Managing pensions risk in corporate groups

5 What will happen if a Type A event occurs? If a Type A event occurs without appropriate steps being taken there can be a number of consequences. (i) Impact on relationship with pension scheme trustees Pension schemes have long term liabilities. Sponsoring employers therefore generally expect to have a long term relationship with the trustees of their scheme. That relationship could be damaged if a Type A event occurs and the trustees are not kept informed or if they consider that their concerns about such events have not been addressed. This could mean that the trustees will be less likely to accommodate employer requests on the funding or investment strategy of the scheme in the future. It may even mean that they look to use any powers available to them under legislation or the scheme rules to address any impact on the scheme and/or raise concerns with the Pensions Regulator. (ii) Regulatory risk The Regulator has powers (known as ‘moral hazard’ powers) to make third parties contribute to or support the pension scheme by issuing contribution notices or financial support directions – even if they do not have a direct legal relationship with that scheme. A Type A event will not in itself necessarily provide a legal basis for the Regulator to use its powers, but it can provide a trigger and justification for the Regulator to consider doing so. The Regulator can use its powers against any party which is ‘associated with’ or ‘connected’ to a participating employer (or former employer). This is a wide test and will, for example, catch other companies in the same corporate group as the employer, directors (or shadow directors) of an employer, or a shareholder with at least one-third of the voting rights with the employer or its parent company. In addition, the following tests need to be met. • For a contribution notice: there has been an act with a main purpose of avoiding a pension liability or an act that has detrimentally affected the security of scheme benefits. • For a financial support direction: the employer is ‘insufficiently resourced’ or a service company. • In both cases: the Regulator considers it ‘reasonable’ to issue such an order. The Regulator’s powers are wide and this is a relatively untested area. Quantum will also depend on what the Regulator considers ‘reasonable’ (up to the value of the scheme’s buyout deficit). The government is expected to publish its White Paper setting out the next steps for reforming the regulation of defined benefit schemes in Spring 2018. A Green Paper published in February 2017 sought views on proposals for change including compulsory clearance and punitive fines where the Pensions Regulator exercises its anti-avoidance powers. For further details see our briefing. (iii) Disclosure obligations Sponsoring employers are required to notify the Regulator about certain Type A events and may have further contractual obligations to notify trustees at an earlier stage in the corporate process. Type A events Managing pensions risk in corporate groups

3 Have you made a decision in the right way? Corporates, shareholders and directors may be more likely to face regulatory action to protect the pension scheme if they have not properly considered the impact of their decisions on that scheme. If a transaction is likely to affect the pension scheme, there may be ways to mitigate that effect and protect group companies from regulatory action – if you consider the key issues at the right time. Proper consideration which has been thoroughly documented will put corporates, shareholders and directors in the best place to defend any subsequent regulatory action. What type of corporate activity can affect a pension scheme? The pension scheme will be affected by anything that affects the ‘employer covenant’, that is ‘the legal obligation and financial ability of the employer to support the funding needs and investment risk of the scheme.’ Examples of this type of activity include: • reductionsof capital; • dividends; • restructurings and reorganisations; • new debt or security to creditors; • sales and acquisitions (and related financing and restructuring); and • switching to having a service company (rather than trading entity) as principal employer. Scheme trustees, and the Pensions Regulator, will be concerned about any events which would significantly weaken the employer covenant – ie events which are materially detrimental to the ability of the relevant pension scheme to meet its liabilities. These are known as ‘Type A’ events. Corporate activity that affects pension schemes Managing pensions risk in corporate groups

4 How do you spot a ‘Type A’ event? In order to assess whether a Type A event will occur, you need to compare the employer covenant before and after that event has occurred, both: (i) on an ongoing funding basis (ie what is the impact on the employers’ ability to meet the ongoing funding payments); and (ii) on a distressed scenario for the employer group (even where that distress scenario is considered highly unlikely). A key test for sponsoring employers will be whether the financial support for the relevant scheme (looked at on an individual supporting entity basis) is weakened by any of the proposed transaction steps. Examples of Type A events are events which reduce: • expected contributions to the pension scheme; • the ability of the sponsoring employer or group entities to pay such contributions to the scheme – eg additional financial commitments, restrictions on capital flow, increased dependency on other parts of the group; and • what the scheme can recover if insolvency occurs – eg reducing assets of supporting entities through dividends, or granting, repayment or change in the priority status of intra-group loans. This can be complicated, as: • identifying the extent of the employer covenant may not be straightforward. It will include not only the employers of the scheme, but other companies which lend covenant support to the scheme – such as any guarantors, subsidiary companies and other group companies on which the employers rely; • the relevant corporate activity may involve a large number of individual steps which will need to be considered both separately and in the round to establish the potential impact on the schemes; and • some steps may appear to be neutral to the scheme’s covenant, but in fact involve a potential detriment (for example, because they result in structural subordination of the scheme’s claims). This is likely to require both a legal and financial assessment. Type A events Managing pensions risk in corporate groups

