The Court of Appeal has upheld the decision of the High Court in the matters of Nortel GMBH and Lehman Brothers International (Europe) (both in administration) and other companies.  The High Court had decided that liability under a Contribution Notice issued by the Pensions Regulator against a company in administration or liquidation, in relation to liabilities of a defined benefit pension scheme[1], is an expense[2] of that insolvency process.  Accordingly, the Court of Appeal has confirmed the further extension of the type of expenses that may be considered to have the priority given to an expense of an insolvency process. 

This decision will be of enormous concern to office holders who may find themselves with insufficient funds available, after payment of Contribution Notice liabilities, to fund their own remuneration and to floating charge holders and unsecured creditors who will find the funds available to them to satisfy their claims depleted by the prior satisfaction Contribution Notice obligations.

The liability in question arises out of the provisions of the Pensions Act 2004.  The Act gave the Pensions Regulator (tPR) the power to impose a Financial Support Direction (FSD) upon a company connected and associated[3] with an employer of a defined benefit pension scheme[4].  This power was given to tPR, in particular, to assist the members of an underfunded pension scheme where the employer is a company with no or few assets but is within a group of companies that have assets that the employer has no direct recourse to where the “rich” group companies benefit from the activities of the “poor” employer.  Service companies are specifically referred to in the Act as falling within the reach of tPR but any employer within a group may have the characteristics (of being “insufficiently resourced”) that may expose the rest of the group to becoming a target for tPR’s use of these “moral hazard” powers. 

Companies within the relevant group can be required, by tPR, to provide support to the pension scheme by issuing an FSD against them.  tPR does not specify the support required but this may, for example, be in the form of a guarantee and/or security. If the recipient of an FSD fails to provide support to the pension scheme, then tPR can issue a notice requiring payment of a sum up to the full amount of the pension scheme liability.  This notice is a Contribution Notice.

In the case of Lehman Brothers the liability to the scheme is £125 million.  In Nortel it is £2.1 billion.  An FSD has not yet been issued by tPR in relation to most of the parties to the appeal but Warning Notices setting out tPR’s intention to do so are currently the subject of an appeal to the Upper Tribunal (Tax and Chancery Chamber).

In an administration or liquidation assets are realised and distributed to creditors in an order prescribed by the Insolvency Rules 1986.  Expenses of the insolvency process have priority over other creditors save for those with fixed charges. 

The payment obligation imposed by a Contribution Notice is not stated, in the Pensions Act 2004 nor in insolvency legislation, to be a debt provable in an insolvency process.  The question for the Court was as to whether the obligation is nevertheless provable and, therefore, an unsecured claim or should be treated as an expense of an insolvency process or fall into a “black hole” only being paid in the highly unlikely event that funds are available after payment of expenses, charge holders and unsecured creditors.

A provable debt is one which a company is subject to at the date of liquidation or may become subject to pursuant to an obligation arising before that date[5]. 

The types of payments becoming due, in the course of an administration, that are treated as expenses has been clarified and some would say extended through case law, from Toshoku[6] in 2002 to Goldacre (Offices) Ltd –v- Nortel Networks UK Ltd[7] in 2009. In the latter case it was decided that rent obligations of a company, although obligations of the company subject to lease entered into prior to its administration, would be an expense of an administration if they fell due during the process and whilst the administrators were deemed to be using the premises for the purpose of the administration.

Before the High Court, it had been determined that, in certain situations, a Contribution Notice would be provable in an insolvency process.  This would be the case where an FSD was issued in an administration of a company and a Contribution Notice followed after the company had moved from administration into liquidation or if the Contribution Notice followed the FSD and the company then moved into liquidation.  The Contribution Notice would arise in the liquidation from a pre-existing obligation and was therefore a provable debt in the liquidation but not the administration.  This was not the subject of the appeal.

The appeal was around the issue of categorising the Contribution Notice liability where liquidation does not follow the administration or liquidation does follow but the FSD and Contribution Notice are issued in the liquidation and not the prior administration.  The High Court held that the Contribution Notice would, in these circumstances, be treated as an expense giving the obligation under it “super priority”.  In the appeal the Nortel administrators argued that the liability was a provable debt.  The Lehman administrators argued that it fell into a black hole.

The High Court and the Court of Appeal considered whether the fact that an FSD may arise from circumstances that exist prior to any insolvency process meant that the resulting Contribution Notice was a contingent claim in existence at the time of the insolvency, rendering it a provable debt.  Both Courts found that it did not.  It was considered that there was insufficient certainty that tPR would use its discretionary powers to render a company liable for an obligation to a pension scheme that, up until its powers were invoked, only the employer company could have been liable for.  The Court of Appeal did not consider whether the obligation could have arisen earlier than upon the issue of an FSD, for example, at the time that tPR’s Determinations Panel determines that the FSD should be issued or upon the earlier issue of a Warning Notice.

Having decided that a Contribution Notice did not, when issued against a company in administration or liquidation, create a provable debt in that process, the Court was left with a choice of either deciding that the obligation created had super-priority and therefore greater priority than the scheme debt held as against the employer or was neither a debt nor an expense and therefore had lower priority than the scheme debt held.  Neither the High Court nor the Court of Appeal considered either conclusion to be satisfactory, particularly when comparing the purpose of an FSD and Contribution Notice i.e. protecting scheme members, against the competing interests of unsecured creditors. 

Both Courts considered that the position as decided in Toshoku was to be applied to the circumstances before them.  In Toshoku the Court found that tax liabilities imposed by statute were  an expense of an insolvency process where the relevant statute specifically intended and provided that the obligation would be imposed upon a company in insolvency.  In Nortel and Lehman it was acknowledged that the Pensions Act 2004 did no such thing and left it to insolvency law to determine the priority of a Contribution Notice.  However, it was considered to be highly likely that that the regime would be used in the case of an insolvent employer and a real risk that other potential targets in the group would also be insolvent at the time that tPR came to use its powers.  For that reason the obligations of a company under a Contribution Notice imposed upon it whilst in an insolvency process is an expense of that process.

Office holders of group companies in the same situation will need to consider applying to the Court for an order varying the order of priority of expenses or face difficult decisions as to how to progress an insolvency where office holder remuneration and expenses may not be paid.  It was acknowledged by the High Court that, unless the order in which expenses are to be discharged is varied by the Court, the decision in this case could deal a crippling blow to the rescue culture in cases where defined benefit pension schemes are involved.

Financiers will need to factor into lending decisions the possibility of substantial liabilities, not shown on a company’s balance sheet that would, if they arose, have priority over lending secured by a floating charge and all unsecured lending.

The main beneficiary of this decision is likely to be the Pension Protection Fund (PPF), the government’s lifeboat for pension funds which would otherwise foot the bill for underfunded schemes with an insolvent employer.   It is expected that the decision will be appealed to the Supreme Court.  Various sector groups will continue to lobby for a change to pensions and/or insolvency legislation.  The government will have a difficult policy decision to make, supporting business and the rescue culture or pension scheme members and the PPF.  For now, its pension schemes 1 – business and rescue culture 0.