TECHNICAL PMI. Assessing the strength of the employer s covenant. The Pensions Management Institute

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1 PMI TECHNICAL JUNE 2006 The Pensions Management Institute Pensions Professionals in practice Assessing the strength of the employer s covenant Samantha Bewick, Director, Restructuring, KPMG LLP (UK) What are the nuts and bolts processes involved in the procedure? Business overview The business is set in its historical and sectoral context. This will typically include a short summary of its development, a description of how it has reached its current situation, and may cover its position among its closest comparators and competitors. Where the business is distressed, this section will include reasons for the decline in performance. Historical financials A review of the historical financial position and key business ratios assists in putting the company s performance in context. It also provides a baseline for the review of the forecasts, indicating areas where the forecasts are based on assumptions which are materially different from the company s actual experiences. Review of the historical position also indicates trends in the company s key indicators, such as a slow decline in margin or a change in the sales or product mix. It may also point up a gradual increase in a certain cost - for example wage levels. Forecast profit and loss account, cashflow and balance sheet The key aspect of the forecast review is to test the robustness of the assumptions made regarding key areas. When considering the profit and loss account these will include turnover, the components of the cost of sales; wages and key operating costs. When considering cashflow, the starting point must be the current cash or overdraft balance, reconciled to the bank accounts. The assumptions will include interest rates and debt repayments and expected capital expenditure. The forecast balance sheet is of most use as a check on the integrated nature of the forecasts, in particular to tie together the cash impact of debtor and creditor monies against the turnover/cost of sales/operating costs. Assumptions A robust review of the assumptions contained in the forecast provides most value to trustees and pensioners. However, it should be noted that the reliability and accuracy of forecasts and business models declines dramatically with time, and that therefore they are only really of use in assessing the position of the employer over a relatively short timeframe (say 1-2 years) when compared to the maturity profile of a pension scheme. Executive summary Following the Pensions Act 2004 there is a requirement on trustees to assess the strength of the employer s covenant at the time of the actuarial valuation, and at any time when they might be worried that the employer is no longer a going concern. In line with the Pension Regulator s ( the Regulator ) guidance to trustees of a scheme having a deficit that they should negotiate in the same way as would a bank having a large unsecured debt, trustees should obtain a similar report as would a bank on the financial position of a company about which there are concerns. The typical report which a bank requests when it has concerns over the repayment of its debt is known as an Independent Business Review, or IBR. In a pensions context, this is often referred to as an Employer Covenant Review, or ECR. 1

2 In the context of employer contributions, the ECR will be of most help for the year ahead, as cash flows are more readily predictable over this shorter timescale. The ECR can, assuming that the employer s financial model is up to it, be sensitised to show the effects of changing the assumptions made, both positively and negatively. This will help trustees to assess the margin for error in setting contribution rates - whether there is material free cash which can be used to reduce deficits, whether some small change to the key assumptions will have a major detrimental effect on the business forecasts, and whether the contributions being requested are sustainable. Illustrative liquidation outcomes If requested, a liquidation outcome statement provides a guide to the amounts that a secured or unsecured creditor might receive on an insolvency. However, it is by no means a valuation of the company and is only an illustration based on the knowledge and experience of the practitioner. It is of use to the trustees if they are unsure of the going concern status of the employer and if they are concerned during a restructuring that they may not be getting the best deal - they can compare their current position with the position after the restructuring is completed (on the terms proposed) and see whether they are materially disadvantaged. They may also use it as a guide to the improvement in their position if they were granted security over certain assets. A liquidation analysis is not: a guarantee of continued solvency, even if all creditors are shown as being paid in full; an opinion on going concern; a guarantee of what the Scheme would receive as a creditor following the insolvency of the employer; a guarantee that the Scheme is, or would be, eligible for entry into the PPF if the employer became insolvent; an actuarial review; a company valuation. The Regulator has indicated that it is very keen to see liquidation analyses for the expected