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South Africa: Directors’ duties (4 of 8) – CEO employment agreements

13 May 2024
– 9 Minute Read

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Overview

  • Whereas most companies use standard form employment agreements or letters of appointment to engage employees, particular care needs to be taken in the drafting of CEO contracts.
  • There are specific issues that need to be considered and dealt with in such contracts, including: remuneration and sign-on bonuses, long-term incentives and short-term incentives, duration, restraints, notice periods and garden leave, change of control and golden parachutes and dispute resolution.

This is the fourth in a series of articles on the duties of directors in relation to employment, employment law and employee benefits. Senior consultant Graham Damant, has discussed these issues at length with Bowmans’ partner Chris Todd in two ‘Value of Knowing’ podcasts. The first (on our website here) covers what boards in South Africa need to know about employment, employment law and employee benefits to meet their fiduciary duties avoid liability. The second (on our website here here) highlights the obligations and duties of boards in South Africa in relation to CEOs. Subscribe to’ The value of Knowing’ podcast on Apple Podcasts or Spotify.

In the first article we identified six themes where the King Code of Corporate Governance deals with the duties of directors in relation to employment law and employment generally. In this article we deal with two of those themes, namely the board’s duty to appoint the chief executive officer and the board’s duty to delegate authority in a manner that contributes to role clarity.

The actual selection and appointment of a CEO does not usually give rise to any legal difficulties. There have been one or two instances where the person not selected is aggrieved, but very few of these end in dispute. The one obvious area where there may be a legal dispute is if discriminatory criteria are used in selection.

Where legal difficulties do arise is where insufficient consideration is given to the contractual terms on which a CEO is to be engaged.

Whereas most companies use standard form employment agreements or letters of appointment to engage employees, particular care needs to be taken in the drafting of CEO contracts. There are specific issues that need to be considered and dealt with in such contracts. These include:

  • remuneration and sign-on bonuses;
  • long-term incentives;
  • duration;
  • restraints;
  • notice periods and garden leave;
  • change of control and golden parachutes; and
  • dispute resolution clauses.

Increasingly companies have been required to offer sign-on bonuses to CEOs to compensate an incoming CEO for the long-term incentive awards they will lose as a consequence of resigning from their current employment.  A sign-on award is intended to, as far as possible, replicate the award that is forfeited. This means that the vesting periods need to be replicated. The replacement award or cash will only vest when the replaced award would have vested and is conditional on the CEO being in the employ of the company when it vests.

If performance conditions were attached to the award, the calculation of the replacement awards becomes more complex. Either a discount can be applied and agreed on up front or alternatively it can be linked to performance benchmarks for the company. What is finally determined is a function of negotiation and agreement.

Most CEO contracts contain provisions dealing with remuneration, long-term incentives and short-term incentives. As variable remuneration is increasingly the most important aspect of compensation, care needs to be taken in the drafting of such clauses. While the CEO may want certainty regarding the value of such awards or the basis of their calculations, such awards remain discretionary. Incentive plans evolve over time and the company needs to be able to retain the discretion to amend plans from time to time. It is accordingly necessary that sufficient flexibility is introduced into the wording of such contracts to allow the company to determine the awards. Similarly, increases in remuneration should remain discretionary and should not be linked to benchmarks. The exercise of the discretion must of course be rationally and reasonably exercised (as will be dealt with in the section on incentive plans).

In terms of duration, most CEO employment contracts are of indefinite duration. They will terminate on the normal or agreed date of retirement unless terminated for cause or by resignation or mutual agreement prior to the retirement date. Termination for cause requires that there is a defensible reason for termination based on misconduct, poor performance or incapacity. There will seldom be a defensible basis to retrench a CEO as the position is always required. It would only arise in the event of a merger with another company where the merged company may find itself with two CEOs.

Even if the contract is terminated for cause, it will be necessary for the company to give the CEO notice (unless the CEO is guilty of gross misconduct). 

