The Pensions Regulator introduced the clearance procedure in April 2005. It allows the regulator to confirm whether or not a particular event, action or situation will lead it to use its anti-avoidance powers.
The regulator has reviewed how clearance has operated in practice. As a result it has decided to publish revised clearance guidance. Consultation on the guidance closes on 2 November 2007. This briefing note considers the draft guidance.
The anti-avoidance regime and clearance: a quick reminder
The Pensions Act 2004 gave the regulator the power to issue contribution notices (CNs) and financial support directions (FSDs). CNs and FSDs are the anti-avoidance provisions. The regulator may issue a CN which requires an amount up to and including the employer debt due from an employer to be paid to the scheme, where the regulator considers that the main purpose (or one of the main purposes) of the act or failure to act was:
- To prevent the recovery of the whole or part of the employer debt which was, or might become, due from the employer in relation to the scheme, or;
- Otherwise than in good faith, to prevent an employer debt becoming due, or to compromise, reduce or otherwise settle such a debt.
The regulator may issue an FSD to an entity connected or associated with an employer which is either a service company or insufficiently resourced and which participates in an underfunded defined benefit pension scheme. An FSD compels the recipient to put in place financial support (approved by the regulator) for the employer’s obligations where the recipient has sufficient resource in its own right to ‘plug the gap in funding’.
Clearance is the (voluntary) process by which the regulator confirms that, based on the information provided, the regulator will not issue a CN or an FSD in respect of a certain event, for example a corporate transaction. A clearance statement only binds the regulator in relation to the circumstances set out in the application.
Why is the regulator consulting on revised guidance?
The regulator is revising the clearance guidance to take into account its experience of running the procedure over the past two years as well as significant developments in the marketplace, including the way the market has increasingly considered the scheme as a creditor and the impact of FRS17.
Who should seek clearance?
The draft guidance states that clearance is voluntary. However, the regulator expects employers (including those connected and associated with the scheme employer), parties who may become the employer, or become connected or associated with the employer, should apply for clearance.
Trustees should not apply for clearance themselves but they should be involved in the application process. However, they should seek to identify at an early stage any material risks to members’ benefits. The trustees should establish procedures to identify and measure these risks and take appropriate action.
When should clearance be sought?
Clearance should be sought in relation to events which are materially detrimental to the scheme’s ability to meet its pension liabilities (type A event). All type A events will have one or more of the following effects either immediately or in the future:
- Prevent recovery of the whole or part of the employer debt.
- Prevent the employer debt becoming due, compromise or settle the debt.
- Reduce the amount of the employer debt which would otherwise become due.
- Weaken the employer covenant because:
- It has an impact on the employer’s ability to meet its ongoing scheme funding commitments, or has an impact on those commitments.
- It reduces the dividend that would be available to the scheme on employer insolvency.
There are employer-related events and scheme-related events. An employer-related event will only be a type A event if the scheme has a relevant deficit (see below). A scheme-related event may be a type A event, whether or not the scheme has a relevant deficit.
How should detriment be identified
Employers and trustees should have systems in place to ensure that trustees have:
- Appropriate information to have a present and ongoing understanding of the employer’s covenant.
- An early indication of possible detrimental events.
- Information to enable them to understand the impact of any detrimental event on the scheme.
Examples of employer-related events
The draft guidance gives examples of events which could be type A events including:
- Change in the level of security given to creditors.
- Reduction in overall assets of employer or wider employer groups.
- Change to group structure, including a change of control.
- Change to employer in relation to the scheme.
- Sale and leaseback transactions.
- Granting or repayment of inter-company loans especially where the loan is not arm’s length, is not properly documented or where there is a credit risk.
- Phoenix events where the employer re-emerges as substantially the same entity following an insolvency event.
How are employer-related events assessed?
Trustees and employers need to reach a decision whether an employer-related event is a type A event. To do this they need to:
- Compare the pre and post event employer covenant.
- Assess whether any covenant weakening is materially detrimental to the scheme’s ability to meet its liabilities.
- Identify if the scheme has a relevant deficit.
The draft guidance makes it clear that the trustees need to identify all the employers in relation to the scheme, their legal obligations to the scheme, as well as their legal relationship within the wider group. In addition, the draft states that the trustees should consider the covenant of the employer’s wider group.
How should weakening of employer covenant be assessed?
To assess whether an event weakens the employer covenant, it is necessary to consider where the pension creditor sits on insolvency and then consider the impact of the event. An event may also be detrimental because of its impact on the employer’s ability to meet its ongoing scheme funding obligations.
