as recommended by the Company Law Review?

Q7 Should companies legislation provide for the prohibition of rolling contracts having a notice or contract period in excess of the period permitted by section 319, as recommended by the Company Law review?

Q8 Should companies legislation provide for the prohibition of covenants which provide for more compensation than would be available under a one year or three year term contract, as appropriate?

The key issue among the 8 questions for consultation is whether there should be legislation, or just voluntary action, to stop large payments of compensation to departing directors. Cynics among the financial journalists believe the government will not legislate anyway. However the consultation paper's serious legislative proposals are those endorsed by the Company Law Review, so they are destined for the statute book anyway. As this Secretary of State showed no hesitancy in pressing ahead with the Remuneration Report Regulations, it is quite possible that she will legislate to implement the specific Company Law Review recommendations.

However, the consultation paper's comments about the impracticability of Archie Norman's Bill -- the Company Director's Performance and Compensation Bill -- strongly suggest the D.T.I. have no wish to interfere in the long-established contract law principles on damages. Therefore, the point of attack will be the length of director's contracts.

Under particular scrutiny is the recommendation to amend section 319 of the Companies Act. The change would limit directors to a three year initial fixed term and, from the second anniversary of their appointment, to twelve months notice. Shareholders will still be able to vote to approve more generous arrangements for their directors, should they wish. Liquidated damages or covenanted payments would be similarly limited by law. Damages payments would, by simple operation of the ordinary common law principles, equally be controlled.

Copies of the consultation paper are available at www.dti.gov.uk/cld/current.htm The closing date for responses is 30 September 2003.