The proposed restrictions on termination payments for directors and executives loom as a major headache for many companies, their shareholders, their directors and their senior executives.
However, it is hoped that the draft released by Treasury is more of a work in progress than a near-final product. It is clear that the draft amendments need a lot more work. Clayton Utz has made a submission to Treasury, drawing attention to drafting and policy issues contained in the amendments. If you would like a copy of the submission, please contact one of the Clayton Utz partners listed below.
Among the issues we have identified are the following.
More pain, little gain?
In broad terms, the Corporations Act currently requires shareholder approval for termination payments to directors and some senior executives if those payments are greater than seven times the director's or executive's final annual remuneration.
As is now well-known, the Government intends to reduce the threshold from seven times annual remuneration to one year's base salary. The draft Bill also clarifies the types of benefits that are caught by the legislation. For listed companies, it will also extend the range of persons covered by the provisions to include officers who were named in the annual remuneration report.
Until now, many companies have not had to worry about seeking shareholder approval, because the statutory monetary threshold was well above any termination payments made to retiring directors and executives. The radical lowering of the threshold would therefore impose new compliance costs on many companies. In the case of many small companies, where there is usually only a handful of shareholders, those new compliance costs would not be offset by any benefit to the shareholders, since the shareholders themselves are often the directors and the senior executives, and so are unlikely to withhold approval of termination payments.
Conversely, the amendments may have the unintended effect of lessening shareholder control of director and executive remuneration packages as a whole.
It is expected that the proposed changes will lead to directors' and senior executives' insisting on upfront payments (by way of increased sign-on bonuses and higher annual remuneration) to compensate for the possibility that shareholders may refuse to approve their previously-agreed termination payments. Since shareholders cannot override sign-on bonuses and annual remuneration, compensatory front-ending of director and executive remuneration may actually end up reducing shareholders' ability to influence the total package received by directors and executives. However, changing the mix of the total remuneration package may also have flow-on effects on the amount of tax for which executives and directors will be liable.
A move to upfront payment would also reduce the proportion of remuneration that is at risk. Companies faced with demands for increased front-end remuneration would need to bear in mind that such payments run the risk of decoupling remuneration from performance.
It is claimed that the amendments will empower shareholders to "disallow excessive termination benefits, particularly where they are a reward for poor performance".
If that was how the proposed amendments actually worked, it might be difficult to disagree with them. In fact, however, the amendments do not make any reference to "poor performance": shareholders would be able to disallow termination payments for any reason they liked.
This problem is compounded by an amendment that would only allow shareholders to vote on a termination payment after the director or executive had retired. The stated purpose of this change is to put shareholders "in a better position to exercise an informed vote". In fact, this tips the scales completely against the interests of former executives and directors: at the point of retirement, they will have no assurance about whether they will receive their agreed entitlements.
The position is even worse for any director or senior executive who had served for less than one full year. Under the proposed amendments, such a person would only be entitled to a fraction of a year's salary by way of termination benefit without shareholder approval. For example, if the director or executive served for three months, he or she would require shareholder approval for a termination benefit greater than three months salary.
Again, this is likely to encourage directors and senior executives to demand the front-ending of payments, rather than running the risk of seeing their termination entitlements disallowed by shareholders.
The proposed amendments also contain a number of problematic drafting issues.
For example, "payments of superannuation" are exempt from shareholder approval, provided that they are no more than "the maximum amount required or permitted by a law of the Commonwealth". It is unclear what the effect of this change is. There is no Commonwealth law which sets a maximum amount for payments out of a superannuation fund, and employer contributions into superannuation are subject to both a required amount (9%) and a maximum permitted amount ($25,000 for someone under 50 and $50,000 for someone 50 or over).
Another problem is that the one year threshold is calculated by reference to the director's or executive's "annual base salary". Directors' payments to non-executive directors are not "salary": if left unchanged, therefore, this amendment would mean that non-executive directors would require shareholder approval for any termination payments, regardless of size, because their threshold would be zero.
Equally worrying is the fact that it's unclear how the draft amendments would affect existing contracts.
A transitional provision says that the amendments only affect contracts "entered into, or extended, on or after" the amendments come into law.
On the surface, that looks as though existing contracts aren't covered (provided they're not "extended"), but the reality may be quite different.
It is not unusual for senior executives' contracts to be amended from time to time. One legal issue that can arise when a contract is amended is whether the amendments are so significant that they have resulted in a totally new contract. This is something which can only be decided by a Court: there is no bright line test. As a result, the Government's proposed amendments may ultimately affect even directors and executives who currently have contracts that provide for termination benefits if those contracts are amended after the proposals come into law.
Timetable for change
At this stage, it is impossible to make an accurate prediction of when the final version of the amendments will be published and when they will become law. This is unfortunate, because companies cannot start planning for the new rules until their precise wording is known.
The closing date for comments on the proposals was 2 June.
Clayton Utz will be monitoring these developments closely and will keep you informed both of the progress of the changes and their effect.In the meantime, please feel free to contact any of the partners listed below.