This briefing sets out the purpose of the “moral hazard” or “anti-avoidance” framework of powers of the Pensions Regulator (the Regulator) created under the Pensions Act 2004 and extended under the Pensions Act 2008. It is an update to our initial briefing note produced in June 2005 and the subsequent note published in April 2007, and it examines the circumstances in which the anti-avoidance provisions apply and the persons who may be affected by them. It also looks at the conditions which need to be satisfied before the Regulator issues a contribution notice or a financial support direction and the clearance procedure under current legislation and replaces our clearance briefing dated May 2008.
Purpose of the framework
The Pensions Act 2004 (the 2004 Act) gives the Regulator wide-ranging powers aimed at preventing employers from avoiding their funding obligations in respect of under-funded final salary (defined benefit) pension schemes (the so-called “moral hazard” provisions). The Regulator also has linked statutory objectives to protect the benefits of scheme members and to limit calls on the Pension Protection Fund. The framework includes powers for the Regulator to issue contribution notices, financial support directions and restoration orders. 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 defined benefits 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 acquisitions 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 (see below), which gives employers and potential purchasers comfort that they will not fall foul of the moral hazard provisions.
In addition, under the Pensions Act 2008 (the 2008 Act), the Regulator’s anti-avoidance powers were extended so that a contribution notice may be issued where it considers that an act or a failure to act is “materially detrimental” to the likelihood that members will receive their accrued scheme benefits. This power came into force on 29 June 2009 but applies retrospectively to 14 April 2008.
To whom does the anti-avoidance framework apply?
The Regulator’s powers to issue contribution notices and financial support directions apply to defined benefit schemes and it is on these powers that this briefing concentrates. The Regulator also has a power to issue a restoration order where there has been a transaction at an undervalue, although these are likely to be rarely applied in practice. However, certain schemes fall outside the moral hazard framework and the anti-avoidance provisions to not apply to the following:
- unregistered pension schemes, provided they have never been registered;
- unfunded public service pension schemes;
- the Local Government Pension Scheme;
- centralised pension schemes for non-associated employers providing only certain benefits; and
- any scheme where a public authority has given a guarantee that the scheme’s assets will meet its liabilities.
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 funding shortfall in a scheme. A contribution notice can relate to a series of acts as well as a single act.
When may a contribution notice be issued?
The Regulator has, since the material detriment powers came into force on 29 June 2009, had the power to issue a contribution notice to a person only if it is of the opinion that the following conditions (under section 38 of the 2004 Act) are satisfied:
- the person was party to an act or a deliberate failure to act on or after 27 April 2004; [s38(5)(b)(i)] and
- the act or failure to act falls meets one of the following tests:
- the material detriment test is met (this applies to acts occurring on or after 14 April 2008); [s38(5)(a)] or
- the main purpose or one of the main 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; [s38(5)(a)(i)] or
- the main purpose or one of the main purposes of that act or failure to act was to prevent such a debt becoming due, to compromise or otherwise settle such a debt or to reduce the amount of such a debt. For acts or failures to act occurring before 14 April 2008, the Regulator must also be of the opinion that the main purpose or one of the main purposes of the act or failure was “otherwise than in good faith”. The good faith component does not apply to acts or failures occurring after that date. [s38(5)(a)(ii)]
The material detriment test
The Regulator has issued a new code of practice setting out the circumstances in which it expects to issue a contribution notice under the new material detriment test. The code came into force by Commencement Order on 29 June 2009.
The new power will apply in the following situations:
- the transfer of the scheme out of the jurisdiction;
- the transfer of the sponsoring employer out of the jurisdiction or the replacement of the sponsoring employer with an entity that does not fall within the jurisdiction;
- where sponsor support is removed, substantially reduced or becomes nominal;
- the transfer of liabilities of the scheme to another pension scheme or arrangement which leads to a significant reduction of the sponsor support in respect of these liabilities or the funding to cover these liabilities;
- a business model or the operation of the scheme which creates from the scheme, or which is designed to do so, a financial benefit for the employer or some other person, where proper account has not been taken of the interests of the members of the scheme, including where risks to members are increased.
