The Supreme Court has today ruled on the ranking of certain pension liabilities when issued to companies in administration or liquidation.

In a decision that will have significant consequences for lenders to groups of companies that have a defined benefit pension scheme, the ability to restructure such groups, and the rescue culture in general, the Supreme Court overturned earlier decisions of the High Court and Court of Appeal, finding that a Financial Support Direction or Contribution Notice issued by the Pensions Regulator against a company after it had gone into administration or liquidation will not have priority ranking as an expense of the insolvency proceedings and will instead rank as a provable debt.

Herbert Smith Freehills partners Kevin Pullen and Stephen Gale, assisted by Gawain Moore and Aoife Gannon and Pensions partner Roderick Morton, advised the Nortel Administrators on their successful appeal in this case.

For a link to the judgment, please click here.

1. Background

When an employer under a defined benefit pension scheme that is in deficit enters administration or liquidation, a debt (the "Section 75 debt") is due from the employer to the scheme under section 75 of the Pensions Act 1995 (the "1995 Act"). Under the 1995 Act, the Section 75 debt is deemed to arise immediately before the administration or liquidation, and accordingly, the Section 75 debt will be an unsecured debt provable in the insolvency i.e. it will rank pari passu with all other unsecured creditors and paid after secured creditors with fixed charges, expenses of the administration, any preferential payments and secured creditors with floating charges.

Often referred to as the "moral hazard powers", the Pensions Regulator ("TPR") has, in certain circumstances, discretionary powers to issue a direction requiring a company connected or associated with the employer to put in place reasonable financial support for a pension scheme in deficit (a financial support direction ("FSD")) and if the company fails to comply with a FSD a notice requiring a specific payment to be made to the scheme (a contribution notice ("CN")).

The powers to issue a FSD/CN were created by the Pensions Act 2004 (the "2004 Act") and were designed to ensure that corporate groups with a defined benefit pension scheme were not able to deliberately structure their affairs to avoid making proper contributions to the pension scheme. In contrast to the Section 75 debt, there was, until now, no clear legislation or Court authority as to the status of any FSD or CN when issued to a company in administration or liquidation.

2. Facts

In June 2010, TPR sought to impose FSDs against several companies in the Nortel estates. The Nortel Administrators sought confirmation from TPR that it would not issue a CN for an amount which would mean that the Administrators were unable to pay all administration expenses in full, or make any distribution to unsecured creditors.

Following TPR's response that it was not able to give such confirmation, in September 2010, the Nortel Administrators applied for directions from the High Court as to whether any FSD or CN issued to a company after it enters into administration or liquidation (an "insolvency event") creates any obligation on the company or its office holder and if so, how that obligation would rank in the company's insolvency.

3. Decisions of the High Court and Court of Appeal

In widely reported decisions, the High Court and Court of Appeal held that on the basis of existing Court of Appeal authority, it was necessary for a debtor to be under an existing legal obligation at the date of insolvency in order for a debt to be provable and, prior to the issue of a FSD, a target could not be said to be under a legal obligation as it was dependent on the exercise of discretionary powers by TPR. Accordingly, a CN issued in such circumstances was not a provable debt.

Having found that the liability under a FSD or CN was not a provable liability, this left two options. The liability was either a non-provable liability, in which case it would rank for payment from any surplus after paying all other creditors, or it was an expense.  In the proceedings, the first option was referred to as the "black hole" as in the majority of insolvencies, there is no surplus and accordingly no recovery would be made under a FSD/CN.

The High Court and Court of Appeal reluctantly concluded that the decision in re Toshoku Finance plc [2002] 1 WLR 671 established a "general rule", that where a statutory liability is imposed on a company in administration or liquidation which is not provable, it will be a necessary disbursement of the insolvency and rank as an expense.

The effect of these rulings was to promote FSD/CN liabilities issued to companies in administration or liquidation to priority status ranking ahead of the claims of preferential creditors, floating charge holders and unsecured creditors. In accordance with the statutory priorities under Rule 2.67 of the Insolvency Rules 1986 ("IR 1986") the liability would also rank ahead of the Administrator's own fees and remuneration.  In circumstances where a company had a substantial pension deficit (for example, the estimated Nortel Section 75 debt is £2.1billion) a CN issued against a company in that group could potentially wipe out any return to lower ranking creditors of that company and render an administration insolvent (i.e. unable to discharge all expenses of the insolvency).

