Executive termination payments – who wins in a market slump?
Executive termination payments – who wins in a market slump?
- Golden handshakes negotiated during boom times come under scrutiny in market downturns.
- Shareholder approval for the payment of a proposed termination benefit must be obtained at any time prior to the payment or provision of that benefit.
- Companies and incoming executives should ensure termination arrangements form a key part of any contract negotiation.
There is now, more than ever, an increasing focus by stakeholders on executive remuneration. This is demonstrated by the amount of high profile companies receiving
‘strikes’ against their remuneration reports during this AGM season. Similarly, executive termination packages are also becoming an increasing area of shareholder and
The market downturn in recent years has left many industries facing difficult choices about excess business and staffing capacity. While the inclusion of ‘golden handshakes’ in employment contracts has been common practice in corporate Australia for many years, arrangements negotiated during a market boom or period of strong company performance are now under scrutiny. This has had a considerable impact on the resources, manufacturing and retail sectors, as well as other distressed businesses subject to takeovers by private equity, often impacting long-serving and loyal executives.
In light of these circumstances, many companies are struggling to balance the interplay of competing interests between their board, their shareholders and the departing executive in negotiating suitable severance packages (either at the time of entering into the employment arrangement, or as a compromise to avoid possible claims when the employment arrangement is coming to an end), while at the same time ensuring they are made in compliance with Australia’s stringent legislative requirements.
It is therefore vital to ensure new contracts are structured appropriately in setting out termination packages, as well as any amendments negotiated to pre-existing agreements where a termination event may arise from a change in circumstances.
Executive termination payments are heavily regulated by legislation following amendments to the Corporations Act 2001 (Corporations Act) in 2009, which ultimately sought
to lower the threshold at which termination benefits would require shareholder approval.
The payment of termination benefits to senior executives is regulated by Division 2 Part 2D.2 Corporations Act, which prohibit the payment of termination benefits to certain senior executives unless the benefits are approved by shareholders, or a specific exemption applies.
For listed companies, the ASX Listing Rules impose additional requirements on termination benefits. Specifically:
- termination benefits (or increases in them) cannot become payable to an officer due to a change in the shareholding or control of the company that is in a takeover context)1 and
- absent shareholder approval, no officer can become entitled to termination benefits if the value of all termination benefits payable to officers will exceed five per cent of the equity interests in the company. 2
Shareholder approval requirements
Shareholder approval for the payment of a proposed termination benefit must be obtained at any time prior to the payment or provision of that benefit (retrospective approvals to ratify earlier payments are not permitted). This enables companies to seek pre-approval for a benefit that may potentially be payable in the future, a
trend that companies are increasingly using to secure termination benefits.
The requirements for valid shareholder approval require that:
- an ordinary resolution is passed at a general meeting of the company
- the details of the benefit must be set out in the notice of meeting and
- neither the retiree nor their associates must vote on the resolution.
What about contracts entered into before the Corporations Act amendments?
The Corporations Act amendments included grandfathering provisions in respect of contracts entered into prior to 24 November 2009. Provided that a contract was not varied (particularly in relation to the remuneration structure, other than in the context of contractually prescribed remuneration increases), renewed or extended after that date, the current legislative prohibitions are unlikely to apply.
Who do the restrictions apply to?
For a disclosing entity, the restrictions apply not only to directors, but to any person who holds a ‘managerial or executive office’, or has at any time during the last three years prior to retirement held a managerial or executive office. This expressly includes persons whose details were included in the company’s directors’ report for the previous financial year.
For all other companies, the restrictions apply only to directors of the company.
The restrictions will apply irrespective of whether or not the company contracts directly with the employee, or where the employee has a company through which they provide their services.
What is a benefit?
A ‘benefit’ given in connection with a person’s retirement from office includes (but is not limited to):
- payment or other valuable consideration, including:
- payment in lieu of notice
- accelerated or automatic vesting of share-based payments or entitlements on termination
- an amount paid as a voluntary out-of-court settlement in relation to termination of employment or
- an amount paid pursuant to a restraint of trade clause
- real or personal property of any kind or
- any legal or equitable right (including a legal or equitable estate or interest in real or personal property).
Which benefits are exempt?
Shareholder approval for a termination benefit is not required where:
- the benefit is a genuine payment for breach of contract or given as consideration for the person holding that office or position
- the benefit is a payment for past services the person rendered to the company
- the benefit is specifically excluded from the definition of ‘benefit’ in the Corporations Act, such as genuine superannuation payments or accrued benefits (such as leave) or
- most importantly, the value of the benefit, when added to all benefits already given in connection with the retirement, does not exceed the average annual base salary of the retiree during the time the retiree held that position (the ‘Monetary Cap’). Base salary does not include the total remuneration package of the retiree such as any incentive entitlements that can be triggered by termination. Given that the Monetary Cap is calculated by reference to the base salary only, many termination entitlements are likely to exceed the Monetary Cap due to the composition of most modern remuneration packages (that is, a large proportion of the package is based on incentive plans rather than
an annual base salary).
