The Government has made no secret of its concerns about some innovations in the pensions market and, in particular, alternatives to pensions buy-outs. It says that the Regulator's moral hazard powers need to be changed to keep pace with these innovations and has now tabled amendments to the Pensions Bill (there was an announcement about this in April of this year). At the same time, the Pensions Regulator has issued draft content for a code of practice, setting out the circumstances in which it would expect to issue a contribution notice ("CN") where the proposed new "material detriment" test is applied. Most of the amendments will take effect from 14 April 2008 (when the decision to amend the moral hazard laws was first announced).

The Regulator is keen to allay fears about what these changes might mean for business activity levels and has repeated its assurance that it does not want to hamper market activity or innovation. Although this provides some measure of comfort, it is also apparent that the circumstances in which the Regulator expects to use its power to issue a CN under the new material detriment test could be very broad. There will therefore be some anxiety as to how these new powers will operate in practice.

How will the proposed changes work?

New material detriment test

The Government wants to introduce an extra ground upon which the Regulator will be able to issue a CN. Under the new ground, a CN can be issued where the effect of an act (or failure to act) is materially detrimental to the likelihood of benefits earned before the act/failure being received. This is similar to the test set out in the Regulator's clearance guidance.

The Bill contains a (non-exhaustive) list of factors that the Regulator must consider when deciding whether the act/failure is detrimental (for example, the extent to which any person is likely to be able to discharge an obligation to make a payment, or to transfer an asset, to the scheme).

The draft content for the code issued by the Regulator lists the circumstances in which it expects to issue CNs on the material detriment test. The circumstances listed are:

  • transferring the scheme out of the UK;
  • transferring the sponsoring employer out of the UK and as a result materially reducing the level of employer support or legal and regulatory protection for the scheme members;
  • severing employer support for the scheme so that the scheme has no employer support, or the level of employer support is substantially reduced or becomes nominal;
  • transferring scheme liabilities to another scheme or arrangement with insufficient employer support or insufficient funding; and
  • a business model or the operation of the scheme in such a way that is designed to create a financial benefit for the employer or some other person from the scheme, but where inadequate account has been taken of the interests of the members, including where risks to members are increased.

The scope of the last circumstance is not clear and could be interpreted very widely. It will no doubt be the source of considerable comment when the full draft code is consulted on. Will there be unintended consequences?

There will be a statutory defence available, as a result of which the benefit of hindsight will not be available to the Regulator. The new defence requires that the person, before becoming party to the act/failure, considers the extent to which there may be a resulting material detriment to the likelihood of accrued benefits being received. The defence also requires the person to eliminate or minimise the potential detrimental effect and to show that s/he could reasonably conclude (given the relevant circumstances at that time) that the act/failure would not be materially detrimental. The Government views this defence as a form of self-regulation.

What the Regulator will need to consider before issuing a CN

As well as the existing list of matters that the Regulator must consider before issuing a CN, the proposed changes require it to also consider:#

  • the reasonableness of a party's actions in the circumstances of the case;
  • where relevant, whether there was a transfer of value to the party who could be subject to the CN (this fits in with a similar existing requirement for financial support directions); and
  • where relevant, the effect of the act/failure on other creditors and the likelihood of their being paid.

The requirement to consider the reasonableness of a party's actions should, hopefully, ensure that the Regulator will apply its powers sensibly and is directly linked to the removal of the "otherwise than in good faith" requirement (see below).

"Otherwise than in good faith" gone

For practical (mainly evidential) reasons, the Government wants to remove the "otherwise than in good faith" requirement. The law currently requires the Regulator to demonstrate that the main purpose requirement (to compromise/reduce or avoid a debt) and the absence of good faith requirement are both met.

The alternative test for issuing a CN (where the main purpose of the act/failure is to prevent the recovery of all/part of the debt which is due or might become due) does not require proof of an absence of good faith. The proposed change will therefore bring these two tests into line with one another.

The Government says that the new requirement for the Regulator to consider the reasonableness of a party's actions in the circumstances (see above) will be a more appropriate way of assessing whether a CN should be issued.

Series of acts/failures

The law will be clarified to say that a CN can cover a series of acts/failures as well as a single act/failure. The original plan (in the April 2008 announcement by the Government) was for this change to come into effect from 27 April 2004 (when the moral hazard laws were first made) but, following concerns voiced by consultation respondents, the change will now come into effect from royal assent of the Bill.

