Exercise of discretion in share plans: can discretion ever be absolute?

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There are a number of occasions when a company operating a share plan will need to exercise its discretion.  On grant, a decision needs to be made as to who will receive an award, how many shares will be subject to it and what other conditions (such as those relating to vesting and performance) will apply.  Plan rules often give the grantor a discretion as to how to treat awards held by leavers.  This might include deciding whether they are a “good” or “bad” leaver, whether and to what extent their award will vest and the point at which they will be able to exercise their rights.  The potential for having rights taken away at the apparent whim of the board could reduce the incentive value of share plan participation.  To redress this, it is common for plan rules to require that any discretion is exercised “fairly and reasonably” (indeed, certain UK tax-advantaged share plans will be expected to contain this qualification).  However, some plans are drafted to give the board an “absolute” discretion in certain circumstances.  Irrespective of the impact of such wording on employee morale, recent decisions in the English courts demonstrate that anybody exercising such a discretion needs to tread carefully.

 

A difference between commercial contracts and employment contracts

As a general rule, parties to commercial contracts have the freedom to agree to whatever terms they want, regardless of how reasonable they are.  However, the UK courts have taken a different approach to employment contracts acknowledging that the balance of bargaining power between employer and employee is not equal. Unlike commercial contracts, employment contracts contain an implied term of trust and confidence which, in essence, requires an employer to act fairly and treat its employees responsibly and in good faith.  This was brought to light by Lord Hodge in the Supreme Court case of Braganza v BP Shipping Limited[1], where he said that:

the personal relationship which employment involves may justify a more intense scrutiny of the employer’s decision-making process than would be appropriate in some commercial contracts“.

Therefore, although the courts are generally reluctant to interfere in the exercise of discretion, the inequality between parties to an employment relationship and the implied term of trust and confidence means that they are more prepared to scrutinise the exercise of discretion towards an employee than in other contractual relationships.

 

Discretion must be exercised “reasonably”

Even in the context of commercial contracts, the general rule is that any power given to one party to make decisions that affect both parties must be exercised (i) honestly and in good faith, (ii) for the purposes for which it was conferred and (iii) must not be exercised arbitrarily, capriciously or unreasonably (Abu Dhabi National Tanker Co. v Product Star Shipping (No. 2)[2]).  The concept of “unreasonableness” has been interpreted as meaning “irrational”.  In Clark v Nomura International plc[3], a senior trader was eligible for a bonus that was dependent upon his individual performance.  The trader was dismissed for misconduct but in the months prior to his dismissal he had earned significant profits for the bank.  The bank decided not to award him any bonus because, in the circumstances, there was no need to retain and motivate him.  The High Court found that the bank had taken the wrong approach towards the bonus and decided that the trader was in fact entitled to a payment.  The trader’s employment contract stated that the bonus would be based on individual performance therefore it was not possible to take other factors (such as the need to retain and motivate the employee) into account.  In the words of Burton J “the right test is one of irrationality or perversity (of which caprice or capriciousness would be a good example) i.e. that no reasonable employer would have exercised his discretion in this way.”

Nevertheless, the courts continued to be reluctant to interfere in private contractual arrangements and the bar for showing that discretion had been exercised unreasonably remained high.  In Commerzbank AG v Keen[4] the Court of Appeal ruled that it would “require an overwhelming case to persuade the court to find that the level of a discretionary bonus payment was irrational or perverse in an area where so much depended on the judgment of the bank in fluctuating market and labour conditions.”

This changed with the 2015 case of Braganza where the Supreme Court adopted a new approach to reasonableness in an employment context.  It determined that reasonableness should be tested by applying the higher standard used to review the actions of public bodies (known as “Wednesbury unreasonableness” as it was first applied in the case of Associated Provincial Picture Houses Ltd v Wednesbury Corpn[5]Wednesbury established that reasonableness should be assessed in two stages; first, the decision maker must take into account relevant factors and not take into account irrelevant factors in exercising its discretion (the “process” limb); second, the conclusion must not be so unreasonable that no reasonable decision maker could have reached it (the “outcome” limb).

In Braganza, the facts concerned death in service benefits under an employment contract which could not be paid if “in the opinion of the company or its insurers” the death resulted from the employee’s suicide.  The company, having considered the findings of an investigation team (which were actually tasked with looking into whether the company’s systems could be improved), concluded that suicide was the most likely explanation for the employee’s death.  Accordingly, no death in service payment was made to the employee’s widow who brought a claim for breach of contract.  The Supreme Court found that the company had not taken sufficient account of the possibility that the death was accidental and therefore had failed to follow the “process” limb of the unreasonableness test.  The widow’s claim for the death in service benefit therefore succeeded.

This was a particularly tragic and unique case and it remains to be seen how extensively the courts will apply the public law concept of Wednesbury unreasonableness to dealings between employers and employees.  In the later case of Patural v DB Services[6] relating to banker bonuses, the High Court followed the Braganza approach but did so with some reluctance noting that public authorities have different duties to employers and businesses in that they must act in the public interest.

 

How is the discretion worded?

As Braganza and the cases that followed it show, applying the correct process is essential in proving that a discretion has been applied reasonably (and therefore validly).  Even before Braganza, it was clear that a board’s discretion might be limited by the particular way in which it is drafted.

In Mallone v BPB Industries Limited[7] the company’s share option plan gave the board an absolute discretion to decide the “appropriate proportion” of the option that could be retained and exercised by a leaver.  In the relevant circumstances, the board decided that the appropriate proportion for the departing employee was nil because there had been some issues over his recent performance.  This was in spite of the fact that, at the time of his departure, his option had vested in part during a period of time when he had performed well.  The court held that the discretion did not mean that the directors could make any decision they wanted.  The rule required them to determine the “appropriate proportion” and in doing this they were required not to reach a decision that “no reasonable employer could have reached”.  In Mallone it was held that a decision to completely deprive a leaver of vested options in the absence of misconduct was irrational and perverse.

The share option case of McCarthy v McCarthy & Stone plc[8] also concerned the interpretation of a leaver provision.   Under the rules of the company’s share plan, the remuneration committee had a discretion to determine whether the option was exercisable by a leaver.  In doing so, it was required to consider the extent to which any performance condition had been met at the employee’s departure.  The case concerned an employee that left the company and sought to exercise an option where the performance condition had been met in full.  The remuneration committee exercised its discretion and allowed him to exercise the option but (in light of allegations of the employee’s misconduct) only in respect of three quarters of the shares subject to it.  The court held that the option should be exercisable in full because the language of the rule required the remuneration committee to do two things in sequence; at the first stage the committee had an absolute discretion to decide whether or not the option should be exercisable.  However, the court went on to find that once the committee had decided that the discretion should be exercised, the only determination to be made at the second stage was the extent to which the performance condition had been met.

As these cases demonstrate, the wording of any discretion is likely to be scrutinised carefully by the courts and interpreted narrowly in respect of the person exercising it.  They also stress the importance of drafting a discretion widely and in clear terms.

 

Is there a commercial basis for the discretion?

Even where the drafting of plan rules appears to give an absolute discretion, the courts may question the commercial basis behind its use.  A recent example of this is the share option case of Marcus Watson, Rob Hersov and Twysden Moore v Watchfinder.co.uk Limited[9]. In Watchfinder, the three claimants requested specific performance of a share option agreement which they had entered into with the company.  The agreement provided that the option could only be exercised with the consent of a majority of the board.  If consent was not given then the option would lapse on a set date.  The claimants sought to exercise the option but were told that they could not as board consent had not been given.  They sought a ruling from the court on the basis that as a matter of construction or by an implied term it was not open to the company to refuse consent unreasonably, capriciously or arbitrarily.

The court found in the claimants’ favour, stating that it could not be a correct construction of the relevant clause that the board had an unconditional right to veto the exercise of the options.  If that was the case then the option would be meaningless because the award of shares would be entirely within the power of the company and the position would be no different to any other person seeking to buy shares in the company.  This did not mean that the discretion could be ignored entirely; applying the Braganza “two stage” test, the question was whether there had been a proper process in exercising the discretion and whether the outcome was one that no reasonable decision maker could come to.  On the facts, it was apparent that there had been barely any discussion or focus on the relevant matters in exercising the discretion at all.  Accordingly, the claimants were permitted to exercise their options.

