A decision to part ways is never easy, emotionally and very often legally.
Dismissing directors can be a particularly treacherous process to undertake, especially in situations where the director in question is also an employee and/or a shareholder. To compound the issues further, the individual will often be friends or long-time business colleagues with those who they have made the difficult decision to part ways.
In this article, we consider the key questions which companies ought to bear in mind when looking to achieve a smooth and efficient departure of a director.
Where HR is involved, it is important not to treat the termination process or any negotiation in the same way as dismissing an employee, because there will be additional legal issues in play, and more traps for the unwary.
What role does the individual occupy?
Often the individual will have three distinct relationships with the company:
Each relationship comes with a different matrix of rights and obligations and a different means of coming to an end.
It will be often necessary to come to an arrangement which results in the individual ceasing to act, at a minimum, as both a director and an employee/consultant. In many cases the other directors, particularly in start-ups or smaller private companies, would also seek to bring the “shareholder” relationship to an end at the same time.
To increase the chances of achieving a clean break from all three roles, it is vital to identify and deal with each relationship from the outset.
1. How to remove: directors
When removing a director, a company should review the provisions provided in the company’s articles of association, any shareholders’ agreement and that director’s employment contract (often referred to as a “service agreement”) or consultancy agreement (if any):
- Articles of association. Most articles of association will contain a list of circumstances when a director will be deemed to have resigned, which usually include statutory disqualification, bankruptcy, mental disorder and prolonged absence. Many articles of association will also contain a provision allowing the Board to unilaterally remove a director upon agreement by the majority of the board.
- Shareholders’ agreement. If the director in question is a party to a shareholders’ agreement, it will be important to check if any relevant provisions apply, for instance identifying if there are any provisions which allow the individual to re-appoint him or herself as a director or a right which he/she has to veto the proposed termination unless specific grounds have arisen.
- Service/consultancy agreement. If the director in question is subject to a service or consultancy agreement, look for any resignation of directorship clause – this may include useful provisions, such as:
- an obligation on the individual to resign as a director upon termination of employment; and
- a power of attorney, allowing a resignation letter and other relevant documents to be signed by the company if the outgoing director refuses to do so.
If, having reviewed these documents, there does not seem to be an efficient mechanism to remove a director who is refusing to resign, the next place to go is the Companies Act.
Key legislation – section 168 Companies Act 2006
Section 168 of the Companies Act 2006 allows a director to be removed by an ordinary resolution of the shareholders. This provision applies regardless of anything contained in any other agreements. However, this method generally requires the convening of a shareholders’ meeting on 28 clear days’ notice and permits the director in question to make representations at the meeting. Therefore this method of removing a director is not always going to be practical, especially where the rapid exit of a director is desired. If this method is used, a check of the articles of association should be conducted to confirm whether any shares exist which give holders enhanced voting rights, for instance, which might permit the director in question (if they hold shares) to weighted voting on any resolution to dismiss them.
2. How to remove: employees
A director is an officer of the company, which is a role distinct from any other relationship he or she may have with the company.
In many cases, directors will also be employees of the company, enjoying the usual statutory and contractual employment rights which employees have, such as the statutory right not to be unfairly dismissed (which arises after two years’ continuous employment).
If the departing director is also an employee of the company, any resignation letter or agreement which they sign can be effective to waive common law claims (e.g. breach of contract or negligence) which they may have against the company. However, this will not be effective to prevent bringing statutory claims against the company, such as unfair dismissal, discrimination or whistleblowing.
Consideration should therefore be given to whether it is preferable to enter into a settlement agreement with the departing director to ensure any statutory claims they might hold are validly waived.
Where a director is also an employee of the company, a review of their service agreement will be central to any discussions around their dismissal. For instance, many agreements will include provisions that require an employee to resign their office as director if their employment is terminated. Specialist employment advice should always be sought however when proposing to remove a director who is also an employee, to ensure any employment risks are identified and mitigated where possible.
Key legislation – section 217 Companies Act 2006
A final note – when negotiating compensation to a director for loss of office, section 217 of the Companies Act provides that payment to a director of compensation for loss of office must be approved by the shareholders. This does not, however, usually prevent payments made in good faith pursuant to an existing legal obligation or for damages for breach of contract. Therefore, where compensation has been agreed in advance in the service contract, for example a golden parachute, in our experience that compensation should be justified without the need for shareholder approval under section 217.
3. How to remove: shareholder
Where a shareholder director holds a large percentage of a company’s shareholdings (particularly where they hold over 25% of the company’s shares and can thereby prevent the passing of special resolutions, which typically require the support of those holding 75% or more of the shares in the company), it will often be desirable to negotiate the sale of that individual’s shares simultaneously with their removal as a director.
However, by far the most difficult challenge is achieving the successful exit of a shareholder director in the absence of a negotiated departure. A common misunderstanding is that there is always a contractual or statutory right for the company to buy back a shareholder’s shares against his or her wishes. In fact, unless there is a clause in the shareholders’ agreement or the company’s articles, there is no such right.
An in-depth article discussing the ways a company can resolve shareholder disputes (which includes negotiating an exit) is available here. The principal methods of removing a shareholder include:
- good/bad leaver provisions – these are contract terms which allow companies to claw back shares from shareholders, subject to certain conditions. In particular, the company will need to consider and apply the evaluation criteria of ‘good’ and ‘bad’ leavers to determine what price is to be paid in return for the shares: for bad leavers this will often be minimal, whereas those who are asked to leave without having committed misconduct may be entitled to a higher price; and
- compulsory winding up – the directors and shareholders could decide that the only option is to discontinue the business and wind up the company. A petition to the court would be required to carry this out, but if successful the relevant shareholder may be left with very little after the distribution of the company’s assets.
The company may also consider offering inducements to encourage a director shareholder to agree a settlement. The benefits of a settlement include:
- a favourable tax rate (if entrepreneur’s relief applies, tax should only be charged at 10% on a share sale);
- a possible tax-free payment of £30,000 in compensation for loss of office (although there are often difficulties in making such a payment on a tax-free basis and advice should be taken);
- a relaxation of restrictive covenants such as non-compete obligations; and
- an agreed reference and press release.
If those inducements are not available or are commercially unacceptable to the other directors, the shareholder may be more motivated by the threats associated with declining the offer:
- removal as a director/employee putting at risk the leaver’s entrepreneur’s relief;
- bringing in an administrator and looking to action a “pre-pack” sale often has a galvanising impact; and/or
- reducing the price offered by the other shareholders for the shares if the leaver continues to hold out.
If it is not possible to achieve the successful negotiated exit, the company should consider whether the impact of the refusing shareholder can be limited. For example, if he or she has enhanced rights under the shareholders’ agreement, such as membership of a group of shareholders whose consent must be obtained for certain business decisions, the company should consider whether amendments to the shareholders’ agreement can be made to remove that individual from the consent group.
Key legislation – section 994 Companies Act 2006
At this point in the process, you might find that everything is in order to have the shareholder director removed. However, before you take any decisive step you should finally consider whether section 994 of the Companies Act applies. Section 994 gives protection to a shareholder who can show that the affairs of the company are being conducted in a manner which is “unfairly prejudicial” to their interests as a shareholder. If the shareholder can satisfy the court that the proposal is unfairly prejudicial, the court has a broad power to prevent the proposed changes being made and to make orders for the conduct of the company in the future. This is a key weapon in the arsenal of the individual and the risk of such a petition will need to be considered by the other directors particularly where there is a negotiation with the director over compensation.
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