When negotiating commercial leases, it is common for landlords to offer incentives to prospective tenants to encourage them to enter into the lease - for example a contribution to the tenant's fit out, reduced rent over the term or a rent-free period.
Incentive clauses often include a 'clawback' right where landlords reserve the right to have the tenant repay all or part of the value of the incentive if the lease is terminated earlier than the agreed expiry date, usually as a result of the tenant's default.
While this may be the case, penalty clauses, which penalise a party for breaching a contract by requiring a significant fee in compensation, are void. This occurs when the sum is unconscionable when compared to the greatest loss that could have arisen from the breach, and therefore not a genuine estimate of damages.
Whether incentive clawback provisions can be considered penalty clauses was discussed again recently in 148 Brunswick Street Pty Ltd v Strategix Training Group Pty Ltd [2021] QDC 38 [148 Brunswick].
Clause or penalty?
In 148 Brunswick, the landlord [plaintiff] and tenant [defendant] agreed to a variation of the lease, which contained financial incentives.
The incentives included:
- six months' rent free;
- $50,000 for the tenant's fit-out of the premises; and
- reduced rent for the balance of the lease term.
The deed of variation also contained a right for the tenant to terminate the lease early, but if the tenant exercised this right it would be required to repay the value of all incentives provided by the landlord.
The tenant exercised its right to terminate the lease early and the landlord commenced proceedings to recover the value of the incentives, plus some unpaid rent and outgoings. The tenant submitted to the court that the obligation to repay the incentives was a penalty. The landlord argued that the obligation to repay the incentive was not a penalty and did not arise due to any breach by the tenant, but rather was consideration for the tenant exercising the option to shorten the term of the lease.
Findings
148 Brunswick was only a hearing for an application for summary judgment brought by the landlord and was dismissed by the District Court of Queensland as the issue 'was not so clear cut that the defendant had no real prospect of successfully defending the plaintiff's claim' and on the basis that the law of penalties is not confined to payments [or other obligations] imposed upon breach of contract.
In other words, the tenant has real prospects for successfully resisting the clawback of the incentives.
However, Judge Barlow QC also expressed the view that, on the particular facts of 148 Brunswick, there were "good grounds for the court to find that the clause [was] simply the result of a fairly negotiated, even though possibly harsh, commercial bargain" and that "the doctrine of penalties cannot be applied simply to relieve a person from the harsh consequences of a bargain freely entered into". In other words, in this instance, because the incentive clawback was attached to the right of early termination and the tenant has, in effect, received something in exchange, the clawback may not be considered a penalty.
What Next?
Judge Barlow QC's comments indicate that, in his view, the landlord may yet succeed at trial.
If that is right then it cannot simply be assumed that incentive clawbacks will always be unenforceable penalties, and they must always be considered in light of the specific facts.
In the words of Judge Barlow QC in this matter, "unfortunately, the 'tortuous path' in the development of the doctrine of penalties must continue, and this case sits somewhere along that path".
For more information, or to discuss how the above decision could apply to your circumstances, please contact a member of our Real Estate & Projects team.
The government is proposing to ask the FRC [to be replaced by ARGA] to amend the UK Corporate Governance Code [the Code] to strengthen malus and clawback provisions for directors' remuneration in listed companies.
This forms part of the government's recent consultation paper setting out proposals for audit and corporate governance reform. For a summary of the other key points of the consultation paper, see our briefing here.
Increasing the accountability of company directors is one of the overall themes of the consultation.
What are malus and clawback provisions?
Malus provisions allow a company to reduce or cancel a senior executive's bonus or share award before it has been paid out [or the shares issued or transferred]. In contrast, clawback provisions allow the company to recover a bonus or share award after it has been paid out.
Clawback is legally and practically more difficult to operate than malus. For this reason, share awards are often deferred for a period after vesting, typically two years, during which time malus provisions can be operated rather than having to pursue directors personally. Any annual cash bonus paid out at the end of the year, however, can only be recovered through clawback unless the reduction can be set off against other awards.
These provisions are normally contained in the rules of senior executive share plans and bonus arrangements and often too in directors' service contracts and/or remuneration policies.What does the Code currently say on malus and clawback?
The Code applies [on a comply or explain basis] to premium listed companies. It currently provides that variable remuneration schemes and policies should include provisions that would enable the company to recover and/or withhold sums or share awards from executive directors and specify the circumstances in which it would be appropriate to do so.
The Code leaves it to individual companies to decide what the appropriate triggers should be for operating malus and clawback. The latest Guidance on Board Effectiveness [the FRC Guidance] does, however, already suggest that triggers might include payments based on erroneous or misleading data, misconduct, misstatement of accounts, serious reputational damage and corporate failure.
What is the government proposing?
The government proposes initially to ask the responsible body for the Code to consult on two changes to the Code: to recommend certain minimum triggers for malus and clawback and that these apply for at least two years after an award is made.
The minimum triggers proposed are:
- material misstatement of results or an error in performance calculations;
- material failure of risk management and internal controls;
- misconduct;
- conduct leading to financial loss;
- reputational damage; and
- unreasonable failure to protect the interests of employees and customers.
Because the changes would be to the Code, they would apply only to premium listed companies and would operate on a comply or explain basis. At a later stage, following a review, the government will consider broadening the application of the changes to apply to all listed companies, possibly through the Listing Rules. This would also have the effect of making the changes compulsory as companies cannot comply or explain in relation to the Listing Rules: they are mandatory.
A sub-set of listed companies operate in the financial services sector and are thus also required to operate a number of separate malus and clawback rules by the financial regulators. Under these normally much harsher regulatory regimes, the malus and clawback rules may apply for much longer and capture far more employees than under the Code. These regimes are not affected by this consultation.
Companies which are unlisted or quoted on AIM will not be affected by these proposals. This is in contrast to several of the paper's other proposals.
What practical impact would these changes have?
The government acknowledges in the consultation paper that, according to a 2018 survey, 90 per cent. of FTSE 350 companies already have malus and clawback provisions in place. Its concern, however, is that the triggers for applying these provisions are not wide enough. They usually cover the misstatement of results or an error in performance calculations but far fewer include reputational damage or failure of risk management.
The government may be a little behind the curve on this as the survey it cites is two reporting years old and was conducted before the current version of the Code and the FRC Guidance took effect. With many directors' remuneration policies up for a shareholder vote in 2020 as part of the usual three-year cycle, malus and clawback provisions were one of the key areas of focus for institutional investors and many listed companies have already reviewed and expanded their triggers. In practice, therefore, these proposals may have very little effect as the proposed changes have largely already been implemented.
It is not uncommon, for example, to see reputational issues covered as well as matters such as health and safety failings [in relevant sectors]. Additionally, companies often include corporate failure as a trigger, in line with the FRC Guidance, although the government's proposals go further than this with their reference to "conduct leading to financial loss" which is a much broader concept and will need careful definition to avoid capturing all loss-making situations. Should these changes take effect, companies might wish to qualify this trigger, for example by introducing an element of significance in terms of the size of the financial loss. It is also not clear whether some of the failings identified would be required to be individual or corporate shortcomings.
By contrast, one of the proposed triggers which is not usually seen at present is the "unreasonable failure to protect the interests of employees and customers". This ties in with recent reforms to disclosure requirements under which certain companies must report on how directors have had regard to stakeholder interests in performing their duty to promote the success of the company and also report on employee engagement. The use of the word "unreasonable" allows some scope to justify actions taken.
In terms of the proposed two year time period for recovering remuneration, listed companies generally already have malus and clawback provisions in place for at least two years from the date of the award, and so this will not have too much impact. Indeed many operate them in the two years after vesting, not just from the date of the award, and so will exceed the requirement.
Regardless of the detail, what the proposals will serve to achieve is to continue the pressure on companies to examine their malus and clawback provisions in all plans [not just LTIPs]. Malus and clawback will become embedded still further in the minds of companies, participants and investors alike as an issue, requiring disclosure and communication to those concerned, and leading to a requirement to demonstrate malus and clawback has occurred when relevant events warrant it.
What next?
The consultation closes on 8 July 2021. Depending on the outcome, the relevant regulator in place at the time will then be asked to consult [further] on changing the Code. Any changes, therefore, are likely to be some way down the road and probably 2022 or even 2023 remuneration will be the first to be formally affected by these proposals [which would not normally be required to be operated on remuneration already awarded]. Companies may voluntarily adopt the changes sooner and many are, as stated above, already complying.
Further information
For more information about the proposals or for assistance with formulating malus and clawback provisions, their disclosure or operation, please contact either of the people named below.