The High Court has found that IBM UK Holdings Limited, the Principal Employer of two IBM defined benefit pension plans (the "Plans"), breached its duty of good faith to members of those pension plans. The case relates to proposed changes to the Plans that involved closing them to further accrual and freezing increases to pensionable pay for a limited period. The High Court found that these changes "confounded" the "reasonable expectations" of members that their benefit accrual in the Plans would continue into the future, except where there was a change in financial economic circumstances of the business. These reasonable expectations had been created by communications made by IBM to members directly and via the Plan trustees during the course of two previous successive changes made to members' pension arrangements. The Court also found that IBM had breached its good faith duty to employees over the way in which it had consulted with the employees in relation to the proposed changes to their pension arrangements. We understand that IBM intends to appeal.
This case is a timely reminder of the need to be careful, when communicating with members, that promises are not inadvertently made or expectations created which can cause problems in the future. Many pension schemes implement risk and cost reduction measures which are billed as an alternative to closure; this case might make employers reconsider that approach.
IBM UK Holdings Limited ("IBM") was the principal employer of the IBM Pension Plan (the "Main Plan") and the IBM IT Solutions Pension Scheme (the "I Plan"), a defined benefit (DB) scheme set up to accommodate employees transferred in following various outsourcing arrangements and corporate acquisitions).
The Main Plan had four DB sections (which were closed to new joiners), a defined contribution (DC) section called the "M Plan", and a further DC section, the "Enhanced M Plan".
In 2009, a package of changes to the DB sections of the Main Plan and the I Plan (known internally within IBM as Project Waltz) were announced to members. The trustee of the Plans was reluctant to implement these changes, citing two key concerns:
- The validity and scope of the unilateral power under the Main Plan which IBM sought to use to close the Plan to future accrual;
- The question of whether the Project Waltz changes were a breach of the implied duty of good faith to employees.
IBM applied to the court for declaratory relief in relation to the proposed changes. It is nominally the Claimant in the case and the trustees and representative beneficiaries are the Defendants.
The "Project Waltz" changes
The Project Waltz changes had the following key elements:
- The DB sections of the Main Plan (apart from in relation to certain chosen employees) and the I Plan would be closed to future benefit accrual from 6 April 2011.
- While salary linkage on past service benefits would nominally continue, DB members would be offered changes to their contractual terms by which future pay increases would not be pensionable for DB purposes, pursuant to the principle in South West Trains v Wightman. Under this principle, broadly, employers are able to implement changes to employees' pension arrangements via contractual agreement with the members even when that would not be possible under the pension scheme rules. In this case, the freezing of pensionable pay is called the "2009 Non Pensionability Agreements".
- Any member who did not agree to the change would receive no salary increases in future. Following opposition from members, this proposal was modified so that any dissenting member would receive no salary increases only during the period 2009 to 2011, after which the position would be reviewed.
- An "early-retirement window" would be opened in November and December 2009 under which active defined benefit members in the Main Plan who would be aged 50 or over by 5 April 2010 could apply to take early retirement with IBM's consent. If consent was granted, these members would be able to take early retirement on the favourable terms that had applied until then.
- A new early retirement policy would be introduced from 6 April 2010 under which IBM would not consent to early retirement on the favourable terms, apart from in exceptional circumstances such as ill-health. Instead, early retirement would be granted on "cost neutral" terms.
- M Plan membership would be made available to former active members of the DB Plans from 6 April 2011.
Warren J looked at each of these proposals in turn.
Closing the DB sections of the Main and I Plans
The Main Plan had been governed by a trust deed and rules dated 14 December 1983 (the "1983 Deed and Rules"), which were later replaced by a definitive deed and rules dated 1 October 1990 (the "1990 Deed and Rules").
The 1990 Deed and Rules contained a power (the "Exclusion Power") allowing the Principal Employer by notice in writing to the trustees "to direct that a person or class of person shall cease to be eligible for membership of the Plan".
IBM sought to use this power to close the DB sections of the Main Plan to future accrual. A number of issues were raised by the Defendants in relation to the power itself and its purported exercise:
- Warren J held that the power was validly introduced into the 1990 Deed and Rules.
- However, given that the power did not exist in the 1983 Deed and Rules, he held that the power was subject to the restrictions in the scheme's power of amendment.
- As a result, while the Exclusion Power could be used to close the scheme to future accrual, the amendment power required that salary linkage must be maintained.
The good faith duty in the employment and pensions context
An employer's duty of good faith (of mutual trust and confidence) exists both in the employment context (where it arises by virtue of an implied term in the contract of employment) and, separately, in the pensions context.