position both before and after transactions seeking clearance. What about lenders? The lenders to a company or group are likely to be at least as concerned about its solvency as is the pension fund. They are also likely to receive more information from the group: for example there will normally be information covenants in the lending documents which might require the group to supply quarterly or half-yearly management accounts, details of aged debtors or creditors or other financial information. In this way the lender will monitor the company. Lenders will, of course, also monitor whether interest and repayments on the loan are being made in a timely fashion. Normally lenders will recognise the first signs of distress in a company through this monitoring and will take steps to investigate the position. It is possible that lenders might request access to the report provided to the trustees as part of their monitoring. Should a lender wish to investigate further, then it will request an IBR as part of its decision-making process, as discussed above. It would be very unusual for a lender to notify the pension scheme that it was requesting an IBR. The lender will be interested and/or concerned to know of any major changes in the position of the pension fund, whether that be in regard to contribution rates or one-off payments to the fund. Either will critically affect the cashflow from which it expects repayment of its lending. This would be reviewed as part of the IBR and in the current climate the actuarial assumptions leading to the contributions required to fund the pension scheme may well be critical. Where pension costs are significant then consideration may be given either at the IBR stage or in negotiations thereafter as to ways of reducing or deferring these costs. Consideration of the options available may reach quite an advanced stage before the company or the lender opens negotiations with the Trustees or with the Pensions Regulator, in order that the employer has fully thought through its options and its financial position. In mid-market, and indeed in many larger, companies it would be unusual for the lender not to have fixed and floating charges over the whole of the company s business and assets. In such a case the lender will have priority over other creditors by virtue of its security. The pension fund will rank as a preferential creditor for any unpaid contributions to which Schedule 4 to the Pension Schemes Act applies, but will only rank as an unsecured creditor for the whole of the S75 deficit, should the company enter insolvency. A preferential creditor is paid from the 42

3 amounts realised from floating charge assets before the floating charge holders can be paid. The preferential amounts are broadly: earner s contributions deducted from earnings in the four months prior to the date of insolvency and not paid over to the pension scheme; and/or employer s contributions to a contracted out scheme, payable in the 12 months prior to the date of insolvency and not paid over to the pension scheme. However, if trustees are in any doubt about the amounts which should be claimed they should take specialist insolvency advice. In a group situation the lender will be likely to have security over the whole of the group, including a secured crossguarantee structure designed to ensure that regardless of where the lending is made within the group, the lender has recourse to the assets of the whole of the group. This means that on an insolvency the lender will have first call on the assets, subject only to the costs and expenses of the procedure and (from assets subject to a floating charge only) preferential creditors. Unsecured creditors will only be entitled to share in the remaining assets (if any) after the secured lender s loans have been fully repaid. If there is no secured lending, then the lender and the pension scheme, and all the other unsecured creditors, will all rank equally behind the costs and expenses of the process and the preferential creditors. If the lender is concerned about the solvency of the group, then it may request enhanced (or new, if it has none) security in order to protect its position. If a lender has security then it will generally have the power to appoint an insolvency officeholder (an administrator, normally, although a receiver may be appointed in rare circumstances.) As for any unpaid creditor, it also has the power to petition for a winding-up (liquidation). Even where an administrator is appointed by the secured lender, his/her duties are to the general body of creditors. What next for the trustees? Clearly, the actions that the trustees may take will depend on what the report reveals. If the ECR suggests that the company is in a relatively comfortable financial position, then the trustees and the company can use the report to assist them in agreeing an appropriate and affordable contribution schedule and/or recovery plan. There would be little monitoring of the position required as long as contributions and the payments to the recovery plan were made in accordance with the relevant schedules. However, should there be persistent, or uncorrected, failures to pay the required amounts then the trustees should consider much closer monitoring, as discussed below. The report might also suggest ways in which the company could realise or secure surplus