In finding that the Toshoku case had established a general rule relating to the ranking of statutory liabilities, the High Court and Court of Appeal also elevated other non-provable statutory liabilities to the same expense status. 

Understandably the decisions created significant concern in the insolvency profession and for lenders and counterparties to any company in a group with a defined benefit pension scheme in deficit.

In response, TPR issued a statement in July 2012, noting its awareness of "the importance of an effective restructuring and rescue culture" and that it "did not intend to frustrate its proper workings, nor those of the lending market".  However, without confirmation as to how TPR would exercise its powers in practice, this gave little comfort to office holders or lenders, and led to further uncertainty as to how TPR would exercise its discretion to issue FSDs/CNs in the context of its statutory objectives to protect pension benefits and reduce compensation being payable by the Pension Protection Fund.

4. Supreme Court decision

The Supreme Court considered four alternative arguments on the effect of the liability of a company under the 2004 Act, in a case where the FSD/CN is served on a company after an insolvency event:

  1. the potential liability was a provable unsecured debt ranking pari passu with other unsecured creditors; or
  2. the potential liability constituted an expense of the administration; or
  3. the FSD/CN constituted a non-provable debt payable out of any surplus available after payment in full of any unsecured creditors; or
  4. if the liability was a non-provable debt, then the Court could direct administrators to treat the potential liability more favourably.

In a unanimous decision delivered by Lord Neuberger, the Supreme Court upheld the appeal holding that the liability was a provable debt.

5. A proveable debt

The Court accepted the argument of the Nortel Administrators that a FSD issued against a company in administration was a contingent liability arising from an obligation incurred by the company before entering into administration.

In doing so, the Court concluded that the Court of Appeal authorities of Glenister v Rowe [2000] Ch 76 and Steele, R (on the application of) v Birmingham City Council & Anr, [2006] 1 WLR 2380 which adopted a narrow meaning of "contingent liability", had been wrongly decided, and the fact that TPR has discretion as to whether to issue a FSD or CN does not mean there is no contingent liability within the meaning of the IR 1986. The Court confirmed previous decisions such as Day v Haine [2008] 1 CR 1102 that the categories of provable debts should be as wide as possible.  This view had also been expressed in another decision in favour of the Nortel Administrators, Unite (The Union) v Nortel Networks UK Ltd [2010] EWHC 826 (Ch), in which Norris J said the "the court should incline towards restricting the category of claims which are not provable".

To ascertain whether the FSD/CN liabilities were provable debts in these circumstances, the critical question was what constituted an "obligation incurred" for the purpose of rule 13.12(1)(b) of the IR 1986. Where an obligation arose as a result of a contract entered into by a company, identifying the obligation incurred would likely be a straightforward matter. However, in this instance, where an arrangement, other than a contractual arrangement, gave rise to an "obligation" the position was less straightforward.

Cautious of laying down a universally applicable formula as to when an obligation could be incurred by statute for the purposes of rule 13.12(1)(b) of the IR 1986, Lord Neuberger suggested that, the company must have taken, or been subjected to, some step or combination of steps which (a) had some legal effect (such as putting it under some legal duty or into some legal relationship), and (b) resulted in it being vulnerable to the specific liability in question, such that there would be a real prospect of that liability being incurred. If these two requirements were satisfied, it would also be relevant to consider (c) whether it would be consistent with the regime under which the liability is imposed to conclude that the step or combination of steps gave rise to an obligation under rule 13.12(1)(b).

As to (a), it was noted that on entering into administration each of the applicant Nortel companies were members of a group of companies and had been such a member for the preceding two years (the relevant period in determining whether a company can be subject to the FSD regime). Membership of a group of companies was a significant legal relationship, carrying with it legal rights and obligations.

As to (b), at the date the companies entered into administration they were vulnerable to the issuance of the FSD, to the extent that facts and matters exist which establish the potential liability of the companies to the issuance of a FSD. In respect of (c), it was found that it was consistent with the regime under the 2004 Act to conclude that an obligation had arisen under rule 13.12(1)(b) of the IR 1986.

