The Redundancy Payments Service and claims by director-shareholders

Jon Curtis, from Ironmonger Curtis LLP (a firm of solicitors working primarily with SME’s), shares his expertise in Redundancy Payments and Claims by directors and shareholders. Jon is founding partner of Ironmonger Curtis LLP and head of the Employment Law team. He also designed ‘myHRtoolkit’, the popular HR admin tool kit, with such an impressive CV we were happy to have him share his knowledge with us. Ironmonger Curtis LLP, is a Sheffield based law firm who specialise in small to medium sized businesses.

The Redundancy Payments Service

When a business goes pop, and cannot afford to pay redundancy money, employees (and employees only) can claim redundancy money from the National Insurance Fund (NIF) by making a claim to the Redundancy Payments Service (RPS). The issue becomes contentious when director shareholders claim: sometimes the RPS will argue that a director shareholder is not an employee, and hence not entitled to a payment. This article sets out some of the law surrounding this contentious issue.

What is the problem?

Basically, the RPS resents paying redundancy money to individuals they think were not really employees. It must be very tempting for non-employed directors of doomed businesses to start calling themselves an employee, and quickly write out an employment contract, in order to claim once the business goes bust. In other cases, directors may have wrongly called themselves employees all along, but in reality have not been employees. This is compounded by a further issue that some shareholder / directors who do not really consider themselves to be employees pay themselves a low salary in order to take advantage of the tax free employment threshold. The issue is important given the current number of insolvencies. Claims by directors for payment from the NIF were 12,000 in 2008 by way of example; so the stakes are fairly high.

Who can claim from RPS?

Only employees can claim. Other types of retained staff, for example those who are self-employed or ‘workers’, are not eligible to claim.

So what is “an employee”?

The issue of “what is an employee” is rather “vexed” (as we lawyers say). An employee is defined as:

“an individual who has entered into or works under (or, where the employment has ceased, worked under) a contract of employment” (section 230(1) Employment Rights Act 1996 (“ERA”)).

A contract of employment is a:

“contract of service or apprenticeship, whether express or implied, and (if it is express) whether oral or in writing” (section 230(2) ERA).

For a contract to be a contract of service (and the individual to be an employee), there must be, as a minimum:

  • an obligation on the employer to provide work and to pay the worker in return;
  • an obligation on the worker to provide at least some of the work personally;
  • an agreement by the worker – either expressly or by implication – to be the subject to the control of the employer, to a sufficient degree.

If one or more of these requirements are missing, the worker is unlikely to be an employee. For the marginal cases (there are many as there is a big grey area), tribunals may also take the following into account:

  • Degree of integration into the business (employees tend to be “around” more);
  • Ability to undertake other activities (employees are less likely to be able to take off when they want to);
  • Nature and length of the engagement (employees don’t tend to have “engagements”);
  • Whether the person is paid a fixed wage or salary;
  • Tax status and benefits provided (although this is not particularly important the courts will look at what the parties have agreed on tax);
  • How the parties describe the relationship (again, what the parties call the relationship is not determinative by any degree but sometimes can be revealing);
  • Who provides and maintains the tools or equipment used;
  • The degree of financial risk adopted (employees do not usually take any financial risk);
  • The degree of investment in and management of the business;
  • Whether the individual has the opportunity to profit from their own good performance;
  • Whether the person is paid when absent due to holiday or sickness; and
  • How the parties describe the relationship.

We have set out some important cases on director shareholders and their employment status below.

Directors – are they employees?

The question of whether or not you are a director is very different to the question of whether you are an employee. It is a totally different test, and while the two often overlap they should not be confused. A director is what the law calls an “office holder”. Traditionally, directors and other “office holders” were not considered to be employees given that they would have certain privileges attached to that position. However, the world has moved on and it is now very commonly the case that office-holders also have a contract of employment and therefore are employees. This was confirmed in the case of Johnson – v – Ryan [2000] ICT 236, where the EAT identified three categories of officer-holder, and gave company directors as an example of those who could be both office holders and employees. Whether or not a director will be an employee will depend on whether they meet the employment status test above. You will notice that the fact that individual is a director is not really relevant in judging this. Speaking very generally, executive directors tend to be employees, while non-executive directors who are not really involved in the day to day management of the business, are considered to be office holders, but not employees.

Why is shareholding important?

