Limits on termination payments: Exposure Draft legislation released

Background

Following the announcement on 18 March 2009 proposing reforms to the Corporations Act 2001 (Cth) (Corporations Act) in respect of termination payments to certain executives, on 5 May 2009 the Minister for Superannuation and Corporate Law, Senator Nick Sherry, released an Exposure Draft of the Corporations Amendment (Improving Accountability on Termination Payments) Bill 2009 (Exposure Draft).¹

The government’s media release² regarding the Exposure Draft provides that the legislation is required ‘to address community concerns over executive “golden handshakes”’.

As anticipated, the Exposure Draft provides that the amendments to the Corporations Act will not be retrospective in their application to contracts settled prior to the commencement of this legislation (which will likely be later this year).

In this article we discuss the proposed amendments and suggest some practical issues which may arise from these draft amendments.

Summary

The amendments include the following:

• termination payments are to be capped at one year’s average base pay unless shareholder approval is obtained
• the shareholder approval requirement is extended to cover termination payments made to senior executives and key management personnel of disclosing entities (and anyone who has held such a role in the three years before termination) rather than just directors. However, for non-disclosing entities the requirement will only apply in respect of directors (and anyone who has held such a role in the three years before termination)
• the definition of ‘termination benefit’ in the Corporations Act will be expanded and clarified to catch any payment, other consideration, property or right, including the accelerated or automatic vesting of options and payments in lieu of notice. The expanded definition does not include a ‘deferred bonus’. Further, power is given for expansion of the definition by regulation
• the shareholder vote to approve termination benefits must be held after a director’s or executive’s employment has been terminated rather than at any point before the benefit is paid or provided, in order to allow shareholders to ‘assess golden handshakes in the context of the recipient’s actual performance’
• a company will be prohibited from holding a general meeting for the sole or dominant purpose of voting on a termination benefit
• unauthorised termination benefits are to be repaid immediately with any unpaid benefits held on trust by the executive for the company, and
•  penalties for breach of the shareholder approval requirement will be increased.

Reducing the cap on termination benefits

As currently in force, the Corporations Act prohibits the provision of a benefit in connection with a person’s retirement from a board or managerial office unless the company obtains shareholder approval or a specific statutory exception applies.

The exceptions to the need for shareholder approval apply in respect of payments made in consideration for the agreement to take office, damages payments for breach of contract and payments for past services rendered, and are subject to a formulaic cap (generally equivalent to up to 7x total annual remuneration).

The Exposure Draft replaces the formulaic cap with a new threshold of one year’s base salary which is calculated by averaging the amount of base salary the person received in the last three years of service with the company. The new concept of base salary ‘has the meaning generally accepted within the accounting profession’. No further guidance is given.

As we have previously commented, the introduction of the new statutory cap on termination benefits will likely result in companies being required to seek shareholder approval of termination payments more frequently.

Extension of termination payment approval requirements to key management personnel

Currently the Corporations Act only imposes the shareholder approval requirement in respect of benefits made to a director of the company or its related bodies corporate or someone who has been such a director in the 12 months preceding termination.

The Exposure Draft extends the scope of the requirement for shareholder approval of termination benefits for companies who are disclosing entities to include the same class of people whose remuneration is disclosed in the company’s last annual Remuneration Report, together with anyone who has held such an office in the three years before termination.

This expanded scope will catch the following categories of executives:

• if the company is part of a consolidated group, each member of the group’s key management personnel, its five most highly remunerated company executives and its five most highly remunerated group executives, and
• if the company is not part of a consolidated group, each member of its key management personnel, and its five most highly remunerated company executives.

The term ‘company executive’ means the secretary or people who make decisions which affect the whole or a substantial part of the company’s business, or have the capacity to affect the company’s financial standing.

‘Key management personnel’ is defined in the Australian accounting standard as persons having authority and responsibility for planning, directing and controlling the activities of the entity, directly or indirectly, including any director (whether executive or otherwise) of that entity.

If a company is not a disclosing entity, the requirement for shareholder approval will only apply in respect of directors of the company (or a related body corporate), and anyone who has been a director in the three years before termination.

The identification and determination of who are key management personnel is already a source of some difficulty for companies because the definition is challenging to apply in practice. In particular, identifying key management personnel may be made difficult in the context of executives changing roles or leaving or commencing employment part way through the year and because categorisation will depend on actual responsibilities and influence rather than role descriptions and reporting lines.

In expanding the scope of the requirement in this way, the Exposure Draft will ensure that companies must consider as a matter of course whether departing employees fall within the requirement.

Further, this amendment will likely make negotiations with employees more problematic given that it may not be known at the time of engagement whether an employee will satisfy the definition of key management personnel. Companies may therefore need to re-examine their standard form contracts of employment to ensure that they contain some of the provisions which would likely exist in contracts for more senior executives. This may include a provision to limit termination payments to an amount not requiring approval.