Similarly, should the CEO want to resign, they will be required to give notice. This then raises the question of what notice periods should be applied. Most companies do not use the standard one-month notice period applicable to most employees. Instead, they provide for either a three-month or a six-month notice period. The reason for this is that in the case of a CEO one month’s notice is not sufficient for the company to identify and install a successor – even on an interim basis. The company could be placed at risk by a sudden departure. The downside to a longer notice period is that, if the company wishes to terminate employment, it usually does not want the CEO to stay on. In these circumstances it usually results in the notice pay being paid out without the CEO working.

There was a stage where CEOs were contracted on a fixed-term basis – usually for periods of five years. This was particularly prevalent in government and parastatal appointments. The intention was to align the appointment with Parliamentary terms. This, however, is no longer prevalent. The only basis for employing a CEO on a fixed-term basis is if there is an operational need to do so. For instance, a CEO employed to implement a turnaround strategy that is of limited duration, or a CEO employed on a visa.

Aligned to notice periods is the issue of garden leave. In many instances, a company may not want a CEO to work their notice. In these circumstances the company has two options – to pay in lieu of notice or to require the CEO to go on garden leave. Garden leave neutralises a CEO during the notice period as it prevents them from taking up alternative employment during this period – particularly with a competitor. While it may be argued that a CEO does not have a right to work and can be placed on garden leave regardless of whether the contract permits it or not, it is advisable to include a provision that entitles the company to place the CEO on garden leave.

Aligned with the issue of notice pay and garden leave, it is also necessary to consider whether the contract should include a restraint of trade, precluding the CEO from taking up employment with a competitor for a period of time. The CEO is in possession of strategic and confidential information. If taken to a competitor, this would provide the competitor with a substantial advantage as well as place the company at risk. It would accordingly be usual to introduce restraint provisions into a CEO contract.

A number of CEO contracts have change of control clauses. These usually involve the payment of a sum of money and permit the early vesting of long-term incentive awards in the event of a change of control. It is difficult to understand what advantage accrues to the company by introducing such a clause. A change in shareholding should ordinarily be of no consequence to a CEO. Their employment should remain unchanged. 

The only purpose of such clause would then be that it acts as a ‘poison pill’ to deter a would-be acquirer from assuming control. It is difficult to argue that directors would be acting in the best interests of the company by introducing such provisions. If the clause is drafted on the basis that, if following a change of control, the acquirer does not want the CEO to remain in its employ, then certain payments are triggered, this may be more defensible. This, then, would be regarded as a ‘golden parachute’ to serve as comfort to a CEO that they will not simply be dismissed following a change of control. It is necessary to ensure that the rules of any long-term incentive scheme are aligned with the provisions of the contract, as difficulties can be created if the contract provides for early vesting on a change of control, but the rules of the scheme do not.

The final issue pertaining to the contract that needs to be determined is whether to introduce a private dispute resolution clause into the contract. A private dispute resolution clause provides for mediation of any disputes followed by private arbitration in front of an arbitrator selected from a panel of arbitrators. The major advantage of this is that any dispute is kept confidential.  Given the sensitivity of information that may need to be disclosed in the course of litigation, the confidentiality of the process can be of material advantage to the company.

One of the themes of the King Code is a requirement to delegate authority in a manner that gives rise to role clarity.  Usually, full operational responsibility is delegated to the CEO. There are aspects where sign-off and approval will still be required by the board. So, for instance, the board is required to approve the strategy proposed by the CEO. The board is required to satisfy itself that the persons to be appointed to executive positions have the requisite skills and competencies to perform the role.

The importance of a proper delegation of authority is that section 76 of the Companies Act provides that directors are entitled to rely on persons to whom they have delegated duties in the discharge of their fiduciary duties. Delegation does not, however, mean abdication. The board is required to monitor and measure the CEO’s performance and part of that monitoring would be assessing whether they have performed the tasks delegated to them.

All articles in the series: