Directors’ remuneration: is fair ‘fair’?
- By Victoria Palfrey
THE COMPANIES ACT:
Section 161 of the Companies Act provides a framework for Boards of Directors to approve remuneration to directors. The Act states that a board may authorise payments to directors if that remuneration is “fair to the company” (subject to a company’s constitution).
Directors voting in favour of the proposal must certify that such remuneration is “fair” and give the reasons for their opinion. If this process is not followed, there is a risk that directors may have to repay money to the company, unless they can establish that their remuneration was fair.
The Act does not define “fair” but the test is whether the directors “reasonably considered” such remuneration to be fair (i.e. directors can’t simply approve enormous remuneration to themselves, sign this off as “fair” and assume that they are protected by the Act). In good times, this point rarely falls under the spotlight but it is often an issue when companies go into liquidation, which is what happened in Madsen-Ries v Petera.
MADSEN-RIES V PETERA:
Mr and Mrs Petera were the directors of Petranz and had not followed the statutory process for approving their remuneration. The company went into liquidation and owed substantial amounts to the IRD. The liquidator and the company took the directors to court and sought to recover salary payments.
The High Court found that creditors’ interests should be considered when directors’ remuneration is set. However, it determined that the directors’ (relatively modest) salaries were fair because the company had gained full value from the work carried out by Mr and Mrs Petera. The company had derived profit because of the directors’ work and had also had its administrative requirements attended to by the directors.
The Court of Appeal noted that creditors’ interests must be considered where directors authorise a distribution, or other transfers to shareholders, but found that creditors' interests need not be considered in the case of approving directors’ remuneration.
The liquidator appealed the matter to the Supreme Court on the grounds that the previous courts had not considered the company’s worsening insolvency at the time payments to directors were made. However, the Supreme Court did not determine whether creditors’ interests should be considered at such time as directors’ remuneration is set.
It noted that the High Court had accepted that creditors’ interest were relevant to the analysis of whether directors’ remuneration was ‘fair’ but had nevertheless found that Mr and Mrs Petera had sufficiently established that their remuneration was fair, so even if creditors interests should have been considered, the High Court found that the directors’ salaries were fair. The Supreme Court declined to undertake its own assessment of whether the payments were fair in the circumstances.
WHAT DOES THIS MEAN FOR DIRECTORS?
Directors must certify that remuneration is “fair”, but do not necessarily have to consider creditors’ rights in doing so. However, there are various other duties that directors must meet which do require a consideration of creditors’ interests, and which may be breached if a company of questionable solvency continues to trade, for example:
- The duty to act in the best interests of the company
- The prohibition on reckless trading
- Powers to be exercised for proper purpose
- Duty of care
Therefore, continuing to trade while insolvent and paying yourself a salary throughout that period may not ultimately result in having to repay your salary pursuant to section 161 of the Act but may well attract liability for reckless trading (which can have the same outcome). Although the courts did not require repayment of any salary amounts in this case, directors must be very clear on their duties once their company shows signs of becoming insolvent.
A good rule of thumb when setting directors’ remuneration is to consider what directors’ actual day-to-day roles are and what the company would have to pay an employee to replace that director. It seems fair to include some uplift in that amount to compensate for directors’ personal liability but, in most cases, our clients are both directors and shareholders and should really be making their money in the context of being a shareholder.
If you are concerned about your obligations in this respect, or are a creditor and have concerns about the behaviours of one of your debtors, please do not hesitate to contact us.