6. Administration expenses

Having determined that the liability under any FSD/CN would be provable, it was not necessary for the Court to determine whether the liability was an expense. 

However, perhaps with a view to mitigating the potential issues which could arise out of the "general rule", the Court went on to expressly reject the lower Courts' interpretation of Toshoku and held that there is no such general rule.

Instead the effect of Toshoku, as properly interpreted, was that the status of any liability imposed upon a company after an insolvency event was a legislative decision which would depend upon the particular liability in question. In particular, a "necessary disbursement" failing within rule 2.67(1)(f) of the IR 1986 would only arise "out of something done in the administration (normally by the administrator or on the administrator’s behalf), or if it is imposed by a statute whose terms render it clear that the liability to make the disbursement falls on an administrator as part of the administration – either because of the nature of the liability or because of the terms of the statute". In the latter case, it must reasonably have been intended by the legislature that the liability should rank ahead of provable debts.

In addition to these two categories, Lord Neuberger also seemed to suggest that statutory liabilities which were found to be liquidation expenses, for example business rates, could also be justified as an administration expense in order to avoid a situation whereby the relevant statutory authority, in this case the rating authorities, would be worse off because a company had opted for administration rather than liquidation.

7. Non-provable debt

Although not required to consider whether the FSD/CN could in these circumstances constitute a non-provable debt, Lord Neuberger commented, obiter, that the notion that a liability pursuant to a FSD issued against a company in insolvency proceedings would rank behind the company’s provable debts, was less surprising than the notion that it should rank ahead of them.  

8. The Court's discretion - "no roving commission"

The Court then considered the final alternative, that if it had reached a different view on the provable debt issue it would nonetheless have discretion to direct the administrators treat the FSD as a provable debt.

As to this, Lord Neuberger stressed that the Court did not have a "roving commission to change the statutory priorities in a particular case simply because it does not like the consequences of those priorities". He further noted that it would be wrong for the Courts to override the statutory ranking, especially given it would cause significant prejudice to others (in this case the creditors with provable debts).  

9. Comment

This is a landmark decision on administration and liquidation expenses and the scope of provable debts and will be welcomed by insolvency practitioners and lenders.

If the Court had accepted the primary written position of TPR and the other Respondents, it is possible that legislation would have been required to mitigate the consequences.

The immediate effect of the judgment should be to allow office holders to discharge their statutory duties without the threat that TPR could subsequently seek to issue a CN for an amount which would leave the office holder with an insolvent insolvency, and at risk of potential personal liability in respect of earlier expense payments which would rank below the liability under the CN. 

Likewise it should enable office holders who have delayed making distributions to preferential creditors and floating charge holders pending the outcome of the Appeal to distribute, without reference to TPR and any unsecured liability to a group pension scheme.

That said, although the judgment has confirmed the position in the Nortel insolvencies, the three step test set out by Lord Neuberger may not, in all cases, lead to the outcome that a FSD or CN is provable.  Lord Neuberger noted that the relevant companies had been part of the group for more than two years.  What would be the position if the company had only joined the group in the few months leading up to insolvency?  Are such companies intended to be liable under the FSD regime and if not, does this mean that any liability under a FSD or CN falls into the "black hole"?

There also remains a question as to how an Administrator could respond to a FSD, given that the remedy for non-compliance with a FSD is the issuance of a CN under section 47 of the 2004 Act and any such CN will only rank as an unsecured debt.  Could an Administrator who offered anything more than de minimus financial support be exposed to criticism from other creditors when at the time the FSD is issued, there may be no certainty as to the quantum of any CN or if one will ultimately be issued at all?  Given this uncertainty, it is likely that Administrators will seek directions from the Court as to whether they are able to offer anything more than de minimus financial support.

More generally, the judgment raises some interesting consequences for the UK insolvency regime.

Administration Expenses

While the Court's rejection of the 'general rule' in Toshoku will be welcomed by insolvency practitioners and other stakeholders, the Court noted that in determining what may be a "necessary disbursement" by the Administrator in the course of the administration, it would be "dangerous to treat any formulation as an absolute rule". 