The legislation and the code fall short of actually defining what “material detriment” means in practice, but the test will only engage where there is a material detriment to the likelihood of the accrued scheme benefits being received. The 2008 Act prescribes a number of factors which the Regulator must take into account in deciding whether the material detriment test has been met. These include: the value of, and the effect of the relevant transaction on the value of, the scheme’s assets and liabilities; the level of employer support for a scheme and the extent that a person is able to discharge any liability towards a scheme.
The statutory defence to the material detriment test
As noted above, the 2004 Act provided that a contribution notice could be issued against an employer only where the act or failure to act was committed “otherwise than in good faith”. This defence is no longer available, applying only to acts prior to 14 April 2008.
Under the 2008 Act, a statutory defence will be available for parties to use against the issue of a contribution notice under the material detriment test, provided that three conditions are met. These are:
- before becoming a party to the act or failure to act, the person gave due consideration to the extent to which the act or failure to act might detrimentally affect in a material way the likelihood of accrued scheme benefits being received; [s38B(3)]
- where, as a result of that consideration, there was considered to be a potential detriment, the person took all reasonable steps to eliminate or minimise the potential detrimental effects that the act or failure might have on the likelihood that the pension scheme members would receive their accrued benefits; [s38B(4)] and
- at the time of the act or failure the person, having regard to all the relevant circumstances prevailing at that time, could reasonably conclude that the act or failure to act would not detrimentally affect in a material way the likelihood of members’ accrued benefits being received [s38B(5)].
The Regulator is planning to publish guidance on the application of the statutory defence in due course.
When does a section 75 debt arise?
Broadly, under the Pensions Act 1995 (1995 Act)
- on the cessation of an employer’s participation in a multi-employer defined benefit pension scheme (technically, on the employer ceasing to employ employees in the category of employment to which the scheme relates); or
- on the winding-up of the pension scheme; or
- 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 i.e. the full cost of purchasing annuities for all of the liabilities of the scheme from an insurance company.
Contribution notices where there has been a transfer
The Regulator has the power to issue a contribution notice where a scheme has received a bulk transfer from another scheme, if the criteria for a contribution notice would have been met in relation to the transferring scheme. This new power was introduced by the 2008 Act and applies retrospectively to any transfers made on or after 14 April 2008.
The imposition of a contribution notice must be reasonable
Before issuing a contribution notice, the Regulator must be of the opinion that it is reasonable to do so [s38(3)(d)]. Following amendments inserted by the 2008 Act, the 2004 Act now requires the Regulator to have regard to the extent to which it was reasonable for the person to act or fail to act the way he did in all cases where the act or failure occurred on or after 14 April 2008. In addition, the Regulator may, where relevant, consider the following:[s38(7)]
- 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 or has had control of the employer);
- any connection or involvement which the person has or has had with the scheme;
- whether the person failed to comply with the notifiable events regime and had a duty to report a notifiable event;
- all 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.
Where the act or failure to act occurred on or after 14 April 2008, the Regulator may also consider:
- the value of any benefits which the person received, or was entitled to receive, directly or indirectly from the employer or under the scheme; and
- the likelihood of relevant creditors (i.e. creditors of the employer and creditors of any other person who has a liability to the scheme) being paid and the extent to which they are likely to be paid. [s38(7)(ea) and (eb)].
There is also scope for additional factors to be specified in regulations, although there were no further factors at time of writing.
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 “associate” apply. An associate 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.
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 may review any act or failure to act up to six years after the act or failure to act, as far back as 27 April 2004. For this reason, it is particularly important that decisions relating to the scheme, its funding and any considerations relating to the employer debt are fully documented, along with reasons why the parties decided on a particular course of action.
Financial support directions
What is a financial support direction?
The Regulator may issue a financial support direction to require other companies who have sufficient resources within a group company structure to support a defined benefit pension scheme in circumstances where one company in the group participates in that scheme but is unable to meet its funding liabilities.
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” at any time during the financial support direction look-back period.
Until 6 April 2009 the look-back period was the 12 months prior to the issue of the financial support direction. However, new regulations extend the look-back period for financial support directions to 24 months with effect from 6 April 2010. The look-back period will increase gradually in the period between the two dates.
