New rules on moral hazard, announced in April 2008, have now been tabled as amendments to the Pensions Bill. According to the Government the new powers have been framed "so that they do not have an undue impact on legitimate business activity". As expected, the Pensions Regulator is to be given wider powers to issue contribution notices. These provisions will be supported by a code of practice to be issued by the Regulator. We summarise the new rules and consider how this might affect corporate behaviour.
INTRODUCTION TO CHANGES
The "moral hazard" powers enable the Pensions Regulator to issue contribution notices and financial support directions against those involved in defined benefit occupational pension schemes to prevent liabilities being "dumped" on the Pension Protection Fund and to protect member security. In May 2008 we issued a briefing outlining the proposed changes as originally announced.
The major changes affect contribution notices. There is a new test of "material detriment", the removal of a "lack of good faith" requirement, a revised test of reasonableness and a new code of practice from the Regulator. There are also changes in relation to bulk transfers and the test for imposing financial support directions.
Issuing a contribution notice
The Regulator will be able to issue a contribution notice where there is an act or failure to act and:
- the "material detriment" test is met; or
- the main purpose, or one of the main purposes, was to
− prevent the recovery of all or part of the statutory debt; or
− prevent the statutory debt becoming due or to compromise, settle or reduce that debt.
Previously the final limb of this required there to be a lack of good faith - this has been removed making it easier for the Regulator to impose a contribution notice.
Material detriment test
This test is met where the Regulator is of the opinion that "the act or failure to act has detrimentally affected in a material way the likelihood of the accrued scheme benefits being received".
In deciding whether an act meets the material detriment test the Regulator must have regard to matters it considers relevant, including:
- the value of the assets and liabilities of the scheme or a transferee scheme and the effect of the act or failure to act on those assets or liabilities;
- the scheme obligations of any person and the effect of the act or failure to act on those obligations;
- the extent to which any person is likely to be able to discharge any scheme obligation and the extent to which any act or failure to act might affect that; and
- other matters which may be prescribed.
There is a defence to the material detriment test where the person against whom the Regulator intends issuing a contribution notice can show each of the following:
- he gave due prior consideration (such that a reasonably diligent person would have done) to the extent to which the act or failure to act might have a materially detrimental effect on accrued scheme benefits;
- as a result, he took all reasonable steps to eliminate or minimise any potential detriment identified; and
- in all the circumstances prevailing at the time of the act or failure to act, it was reasonable for him to conclude that accrued benefits would not suffer a material detriment.
When issuing a warning notice that it intends issuing a contribution notice under the material detriment test, the Regulator must inform the recipient that this defence is available.
Before issuing a contribution notice under either limb the Regulator must be of the opinion that it is reasonable to do so having regard to:
- the extent to which it was reasonable in all the circumstances for the person to act in the way he did; and
- such other matters as the Regulator considers relevant.
Matters the Regulator should consider include:
- the degree of involvement;
- the relationship with the employer and with the scheme;
- all the purposes of the act;
- the value of any benefit received (directly or indirectly) from the employer or the scheme; and
- the likelihood of other creditors being paid and the extent to which they are likely to be paid.
Other changes include:
- a contribution notice may be issued in relation to a series of acts rather than requiring the tests to be met in relation to a single act
- where a transfer has been made from a scheme, the Regulator may issue a contribution notice in relation the transferor scheme, the transferee scheme or both.
The amendments are to be retrospective to 14 April 2008. This means the Regulator will, once the provisions come into force, be able issue contribution notices on the revised grounds in relation to acts or failures to act on or after 14 April 2008.
The majority of the provisions will come into force on Royal Assent. In the meantime, the Regulator will continue to apply the new provisions only in relation to specific sets of circumstances as announced in April 2008 (see our May 2008 briefing).
There will be a delay in the material detriment test coming into force, until the date on which the accompanying code of practice (see below) is effective. This may be quite few months after Royal Assent as the Regulator is going to consult on the draft code and it then has to be laid before Parliament for 40 sitting days. Once in force, the Regulator will be able to look back at acts and failures to act which have taken place in the previous six years, subject to a back-stop date of 14 April 2008.
FINANCIAL SUPPORT DIRECTIONS
The changes in relation to financial support directions are less dramatic. The two changes are that:
- where a transfer has been made out of a scheme, the Regulator may issue a financial support direction in relation the transferor scheme, the transferee scheme or both.
- when considering whether a company is "insufficiently resourced" the Regulator may look at the aggregate resources of the group and its associates rather than having to identity a single company.
CODE OF PRACTICE
The Regulator is to be required to issue a code of practice setting out the circumstances in which it expects to issue contribution notices as a result of the material detriment test being met. The draft wording for the code produced by the Regulator lists the following circumstances:
- the transfer of the scheme out of the UK jurisdictions
- the transfer of the employer out of the UK jurisdictions where there is a material reduction in employer support or legal and regulatory protection for members
- the severing of employer support for the scheme (this would include a substantial reduction as well as complete removal)
- the transfer of scheme liabilities to another scheme or arrangement which does not have sufficient employer support or is not sufficiently well funded
- using the scheme to create financial benefit for the employer or other person where inadequate account has been taken of the interests of the members.
The Regulator also intends issuing guidance materials on the statutory defence to the material detriment test, practical guidance on transactions which might fall under the second limb of the contribution notice test and some minor changes to the clearance guidance.
WHAT DOES THIS ALL MEAN?
We have a number of concerns about the new provisions:
- given the width of the material detriment test we would have preferred its application to be expressly restricted in the legislation - or failing that for the Regulator to bind itself with a definitive statement of when and how it will apply the test. The draft code of practice goes some way in this direction but some parties may be unwilling to take the risk that the Regulator might not in the future change its practice and revisit transactions. This would be difficult to challenge in the courts
- the code of practice and the statutory defence does not cover the main purpose test - this means that even where all parties have acted in good faith a contribution notice could be issued where a statutory debt is delayed, compromised or reduced as long as the Regulator considers it reasonable to do so
- the proposed changes, and the uncertainties they bring, are likely to push more employers into seeking clearance. This has time and cost implications as well as being likely to result in substantial mitigation having to be provided to the pension scheme trustees.
- if clearance is not sought, those dealing with a pension scheme leave themselves open to the risk of a contribution notice. The fifth head in the code of practice is very wide and not limited (as suggested in the policy announcements when the legislation was first proposed) to uninsured buy-outs and other such potentially risky innovative models