Paul Emerton - Reduction in Notice Periods
The case for a reduction in notice periods of service contracts for UK directors
Paul Emerton, Head of UK Stewardship and Governance, Old Mutual Global Investors
On 17 February 2015, Old Mutual Global Investors announced that it expected UK companies to reduce the service contracts of directors to a notice period substantially below 12 months. This note is intended as a contribution to a wider discussion by companies, investors and other interested parties.
Why are we asking for a reduction in service contracts now?
On 3 February, Tesco PLC announced that it had agreed to make contractual payments to its former Chief Executive Officer and Chief Financial Officer, the sums involved being £1.2m and £0.97m, respectively.
Our own statement on contractual notice periods referred to the example of Tesco because it highlighted a structural flaw. Tesco was obliged to make payments, in this case broadly equivalent to 12 months of salary, in the absence of sufficient evidence to establish gross misconduct (although Tesco may attempt to reclaim the payments depending on the findings of the Serious Fraud Office which is investigating Tesco’s supplier payments).
I am not criticising the decision of Tesco to make the payment. The company faced a contractual obligation. Failure to meet its contractual obligations could have resulted in legal action. That could present a risk – any litigation might have been lost and it would have distracted management from its key role, namely turning Tesco around. Which outcome would have been preferable? Tesco locked in a court battle, or reaching a settlement? Faced with those choices, Tesco chose the sensible option.
The level of the payments re-opens the case for examining whether it is in the interests of our clients – or anyone – to have 12-month service contracts. We have concluded that we will take a stand against such contracts, effective from March 2016.
But contract notice periods having been falling for years …
In the 1990s, three-year service contracts for executive directors were common, prompting Alastair Ross Goobey at Hermes Pension Management to start a campaign to reduce notice periods. He was successful: contracts were duly reduced to two-year notice periods. A few years later, shareholders encouraged companies to move to a one-year contract, to the point where it is now rare that a UK director has a contract exceeding 12 months.
A primary reason for seeking the reduction of three- and two-year service contracts was that they often constituted a reward for failure: they could provide, respectively, three or two years of salary, bonus, pension and benefits even if the performance of the company was atrocious. Even though today we have one-year contracts, executive salaries and other elements of their remuneration have increased significantly faster than that of the rest of the population in the last ten years. This increase has effectively put us back to where we were when two-year contracts were widespread.
According to KPMG’s Guide to Directors’ Remuneration 2014, the median salary for a FTSE 100 chief executive was £837,000. If a CEO is fired for performance that is, at best, mediocre but not outright failure, a company in the top half of the FTSE 100 is potentially liable to provide him, or her, with at least £837,000. That sum equates to a multiple of 30 times’ UK median earnings (not simply salary) of approximately £27,010. £837,000 is a lifetime of earnings for a material proportion of our fellow citizens.
We all win
No-one will have failed to notice the mounting criticism over the ever-growing level of rewards for executives, especially when income levels for much of the population have remained stagnant. This coincides with a generally low level of trust in business.
On pay levels, there are vast differences for executive directors in comparison with most people across every element of the remuneration structure: CEOs have higher salaries, greater bonuses, share awards (noting that few people even receive share awards or, indeed, bonuses), higher contributions to pensions, more benefits – and longer contracts. Because of the pressure and skills involved, executive pay will be at a premium and reward for successful executives will remain high. However, reducing notice periods to levels closer to (or even at the same level as) their workforce will be a small step to recognising, and addressing, inequality. It will not, alone, fix the breakdown of trust between business and society but it is a start.
It will be to the credit of senior executives if they move to align themselves, in this regard alone, a little closer to their staff, who could lose their jobs at short notice.
Looking at the macro-economic case, businesses and capitalism are about the efficient allocation of resources. Long service contracts are a hindrance to this. There is, therefore, a case that shorter contracts will help the UK economy.
Will it be damaging to companies if service contracts are reduced to shorter notice periods?
No. Companies may claim they need people to remain in their roles. However, by the very act of resigning, those people are no longer committed to their roles, or are not focused. The authority of those on notice periods starts to ebb away immediately.
For staff leaving to join a competitor, contractual provisions restricting poaching of clients or other staff and use of intellectual property are enforceable under English law and may be longer than the actual length of the notice period in the service contract.