Shareholdings are not really important unless they are substantial. If an individual owns 3% of the company he works for this will not dictate either way whether or not he is an employee. But what about if a director holds 99%? Any one individual with more than 50% of the shareholding effectively controls a company and is therefore referred to as a “controlling shareholder”. Under older case law, it was considered unlikely that a controlling shareholder would be an employee. The logic was that the individual was not really under the control of the Company, and so could not meet the minimum criteria for employment status set out above. For example, in the case of Buchan – v – Secretary of State for Trade and Industry [1977] IRLR 682 it was decided that the two directors concerned (who were also controlling shareholders who could block decisions at board level including decisions to dismiss themselves) were not under the control of the company so could not be considered employees. However, more recent case law has moved away from this approach, culminating in the Court of Appeal decision in Neufeld (below). A brief summary of the key cases is as follows:

Case one: State for Trade and Industry – v – Bottrill [1999] IRLR 326

In this case, the Court of Appeal departed from the traditional view regarding lack of control, stating that it would not necessarily be the case that a director who is also a controlling shareholder will not be under sufficient control for there to be an employment relationship. The court held that, whilst the fact that an individual was a controlling shareholder was important (and sometimes decisive) there are a number of other factors to be considered when considering the employment status of a director who is a controlling shareholder. If the contract is genuine and not a “sham”, a tribunal would need to move on to consider whether there is a contract of employment, taking these other factors into consideration.

Case two: Clark – v – Clark Construction Initiatives Limited and Utility Consultancy Services Limited UKEAT/0225/07

In this case, the EAT considered the question of whether there was a genuine contract of employment. It considered that in the following three types of case, it would be legitimate for a tribunal to decline to give effect to an alleged contract of employment. Effectively, these are the three scenarios where there will be no genuine contract of employment:

  1. Where the alleged contract of employment was a “sham”;
  2. Where the contract had been entered into for an ulterior motive (e.g. to ensure receipt of benefits from the RPS); and
  3. Where the conduct of the parties did not reflect the contract (either because it was never intended in the first place, or because the terms had changed in practice).

The EAT also gave relevant guideline factors for a tribunal to consider, as follows:

  • The fact that an individual is a controlling shareholder or in practice is able to exercise real or sole control over the company does not prevent an employment contract arising.
  • The fact that the individual has built the company up or profited from its success will not necessarily mean that no contract exists.
  • The fact that the parties conduct themselves in accordance with the contract will point towards the contract being valid and binding. Conversely, the fact that the parties’ conduct is inconsistent with the contract will point away from the fact that a controlling shareholder is an employee.
  • The assertion that there is a genuine contract will be undermined if the terms have not been identified or put into writing.
  • The fact that the individual takes loans from the company or guarantees its debts may exceptionally be relevant in analysing the true nature of the relationship but in most cases such a factor is unlikely to carry any weight. There is nothing intrinsically inconsistent in a person who is an employee doing these things and in many cases involving small companies, it will be necessary for the controlling shareholder personally to have to give bank guarantees.
  • The fact that an individual is a controlling shareholder may be relevant and even decisive but that fact alone will not necessarily justify a tribunal finding that there was no contract in place.

The facts and the decision

Mr Clark had initially been the sole shareholder of the business. He later (in two transfers) transferred all of his shares to a Mr Grew. Whilst initially Mr Clark had been paid a small salary and had also received large loans from the company, when all shares had been transferred to Mr Grew, he remained in his position of Managing Director but started to receive a salary reflective of his position (summer 2005). Less than 12 months later, Mr Clark and Mr Grew fell out, and claims by Mr Clark, including a claim for unfair dismissal, followed. The tribunal accepted that Mr Clark had become an employee after all shares were transferred and Mr Clark began to receive a salary. However, it did not accept that Mr Clark had been an employee before that time, placing emphasis on the fact that he had been able to structure his finances in a tax efficient way on the advice of his accountant, which is something that ordinary employees would not be able to do. As Mr Clark had been genuinely employed for less than a year, he did not have the required service to bring an unfair dismissal claim. Mr Clark appealed but his appeal was dismissed. The EAT agreed that the method of payment prior to summer 2005 was unusual, but said that this did not in itself prevent an employment relationship. However, the court felt that the fact an employment contract had never been drawn up was an “extremely powerful factor” suggesting that the contract did not regulate the relationship between Mr Clark and the company, and that the limited nature and impact of the contract could be taken into account. In short, there was no genuine contract prior to summer 2005.

Case three: Secretary of State for Business, Enterprise & Regulatory Reform v Neufeld & Anor [2009] EWCA Civ 280 (02 April 2009)

In Neufeld, the Court of Appeal was asked by the Secretary of State to give clear guidelines to tribunals on the correct approach when considering the employment status of controlling shareholders. In 2008, the RPS had received approximately 12,000 claims from such individuals, and more were expected given the economic downturn. The Court of Appeal endorsed the approach taken in the case of Clark (above) and held that there was no reason why a controlling shareholder could not also be an employee, if there was a genuine contract which was a contract of employment. In determining whether there is a contract of employment, the Court of Appeal indicated that tribunals should consider the following:

  • What had been done under the contract:
    • Is it followed or ignored?
    • Is it in writing and if not, does the behaviour point convincingly to a contract being in existence?
  • Generally speaking such matters as whether the individual had share capital invested, or had made loans to the company, or personal guarantees are deemed unimportant (although they could be important in a special case).
  • How the employee was paid.

On the facts of the case, both individuals (Mr Neufeld and a Mr Howe) were held to be employees entitled to make a claim from the RPS. If you have any questions about the above, please do contact Ironmonger Curtis.