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Archive for October, 2014

Bonus clawbacks – who picks up the tax?

14/10/2014 | Philip Alfandary
The credit crunch and the subsequent financial crisis triggered a public debate on the question of ‘moral hazard’ in the financial trading sector. At the corporate level, the discussion was about

The credit crunch and the subsequent financial crisis triggered a public debate on the question of ‘moral hazard’ in the financial trading sector. At the corporate level, the discussion was about bank bailouts. At the executive level, it was about bonuses. Pre-crash bonus structures are thought -by some- to have induced employees to ignore long-term risks in order to book short-term income. Should bonuses be clawed back then, if it transpires that unforeseen developments subsequently come to light, indicating earlier performance was in fact ‘faked’?

The market seems to have thought so. The UK Corporate Governance Code states that consideration should be given to the use of provisions that permit an employer to reclaim variable components in bonus structures in circumstances of misstatement or misconduct. The Association of British Insurers, which represents large institutional shareholders has ‘Principles of Remuneration’ which state that companies should operate ‘malus provisions’ (malus provisions allow for the reduction in deferred performance-related compensation upon the discovery of deficient performance). And the Prudential Regulation Authority has proposed extending the window for clawback for up to ten years where a firm or a regulatory authority has commenced an inquiry or investigation into a potential material failure. Other changes relating to the vesting of variable remuneration for senior managers leaving bailed-out banks are also being proposed.

Thus, as clawback provisions are becoming ever more common in employee bonus and share plans, the question of who bears the tax liability when an employee is required to repay cash, and/or transfer shares back to their employer, has yet to be properly resolved. When bonuses are paid, they attract income tax and NIC liabilities. Until now, many bonus plans which have clawback provisions tended to assume that the repayment of tax was not possible, and thus only required that the employee repay any clawbacked bonus net of the original tax deducted. In other words, the employer is left out of pocket.

The Julian Martin Clawback Case

The issue came up recently in the context of a clawback of a ‘golden hello’: A Mr Martin had commenced employment under a contract which entitled him to a £250,000 signing on bonus, which he was taxed on upon receipt. After tax, this equated to a net bonus payment of £147,500.

The employment contract which he signed included a clawback clause: if Mr Martin were to leave the company within five years of his start date, a proportion of his initial payment would have to be repaid.

It turned out that Mr Martin did leave within the five year window, which resulted in him making a repayment to the company of £162,500. This was in fact an amount greater than what he had originally received (£147,500), because of the deduction of tax from the bonus through PAYE and NIC. Mr Martin made a claim for relief for tax that had been deducted on the original bonus payment. After all, this tax was effectively a windfall in the Revenue’s hands.

He had to pursue the case through two sets of tribunals before the Revenue accepted he was entitled to that relief. Why were the Revenue so intransigent on this point? Perhaps much had to do with legislative basis on which relief was claimed: It relied on the term ‘negative earnings’. There was some confusion over what it actually meant. The Revenue weren’t prepared to accept that once the amount was paid, it constituted ‘earnings’ and thus could not qualify for relief as ‘negative earnings’.

How will this decision affect bonuses and employee incentive plans going forward?

Many employers with bonus or share plans will be asking themselves what this case means for their remuneration planning. The first point to make to the reader is that this article focuses on the tax consequences of clawback provisions. The employment aspects of clawing back amounts paid to an employee are going to be more important, and need to be thought about carefully.

From a tax perspective however, this case does suggest that clawback provisions in employment contracts might in the future include a requirement for the employee to pay back the whole amount, ie gross of income tax. This is because the employee is going to be able to reclaim that income tax (this will take time however). As this decision didn’t address employees NIC (which is deducted in the same way as income tax, under PAYE but addressed under different legislation) no relief for employees NIC can be assumed to apply. Similarly, Employers NIC, which is paid directly by the employer (and is their liability) , will not be affected by this case either. However, the Revenue are thought to be sympathetic on this question.

It is also worth pointing out that the tax relief in question here applies to clawback of ‘earnings’. That means signing on bonuses and cash bonus plans are most likely to be eligible for relief in the event of a clawback. By contrast, compensation payments made to employees whose employment has been terminated will not be eligible for relief. This is because compensation for termination of employment does not qualify as earnings.