Every board should already have a succession plan in place to prepare for the departure of senior executives. That does not require the board to be able to immediately appoint a replacement - it is not productive to keep good individuals permanently under threat of immediate succession - but the board, particularly the chair and/or the chair of a board’s nomination committee should have some ideas. (The UK Corporate Governance Code, section B.2 states “The board should satisfy itself that plans are in place for orderly succession for appointments to the board and to senior management, so as to maintain an appropriate balance of skills and experience within the company and on the board and to ensure progressive refreshing of the board.”) A shorter notice period could improve the depth and robustness of a board because it is more likely to need and/or produce an interim or back-up plan.
Success-related longer-term contracts?
There is an argument that longer notice periods could remain but that contracts could be drafted to prevent payments in the event of poor performance. There are examples where payments have been restricted but it can be argued these have often been in some of the more extreme cases. Longer term contracts, which would then be subject to negotiation in the event of dismissal for poor performance, appear to enhance the employment prospects for lawyers but are a diverting, messy solution to a problem which should simply not exist if service contracts contained shorter notice periods.
Similarly, the need for mitigation (defined simply here as only releasing the payment over the course of a year with payments cancelled if the former executive finds another job) is redundant if notice periods are materially reduced. Currently, if the executive is unlikely to find another job, or is effectively retired, mitigation still provides the same significant rewards but is merely drawn out for a year. Thus, remove the cause of the problem, minimise the loss and simply move to shorter contracts.
It will, no doubt, be argued that companies will struggle to recruit or retain executives if they only offer a short notice period. Are notice periods the only reason a senior executive joins or stays at a firm? We would hope not.
Won’t executive pay rise in some other area?
Should directors be rewarded for surrendering 12-month notice periods? No. When companies moved down from two- and three-year contracts, companies - or executives - wanted to be compensated for the “loss” of value of reducing the notice period. This was resisted by shareholders, although we suspect that any compensatory awards were probably hidden in the general upward-ratcheting of senior executive pay.
A reduction in notice periods will, at least, be a further tilting of executive pay towards rewarding continuing excellence or competence, as well as reducing the chances of a reward for failure. (We recognise there is much more work to do on pay structures and performance and what we - companies and investors - need to reward, how and at what appropriate level of risk.)
There will be some instances where companies are likely to be the subject of consolidation (i.e. a take-over bid). We see no case for directors to have the comfort of a potential compensatory reward for failure in the event they are not required after new owners take control. If a company has performed, the executives will have received rewards in the form of long-term incentive plans and bonuses. (A take-over usually leads to a higher share price and consequently a higher value for the shares to which the executives will be entitled in their own shareholdings.) In a properly structured pay package, that should be more than adequate recompense. It will also be the case that if the executives have indeed performed, they will not struggle to find another role.
Are we delivering an ultimatum on notice periods?
Ideally, no. Voting against companies which do not move to low notice periods is a last resort. Voting against any resolution generally represents a failure of constructive engagement and trust. When we engage with companies on a host of stewardship issues, whether it is strategy, performance, people, safety of the workforce or pay, we want to discuss these issues with companies and understand them. If we want a company to pursue a particular course, we like them to accept our ideas willingly. We know, through long experience, that the most productive engagement is typically the result of long discussions but the end goal is for the company to buy into the idea.
This is not a criticism of senior executives generally. It is our hope that we can support companies over the long term. Providing a company has communicated its strategy and demonstrated that it will produce a sustainable return, justifying the use of capital, our views on contracts will, in theory, be academic because we, and other shareholders, will generally be pleased to support the company.
Ideally, executives will see the wider benefits of reducing notice periods and willingly agree to a reduction. A naïve hope, perhaps, but it presents an easy solution to the structural flaw that current executive notice periods in the UK have become. Reducing notice periods for board-level executives is to the advantage of our clients, companies, businesses and other stakeholders, including society generally.
“Substantially less than 12 months”: how substantial?
This may well vary by industry. There may be a case for three months to give chairs and boards scope to implement succession planning, or provide an interim solution. Where boards are confident in their bench strength and succession planning, one month may suffice.
Following our announcement on 17 February, journalists asked the author of this note for his contract notice period. It was three months. It is now one month.