assets for the benefit of the scheme. If the report reveals that the company is in a stressed or distressed position, then the trustees need to consider how best to balance the requirements of the pension fund for contributions and deficit funding against the limited resources which the company can afford. The Regulator has suggested that the pension scheme should negotiate as would a bank with a large unsecured loan. This would involve seeking security and/or guarantees for the debt and agreeing a plan to pay off any remaining unsecured balance. Where the company already has secured lending, then it is unlikely that the lender will consent to the pension fund being granted security ranking pari passu with the lender s security - as this will dilute its return. Depending on the relative sizes of the lender and pension fund S75 debt, the dilution to the lender could be very high. It would be usual for the lender to have a negative pledge clause preventing further security being granted without its consent. However, consent might reasonably be sought for second ranking security, which would give the pension fund a greater right to the assets than other unsecured creditors, although it would still be subordinated to the lender s security. There is only one issue with this - if the security is granted then if an insolvency occurs within a relatively short time then the insolvency practitioner may seek to overturn the security as having been either a preference (s239 Insolvency Act 1986) or as a floating charge which may be avoided (s245 Insolvency Act 1986). For security to fall within these categories it must have been given within 6 months or 12 months of the date of insolvency respectively. Of course, if the company has unsecured assets then the pension scheme can request that those be secured to it. This may still fall foul of the covenants in any lending - which may well prohibit the granting of 3

4 further security without the consent of the existing secured lenders. In such a case the pension scheme will face a difficult negotiation with the company and its lenders. It is likely that the best result it can hope for is pari passu security with the lenders. If a company is stressed or distressed then more extensive monitoring is crucial. Trustees will wish to know as soon as the company is going off-plan, or even as soon as it thinks that it will, so that the trustees can consider the options and potential next steps. There are many levels of monitoring, which should be agreed as part of the trustees negotiations with the company. The first and most crucial is clearly the continued payment of regular and oneoff contributions to the scheme. However, a set of key performance indicators relating to trading, cash generation and profit should also be agreed, so that trends or events which might have a subsequent effect on the ability of the company to fund the scheme can be identified and addressed early. How does it add benefit for trustees? And how can they most effectively communicate the benefits of the process to members? The ECR process allows trustees to satisfy their obligations under the Pensions Act in a commercially useful way, which can be tailored to the position and needs of both the Scheme and the employer. Where a company is in a strong financial position, and the Scheme is well funded, there is no need for an in-depth review. However, should either or both of these not be the case, then a more detailed investigation should be undertaken. The scope of the investigation can be agreed between the professionals, the trustees and the employer so that only that depth of investigation which is necessary can be undertaken. It is of no benefit to the trustees to insist on a detailed investigation, at potentially high cost, if this is not required. Similarly there is no point in an employer trying to restrict the scope of work if there are serious concerns about the level of deficit or the financial health of the company. As ever, a consensual solution is best. This is especially important where lenders are also expressing concerns or requesting an IBR of their own, as it is not helpful for a distressed company to bear the costs of duplicated work. It may be possible for a level of work to be agreed which is overlaid on the lender s IBR rather than a duplication of all of the substantive work. The ECR provides an independent check on what the company can/may be able to afford, without the preconceptions which either the trustees or the employer may have. It is not uncommon for there to be unrealistic views on each side as to the position. An independent view can be helpful in managing expectations on both sides so that the deficit can be dealt with as quickly as possible without prejudicing the company s ability to invest sensibly for its future. This can also provide assistance in structuring a recovery plan that the company can support while filling the deficit, both in terms of timing and amount. With proper planning, it may be possible for lower cash payments to be balanced by the inclusion of non-cash assets (including contingent assets) or guarantees which expire on the meeting of suitable funding benchmarks, for example full funding of the ongoing deficit, full funding of the FRS17/IAS19 deficits, reaching the PPF protected level or ultimately full funding. The trustees who