Consequences of a breach of the Corporations Act
The calculation of the Monetary Cap, together with the classifications of what may constitute a retirement benefit, is a continuous area of uncertainty for many boards, the result of which can give rise to issues of miscalculations and inadvertent breach. Breaches of the Corporations Act can result in severe financial penalties and, in certain circumstances, imprisonment. Any benefits already paid also become immediately repayable to the company by the retiring executive, who is unable to rely on any deed of release they may have entered into as part of their severance arrangements to prevent a claim from being brought against them in this regard.
Alternative benefit structures
In Australia’s current corporate landscape, remuneration packages are an area continuing to plague companies, employees and shareholders, each of whom bring competing interests they will fight to have met. Some frequent practical issues arising in this context include the following.
- The arrangements are often not properly considered until a deed of release is being negotiated, by which time the parties are likely to have substantially less flexibility round the structure of any severance package (it may also no longer be commercially feasible for the company to obtain shareholder approval before the payment is due
to be made). Where a severance package is not agreed from the outset, companies should ensure employment contracts include appropriate carve outs in respect of the company’s obligation to provide benefits where doing so would be in breach of the Corporations Act or (where applicable) the ASX Listing Rules.
- In the current economic environment, retiring executives are more likely to be aggrieved as a result of redundancies (often having agree to take less salary or forego bonuses in recent times), and negotiating the terms of any severance package at the time of their departure is often significantly more challenging against this backdrop.
- Both the company and the executive may have sensitivities towards taking remuneration based matters to shareholders for approval.
- Negotiating equity incentives is increasingly difficult, particularly where the value of the incentive has often dropped during the course of the executive’s employment. The
value of these rights (which often comprises the largest potion of total termination benefits), will count towards the benefit being paid to the departing executive so must not be overlooked. It is therefore imperative to carefully examine the relevant plan rules and conditions applying to any incentives (for example, accelerated vesting conditions) in order to deal with them appropriately within the legislative restrictions.
- Termination negotiations often occur contemporaneously with other business transactions (particularly in the context of a business acquisition), and there may be competing timing and other commercial pressures that the company needs to manage.
As companies continue to struggle with the effective implementation of termination benefits, mixed practices have been adopted by companies in an attempt to balance their need to fulfil contractual obligations to departing executives, while also appeasing concerns held by their board and shareholders.
Prospective shareholder approval for future termination benefits
In recent times, there has been an increase in the practice of companies obtaining prospective shareholder approval for future termination benefits. Shareholder pre-approval can be sought at any time prior to the payment of the relevant termination benefit (before any termination is being contemplated). If approved, employers benefit from not only ensuring compliance with their legal obligations, but also having the flexibility to attract and retain high performing executives.
Similarly, executives obtain certainty under this approach by knowing that their contractual termination entitlements are secure.
This approach is seemingly a straightforward way to sure up the payment of termination benefits, but is not entirely without issue. The commercial reality of relying on approval from shareholders gives rise to uncertainty of terms of employment given the risk that the resolution will be voted down by shareholders, including the ongoing scrutiny and recommendations made by proxy advisors in this regard. Many employees also prefer remuneration negotiations to occur in confidence (although for listed companies, these details are required to be disclosed). Any pre- approval, and the timing of it, will therefore largely be driven by the commercial circumstances of the company and the executive at the time such approval is being considered.
Restructure of executive remuneration packages
Companies may seek to restructure their executive remuneration packages to provide less generous termination benefits to retiring executives to ensure they fall within the statutory exceptions and shareholder approval exemptions. This can be achieved, for example, by increasing the amount of fixed remuneration (that is, the base salary) as compared to short and longterm incentives. Again, this approach is not without risk, including potential adverse consequences to both the company and the executive who may prefer to retain a portion of remuneration benefits as incentive based payments. For example, reducing incentive payments can impinge upon their very purpose of an incentive based payment by reducing the motivation for the executive to focus on the short or long-term performance of the business. Similarly, it is also guarantees a payment to the executive even in circumstances where that executive’s performance hurdles have not been achieved.
Incentive plans can also be amended in relation to acceleration or automatic vesting, although there is a residual risk that any amended structure could potentially result in adverse tax consequences for the executive.
What does this mean for directors?
While often an uncomfortable discussion, companies and incoming executives should ensure termination arrangements form a key part of any contract negotiation to ensure both parties have certainty around these arrangements, and to avoid the potential commercial and reputational impacts that can arise from a company’s inability to be able to satisfy these payments obligations (e.g. because they have not obtained shareholder approval), or worse, a breach of the termination payment requirements.
Further, the interplay of competing interests between the company, its shareholders and the retiring executive will likely continue until market conditions improve. It is rare
that all parties will be satisfied with the approach ultimately taken, and companies therefore need to continue to manage this interplay and be prepared to respond to, and manage, grievances in this regard.
1 ASX Listing Rule 10.18.
2 ASX Listing Rule 10.19.
This publication covers legal and technical issues in a general way. It is not designed to express opinions on specific cases. It is intended for information purposes only and should not be regarded as legal advice. Further advice should be obtained before taking action on any issue dealt with in this publication.