The duty in the pension context (which Warren J called "the Imperial duty", the duty having first been recognised in the pensions context in the case of Imperial Group Pensions Trusts Ltd v Imperial Tobacco Ltd  1 WLR 589) was relevant to the purported exercise of the Exclusion Powers and the withdrawal of the favourable early retirement terms. The duty in the employment context was relevant in relation to the changes to the contractual terms with respect to future pensionable pay increases.
Warren J stated that the duty in both contexts could broadly be expressed in the same language, as follows:
"An employer should not without reasonable and proper cause conduct himself in a manner calculated or likely to destroy or seriously damage the relationship of trust and confidence between the employer and employee."
However, he said that the two concepts should not be elided; the actual "content" of the duty in the employment law context and the pension law context may differ and the employment law principles and cases could not "blindly" be applied to the Imperial duty.
The Imperial duty – a closer look
Warren J made the following points specifically in relation to the Imperial duty:
- The Imperial duty arises where the employer has an otherwise unfettered power. Its scope in any case is subject to the nature of the power, the terms on which employees became members of the scheme and the provisions of the trust deed and rules.
- The exercise of a discretionary power such as the Exclusion Powers, requires "a genuine and rational" as opposed to an "empty or irrational" exercise of the discretion.
- The test is not that of "fairness".
- The test is, however, a severe one - the employer's conduct must be so irrational or perverse that no reasonable employer would have acted in such a way, such that it destroys the relationship of trust and confidence.
- The test is objective.
- The employer can take into account its financial and other interests when exercising the power, subject to the "reasonable expectations" of members. In certain circumstances, it may be irrational or perverse for the employer to give precedence to its own financial interests rather than to the reasonable expectations of members; in other cases (for example radically changed financial or economic conditions of the employer) it may be entirely reasonable, on any view, to depart from those expectations.
Warren J said that the effect of a breach of the duty may be to render the actions of the employer either invalid or partially invalid.
The question which therefore arose was whether the members had Reasonable Expectations that IBM would follow a particular course of conduct and, if so, what those were. Warren J noted that:
- Reasonable Expectations have to have been engendered by the employer.
- They can arise as a result of direct communications from the employer or via communications made by the employer to the trustees and then passed on by the trustees to the members.
- A promise or guarantee could clearly create a Reasonable Expectation. However, an employer's statement of intention could also do so, though the most that members could expect from statements of intent is that the employer will not change its intention without some rational ground to do so.
The Defendants' arguments
The Defendants' asked the court whether the changes proposed under Project Waltz were contrary to the Reasonable Expectations of the members created during communications made to them in the past when the pension benefits had been changed (under so-called Projects Ocean and Soto); and whether there was any justification for IBM's acting contrary to those expectations.
Warren J. noted that the Defendants would have to show that the Project Waltz changes confounded these reasonable expectations so as to destroy or seriously damage the relationship of trust and confidence between IBM and the members.
Projects 'Ocean' and 'Soto'
The Ocean changes in late 2004/2005 principally involved changes to the employee contribution rates.
The Soto changes in late 2005/2006 involved the DB members being given an option to either
- remain within the DB Plans, subject to agreeing that future salary increases would be capped such that only two thirds of any future salary increases would be pensionable; or
- transfer to the DC section of the Main Plan but retain full final salary linkage to their accrued DB benefits. This was coupled with a funding agreement under which IBM would inject a cash lump sum into the DB Plans to extinguish the funding deficit. Members were invited to make an election by June 2006.
The internal communications with members in relation to these projects consisted of webcasts, Q&As, presentations and letters. Analysing these communications over 100 pages of the judgment, Warren J concluded that they could lead to a hypothetical reasonable member to have Reasonable Expectations that:
- benefit accrual (in accordance with the Soto changes) would continue into the future but that a change in financial and economic circumstances (including trading and competitiveness) might cause IBM to make further changes to the Plans and that to do so might be a decision which IBM could reasonably take;
- In relation to past service, up to the time of the implementation of the Ocean proposals, an expectation that a member would be able to take advantage of IBM's then current early retirement policy until 2014 unless there was a relevant justification for a change in policy.
In reaching this conclusion, Warren J cited the use of words such as "sustainability" and a "commitment to sustainability" and putting the plan on a "firm footing for the future" in the context of the explanations given to members as to the impact of the proposed changes on the Plan during the Ocean and Soto changes. Referring to a letter written by the chairman of the Trustee board to members dated January 2006, Warren J noted that
"The reference to “long term” and “no plans for future change” are however stronger than the statements made in relation to Ocean. A reasonable member reading those words in isolation would, in my view, be entitled to form a Reasonable Expectation that, in the long term (whatever that may mean) there would be no changes absent a significant change in economic and financial circumstances."