How then will this decision apply to share and option based employee incentive plans? Will any income tax paid on the acquisition of shares be clawed back? This again will depend on whether the award of the shares falls within ‘earnings’. In some cases, share plans are taxed under different provisions which do not benefit from this ‘negative earnings’ relief. In circumstances where share awards are in fact taxable as ‘earnings’, there may be some scope for the relief to apply. Indeed, if the shares are worth more at the point the employer claws them back then when they were originally acquired, then (and this is conjecture) it potentially opens the door for the employee to enjoy a windfall by being left with income tax relief on a share award never ultimately enjoyed.

This bulletin should not be taken as definitive legal advice on any of the subjects covered. If you require legal advice on any of the subjects covered or any employment law matters please contact Philip Alfandary on 020 7955 1424 or philipa@rosenblatt-law.co.uk

How should employers deal with whistle blowers?

06/10/2014
The recent high profile announcement that Tesco had overstated its first-half profits by around £250m has had a huge impact. A number of senior executives have been suspended; over £2bn has been w

The recent high profile announcement that Tesco had overstated its first-half profits by around £250m has had a huge impact. A number of senior executives have been suspended; over £2bn has been wiped off its stock market value; its reputation has been severely damaged and the retailer has had to alert the Financial Conduct Authority, the City’s chief regulator, which has now launched a full investigation. What is less well known is that the crisis for Tesco was started on a Friday afternoon when a whistle blower alerted Tesco’s General Counsel to the overstatement.

Brian Palmer, a Partner in our Employment Team, explains how employers should best prepare themselves to deal with whistleblowing.

Whistleblowing and the law

“Whistleblowing” refers to the act of reporting or exposing wrongdoing, either within an organisation or externally, for example to a regulator or the press. Protection for whistleblowers was introduced by the Public Interest Disclosure Act 1998 (PIDA) following earlier scandals at BCCI, Maxwell, Barlow Clowes and Barings, among others.

Workers have a right not to be dismissed or suffer any detriment at work as a result of making a “protected disclosure”. To be protected the worker must reasonably believe that the information disclosed tends to show that one of following has occurred, is occurring, or is likely to occur:

  • • A criminal offence.
  • • Breach of any legal obligation.
  • • Miscarriage of justice.
  • • Danger to the health and safety of any individual.
  • • Damage to the environment.
  • • The deliberate concealing of information about any of the above.

In addition the worker must reasonably believe that the disclosure is “in the public interest”.

Whistleblowing cases are not subject to the usual qualifying period of employment for unfair dismissal claims or the usual statutory cap on unfair dismissal compensation. Awards of compensation can be considerable, especially as the individual making the protected disclosure may be a well-paid senior employee. Examples of Employment Tribunal awards include:

  • • Tamana v Fyshe Horton Finney, over £100,000 to a company CEO who raised concerns with the Financial Services Authority (FSA) (as it then was) about the company’s relationship with a firm in the United Arab Emirates.
  • • Best v Medical Marketing International Group plc (in voluntary liquidation) one of the largest ever Tribunal awards (£3.4m) to a company director who was automatically unfairly dismissed for raising concerns about his fellow directors’ activities.

Cases can involve significant management time and legal costs, which are usually not recoverable.

Why have a whistleblowing policy?

While PIDA imposes no positive obligations on employers to encourage whistleblowing or to implement a whistleblowing policy, there are good business reasons to have a written policy.

Compliance and internal control

Encouraging a culture where concerns are reported internally at an early stage allows management to address those concerns more easily and avoid more serious regulatory breaches or reputational damage. Employers have an obvious interest in uncovering wrongdoing or dangerous practices within their organisations, while also managing what (if any) information reaches the outside world. Encouraging the reporting of these matters through internal channels may help avoid serious accidents, fraud, regulatory breaches or financial scandals.

Avoid external disclosures

An effective policy encourages early internal whistleblowing making it less likely that a worker will report their concerns externally to the press or other third parties. If the worker does go straight to the press, their failure to follow the procedure means their disclosure is less likely to be protected.