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 the group.
An employer is “insufficiently resourced” if two conditions are met:
- the value of its resources is less than 50 per cent of the scheme’s section 75 debt, as estimated by the Regulator. The estimate must not include any other section 75 debt that has already arisen in relation to the employer; and
- the value of resources of a person who is connected with or an associate of the employer, or (at a time falling on or after 14 April 2008), the value of the aggregate resources of persons who are connected with or associates of the employer and with each other, is at least equal to the “relevant deficit”. The relevant deficit is the difference between the value of the employer’s resources and 50 per cent of the estimated employer debt.
This new alternative test therefore allows the Regulator to impose a financial support direction where two or more companies in a group are sufficiently well-resourced.
No act or omission is required, but the Regulator may only issue a financial support direction if it considers it reasonable to do so.
Financial support directions where there has been a transfer
The Regulator has the power to issue a financial support direction where a scheme has received a bulk transfer from another scheme, if the criteria for a financial support direction would have been met in relation to the transferring scheme. This new power was introduced by the 2008 Act and applies retrospectively to any transfers made on or after 14 April 2008.
Factors in determining reasonableness
In assessing whether it is reasonable to impose a financial support direction, the Regulator must have regard to the following:
- the relationship that the person has with the employer (including whether the person has control of the employer);
- the value of any benefits received by the person from the employer (directly or indirectly);
- any involvement the person has had with the pension scheme;
- the person’s financial circumstances.
To date, the Regulator has issued only one financial support direction, on the basis that the sponsoring employer for the two final salary schemes involved was a service company.
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 “associate” above).
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 be required 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, and thus may require an actual contribution to be made, if a financial support direction is not complied with.
What is the clearance procedure?
It is possible to apply for a clearance statement binding the Regulator not to issue a contribution notice or a financial support direction in relation to specified circumstances. The statement will bind the Regulator so long as there is no material non-disclosure of fact.
Revised clearance guidance was published by the Regulator in March 2008 in which the main changes were:
- an extended list of examples of events, both employer-related and scheme-related, which could be “type A” events;
- the simplification of the classification of corporate events with the removal of “type B” and “type C” events;
- the introduction of a new principles-based approach when deciding whether clearance should be sought in relation to a corporate transaction;
- guidance on how the employer covenant should be assessed;
- the reinforcement of the need for appropriate mitigation where a type A event results in material detriment to the scheme; and
- the updating of the relevant bases for assessing the liabilities of the scheme.
Who may apply for clearance?
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 has to date used 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, for example, to the financial position of a company, it may use a basis other than FRS 17.
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. However, the Regulator does expect a clearance statement to be sought in relation to a type A event.
Employer-related events which are or could be type A events
A clearance application should only be considered in relation to a type A event. Type A events are all events that are materially detrimental to the ability of the scheme to meet its pension liabilities. Employer-related events will only be type A events if the scheme has a relevant funding deficit (which is likely to apply to many schemes - see below). The new guidance sets out a list of examples of situations which could be type A events but the Regulator stresses that these are merely examples and the list is non-exhaustive:
- a change in priority - i.e. a change in the level of security given to creditors. For example, the granting or extending of a fixed charge or floating charge over assets of the employer or the wider employer group;
- a return of capital - i.e. a reduction in the overall assets of the employer or the wider employer group. For example, some dividend payments, share buy-backs, repayment of subordinated debt or distributions in specie, including demergers;
- a change in group structure, including a change of control. This could include a change or partial change to the control structure of an employer or a change to the parent company or the ultimate holding company of the employer;
- a change to the employer in relation to the scheme, including replacement of a participating employer, the merger of two or more employers, or a change to the legal status of an employer - for example, the change from a partnership to a limited liability partnership;
- sale and leaseback transactions;
- the granting or repayment of inter-company loans, particularly where the loan is not on arms-length terms, where it is not properly documented or where there is a credit risk; “phoenix events”, which are described as arrangements by which an employer re-emerges as substantially the same entity following an insolvency event;
- business and asset sales from the employer or the wider employer group, particularly where the transaction is not at arm’s length for fair value, where the sale proceeds are not retained, or where the whole or a substantial part of the operating business is sold; and
- corporate events which would reduce cash flow cover for the wider employer group’s funding commitment to the scheme, including an increase in debt or a re-allocation of debt.
