The Supreme Court has ruled that Financial Support Directions issued by the Pensions Regulator against insolvent companies can be claimed as provable debts in the insolvency process. The previous decisions of the High Court and Court of Appeal that they were to be paid as insolvency expenses have been overruled.

The decision was handed down in the Court’s judgment on the latest appeal in the long-running Nortel and Lehman saga, which arose out of a grey area in the elaborate statutory system for the funding of defined benefit pension schemes.

The background

When a company becomes insolvent, the primary means of extracting funding to secure the liabilities of its pension scheme is the “Section 75 debt”. This is a statutory debt equal to the current deficit in the scheme, as assessed on a conservative basis by valuing the liabilities against the cost of insurance company annuities. It can be recovered like any other provable debt in the insolvency process, and (like other debts) it will almost inevitably end up being scaled back.

The Section 75 debt falls purely on the scheme’s sponsoring employer. Generally speaking, the corporate veil and limited liability will prevent other group companies from being made liable to fund the scheme in an insolvency situation. However, there are some exceptions to this. In particular, the Pensions Regulator can issue a Financial Support Direction (FSD) against a company which is connected or associated with the sponsoring employer if the sponsoring employer is a service company or is otherwise “insufficiently resourced”. This is designed to stop corporate groups from attaching the group pension scheme to an entity which is a man of straw, while keeping assets in other parts of the group. An FSD requires the target company to put specified financial support in place for the scheme. If it fails to do so, the Regulator can require it to pay a specified sum of money to the scheme by means of a Contribution Notice (CN).

The litigation

The litigation arose out of the collapse of the Nortel and Lehman corporate groups. In each case, the Regulator has sought to issue FSDs against numerous group companies which had not participated in the Nortel or Lehman pension schemes. The FSD issuance process has not yet been completed, but legal proceedings were brought in order to determine one crucial preliminary issue – and it is these proceedings which have now finally been determined by the Supreme Court. The question at issue was how, in an insolvency situation, the liabilities imposed by an FSD ought to be dealt with. There were essentially three possible answers:

  1. FSD liabilities count as provable debts, just like a Section 75 debt and the ordinary trading debts of the company
  2. FSD liabilities count as expenses of the insolvency. This would mean that they have priority over all provable debts and other classes of liabilities, except for secured liabilities
  3. FSD liabilities count as neither of the above, and would be effectively irrecoverable in an insolvency situation  

The High Court and the Court of Appeal both arrived at answer 2 - FSD liabilities rank as expenses of the insolvency. This was largely because they felt bound to follow a previous House of Lords decision. The Supreme Court, however, disagreed and arrived at answer 1 - FSD liabilities rank as provable debts.  

The Court’s leading judgment was delivered by Lord Neuberger, who observed that the “sensible and fair answer” was that an FSD should generate a provable debt analogous to a Section 75 debt. In order to be a provable debt, it was necessary that the FSD liability should result from an “obligation incurred” before the onset of insolvency. Lord Neuberger found that the Nortel and Lehman group companies had “incurred” an FSD “obligation” by virtue of satisfying the statutory criteria for the issuance of FSDs before the onset of insolvency, even though no formal process had been set in train at that point for imposing FSDs. He said:  

“....[O]n the date they went into administration, each of the Target companies had become a member of a group of companies.... Membership of a group of companies is undoubtedly a significant relationship in terms of law: it carries with it many legal rights and obligations in revenue, company and common law.

....[B]y the date they went into administration, the group concerned included either a service company with a pension scheme, or an insufficiently resourced company with a pension scheme…. Accordingly, the Target companies were precisely the type of entities who were intended to be rendered liable under the FSD regime…. [T]he Target companies were not in the sunlight, free of the FSD regime, but were well inside the penumbra of the regime, even though they were not in the full shadow of the receipt of a FSD, let alone in the darkness of the receipt of a CN.”

The courts below had been influenced by the decision of the House of Lords in In re Toshoku Finance UK plc [2002] 1 WLR 671. This case had been taken to be authority for the notion that liabilities imposed by statute - like FSDs - automatically rank as expenses of an insolvency. However, Lord Neuberger rejected this notion. He held that, in order to count as an expense, a liability had to have been incurred directly in connection with the insolvency process itself. This could include statutory liabilities, but only where the relevant statute’s “terms render it clear that the liability to make the disbursement falls on an administrator as part of the administration”. This was not the case with FSDs.

Clyde & Co Comment

The Supreme Court’s ruling brings to an end three years of uncertainty which had potentially serious implications for the UK’s insolvency industry and “rescue culture”. If FSDs were an expense, they would rank ahead of insolvency practitioners’ fees, and there was a fear that IPs might decline appointments in cases involving a defined benefit pension scheme.

It is difficult to deny that classing FSD liabilities as provable debts feels like broadly the fairest and most equitable solution: it is how Section 75 debts are treated (and the Section 75 legislation expressly deals with this point). Classing them as insolvency expenses was anomalous, and it seems that the courts had previously arrived at this solution only because they considered themselves bound to do so by a precedent from the House of Lords, and wished to avoid the unpalatable conclusion that they were otherwise irrecoverable. It took the Supreme Court to cut this Gordian knot.