Pensions Act 2004 and Corporate Actions

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1 Pensions Act 2004 and Corporate Actions The Government passed the Pensions Act in November 2004 with the aim of protecting pension schemes. Certain provisions came into force on 6 April There has been much discussion about the impact of the Act on corporate deals. This note: describes the picture that is emerging; and highlights areas where companies and their shareholders or creditors may have to adopt a new approach, particularly in relation to corporate activity. Background The Pensions Act 2004 has to be set against a background of many defined benefit schemes having significant deficits, and some high-profile cases (for example ASW, T&N) of failing companies leaving their schemes with insufficient assets to wind up and secure members benefits in full. Even without the Act, the growth of deficits has led to pension scheme trustees viewing themselves as a significant (often the biggest) unsecured creditor of their sponsoring employer, and (where their trust powers allowed) acting accordingly. So pension scheme trustees played a significant role in some recent high profile takeover attempts, notably WHSmith and Marks & Spencer. This development is likely to continue, especially where trustees have concerns, say, that posttakeover levels of secured borrowing in their sponsoring employer will diminish their prospects of recovering funding for their deficits. The Pensions Act 2004, and The Pensions Regulator (TPR) created by it, are only likely to reinforce this trend. What new laws does the Pensions Act 2004 introduce? The Pensions Act 2004 creates a new Pension Protection Fund (PPF) to provide a minimum level of benefits for members, if their pension scheme s sponsoring employer becomes insolvent. In order to prevent dumping of schemes on the PPF, there are a number of further changes: Scheme specific funding From September this year, pension schemes will need to start funding towards a new scheme specific funding standard, which is expected to be more onerous than the Minimum Funding Requirement, or MFR, which it replaces. Employers will need to agree the appropriate employer contribution rate with their pension scheme trustees (unless the trustees can unilaterally set contribution rates under the existing scheme rules). If agreement cannot be reached the trustees may refer the matter to TPR who can impose contribution rates. Section 75 debts The liability that falls on a sponsoring employer when a pension scheme winds up, or when the sponsoring employer becomes insolvent, must (since February 2005) be calculated on the so-called buy-out basis. This is a basis where the scheme s liabilities are assessed by reference to the cost of securing them with annuity contracts purchased from insurance companies. A debt calculated on this basis is normally significantly greater than a deficit calculated on an FRS 17 basis or the scheme s ongoing funding basis. A /0.13 April 05 1

2 In addition, from later this year, when a single employer withdraws from a multi-employer pension scheme (for example on the sale of a subsidiary from out of a corporate group), it is expected that the section 75 debt triggered by its withdrawal will also be calculated on the buy-out basis, with a less onerous basis (probably the scheme s ongoing funding basis) applying only if TPR is satisfied with alternative funding arrangements put forward. Contribution notices - TPR has new powers to issue a notice to a person requiring them to contribute to a pension scheme up to the amount of the notional section 75 debt which would arise were the sponsoring employer to go into liquidation. A contribution notice may only be issued if the recipient is the sponsoring employer or is connected or associated with it (which includes directors and shadow directors) and was party to an act or omission, one of the main purposes of which was: to prevent recovery of any part of a section 75 debt which was, or might become, due; or otherwise than in good faith, to prevent a section 75 debt becoming due, compromise or settle such a debt or reduce the amount of such a debt which would otherwise become due. The act or failure must have occurred on, or after, 27 April 2004 and within the 6 years prior to TPR issuing the notice. A party to an act includes a connected or associated person who knowingly assists in it. Financial support directions - These can be issued where the sponsoring employer is either a service company or is insufficiently resourced i.e. broadly speaking, does not have enough assets to cover 50 per cent of the notional section 75 debt. The directions can require all companies in the same group as the employer to be jointly and severally liable for the employer s pension liabilities. Clearance statements TPR can issue clearance statements that a proposed course of action will not cause it to issue a contribution notice or financial support direction to the named applicants. Guidance about when TPR would expect clearance to be applied for (TPR s Guidance 1 ) indicates that seeking clearance is recommended where there is an event which is financially detrimental to the ability of a defined benefit scheme to meet its pension liabilities. So, clearance is recommended where the pension scheme has a deficit on: an FRS 17 basis; any higher basis formally adopted for funding the scheme; or a buy-out basis if there is doubt about the employer continuing as a going concern; AND there is a change in levels of security granted to creditors so that the pension scheme would receive less in an employer insolvency i.e. grants of security over more than 25% of existing group/employer assets; 1 TPR s Guidance on clearance statements is available at A /0.13 April 05 2