Expanding the definition of ‘termination benefit’

The Exposure Draft (and regulation) broadens the definition of termination benefit to include:

• any payment or other valuable consideration
• any kind of real or personal property
• any legal or equitable estate or interest in real or personal property
• any legal or equitable right
• any kind of pension
• any payment of superannuation in excess of the minimum required or permitted by applicable legislation
• an amount paid as a voluntary out of court settlement
• the automatic or accelerated vesting of options, and
• a payment in lieu of the giving of notice of termination.

The following are not termination benefits:

• deferred bonus, and
• payment from a defined benefit superannuation scheme that is in existence when the regulation commences.

The categories of and exclusions from the definition of termination benefit may also be varied by future regulation.

Payments made in respect of annual leave and long-service leave entitlements continue to be excluded from the shareholder approval requirement.

The expansion of the term ‘termination benefit’ to include payments in lieu of notice will override the current common law which provides that payments in lieu of notice are not ‘termination benefits’ under the Corporations Act but, rather, payments required to bring about the effective termination of the employment relationship.

This amendment will have a significant effect on the termination of employment of senior executives who are often afforded up to 12 months notice in order to allow businesses adequate opportunity to undertake succession planning and perform recruitment searches with due diligence, but in respect of which a payment in lieu of part or all of the period is often made. This amendment will likely have a two-fold effect:

• companies will more frequently require shareholder approval of termination benefits to executives, and
• executives may more likely remain employed during the period of notice of termination, whether working or not working/’gardening’ (i.e. so that the payment during this period is not included in the cap).

While a ‘deferred bonus’ is carved out of the definition of ‘termination benefits’, this exclusion may not be as broad as it appears. The term ‘deferred bonus’ is not defined in the draft legislation or draft regulations. The only guidance is provided in the Explanatory Memorandum, where a deferred bonus is described as a bonus which has been earned but not yet paid.

Another potential change to executive incentives which would otherwise be caught by the requirement for shareholder approval may be the agreement of vesting periods for equity instruments granted to ‘good leaver’ executives that operate notwithstanding termination, so that they will not be caught by the approval requirement. This should not only avoid such instruments being captured by the legislation but will also be in line with the current views of some stakeholders and corporative governance bodies that long term incentives should continue to be performance tested after an executive’s departure.

Timing of the shareholder vote

The Exposure Draft provides that the vote to approve termination benefits must be held after the director’s or executive’s employment has been terminated, rather than at any point before the benefit is provided (as is the case under the legislation as currently drafted). Further, the company is prohibited from holding a general meeting for the sole or dominant purpose of voting on executive termination benefits.

The requirements discussed above in relation to the timing of the vote to approve termination benefits may make it more difficult to obtain shareholder approval. This is because shareholders may be more likely to approve termination benefits on or soon after appointment rather than after termination, especially if share price or dividend performance is not considered adequate at this time.

Companies will therefore need to ensure that thought is given to the design of any communications strategy as well as the timing of any general meeting where a vote is put to shareholders regarding executive termination benefits.

A possible consequence of these conditions is that executives may delay their departure until shortly before the notice of the next annual general meeting is sent (as it may be less likely that a termination benefit will be approved if a large amount of time has elapsed since the executive's departure). In addition, these conditions may result in market pressure on companies hiring new senior executives to provide ‘sign on bonuses’ as compensation to the incoming executive where that individual has been persuaded to depart from their old company at a time which was not close to a general meeting.

The amendments will also likely affect negotiations with executives prior to their employment with a company as they may require more certainty in relation to their remuneration. This may take the form of changes to the form of remuneration components, for example, components of remuneration that are paid or vest after termination of employment may become more common.

Unauthorised termination benefits and penalties

The Exposure Draft strengthens the current requirements on recipients of termination benefits given without the required shareholder approval. Currently, termination benefits given without approval are held on trust by the recipient for the company. In addition the Exposure Draft provides that such a benefit will be a debt due to the company.

Further, the Exposure Draft significantly increases the penalties for giving a benefit that has not received the necessary approval from 25 penalty units (currently $2,750) to 180 penalty units (currently $19,800) for an individual and up to 125 penalty units (currently $13,750) to up to 900 penalty units (currently $99,000) for a body corporate. The possibility of 6 months’ imprisonment for contravention of these sections of the Corporations Act will also remain.

Which contracts will be covered by the new regime?

The Explanatory Memorandum notes that the proposed amendments, if passed, will not apply retrospectively to existing contracts ‘which have already been settled’. The Exposure Draft provides that the amended law applies ‘in relation to resignations of offices, or positions of employment, held under agreements entered into, or extended, on or after the commencement’ of the provisions. Accordingly, it appears that any extension of an existing contract will be caught by the new provisions, whether or not the terms of the contract are amended.

Submissions on the Exposure Draft

The Federal Government is seeking written submissions on the Exposure Draft by Tuesday 2 June 2009. Freehills is able to assist you in drafting submissions if required.

This article was written by Board & Executive Solutions team members Justine Turnbull, Partner, Sydney, Alex Moule, Senior Associate, Melbourne and Michael Gonski, Solicitor, Sydney.

Endnotes

More information

For information regarding possible implications for your business, contact a member of the Board & Executive Solutions team.