Watchfinder demonstrates that a person given a seemingly wide power of discretion needs to understand its purpose and context and clearly document the decision-making process.

 

Can liability for exercise of discretion be excluded?

Share plan rules usually contain a clause that excludes a participant’s right to compensation for loss of options as part of a claim for breach of their employment contract.  Such provisions are known as “Micklefield” clauses after the case in which they were held to be effective and were not caught by the Unfair Contract Terms Act 1977.  These clauses cannot exclude statutory loss of employment claims (such as unfair dismissal) but as such claims are subject to financial maxima they present companies with a limited exposure.   In some circumstances, these exclusion clauses go further and extend to claims for breach of the award contract through an exercise of discretion (even, in some cases, where the exercise is in a manner that is irrational or perverse).  Such clauses are not appropriate for most forms of tax-advantaged plans but are relatively common in those that do not need to comply with the requirements of the UK tax authorities.  Often the clauses are used for their perceived “deterrent” value without much regard to whether they actually work in practice.

Given that the courts will generally uphold contracts that are clear and agreed between the parties to them, a well drafted exclusion clause should be effective.  However, the application of clause is likely to come under scrutiny and construed against the company seeking to rely on it.  This will particularly be the case where a discretion is used to take away a participant’s vested awards (in the absence of misconduct) as in Mallone.

 

The courts’ approach to exclusion clauses was demonstrated recently in Daniels v Lloyds Bank Plc[10].  This case concerned two executive directors within the Lloyds group who were granted awards under the Lloyds Long Term Incentive Plan (LTIP) to acquire shares provided certain performance conditions were met.  Although the bank’s remuneration committee determined that the performance conditions had been met and that the awards should vest in full, in light of shareholder discontent, the full board decided that it would not be appropriate to reward the two directors in shares and purported to reduce the LTIP awards to nil.

Although there were issues over whether or not the board had a discretion to reduce the awards in the first place, the High Court concluded that, in any, event, any such discretion had not been properly exercised.  The discretion had to be shown to have been exercised rationally and (as in Mallone) there was no sign that the board had considered why it was permissible to “take away the earned bonus of an employee who had not committed any misconduct”.  The LTIP rules contained an exclusion clause which excluded any right to damages for any loss arising as a result of any exercise of discretion in relation to an award.  The High Court held that, despite its broad terms, the clause was only intended to cover loss of rights in the context of employment claims (e.g. loss of rights on the termination of employment, whether lawful or not) and was not able to protect an employer from liability where the employer breached the rules of the plan itself.  To read the clause otherwise did not make commercial sense.

Apart from the case law on how exclusion clauses will be determined, it should also be remembered that UCTA has been replaced by the Consumer Rights Act 2015 (CRA).  Unlike UCTA, it is not yet clear whether the CRA applies to share schemes and companies should always be aware of the possibility that it could be used to strike out an exclusion clause.

 

What we can conclude

Discretionary powers are extremely useful to those operating a share plan especially where awards are held for long periods of time and participants leave in a variety of circumstances.  However, they should be exercised carefully and not treated as a licence by the person exercising them to make any decision they choose.  The case law shows that the following points need to be borne in mind:

  • there is rarely (if ever) such thing as “absolute” discretion and, even when drafted in the widest of terms, the courts are likely to construe it narrowly when evaluating why it was given and its commercial purpose;
  • when exercising a discretion, the correct process must be followed. Appropriate meetings should be held, the reasons behind the decision-making process documented and the outcomes reviewed to ensure that they are not seen as irrational or perverse;
  • a “discretion claim” exclusion clause may be both appropriate and effective but is no substitute for exercising a discretion appropriately in the first place and may be construed by the courts as having a limited application.

 

Travers Smith LLP

Incentives and Remuneration Group

December 2018

[1]        [2015] UKSC 17.

[2]        [1993 1 Lloyds Rep 397].

[3]        [2000] IRLR 766.

[4]        [2007] IRLR 132.

[5]        [1948] 1 KB 223).

[6]        [2016] IRLR 286 relating to banker bonuses.

[7]        [2002] EWCA Civ 126.

[8]        [2007] EWCA Civ 664.

[9]        [2017] EWHC 1275 (Comm).

[10]       [2018] EWHC 660.