3 there is a reduction in the overall level of shareholders funds of a group company resulting from a return of assets to shareholders, for example, by way of dividend payments, distributions in specie or share buy-backs, in the following circumstances: (i) (ii) (iii) the shareholders are not group companies or are outside the EU or would not be subject to a financial support direction; and an employer within the group has negative distributable reserves after reflecting the deficit or after the return of capital is made; and the cumulative annual return of capital is large or unusual, i.e. is more than 2 times the average of the last 3 years returns of capital or reduces dividend cover to less than 1.25 times; or there is a change in the corporate control structure which materially weakens the employer covenant assessed by looking at changes in credit rating, or otherwise key financial ratios such as group assets vs section 75 debt, pension scheme contributions vs cash flow, interest or EBITDA. Additional guidance is likely to be forthcoming on this. Notifiable events Whether or not clearance is obtained, certain events will have to be notified to TPR by sponsoring employers or trustees. These will include matters under corporate control (for example, a decision to cease carrying on business in the UK) and external events (for example, a change in credit rating). It is anticipated that the majority of the scenarios where TPR s Guidance suggests clearance should be sought will be included as notifiable events under future amendments to the legislation. When is clearance required? TPR s approach is to recommend prior clearance for proposals which could seriously prejudice the pension scheme s ability, as an unsecured creditor, to recover funding. In granting clearance, it seems it will consider whether the scheme s position has been protected and its trustees are content for the proposal to proceed for example because they have received additional contributions or security. If clearance is not applied for, TPR should (under future regulations) receive information about what has happened through the notifiable events framework. What are the risks if a transaction proceeds without clearance? There is no direct sanction for failing to seek clearance in accordance with TPR s Guidance. However, if TPR is informed of the occurrence of a notifiable event for which clearance is recommended but has not been sought, TPR is likely to raise questions, including whether the pension scheme trustees were notified in advance of the transaction and whether any concerns they may have had were resolved to their satisfaction. TPR s Guidance implies that the trustees attitude to any proposal will be treated as significant by TPR when it decides whether or not to give clearance. If the trustees were not satisfied (or even involved), TPR might issue a contribution notice or a financial support direction. However, it will not always be easy for TPR to show the circumstances allow it to issue a contribution notice it may be unable to point to an act or omission having as a main purpose the avoidance of a Section 75 debt, for example, or to establish a lack of good faith. This might well be the case where directors have taken advice to satisfy themselves beforehand A /0.13 April 05 3

4 that the transaction will not impact on the corporate group s ability to meet its obligations, including to the pension scheme. Similarly, financial support directions may not have much bite in some circumstances, where the corporate group will be no worse off by having joint and several liability for pension liabilities imposed on it. In addition, TPR can only issue financial support directions and contribution notices where it considers it is reasonable to do so. Matters it must take into account in deciding whether it is reasonable include the degree of connection between the intended recipient and employer in the pension scheme and the intended recipient s financial circumstances. Again this may restrict the circumstances when these directions and notices will be used. Perhaps there would be more of a concern if TPR sought to influence the pension scheme trustees about the proper rate of ongoing employer contributions to meet the scheme specific funding standard. It is possible to envisage scenarios where TPR might even remove particular trustees and make its own appointments to this end. So depending on the line TPR takes, having a robust funding strategy for the pension scheme may become key to smoothing the way for corporate activity. Application to some specific corporate actions Corporate reorganisations Companies will need to be aware that it will not be possible to isolate pension scheme liabilities in one part of the group, because the TPR may impose financial support directions, including joint and several liability for those liabilities on the whole group. Where restructurings involve a change in control in relation to the scheme s sponsoring employer, it may also be appropriate: to check whether the reorganisation is structured in such a way that TPR recommends seeking clearance; and, if so to involve scheme trustees in the process, structure the reorganisation so that they are comfortable with it and, possibly, seek clearance with their backing. Subsidiary sales/acquisitions Companies buying or disposing of subsidiaries will now need to consider the following: how to allocate the cost burden of section 75 debts arising when a single employer withdraws from a multi-employer pension scheme; whether the burden can be alleviated in any permitted way (for example by a transfer of accrued liabilities from a Seller s pension scheme to the Buyer s pension scheme); and whether particular features of the transaction structure give rise to any risks of contribution notices/financial support directions so that a different structure/clearance would be preferable. This last point will apply to business sales/acquisitions too. Takeovers Companies will have to assess whether these are within recommended clearance scenarios and even where clearance is not sought, think about structuring these - where possible - so that pension scheme trustees would be willing to support a clearance application if one were made. In essence, this means taking account of the trustees concerns as an unsecured creditor and the trustees powers which include deciding scheme investment strategy and, from September, a A /0.13 April 05 4