Financial Support Direction: group resources and look back period

For a financial support direction ("FSD") to be issued there must be a single person associated or connected with the employer who is sufficiently well resourced to meet at least the difference between the employer's resources and half the section 75 debt. This has, on occasion, prevented the Regulator from issuing a FSD so the proposal here is to add an extra option. The Government wants FSDs to be available where two or more persons associated/connected with the employer have enough resources to meet the gap between the employer's resources and half of the section 75 debt. This will avoid potential manipulation to put companies outside the Regulator's reach.

FSDs have always been a source of some concern to unrelated investors (and, in particular, to private equity funds in respect of portfolio investments). Acknowledging this, the Government points to the factors that it needs to take into account (for example, the company's connection or involvement in the scheme) and says: "It is unlikely that an otherwise unrelated company in another venture-capital portfolio who is, strictly, connected and associated with an employer but is remote from the employer and its scheme, would find itself liable under a direction for another group's pension deficits." The moral hazard laws have been around for some time. There is no doubt that these laws have had some impact on the way in which business is done, but the predicted tidal flow of clearance applications and frustrated deals has not materialised. Fears about the impact on unrelated third parties have also been greater than the experience (although the recent reporting of Duke Street Capital's payment into the Focus DIY pension scheme may have led to some pause for thought about the implications of these laws for private equity).

Another proposed change for FSDs relates to the look back period (the period during which the employer must be either a service company or insufficiently resourced). The Government will consult on extending the look back period from the current 12 months to (on a gradual basis) 24 months. By definition, this should increase the number of instances in which the Regulator will be able to issue a FSD.

The Government is also proposing changes in relation to bulk transfers which will apply to FSDs (as well as to CNs) – see below.

Bulk transfers

Where a bulk transfer takes place, the Regulator will be able to issue a CN or a FSD to the receiving scheme if the tests for issuing a CN/FSD would have been satisfied had the transfer not happened.

The consultation only envisaged this change in relation to CNs, so making a similar change in respect of FSDs is a new proposal.

The Government also says that where the bulk transfer is itself detrimental then the material detriment test for issuing a CN will be available.

Notifiable events

Notifiable events are those events which trustees and employers (each has a separate list of events) must tell the Regulator about. The intention is to alert the Regulator to the possibility that a scheme is at risk. Experience has led the Regulator to recommend that the list of events be shortened and the DWP has agreed. This will be the subject of consultation, scheduled for later in the year.

Reducing the number of notifiable events – in the context of the Regulator viewing the reporting of those events as unnecessary - is likely to be welcomed by trustees and employers.

The events which the Regulator wants to see removed are:

  • two or more changes in the holders of any key scheme post within the previous 12 months;
  • any change in the employer's credit rating, or the employer ceasing to have a credit rating; and
  • two or more changes in the holders of any key employer posts within the previous 12 months.

Some events only become notifiable if, among other matters, the scheme is below the Pension Protection Fund buyout level at the most recent valuation (or if no PPF valuation has yet been conducted the scheme funding is below the minimum funding requirement level). The Government is now proposing that for schemes which have a scheme funding regime valuation then the SFR is the level at which the test should be set. If there are any schemes which do not yet have a SFR valuation, the Government wants the test to be the higher of the PPF buyout level and the FRS17 value of liabilities.

Timings

Most of the amendments will take effect from 14 April 2008 (when the decision to amend the moral hazard laws was first announced). The exception to this is the clarification that CNs can be issued in relation to a series of acts or failures to act (and not just in relation to single acts/failures). That change will take effect from when the Bill receives royal assent (but where the material detriment test is being considered the effective date will be 14 April 2008).

The Regulator has said that until the changes are brought into force it will continue to use its powers in line with its statement on 25 April, which said that the amended powers would only be used if certain other circumstances also applied (for example, transferring the assets and liabilities of the scheme to another scheme without adequate employer support).

What other changes are in the pipeline?

A formal consultation on the full draft code of practice is planned for later in the year.

The Regulator also plans to update its clearance guidance, to cover the statutory defence to the new material detriment test. It has confirmed that there will be no significant change to the meaning of a Type A event.

Guidance about the kinds of transaction that might be caught by a CN following the removal of the "otherwise than in good faith" requirement is also promised.

Regulations will be made but only for limited purposes (for example, in relation to the material detriment factors and statutory defence).

Conclusion

We are not expecting the proposed changes to have a major impact on most deals. This will depend, however, on how the Regulator will apply the list of circumstances in which it expects to issue a CN. This is particularly the case with regard to the "business model/operation of the scheme" situation: will this be restricted to cases of 'scheme abandonment', for example?