Was there a breach of the implied duty?
The changes as a whole
Having established the Reasonable Expectations (as above), Warren J held that the Waltz changes as a whole were so severe so as to amount to a perverse and irrational conduct resulting in a breach by IBM of its Imperial duty and its contractual duty of trust and confidence. The statements made to members and the communications during Soto and Ocean were intended to be, and were, acted upon by the members in making the choices which they did.
Warren J did not agree with IBM's justification that, even if members did have Reasonable Expectations, the changes were justified by IBM’s business interests including targets imposed on IBM UK by its US parent. He found that the changes were largely driven by the US parent company whose aim was (he found) to minimise its pensions accounting costs, and to maintain its Earnings per Share ("EPS") targets for shareholders. He held that IBM's justification that it was acting on the instructions of its parent company was not of itself a justification for acting contrary to members’ reasonable expectations. It was necessary to examine the parent company’s reasons - the changes would not have been necessary unless IBM had not been using 'pension profits' to help meet the EPS targets. These EPS targets had been set at a time when IBM’s statement had given rise to the Reasonable Expectations. The US parent had not developed proposals to meet these targets in such a way so as to give effect to members' Reasonable Expectations.
To the extent IBM's actions were driven by a freestanding desire to make "‘ordinary’ operational improvements to the UK business", Warren J held that the extensive Waltz changes were not justified and that proposals of "far less severity could and would have been devised".
The changes individually
Warren J also held that the individual elements of the Project Waltz changes may have themselves given rise to a breach of duty.
He found that IBM had acted contrary to its Imperial duty in its purported exercise of the Exclusion Power because it had done so in a way that was inconsistent with members' Reasonable Expectations.
In freezing salary increases for 2 years, IBM was not in breach of its duty. However, members who made elections when the proposal was for an indefinite freeze could have a claim of damages.
The introduction of a new early retirement policy with effect from 6 April 2010 was inconsistent with members' Reasonable Expectations that the policy would not change until 2014. Warren J also criticised the early retirement window during which members had to elect to take early retirement on favourable terms as being too short.
Employer consultation requirements
Warren J held that IBM was in breach of its contractual duty of good faith in relation to the way in which it consulted with members over Waltz.
He stated that the essence of consultation is the "communication of a genuine invitation, extended with a receptive mind, to give advice, and a genuine consideration of that advice; sufficient information must be supplied by the consulting to the consulted party to enable it to tender helpful advice" (citing Pitmans Trustees Ltd v The Telecommunications Group plc  PLR 213, Ch D).
Warren J held that IBM did not carry out the consultation in a way that was 'open and transparent'. The closure was initially explained as planned for 2010 in order to preserve IBM's negotiating position with the Trustee. IBM was using the prospect of closure in 2010 as a tactic to persuade the Trustee and members to accept the package that was on offer. It also withheld the real reason behind the Project Waltz changes from the members (i.e maintaining EPS targets) and did not consider suggestions made by members during the consultation process.
This is the third in the line of cases involving IBM. In 2012, the High Court had held that IBM's refusal to consent to an amendment to the DB section of the IBM pension plan did not amount to a breach of relationship of trust and confidence to its employees. For our update on that decision, click here.
Earlier, the High Court had partially granted an application for rectification of the governing documentation of a defined benefit section of the plan it relation to its early retirement provisions.
The current Project Waltz judgment spans some 435 pages. It provides useful guidance as to the duty of good faith both in the pensions context as well as in the employment (contractual context), their common elements but also some differences.
The key aspect of the decision is the development of the concept of "Reasonable Expectations" of employees and scheme members and how that may affect whether an employer has breached its duty of good faith. It sends a clear message to employers that before making significant changes to members' pension benefits, they should consider any "Reasonable Expectation" that members may have as a result of communications made earlier in the scheme's history. We may see an increase in incidences of members challenging proposals for changes to their pension arrangements (and past changes) based on previous communications made to them.
The case also emphasises the need for caution when proposing scheme changes and communicating them to members and trustees, as these could be relied on to challenge further changes to members' benefits in the future. There is an understandable desire from employers to explain the reasons for changes. It is not uncommon for employers to refer to changes as being "an alternative to closure". Such statements must now be seen as suspect as they could create a Reasonable Expectation that, if the current changes are agreed, there will be no future changes. It is also not uncommon for trustees to accept changes which are an alternative to closure as being in the best interests of members; trustees may now have to look at how much diligence they do on previous communications before agreeing to such changes.
Many scheme booklets contain express statements that pension benefits are not guaranteed and that future benefits are subject to change at any time. It is clear from this case that this is not sufficient to protect employers from inadvertent promises.