have requested an ECR then have a basis for negotiation with the employer which includes a view of the position if the company should become distressed or fail. This gives them some comfort that should this occur, they have taken proper advice and reasonable steps to protect their members in the circumstances leading up to distress or failure. If the steps that have been taken include putting in place monitoring of key performance indicators, and this monitoring has been done, then there may be early warning of issues arising. In this case intervention can be started early which gives an increased likelihood of successfully bringing the employer back on plan. Benefits to members The benefits to members of the ECR are one step removed from those for trustees. However, anything which enables trustees to have better information will assist in establishing a clear path to filling any deficit and agreeing a sensible contribution schedule, both of which eventually benefit members in that the assets of the pension scheme available to meet pension liabilities are increased. Of course, if the ECR assists trustees to negotiate one-off payments or non-cash assets to increase the assets of the pension scheme, or to agree an increased contribution level, then there is a clear, tangible benefit immediately. 4

5 The ECR may also assist trustees to communicate an agreed, sensible recovery plan to fill the deficit. This will help members understanding of the position of the pension scheme and the actions that the trustees are taking to strengthen it, which may help them assess their personal position and any further steps that the member needs to take to prepare for their retirement. What happens if an employer refuses to pay? The powers of the trustees will largely depend on the trust deed, subject to any overriding powers granted by the Pensions Act 2004 or determinations made by the Regulator. However, if agreed payments are not made enforcement is ultimately the same as for any other debt: i.e. the service of demand for payment and, if that is not acted upon, enforcement by means of judgement and eventually petition for the employer s insolvency. Whether forcing the employer into an insolvency is an option which should be pursued is a case by case decision requiring careful thought on the position of the company should it go into insolvency, the possible returns to unsecured creditors and the effect on employees (who may or may not be members of the pension scheme). The ECR which the trustees have obtained will assist in this decision-making process, but it should not be the sole matter on which the trustees base their decision. Legal, actuarial and potentially specific insolvency advice following the ECR should also be taken. Creditor position of the scheme on an insolvency This article does not deal with the notifications and interactions between the trustees and the Regulator or PPF, simply with the position of the scheme as a creditor of an insolvent company. Once a company becomes insolvent, an insolvency practitioner is appointed to deal with the assets and agree the liabilities. The cash arising from the realisation of the assets is then distributed in the order of priority laid down in the Insolvency Act. The pension scheme is likely to be a very substantial unsecured creditor, whose claim will be administered by the PPF. However, the order of payment of creditors, subject to there being sufficient funds under any given category, is as follows, those occurring earliest in the table being paid first: Priority of payment Fixed charge Floating charge Uncharged assets assets assets Costs and expenses Fixed charge holder Preferential creditors Floating charge holder Unsecured creditors Shareholders 5

6 Conclusion The ECR provides trustees with a review of the employer s financial and business position, including an illustration of the pension scheme s likely position if insolvency should occur. This can be used to assist in negotiations with the employer covering the ability of the business to make current or increased contributions to the pension scheme, the availability of other assets which could be transferred to or secured to the pension scheme, and the employer s ability to make one-off cash contributions. Any of these might occur as part of the on-going funding or as part of an agreed recovery plan. Should the trustees find that the employer is distressed, then the findings of the ECR will help them to negotiate on informed terms as part of the restructuring process, both with the employer and with the lenders and other key stakeholders. For members, the benefits of the trustees obtaining an ECR flow through in the strengthening of the pension scheme s funding position and the increased ability of the trustees to provide information which members can use to help themselves assess their own pension position. Samantha Bewick, Director, Restructuring, KPMG LLP (UK) The views and opinions expressed herein are those of the author and do not necessarily represent the views and opinions of KPMG LLP (UK) Opinions expressed in this publication are the personal views of the contributor(s) and should not be regarded as the official views of the PMI. Published by The Pensions Management Institute, PMI House, 4-10 Artillery Lane, London, E1 7LS. Telephone: Facsimile: enquiries@pensions-pmi.org.uk 6