Reputational damage, staff morale and customer confidence

An external disclosure of suspected malpractice, especially to the press, will lead to negative publicity for the employer, damage staff morale and customer confidence. Any claim brought by a whistleblower, who believes they have suffered reprisals, is likely to have a similar effect.

Referrals to the Regulator

When a whistleblowing claim is lodged with an Employment Tribunal, the relevant regulator will be notified. This is likely to lead to a level of regulatory scrutiny of allegations made.
Employers who can point to a clear and well-publicised process available to enable genuine whistleblowers in order to raise concerns will be better equipped to deal with such scrutiny than those who do not.

Minimise litigation risk

By helping to protect whistleblowers, a clear message is sent to staff and management about the importance of whistleblowing, minimising the risk that whistleblowers will be dismissed or suffer a detriment, which could lead to litigation under the whistleblowing legislation.

Avoiding criminal liability for bribery

The Bribery Act 2010 created a strict liability corporate offence that applies where an organisation fails to prevent bribery by a person “associated” with it. It is a defence is to show that the organisation had in place “adequate procedures” designed to prevent bribery. The government Guidance stresses that it is important for organisations to have in place effective whistleblowing policies and procedures that encourage employees to report bribery.

Public bodies

The Government expects all public bodies to have written policies. The whistleblowing arrangements in local authorities and NHS bodies are assessed as part of their annual audit process.

Listed companies

The UK Corporate Governance Code requires UK listed companies to have written whistleblowing arrangements or to explain why they do not. The company’s audit committee is responsible for keeping them under review.

Drawing up a whistleblowing policy

The principal objectives of a whistleblowing policy and procedure should be to:

  • • Convey the seriousness and importance that the employer attaches to identifying and remedying wrongdoing.
  • • Encourage workers to raise concerns internally as soon as possible and to give them the confidence to do so.
  • • Remind workers (often by cross-referring to other policies and codes of conduct) of the standards of behaviour expected of them.
  • • Ensure workers know whom to approach with a concern and to enable them to bypass the person, management level or part of the organisation to which the concern relates.
  • • Outline the procedures for investigating disclosures and what steps might be taken if wrongdoing is uncovered.
  • • Make it clear that those who victimise genuine whistleblowers or abuse the system by making malicious allegations will be open to disciplinary action. (Since 25 June 2013, the act of a worker in subjecting a whistleblower to a detriment is now being treated as having been done by the employer. The employer will have a defence if it took all reasonable steps to prevent the detrimental treatment.)
  • • Provide access to further sources of advice and guidance on whistleblowing.

A whistleblowing policy in practice

Overall responsibility

Overall responsibility for whistleblowing can rest with the board, CEO, company/group secretary, legal or finance functions. Day-to-day responsibility can be delegated to the HR, internal audit or compliance functions. It may be best to appoint a specified individual or individuals to whom people can report their concerns, such as a designated Whistleblowing Officer.

Who should handle disclosures?

Select personnel to encourage and facilitate internal disclosure and in whom staff will have confidence.

Role of management

While workers should be provided with a route other than direct line management through which to raise concerns under the policy, take care not to alienate line managers. They will usually have a valuable part to play. A policy which excludes line management altogether is likely to be impractical and bureaucratic.

Set the right tone

All employee policies and procedures should be easy to understand and operate. It is unlikely workers will have the confidence to come forward with their concerns if the policy is complex, unclear or full of legal jargon.

What disclosures should be covered?

To obtain protection under PIDA whistleblowers need to have a “reasonable belief” before they come forward. However, employers may want to know about issues which do not necessarily fall within the concept of a qualifying disclosure, such as conduct which is unethical or a breach of professional conduct rules or internal procedures that do not have the force of law. The policy may also encourage staff to raise issues or ask questions where they are unsure if their concern technically qualifies as whistleblowing. Otherwise workers may feel that they need to gather evidence to safeguard their position or simply in order to be believed. Furthermore, the worker’s perceived need to protect his or her position may delay the disclosure (and the employer’s own investigation) or worse, deter the worker from raising the matter at all.
To encourage whistleblowers to come forward as early as possible, for example, employers may simply require a “reasonable suspicion” or even just a “concern” about suspected wrongdoing.