5 significant role in setting employer contributions so as to ensure unexpected pension scheme liabilities are not going to arise post-takeover. Private equity deals There has been much concern in the private equity industry that the new Pensions Act may lead to investee companies and investors being required to contribute towards a deficit in a defined benefit pension scheme of an investee company. TPR s Guidance suggests that a clearance statement should be obtained if, in the context of private equity transactions: the target being acquired has a defined benefit pension scheme; the scheme is in deficit on an FRS 17 or other relevant basis; and security will be put in place over more than 25% of the group/target s assets (likely in most private equity buyouts which tend to be highly leveraged) or there will be a change of group ownership which negatively affects its credit rating (likely where so much new debt is being put in place). TPR s Guidance specifically suggests that in this scenario, pension scheme trustees might consider seeking the grant of security for the pension scheme deficit. Pensions advice should be sought in these circumstances, even if only the first two bullet points are present, as notification issues may still arise. It may also be worth seeking clearance on exit disposals, to ensure that a disposal releases investors from all potential liabilities, as otherwise TPR can look back 9 months in considering a financial support direction. Restructuring These are likely to become more difficult. Any company insolvency (including administration) potentially makes the pension scheme eligible for the PPF and will probably lead to TPR appointing an independent trustee for the scheme. The Board of the PPF, rather than the scheme trustee, will be the only entity able to compromise section 75 debts in relation to the scheme. Few steps affecting the scheme will be able to be taken without its (or TPR s) acquiescence. Even in a restructuring involving no company insolvency, great care will need to be taken to ensure that any steps to control/minimise risk from the pension scheme deficit are not likely to be undermined by the issue of contribution notices or financial support directions. Reductions in capital Again, companies will need to consider whether there is any value in seeking clearance before making a reduction and, if so, what steps are likely to be required to ensure their pension scheme trustees will support the application. Except in the case of unlimited liability companies, reductions of capital including those which involve a return of capital to shareholders or which create distributable reserves which are then to be used to pay large or unusual dividends require Court approval. Reductions of capital may also be a component in a scheme of arrangement to give effect to a larger transaction such as a demerger. It is the practice of the Court in the sort of reductions in which it may be appropriate to seek clearance from TPR to require that protections are put in place so that all relevant creditors at the date of the reduction are not adversely affected. So that the Court can determine the appropriate level of protection, it is incumbent upon the company to disclose all material facts when it seeks the Court s approval. It may now therefore be necessary in cases where TPR recommends that A /0.13 April 05 5

6 clearance be sought to explain the position under the Pensions Act and any relevant claims which the trustees may have. The Court may be reluctant to approve a reduction where clearance has not been obtained in accordance with TPR s Guidance. Share buy-backs/payment of dividends Companies seeking to re-purchase shares (approval for which is now commonly sought at all AGMs) or pay dividends may find that clearance is recommended if these actions could have a serious adverse effect on the ability of the company s pension scheme to meet its liabilities. Summary The introduction of the Pensions Act 2004 means pension issues will need to be considered in a much wider range of corporate transactions and at an early strategic planning stage. Companies will generally have to take account of the likely attitude of their pension scheme trustees to any proposal and, where relevant, factor into timetables the need to seek clearance from the regulator. If you would like any further information, or to discuss any of the issues arising from this note, please contact Philip Heyes (Corporate) or Rosalind Knowles (Pensions), or any of your usual contacts at Linklaters. Contact details: Philip Heyes philip.heyes@linklaters.com Rosalind Knowles rosalind.knowles@linklaters.com This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts at Linklaters. Linklaters. All Rights Reserved 2005 Please refer to for important information on the regulatory position of the firm. We currently hold your contact details, which we use to send you special reports such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this special report or other marketing communications, please let us know by ing us at marketing.database@linklaters.com A /0.13 April 05 6