In the context of statutory liabilities, as noted above, the Court held that a liability will be a necessary disbursement "if it is imposed by a statute whose terms render it clear that the liability to make the disbursement falls on an administrator as part of the administration – either because of the nature of the liability or because of the terms of the statute".

This will have to be considered on a case by case basis.  While in some cases it may be clear from the terms of the statute (as in Toshoku), in other cases  the terms of the statute may be silent as to whether the liability is imposed on a company in administration or liquidation (as was the case with rates in Exeter City Council v Bairstow [2007] Bus LR 813).

If there is doubt as to whether the terms of a statute are intended to apply to the company in administration, in circumstances where the liability could be significant, an Administrator would be well advised to seek further directions from the Court.

Provable Debts

For obvious reasons the judgment will be welcomed by any individuals currently in bankruptcy proceedings.  In overturning the decisions in Glenister and Steele, the Court has changed the accepted law and held that orders for costs made after the commencement of bankruptcy will be provable debts and, in the words of Lord Neuberger, help ensure "that the former bankrupt can in due course start afresh".  It is unclear how the judgment will affect bankruptcies where a Trustee in Bankruptcy may already have part distributed on the basis of the previous law as set out in Glenister and Steele.

The decision that an exercise of discretion post-insolvency will not automatically result in a debt being non-provable will mean that other liabilities previously viewed as falling into the "black hole" (in the case of companies) or outside of the bankruptcy (in the case of individuals) will now become provable debts.  It is telling that the judgment specifically quoted the Cork Report (1982) and the "basic principal of the law of insolvency" that "every debt or liability capable of being expressed in money terms should be eligible for proof".

The effect of the judgment will not be limited to administrations, liquidations and bankruptcies.  The judgment is also likely to have an effect on the scope of liabilities compromised under voluntary arrangements under Parts I (for companies) and VIII (for individuals) of the Insolvency Act 1986, many of which define the debts compromised by reference to provable debts under the IR 1986. 

Finance and Restructuring

The judgment will come as some relief to lenders to groups with a defined benefit pension scheme.

In the immediate term, any lender with floating charge security will know that if a FSD or CN is issued to the company, as an unsecured liability, it will rank behind both the fixed charge and the floating charge, save with the floating charge in respect of the prescribed part.

In the longer term, should the lender be considering taking enforcement action, the reluctance of office holders to take an appointment due to the potential unquantifiable administration expense liability ought no longer to be an issue.

Likewise in relation to cross border insolvencies using a 'COMI' appointment under the EC Insolvency Regulation, the concern that the lower Court's decisions could affect the UK's position as a restructuring friendly jurisdiction ought no longer apply, although there remain questions as to the jurisdiction of TPR to take action overseas and whether any liability under a FSD/CN would be recognised in a foreign insolvency.

In respect of lenders who do not currently have security, it is important to note that the case does not give any guidance as to how TPR ought to exercise its discretion to impose FSD/CN liabilities on target companies.  It is not impossible that TPR could seek to 'scoop the pool' by issuing a CN of a magnitude that would swamp all other unsecured liabilities. The key is therefore to ensure that security is taken from any potential target, which, assuming the security is not challenged on the usual insolvency grounds, will rank the lender ahead of any liability under a FSD/CN.

Pensions

On the face of it, allowing the Appeal and concluding that FSD/CN liabilities rank as provable rather than priority expense debts, may appear to be a bad outcome for pension schemes and their members.  However, the outcome could have been worse if the Court had held that FSD/CN liabilities fell into the "black hole". 

It must also be remembered that the best interests of a pension scheme and its members are served by having a stable long-term employer standing behind it, that is able to finance and to grow its business.  As a consequence of the judgment, lenders relying on floating charge security are likely to be more willing to lend to groups with defined benefit pension schemes, than they would if FSD/CN liabilities continued to rank as an expense.  Indeed if the Appeal had been dismissed, the difficulties faced by such groups in obtaining financing is likely to  have had a negative impact on the business, and in turn a negative effect on the willingness and ability of companies to meet their defined benefit contributions.  There may also have been an increase in the number of companies closing or winding-up their defined benefit schemes, and to the extent groups were not able to successfully refinance or restructure, an increased reliance on the Pension Protection Fund.