Records of the disclosure

Employers should usually make a written record of the key points of concerns raised under a whistleblowing policy. It may be helpful for the employer to have a pro-forma record to ensure consistency of approach, including such detail as the substance of the concern, the types of risk involved, any action already taken or agreed to be taken and whether the worker has requested confidentiality.

Investigations

Complaints should be investigated promptly so that any delay does not create further grounds for complaint and to ensure that relevant evidence is collected before it is destroyed. An employer’s delay or inaction can appear suspicious to a worker who already suspects malpractice. If the worker believes that the matter is not being dealt with or, especially, if evidence is being covered up or destroyed, the worker is more likely to go to a regulator or other external agency.

The Whistleblowing Officer (if there is one) or other responsible person will need to determine the level of investigation required. If the matter needs further investigation, the Whistleblowing Officer should usually appoint an investigator or team of investigators.

The investigators will be responsible not only for looking into the truth of the allegations but also making recommendations for disciplinary action against any wrongdoer and wider change within the organisation.

It may be appropriate to investigate in two stages. Firstly, to determine whether there is prima facie evidence of the alleged wrongdoing (without focusing on individual responsibility). Secondly, to investigate the people involved to determine who is responsible.

Inevitably there may be occasions when a worker has simply misunderstood the circumstances or is motivated by a personal grievance against a colleague (whether maliciously or otherwise). In these cases, the investigator may be able to curtail the requirement for a lengthy investigation through a sympathetic meeting at which the worker’s concerns are put in context. This could dissipate any personal antagonism but, if it does not or the worker is not happy with the explanation provided, the investigator should consider whether further investigation is warranted. The worker should still have the right to raise their concern with a higher level of management.

What other actions should an employer take?

  • • Review any existing policies, procedures, codes and rules, such as those in contracts of employment, staff handbooks and intranets to ensure they are consistent with the whistleblowing policy.
  • • Consider the interaction with grievance procedures. While it is usually wise to separate the grievance and whistleblowing policies, the issues often overlap. Provide workers with guidance on which procedure to use.
  • • Take professional advice at an early stage, in view of the complexity and risk involved.

Pitfalls

Avoid imposing a legal duty on workers to blow the whistle. This is unlikely to inspire confidence and may lead to a number of practical difficulties.

The policy should not be unduly legalistic. Closely following the statutory language is unlikely to encourage a culture of openness. Employers may be worried that too broad a policy will become a “troublemaker’s charter”. However, a legalistic policy will not deter troublemakers and may even encourage them by giving the impression that one of its purposes is to give workers grounds to sue

The policy should not be used for bullying or harassment complaints or other individual grievances.

While it is important to enable workers to report concerns outside the normal management structure, this does not mean that workers should never go to their line manager. This would be both impractical and likely to alienate managers.

Do not overreact to disclosures made where they seem mistaken, there is an appearance of bad faith or where they are external – investigate thoroughly and make extra efforts to prevent victimisation.

Do not rely on confidentiality clauses to prevent external disclosures, as they are unenforceable if the disclosure is protected. Taking action against a whistleblower for breach of confidence may amount to unlawful detriment.

Ensure any existing policy has been updated from 25 June 2013 to:

  • • cover protected disclosures made “in the public interest”
  • • remove the requirement that disclosures must be made “in good faith”
  • • clarify that complaints about breaches of employees’ own contracts of employment should now be raised as a grievance

Where does this leave employers?

Whistleblowing is something which cuts across every business, from bribery and corruption issues to health and safety concerns as well as financial wrongdoing. By putting in place an effective framework, an organisation will be in a good position to avoid incidents of whistleblowing arising in the first place and to manage effectively the consequences of any allegations which are made.

This bulletin should not be taken as definitive legal advice on any of the subjects covered. If you require legal advice on any of the subjects covered or any employment law matters please contact Brian Palmer on 020 7955 1510 or brianp@rosenblatt-law.co.uk

Completion Accounts – How precise do the policies and principles need to be?

