A decision to part ways is never easy, emotionally, financially, and very often legally.
Dismissing directors can be a particularly treacherous process to undertake, especially in start-up companies where the director may be a founder who has played a pivotal role in getting the business off the ground and is often also an employee and/or a shareholder.
To compound the issues further, the individual may be friends and long-time colleagues of the management team making the difficult decision that it is time for them to move on.
In this article, we consider the key corporate and employment law issues for start-ups to keep in mind when looking to achieve a smooth and effective director departure.
What role does the individual hold?
Often the individual will have three distinct relationships with the company:
Each relationship comes with a different matrix of rights and obligations and different legal hoops that will need to be navigated to bring it to an end.
It will be often necessary to come to an arrangement which results in the individual ceasing to act as both a director and an employee. However, in most cases and particularly in start-ups, the cleanest outcome will also be for the individual to cease to be a shareholder given they will have no ongoing role in managing the business.
To increase the chances of achieving a clean break, management need to consider and address the implications of ending each relationship from the outset.
How to remove directors
When removing a director, a company should review the provisions in the company’s articles of association, any shareholders’ agreement and the director’s employment contract (commonly known as a service agreement) as well as being familiar with the relevant provisions of the Companies Act 2006.
- 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 will also allow the Board to unilaterally remove a director upon the vote of a 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 any which allow the individual to re-appoint themselves as a director, or a contractual right to veto their proposed removal unless specific grounds have arisen.
- Service agreement. If the director is an employee with a service agreement, there will usually be a clause relating to the cessation of their directorship, and useful obligations on termination of employment including:
1) An obligation on the individual to resign immediately (without compensation) as a director upon termination of employment; and
2) A power of attorney, allowing a resignation letter and other relevant documents to be signed by the company if the outgoing director refuses to resign.
Section 168 of the Companies Act
However, if neither the corporate documents nor the employee’s service agreement provide an efficient mechanism to remove a reluctant director, section 168 of the Companies Act 2006 (CA) becomes relevant.
Section 168 of the CA 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. The practical barriers and timeframe mean that this is not a particularly attractive route for the business to take, but it does provide a useful legal fallback. It will still be necessary to check the articles of association to confirm whether any shareholders (including the director) may have enhanced voting rights, allowing for weighted voting on the resolution to remove the director.
How to remove employees
A director is an officer of the company and in many cases will also be an employee, with the benefit of the usual contractual employment rights and statutory protection that applies to senior executives.
The director may have a long contractual notice period, potentially of up to (or exceeding) 12 months for example. Protection from unfair dismissal (which generally applies after two years’ service) may also apply, meaning that there would need to be both a fair reason for the dismissal (such as misconduct) and a fair process followed by the company. Where relationships have broken down and the facts leading to the director’s departure are in dispute, it is also common for senior individuals to raise additional high value employment claims such as whistleblowing and/or discrimination.
If the departing employee director signs a director’s resignation letter, this 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 an effective waiver in respect of statutory employment claims, including unfair dismissal, discrimination or whistleblowing.
Consideration should therefore be given to whether the best outcome would be to negotiate a valid settlement agreement with the departing director to effectively waive their statutory employment claims (usually in exchange for a compensation payment), while maintaining any contractual protections for the business such as restrictive covenants.
A review of contractual rights under their service agreement and an assessment of relevant employment claims taking account of surrounding circumstances should therefore be the initial step for a start-up considering the dismissal of an employee director. There may be existing circumstances entitling the company to fairly dismiss the director for misconduct, such as a breach of the directors’ fiduciary duties, for example. Similarly, thought will need to be given to the message that will be communicated to investors, shareholders, and clients.
Specialist employment advice should always be sought to ensure any employment risks and commercial sensitivities are identified and mitigated where possible.
Section 217 of the Companies Act
A final note – when negotiating compensation to a director for loss of office, section 217 of the CA 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. Where compensation has been contractually agreed at an earlier time, for example in a “golden parachute” clause, it may be possible to justify that compensation without the need for section 217 shareholder approval.
How to remove a shareholder
Where a shareholder director holds a large percentage of a company’s shares (particularly where they hold over 25% of the company’s share capital 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 (a) there is a clause in the shareholders’ agreement or the company’s articles, or (b) the shareholder has less than 10% and his shares are being bought as a result of a sale of all the rest of the shares in a company to a third-party purchaser, 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. An examples of a “bad” leaver might be a director who has committed gross misconduct, entitling the company to terminate their employment without notice. The company will need to consider and apply the relevant 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 falling into that category 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 enter into a settlement agreement which takes account of their shareholding. The benefits of a settlement for the director will potentially include:
- A favourable tax rate (for example if Business Asset Disposal Relief applies);
- A possible tax-free termination payment of up to £30,000 (although there are associated complexities and both employment and tax advice should be taken);
- Agreement on the post-sale treatment of any IP that has been developed by the leaver
- A relaxation of restrictive covenants such as non-compete obligations; and
- An agreed reference and press release.
If such incentives are not possible, 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 tax relief;
- Bringing in an administrator and looking to action a “pre-pack” sale often has a galvanising impact;
- The remaining directors all looking to resign and set up a competing business (harder than it sounds to follow through on); 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 a negotiated exit, the company should consider whether the impact of the shareholder’s continuing refusal to leave 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, it may be worth exploring amendments to the shareholders’ agreement to remove that individual from the consent group.
Section 994 Companies Act 2006
At this point in the process, a company might find that everything is in order to facilitate the shareholder director’s departure. However, before any decisive step is taken it is important to 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 a court is satisfied that any proposal is unfairly prejudicial, the court has a broad power to prevent the proposed changes being made and to make orders for the future conduct of the company.
An example of an action that may be subject to challenge may be changing the company’s articles of association (if the proposed leaver has less than 25%) to introduce new good/bad leaver provisions before the exit process is commenced.
This is a key weapon in the arsenal of a shareholder and the risk of any such a petition will need to be taken into account by the other directors, particularly when it comes to considering negotiations over the settlement sum on offer to the departing director.
Conclusion
Dismissal of a director in a UK start-up business requires a meticulous approach, considering a myriad of legal aspects. Management should ensure they understand and address the key employment and corporate law issues before starting down that path. This will make the challenges of the process easier to navigate and the interests of both the business and its stakeholders can be safeguarded.
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