In England, the Pension Regulator (the “Regulator”), who is responsible for overseeing certain pension schemes, may issue “financial support directions” (“FSD”) and/or a “contribution notice” (“CN”) pursuant to its moral hazard powers. The English High Court recently concluded that the Regulator can issue an FSD and/or a CN against insolvent companies as well as solvent ones.1 [2010] EWHC 3010 (Ch). Additionally, the High Court determined that the amounts which arise from the Regulator’s moral hazard regime post-insolvency are to be treated as an administration expense, rather than as an ordinary unsecured debt and therefore rank in priority to all creditors’ claims other than those secured by a fixed charge.  

Background: Defined Benefit Pension Schemes and Moral Hazard Explained

Defined Benefit Pension Schemes

In a Defined Benefit Pension Scheme (a “DB Scheme”), a member’s retirement benefit is defined meaning that the member is promised a certain benefit on retirement depending on the scheme’s accrual rate, his pensionable salary and his length of service. The employer is primarily responsible for funding a DB Scheme (although members may be required to contribute), and the system works on a pooled fund basis, whereby all contributions are paid into a common fund, which is invested to provide the retirement benefits. DB Schemes have become increasingly rare in the private sector given (i) the expense involved due to the volatility of funding requirements and (ii) the difficulty of predicting future funding requirements.  

The Pensions Regulator

Created by the Pensions Act 2004, the Regulator is responsible for schemes that permit an employer to deduct employee’s contributions. One of the Regulator’s primary objectives is “protecting members’ benefits under work-based pension schemes.” Section 5(1), Pensions Act 2004. The Regulator has the power to prevent a company from manipulating its business affairs to avoid pension liabilities.  

The Moral Hazard Regime

The moral hazard regime provides an anti-avoidance framework, whereby pension liabilities are not confined to the employing company, but rather extend to the wider corporate group (which can include group companies, shareholders, individuals such as directors, and even managers of private equity funds). The Regulator has certain powers under the moral hazard regime to ensure that a corporate group does not avoid its pension liabilities. Although the potential consequences of the moral hazard regime are severe, the Regulator has rarely exercised his powers, rather preferring negotiated solutions. The moral hazard regime has been particularly relevant to those companies with DB Schemes that can no longer ensure that pension liabilities remain ring-fenced.  

Financial Support Directions

W here the Regulator determines that an arrangement in place imposes responsibility for funding a pension scheme on a company that is insufficiently resourced to fund the scheme, and there are other companies within the corporate group that are able and that could reasonably be asked to assist with the funding of the scheme, the Regulator may issue an FSD to ensure that the scheme is adequately funded. A showing of avoidance of pension liability or fault is not required.  

Contribution Notices

I f a person fails to comply with an FSD, the Regulator may issue a CN calling for an immediate contribution to the pension scheme. The CN can be issued to a group company or holding company and other persons who are “connected” or “associated” with the employer, in the event that there has been reduction or avoidance of a pension scheme obligation which requires payment into the pension scheme. The conditions for issuing a CN and also the consequences of receiving one are stricter and more severe than that of an FSD.

Lehman/Nortel Judgment — What Has Happened?

The Nortel and Lehman groups include UK companies with DB Schemes with deficits of £2.1bn and £140m respectively. These UK entities are not capable of providing sufficient support to their pension arrangements. In June 2010, the Regulator issued FSDs against a large number of insolvent companies in the Nortel Group and in September, the Regulator took parallel action against a smaller number of Lehman Brothers entities, including Lehman Brothers International (Europe) (“LBIE”) and also the US parent Lehman Brothers Holding Inc.

The administrators of Nortel and LBIE responded by seeking the court’s direction regarding the treatment of the FSDs. Their uncertainty was based on the fact that prior to this case, as a rule, only debts incurred prior to insolvency were provable (unless they constituted administration expenses). The issue was not addressed by the Pensions Act 2004 (which had created the moral hazard regime), and therefore fell within the scope of insolvency legislation: the Insolvency Act 1986 and the Insolvency Rules 1986.