06/10/2014
For the seller of shares in any company, the calculation of the money due for the sale of their shares will be a top priority and a key provision to be negotiated in the share purchase agreement (“

For the seller of shares in any company, the calculation of the money due for the sale of their shares will be a top priority and a key provision to be negotiated in the share purchase agreement (“SPA”). The consideration due for the shares does not need to be a fixed figure; in fact SPAs often contain mechanisms for adjusting the consideration based on the assets and liabilities of the company or its performance leading up to completion. The company accounts used as a basis for assessing the company’s assets and liabilities as at completion are often referred to as ‘completion accounts’. A recent Court of Appeal decision has highlighted the importance of clarity and precision when provision is made in SPAs for the use of completion accounts.

Background to the case

In Shafi v Rutherford [2014] EWCA Civ 1186, one co-owner of a company sold all her shares in the company to the other co-owner. The consideration for the shares was based on a fixed figure to be adjusted by reference to the company’s liabilities pursuant to the completion accounts.

The completion accounts were duly drawn up. These accounts contained a statement that they had been prepared in accordance with a particular accounting standard followed by the company known as the Financial Reporting Standard for Smaller Entities (“FRSSE”).

There was, however, disagreement between the parties in respect of a number of items of equipment which the company leased. The completion accounts, like the company’s previous accounts, treated the leases as operating leases (whereby the lessor retains the risk that the equipment will have a resale value after the lease expires); the buyer argued that the leases were in fact finance leases (whereby the lessee takes on the risks and rewards of the equipment). As the consideration due for the sale of the shares would differ depending on the classification of the leases in question, an expert was instructed in line with the terms of the SPA to resolve the issue.

The expert’s determination

The expert concluded that under FRSSE, the leases were in fact finance leases. However, he then pointed to a clause in the SPA which stated that the completion accounts were to be “prepared in accordance with the accounting policies, principles, practices and procedures adopted by the Company in the preparation of the Accounts [ie. the company’s last set of accounts]”.

As the policy actually adopted by the company in previous accounts had been to treat the leases as operating leases, the expert interpreted this clause as meaning that the completion accounts must classify the leases in the same way. He concluded that he was prohibited from classifying the leases in accordance with FRSSE.

Decision of the court

The Court of Appeal disagreed with the expert’s determination. The court held that the use of the term “practices” in the SPA did not refer to what the company actually did ‘in practice’ but should instead be interpreted as referring to a ‘set of rules’. According to Lord Justice Floyd, the inclusion of the term “practices” after “policies” and “principles” acted to “fill in the gaps not resolved by policies and principles”. The difference between these terms may require further elaboration by the courts to ensure that there is consistency in their use in the future; it seems however that, where an SPA contains such wording, and where a specific accounting policy or principle of the company does not sufficiently resolve a contentious issue arising from the completion accounts, then the general rules of accounting practice followed by the company – in this case FRSSE – will determine the issue.

The court also considered the interpretation of the term “adopt”. Although the company argued that it ‘adopted’ the ‘practice’ of classifying the leases in question as operating leases and not finance leases, the court interpreted the term as being far less specific. The term instead referred to the rules which were stated to be adopted by the company and not the customs actually carried out by the company. According to the court’s interpretation of the clause, the company adopted FRSSE, rather than adopting the classification of the leases in question as operating leases.

Comment

The policy at the heart of the court’s judgment was that the parties could not have intended that erroneous accounting treatment of liabilities should be used when drawing up the completion accounts. The accounts were expressly stated to be drawn up in accordance with FRSSE; it was wrong to imagine that the parties meant for an exception to be made simply because this was how the accounts had wrongly been drawn up in the past. If this is what the parties had intended, they should have stated this expressly in the SPA.

Clarity is key when it comes to setting out the basis on which completion accounts are to be drawn up; uncertainty in the calculation of the consideration due could have devastating consequences for sellers. The court’s ruling in Shafi v Rutherford adds weight to the importance of general accounting rules followed by companies in the context of completion accounts. Where relevant accounting standards have not been followed to a tee, and without explicit wording in the SPA to the contrary, courts will almost certainly ignore a company’s erroneous past accounting practice and instead order the correct accounting standard to be applied to the drawing up of completion accounts. Hidden liabilities could suddenly appear to the detriment of the seller and sellers may find themselves unexpectedly out of pocket.

This bulletin should not be taken as definitive legal advice. Please contact Elizabeth Shaw on 020 7955 1456 or elizabeths@rosenblatt-law.co.uk for further advice.

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