Once the trustees and employer have decided that a weakening of the covenant has occurred, they need to decide whether or not the weakening is materially detrimental to the scheme’s ability to meet its liabilities. Factors which may point to material detriment include the amount the covenant has weakened, the size of the employer/scheme after the event and the amount of the scheme’s relevant deficit.
What is the relevant deficit?
An employer-related event will only be a type A event where the scheme has a relevant deficit.
The relevant deficit will usually be the highest deficit on the following bases:
- PPF section 179 basis for calculating the risk-based pension protection levy.
- Scheme funding requirement (or ongoing where scheme funding is not available).
Exceptions to the above are as follows:
- The relevant deficit may be measured on a higher basis, reflecting the impact of an event identified by trustees and employers, where the employer-related event is significantly detrimental to the scheme’s ability to meet its liabilities (including where there is a significant weakening of the covenant).
- The buy-out basis may be used where there are ongoing concern issues, the scheme is in wind-up or there is scheme abandonment.
Draft guidance: what are scheme-related events?
The draft guidance gives examples of scheme-related events which could be type A events including:
- Agreements to compromise an employer debt: this will always be a type A event regardless of the scheme’s deficit before or after the compromise.
- Apportionment of employer debts pursuant to scheme apportionment rules. This will be a type A event unless, for example, it increases the debt payable by an employer who can afford to pay, it is the practical alternative because of the cost and complexity of the alternatives or there is no net reduction in the covenant.
- Non-payment of employer debts for an unreasonable period.
- Arrangement which prevents an employer debt being triggered.
Draft guidance: how are scheme-related events assessed?
The method for assessing whether a scheme-related event is a type A event will vary depending on the specific event. Trustees should always consider an event in terms of both its immediate impact on the scheme and members’ benefits and the possible impact of the event into the future.
What should happen where there is a type A event?
Where a type A event has been identified, the employer and the trustees should negotiate the most appropriate mitigation to eliminate the detriment to the scheme caused by the event. In doing this, the security which currently exists for the scheme, both from the employer and from parents and connected and associated parties should be taken into account.
The appropriate mitigation should be identified for each type A event. The draft guidance gives some examples of different types of mitigation including:
- Additional contributions of cash or other assets.
- Improvement in priority for the pension creditor.
- Escrow accounts to ensure additional funds are paid to the scheme under certain conditions.
- Standby letters of credit, guarantees or insurance to cover scheme contributions or employer debt.
- Parental or intra-group guarantees.
- Employer financial thresholds to be reported to the trustees if they are breached.
Trustees and type A events
Many of the issues relating to type A events (and whether an event is a type A event) are complicated. The draft guidance steers trustees to carefully consider taking appropriate professional advice. In addition, regardless of whether parties wish to apply for clearance, trustees should enter into negotiations in relation to a type A event. Throughout negotiations, trustees and employers must be aware of the need to maintain confidentiality, and ensure that conflicts of interest are identified and managed appropriately.
Draft guidance: clearance applications
The draft guidance sets out how clearance should be applied for. It makes clear that while it is possible to have a retrospective clearance application this is not encouraged because the trustees’ ability to negotiate effective mitigation may be restricted.
The draft guidance is radically different and much less black and white than the 2005 guidance. The 2005 guidance was rather divorced from the anti-avoidance requirements with the result that market practice swung from always seeking clearance in relevant cases, to not seeking clearance where the parties were satisfied that some scheme mitigation was in place. In contrast, the draft guidance seems to be specifically designed to tie the clearance requirements in to those of the anti-avoidance provisions. We welcome this development.
Not long after the clearance guidance was originally introduced the regulator indicated that it would publish case studies to illustrate how clearance operated in practice. While these case studies have never been published, it is interesting to see how close the draft guidance comes to doing just that. It is likely that the regulator’s past clearance experience has led both to the list of employer-related events and the practical guidance given to trustees to help them assess the employer’s financial position, in particular where the employer is part of a complex corporate group. Again, we welcome this development.
Unlike the 2005 guidance, the draft guidance provides a much stronger push to clearance in appropriate cases. We consider that this is because of the market’s attitude to clearance since its introduction. When clearance was first introduced it was market practice for clearance to be sought in all relevant circumstances. However, as time went on and there was more awareness of the regulator’s attitudes and the level of mitigation it wanted, parties became more bullish about not seeking clearance. It will be interesting to see whether or not the draft guidance will herald a change in market practice.