Assessment of an employer-related event
In assessing whether an employer-related event is a type A event, the guidance suggests that trustees and employers should:
- compare and contrast the pre- and post-event employer covenant of both the sponsoring employer and the wider employer group;
- assess whether any weakening of the employer covenant is materially detrimental to the ability of the scheme to meet its liabilities; and
- identify whether the scheme has a relevant deficit.
Detailed guidance is given on how to conduct each aspect of the assessment.
Scheme-related events which are or could be type A events
Examples of scheme-related events which could be type A events include:
- entering into a compromise agreement. Any attempt to compromise the pension debt due to the scheme is always a type A event, irrespective of the level of the scheme’s deficit before the compromise. Such a compromise is also a notifiable event and, as such, TPR must be informed;
- entering into an apportionment agreement. This is a type A event except where:
- the agreement increases the debt immediately payable by an employer which can afford the increase;
- it is less costly and complex than other alternatives and the apportionment results in the debt that is the actuary’s best estimate of the unmodified pension debt and it is immediately payable by the departing employer; or
- the debt arises when there is no net reduction of the employer covenant. For example, on the consolidation of several employers within the employer group in certain circumstances provided that all employer assets and their pension liabilities transfer;
- the non-payment of a section 75 debt (under the 1995 Act) for an unreasonable period (more than 12 months is suggested); and
- entering into an arrangement that has the result of preventing the triggering of a section 75 debt.
Assessment of a scheme-related event
The assessment of any detriment associated with a scheme-related event cannot usually be achieved solely by reference to the employer covenant and will vary depending on the specific event in question. Trustees should consider both the immediate and the possible future impact of the event on the scheme and on members’ benefits.
Time-frame to apply for the clearance procedure
For its report “Scheme funding: An analysis of recovery plans and clearance applications” which was published in December 2008, the Regulator took into account all cases handled since the inception of the clearance regime in April 2005. There have been some 1200 cases of which the outcome had been delivered in 92 per cent as at the date of publication of the report, although this figure includes applications for clearance, applications for approval of a withdrawal arrangement, investigations into whether the use of contribution notice or financial support direction powers is appropriate, as well as cases where applicants seek assistance in deciding which of these (if any) may be appropriate. We understand that the Regulator receives on average 15 to 30 applications for clearance each month and has issued over 200 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 against determinations must be made within 28 days of the determination.
As noted above, the Regulator has, to date, issued no contribution notices and only one 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 real, and employers and potential purchasers should consider carefully whether an application for clearance is necessary or desirable when undertaking commercial transactions.
As far as the new material detriment test is concerned, many commentators remain confused about the purpose of the code of practice and had hoped that it would include a definition of the term material detriment. However, the Regulator has chosen instead to set out the circumstances in which the code applies which it hopes gives some comfort that regular corporate transactions are not intended to be caught. In addition, the Government and the Regulator have stated that the changes to the contribution notice power are expected to impact upon only a small number of schemes and only in cases “where pension liabilities are being actively avoided or put at unacceptable risk”.
However, employers should still take care when engaging in certain corporate activity to ensure that they undertake appropriate due diligence in respect of the impact of the transaction on their pension arrangements and should seek expert advice where necessary. The new statutory defence to the material detriment test is to be welcomed and employers may still apply for clearance preventing the Regulator from exercising its powers in order to provide additional comfort in circumstances where a type A event is being considered.
The new clearance guidance has moved away from the prescriptive tests set out in the 2005 guidance as a means to decide which corporate events should or could be considered for clearance. Under the new clearance guidance, the Regulator wants to ensure that employers and trustees take appropriate action and protect the scheme as far as possible against any detriment. The extensive guidance on the role and responsibilities of trustees emphasises their duties to assess whether any corporate activity might affect the security of members’ benefits under a defined benefit pension scheme and to take action to minimise or eliminate any detriment to the scheme caused by such activity.