Purpose of the framework

The Pensions Act 2004 (the Act) contains several provisions aimed at preventing employers from avoiding their funding obligations in respect of final salary (defined benefit) pension schemes. These include powers for the Pensions Regulator (the Regulator) to issue contribution notices and financial support directions. The Regulator can impose liabilities not only on employers participating in schemes, but may also pierce the corporate veil and impose liabilities in relation to under-funded final salary pension schemes on other group companies, controlling shareholders and individual directors.

This is a key area for employers and trustees to consider in relation to:

  • sales and acquisition of companies;
  • financial or corporate restructuring;
  • banking transactions;
  • any other transaction which may result in an employer (or group of companies) being less able to meet its funding obligations to a final salary pension scheme.

In this regard, of particular interest to employers and potential purchasers may be the clearance procedure (described in more detail below) which gives employers and potential purchasers comfort that they will not fall foul of the moral hazard framework.

Whom does the framework apply to?

The provisions of the Act apply primarily to occupational final salary pension schemes which are still subject to the minimum funding requirement (MFR) or have become subject to the scheme specific funding requirement (SSFR). The SSFR came into force on 30 December 2005 and will gradually apply to all final salary schemes in place of the MFR.

Contribution notices

What is a contribution notice?

The Regulator can issue a contribution notice requiring a person to pay either the whole or a specified proportion of the shortfall in a scheme.

When may a contribution notice be issued?

The Regulator may issue a contribution notice if it considers that there was an act or deliberate failure to act and one of the purposes of that act or failure to act was:

  • to prevent the recovery of the whole or any part of a debt under section 75 of the Pensions Act 1995 which was due, or might become due from the employer; or
  • otherwise than in good faith, to prevent such a debt becoming due, to compromise or otherwise settle such a debt or to reduce the amount of such a debt.

When does a section 75 debt arise?

Broadly:

  • on the cessation of an employer’s participation in a pension scheme (technically, on the employer ceasing to employ employees in the category of employment to which the scheme relates);
  • on the winding-up of a pension scheme;
  • on the occurrence of an insolvency event in relation to the employer; and
  • where the pension scheme is under-funded on specified actuarial bases. The yardstick against which the deficit in a scheme is measured for the purposes of section 75 is the buy-out basis ie. the full cost of purchasing insurance cover for all of the liabilities of the scheme from an insurance company.

The imposition of a contribution notice must be reasonable

When determining whether it is reasonable to issue a contribution notice to a person, the Regulator must have regard to such matters as it considers relevant, including the following specified matters:

  • the degree of involvement of the person in the act or failure to act;
  • the relationship which the person has or has had with the employer (including whether the person has control of the employer);
  • the purposes of the act or failure to act (including whether a purpose of the act or failure was to prevent or limit loss of employment);
  • the financial circumstances of the person.

Who may be caught by a contribution notice?

Any person who is both:

  • a party to the act or omission;
  • an employer in relation to the scheme.

Any person who is both:

  • a party to the act or omission;
  • a person connected with, or an associate of the employer, including group companies, controlling shareholders and directors.

The broad Insolvency Act 1986 definitions of “connected” and “associated” apply. An associated person includes a person acting within the role of a trustee and may include a director. For these purposes, ‘person’ includes both natural persons and corporate entities, and limited liability partnerships are treated as companies.

Exemptions

The Regulator may not issue a contribution notice against an insolvency practitioner provided that he has acted “in accordance with his functions as an insolvency practitioner.”

Time-frame for imposing a contribution notice

The Regulator can review any act or failure to act up to six years after the act or failure to act, but may not go back before 27 April 2004.

Financial support directions

What is a financial support direction?

The Regulator may issue a financial support direction to other companies (with sufficient resources) within a group company structure to support a final salary pension scheme in circumstances where another company in the group participates in that scheme but is unable to meet its liabilities to the scheme.

When may a financial support direction be issued?

The Regulator may issue a financial support direction if it is satisfied that an employer sponsoring or participating in a pension scheme is either a service company or is “insufficiently resourced”.

An employer is a service company, where in a group of companies, its turnover is solely or principally derived from the provision of services to other members of that group.

An employer is “insufficiently resourced” if the value of its resources is less than 50 per cent of its estimated section 75 liability (calculated on the buy-out basis) and the value of the resources of a connected or associated person (but not individuals except in limited specified circumstances) when added to the employer’s resources would be 50 per cent or more of the estimated section 75 liability.

No act or omission is required, but the Regulator may only issue a financial support direction if it considers it reasonable to do so.

Factors in determining reasonableness

The Regulator must have regard to the following:

  • the relationship that the person had with the employer (including whether the person has control of the employer);
  • the benefit received by the person from the employer;
  • any involvement the person had with the pension scheme;
  • the person’s financial circumstances.

Who may be caught by a financial support direction?

The Regulator may issue a financial support direction to an employer in relation to the pension scheme or to a person who is connected with or an associate of the employer (see notes on ‘connected’ and ‘associated’ above).

