Change of control clauses in directors' service contracts

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Directors' service contracts.

Purpose

Change of control provisions entitle directors to enhanced severance packages in the event of companies being taken over or merged. They are known colloquially as 'golden parachute' clauses. A fairly typical feature of directors’ service agreements in the 1980s, they became less common once the growing interest in corporate governance led to closer scrutiny of executives’ contracts and of provisions for termination payments.

The usual justification for change of control clauses was that they provided security to directors who would not otherwise join or remain. Over time, however, this has lost credibility. The following arguments are likely to be made against change of control provisions:

• Directors’ contracts often include long notice periods; these should be security enough. New owners of a company may lawfully terminate a director’s employment without notice only if there are grounds for summary dismissal.
• Directors who are demoted after a takeover are protected by law: they can resign, claim constructive dismissal and seek damages consistent with their loss.

Enforceability

Code of directors’ duties

To be justified, change of control provisions must be consistent with the code of directors’ duties in the Companies Act 2006. As stated in Chapter 2, the code obliges directors to:

• promote the success of the company;
• act within their powers and use them for a proper purpose;
• avoid putting themselves in a position where their personal interests conflict with their duties as a director.

If the provision for payment seems to be excessive and out of proportion with the benefit to the company, it can be challenged as a breach of these duties. The same applies if there is any evidence to suggest that the provision’s primary purpose was to act as a ‘poison pill’ to deter a potential takeover bidder.

If the board and the remuneration committee believe that change of control provisions are necessary, it is advisable for them to minute the reasons why. They should be confident they can justify them as being consistent with the company’s best interests; disclosure is likely to be necessary within the directors’ remuneration report.

City Code on Takeovers and Mergers

Expert advice should be sought by any public company that wishes to consider amending directors’ service agreements when there’s a possible takeover.

The City Code on Takeovers and Mergers provides that companies that are the targets of bona fide offers, or that expect to be so imminently, must not enter into a contract ‘otherwise than in the ordinary course of business’ unless they have obtained the prior approval of shareholders in general meeting. It also says that:

"The Panel [on Takeovers and Mergers] will regard amending or entering into a service contract with, or creating or varying the terms of employment of, a director as entering into a contract ‘otherwise than in the ordinary course of business’… if the new or amended contract or terms constitute an abnormal increase in the emoluments or a significant improvement in the terms of service. This will not prevent any increase or improvement which results from a genuine promotion or new appointment but the Panel must be consulted in advance in such cases."

The Takeover Code applies to all offers for companies whose shares are traded on a regulated market, and, thanks to the Companies Act 2006, now has a statutory basis.

Liquidated damages clauses and penalty clauses

Where advance provision is made for the damages payable to one party as a result of a breach of contract by the other, the courts will categorise the position in one of two ways. Liquidated damages clauses are those where the pre-estimate of loss is seen as being genuine; penalty clauses are those where it is not and where the sum stipulated is ‘extravagant and unconscionable in comparison with the likely level of loss’. The former are, in principle, enforceable; the latter are void.

If a change of control clause is to be regarded as advance provision for damages, it will be necessary to demonstrate that it was framed on the basis of a genuine pre-estimate of loss. This will require evidence that proper consideration was given to an individual director’s likely circumstances on termination and proper account was taken of their duty to mitigate their loss by seeking alternative employment.

There are those who say that change of control clauses should not be regarded as advance provision for damages payable as a result of a breach but as an express contractual provision under which the company/director is entitled to terminate the contract lawfully. While there is case law that supports this argument, the position is by no means certain. If a remuneration committee does decide that a change of control provision may be appropriate, it remains advisable for it to try to ensure yhat the amount of the proposed payment is a genuine pre-estimate of loss. This is also in a director’s individual interests: it helps ensure that the change of control provision can, in due course, be relied upon.

The Joint Statement

The position of the ABI and NAPF on this issue is succinctly put: "Contracts should not provide additional compensation for severance as a result of change of control."