On December 10, 2011, the High Court ruled in favour of the Regulator and decided that:

  1. the criteria in the legislation for imposing FSDs/CNs did not distinguish between solvent and insolvent companies (and so FSDs/CNs could be issued after the target entered administration/liquidation); and
  2. where an FSD was issued against a company after the commencement of administration/liquidation, the cost of complying with that FSD was an expense of the insolvency ranking above the debts of unsecured creditors.  

Consequences of the Decision


While fixed charge secured creditors will be unaffected by the decision, other creditors owed debts by LBIE/Nortel will only get paid if there are sufficient funds remaining after the distributions relating to the FSDs are paid. The decision has also had the effect of putting a freeze on parts of the administration process, and delaying further the distributions to creditors in LBIE/Nortel.  

Companies with substantial pension deficits and their lenders

Companies with substantial pension deficits, such as British Airways and British Telecom, may struggle to raise funds following this decision. While the decision will be hugely welcomed by pensioners, the ruling has significant implications for lenders and the floating charges they hold given that their fixed charges may be re-characterised as floating charges. Lenders should, therefore, consider this in the context of their due diligence and when drawing up the security package with the borrower (in the event that the borrower has a DB Scheme with a considerable deficit). Additionally, insolvency practitioners may hesitate before accepting an appointment of an insolvent company where the pension deficits (and the risk of being issued a CN/FSD) are such that there is a danger that they will not be paid.

Company rescues generally  

The decision is likely to yield considerable and uncertain liabilities which can arise from the use of moral hazard powers. A company (with a DB Scheme) that is considering restructuring will need to consider the implications of this case carefully and determine whether to seek advance clearance from the Regulator in relation to a restructuring. In particular, FSDs and CNs issued by the Regulator against insolvent companies will now be given super-priority against the claims of unsecured creditors, floating charge holders and expenses of insolvency practitioners. Following this decision, claims will have the following priority ranking in administration:

  1. Fixed Charge Security.  
  2. Costs and expenses of the administration (in accordance with Rule 2.67 of the Insolvency Rules 1986); FSDs and CNs now included at this level.  
  3. Preferential creditors.  
  4. Unsecured creditors up to a maximum of £600,000 if the company’s net property is £10,000 or more.  
  5. Holders of a floating charge.  
  6. Unsecured creditors.  
  7. Post administration interest on debts.  
  8. Deferred creditors.  
  9. Shareholders.  

What Happens Next?

The Judge may be interpreted as having misgivings regarding his ruling, which he sought to blame on a “legislative mess.” The Judge also speculated that the Insolvency Service or Parliament might propose a suitable legislative amendment if they shared his view “that the conferring of super priority as expenses upon the financial liabilities arising from the FSD regime is both potentially unfair to the target’s creditors and inconsistent with a (previous) decision...not generally to elevate employees’ pension claims above the claims of those creditors.” The Judge also invited the prospect of an appeal court being able to navigate a way through the statutory quagmire to arrive at a more equitable solution than he had determined. The administrators of both Nortel and Lehman are expected to appeal the decision.


A resolution of this confusion appears likely, whether by way of a successful appeal or statutory intervention. The decision dismayed those in the restructuring community who had understood moral hazard liabilities to be ranked as an unsecured claim, akin to other pension liabilities. There is clearly a manifest inconsistency in the fact that an FSD/CN issued moments before insolvency would ank as an unsecured creditor, whereas as FSD issued even immediately after insolvency attains “super-priority.” Section 75 debts2 were the means associated (at least until now), with addressing pension liabilities against an employer (on a non-preferential basis) in an insolvency process. Now, it seems that the Regulator can (at least for the moment) circumvent this by issuing a CN/FSD and thereby leap up the priority rankings.