Exemptions

The Regulator may not impose a financial support direction on individuals (such as directors), except in limited specified circumstances.

What is required under a financial support direction?

The person issued with a financial support direction will have to put in place financial support. This may include arrangements under which:

  • all the companies within the employer’s group are jointly and severally liable for the whole or part of the employer’s pension liabilities in relation to the scheme;
  • the holding company of the employer’s group is liable for the whole or part of the employer’s pension liabilities;
  • other forms of support, such as bank guarantees, may constitute financial support.

Failure to comply

The Regulator may issue a contribution notice, ie. requiring an actual contribution to be made, if a financial support direction is not complied with.

Clearance procedure

What is the clearance procedure?

It is possible to apply for a clearance statement binding the Regulator not to issue contribution notices or financial support directions in relation to specified circumstances. The statement will bind the Regulator so long as there has not been a material non-disclosure of fact.

Who may apply for the clearance procedure?

The Regulator expects applicants for clearance, where possible, to have discussed this with the trustees of the pension scheme concerned. Trustees may see clearance applications as opportunities to negotiate improved funding terms. The Regulator has said that it sees itself in the role of a referee rather than a player in negotiations regarding clearance.

What is the ‘price’ for clearance?

The clearance procedure is entirely voluntary. Although there are no hard and fast rules requiring it to do so, in our experience the Regulator is likely to require accelerated payment of the deficit in a scheme in return for granting clearance in respect of a given transaction.

In assessing the financial position of a scheme, the Regulator uses FRS 17 as a benchmark as opposed to the buy-out basis discussed above. (This is generally a more favourable yardstick for employers, but if the Regulator considers it appropriate due to the financial position of a company it may use a basis other than FRS 17.)

It has been the Regulator’s practice to expect that 50% of the FRS 17 deficit of a pension scheme is dealt with at the time of the application with an arrangement to be drawn up to repay the remainder of the FRS 17 deficit over a period of 2 to 5 years (depending on the financial strength of the company).

When will the clearance procedure be applied

The Regulator has issued guidance as to when it may be appropriate to apply for clearance, but does not prescribe any circumstances where a clearance application is mandatory. The guidance issued by the Regulator categorises events affecting employers into three types.

Type A events

Events which have a financially detrimental effect on the pension scheme’s position as a creditor of the company. Where a transaction is a Type A event the Regulator advises that clearance is appropriate. Examples include:

  • changes in priority eg, the granting or extending of a fixed charge or floating charge;
  • return of capital or reduction in company assets eg, payment of dividends, share buy backs, dividend strips, distributions in species, demergers;
  • change in control structure eg, a change in the parent company or ultimate holding company of an employer or a change in connected or associated parties which could be subject to a financial support direction.

Type B events 

Events which are not financially detrimental to the ability of a pension scheme to meet its pension liabilities. Type B events are commercial transactions at arm’s length and the Regulator would not ordinarily expect a clearance application in respect of them. Examples of Type B events include:

  • company mergers and acquisitions, including the sale and purchase of assets, the sale of a non-employer subsidiary, MBOs and MBIs, privatisations and joint ventures;
  • fundraising, including flotation and private placement, venture capital fund raising, rights issues and preference share issues, unsecured debt;
  • other contractual negotiations, for example, operating or finance lease operations;
  • provided that none of the above involves a Type A event.

Type C events

Events which point towards a deterioration in the employer’s covenant, whether inside or outside the control of the company or its directors, eg, the loss of a major customer. Some Type C events may require clearance.

Time-frame to apply for the clearance procedure

Although no published statistics exist, we understand that the Regulator is currently receiving on average 15 to 30 applications for clearance each month and has issued around 120 statements to date, with two applications having been turned down. The Regulator generally deals with each application within 3 weeks (although complicated transactions may take longer) but has processed some applications much more quickly and aims to be sensitive to the commercial timescales of a deal.

Appeals

Appeals against determinations must be made within 28 days of the determination. 

Scheme abandonment

In December 2006 the Regulator issued a discussion paper on scheme abandonment to counteract its concerns over proposed transactions where the perceived primary intent is for the employer to break the link between the scheme and an employer of substance (without the employer meeting the full cost of securing the pension benefits with an insurance company). Consultation is ongoing and we await confirmation of how if at all, any new scheme abandonment rules would dovetail with the moral hazard framework.

Conclusion

As far as we are aware, the Regulator has, to date, not had cause to issue a contribution notice or a financial support direction. However, this should not be viewed as indicative of a reluctance to act, as in our dealings with the Regulator, it is clear that it keeps a very close eye on the financial press with a view to following up any transactions it suspects may fall foul of the moral hazard framework.

As a result, the threat of receiving a contribution notice or a financial support direction remains very real, and employers and potential purchasers should consider carefully whether an application for clearance is necessary or desirable when undertaking commercial transactions.