5 What will happen if a Type A event occurs? If a Type A event occurs without appropriate steps being taken there can be a number of consequences. (i) Impact on relationship with pension scheme trustees Pension schemes have long term liabilities. Sponsoring employers therefore generally expect to have a long term relationship with the trustees of their scheme. That relationship could be damaged if a Type A event occurs and the trustees are not kept informed or if they consider that their concerns about such events have not been addressed. This could mean that the trustees will be less likely to accommodate employer requests on the funding or investment strategy of the scheme in the future. It may even mean that they look to use any powers available to them under legislation or the scheme rules to address any impact on the scheme and/or raise concerns with the Pensions Regulator. (ii) Regulatory risk The Regulator has powers (known as ‘moral hazard’ powers) to make third parties contribute to or support the pension scheme by issuing contribution notices or financial support directions – even if they do not have a direct legal relationship with that scheme. A Type A event will not in itself necessarily provide a legal basis for the Regulator to use its powers, but it can provide a trigger and justification for the Regulator to consider doing so. The Regulator can use its powers against any party which is ‘associated with’ or ‘connected’ to a participating employer (or former employer). This is a wide test and will, for example, catch other companies in the same corporate group as the employer, directors (or shadow directors) of an employer, or a shareholder with at least one-third of the voting rights with the employer or its parent company. In addition, the following tests need to be met. • For a contribution notice: there has been an act with a main purpose of avoiding a pension liability or an act that has detrimentally affected the security of scheme benefits. • For a financial support direction: the employer is ‘insufficiently resourced’ or a service company. • In both cases: the Regulator considers it ‘reasonable’ to issue such an order. The Regulator’s powers are wide and this is a relatively untested area. Quantum will also depend on what the Regulator considers ‘reasonable’ (up to the value of the scheme’s buyout deficit). The government is expected to publish its White Paper setting out the next steps for reforming the regulation of defined benefit schemes in Spring 2018. A Green Paper published in February 2017 sought views on proposals for change including compulsory clearance and punitive fines where the Pensions Regulator exercises its anti-avoidance powers. For further details see our briefing. (iii) Disclosure obligations Sponsoring employers are required to notify the Regulator about certain Type A events and may have further contractual obligations to notify trustees at an earlier stage in the corporate process. Type A events Managing pensions risk in corporate groups

6 Dividends Dividend payments Dividend payments by companies which sponsor defined benefit pension schemes are likely to be scrutinised where there is a significant deficit in the scheme. There is a risk that the level of a dividend or a return to shareholders could later be compared to pension deficit repair contributions and outstanding deficits (eg by the Regulator or the trustees of the scheme). In its funding statement published in May 2017, the Pensions Regulator made it clear it would expect to intervene in schemes where the employer covenant is constrained and payments to shareholders are prioritised, impacting on the affordability of contributions to the pension scheme. The government’s Green Paper on the regulation of defined benefit pension schemes (for further details, see our briefing), published in February 2017, did not specifically mention restricting dividend payment by scheme employers, but it did raise for consultation the question as to whether it should be necessary for businesses to consult with trustees of any underfunded pension scheme in the group prior to the payment of any dividends. For further details on pensions issues on paying dividends, see our briefing. Managing pensions risk in corporate groups

7 How can you manage your pensions risk? Directors, employers and shareholders can manage their pensions risk through the following strategies: • demonstrating that decisions were taken in the right way - ie considering the key issues at the right time and properly documenting that thought process in board minutes; • preparing for future scrutiny – eg by anticipating any concerns that the trustee and Regulator might raise and engaging with them in a way that addresses those concerns; • agreeing appropriate mitigation arrangements with the trustees of the Scheme; and/or • seeking clearance from the Regulator. How can we help you manage pensions risk? We have extensive experience advising employers and trustees on the impact of corporate activity on pension schemes and their employer covenant. We can help you to identify and assess which entities in a corporate group have obligations to the pension scheme, where they support the employer covenant indirectly and how those will be affected by transactions involving group entities. For instance, we can help you identify and assess: • which entities are treated as current or former employers under statute; • the balance of powers between employer and trustee in the trust deed and rules of scheme; • the nature and value of obligations in funding arrangements for the scheme; • which steps in a corporate transaction could benefit or weaken the employer covenant – and the extent to which these steps are linked legally; and • indirect covenant support – ie support for employers to enable contributions to be made, such as: ––supply of personnel agreements with operating companies (including reimbursement for services); and ––parent company financing channels – even though there may not be any direct contractual obligations between employers and parent companies, trustees may take comfort that the parent will support a principal employer in meeting an obligation to procure that contributions are made to the pensions scheme. Managing pensions risk Managing pensions risk in corporate groups