On December 7, 2017, the Basel Committee on Banking Supervision (BCBS) published the Basel III: Finalising post-crisis reforms document.
This briefing sets out the purpose of the “moral hazard” or “anti-avoidance” framework of powers of the UK Pensions Regulator (the Regulator) under the Pensions Act 2004 (the 2004 Act). It is an update to our previous briefing notes on this subject, 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 that need to be satisfied before the Regulator issues a contribution notice or a financial support direction and the clearance procedure under current legislation.
The 2004 Act gives the Regulator wide-ranging powers aimed at preventing employers from avoiding their funding obligations in respect of under-funded defined benefit (including final salary) pension schemes (the so-called “moral hazard” provisions). 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 benefit 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
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.
The Regulator’s powers to issue contribution notices and financial support directions apply to defined benefit pension schemes and it is on these powers that this briefing concentrates. Whilst certain schemes fall outside the anti-avoidance framework, it applies in respect of the vast majority of private sector defined benefit pension schemes that have been registered with HM Revenue and Customs.
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 to a single act.
The Regulator has 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 Regulator also has the power to issue a contribution notice (under Section 47 of the 2004 Act) where there has been non-compliance with a previously issued financial support direction.
The Regulator has issued a code of practice setting out the circumstances in which it expects to issue a contribution notice under the material detriment test. These include the transfer of the scheme out of the jurisdiction and the complete removal or substantial reduction in the sponsor’s support for the scheme.
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.
A statutory defence is available for parties to use against the issue of a contribution notice under the material detriment test, provided that a number of specified conditions are met. These conditions require due consideration to have been given to the effect of the act or failure to act on the likelihood of accrued scheme benefits being received. The defence also requires all reasonable steps to have been taken to eliminate or minimise any such detrimental effects that have been identified.
Before issuing a contribution notice, the Regulator must be of the opinion that it is reasonable to do so. The Regulator must 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 to act occurred on or after April 14, 2008. In addition, the Regulator must, where it considers relevant, consider a number of other factors. These include the person’s degree of involvement in the act or failure to act and the relationship between the person and the sponsoring employer.
The Regulator may issue a contribution notice against
For these purposes, “person” includes both individuals and corporate entities
The Regulator may review any act or failure to act up to six years after that act or failure to act. 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.
Although the act or failure to act which gives rise to a contribution notice must have occurred within this time-frame, the Regulator does not consider this restriction to apply to issues that are taken into account when it assesses the reasonableness of issuing a contribution notice.
The Regulator has decided to issue contribution notices on the following occasions
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.
This support may include arrangements under which
In addition, other forms of support, such as bank guarantees, may constitute financial support.
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 a two year look-back period.
An employer is “insufficiently resourced” if two conditions are met
No act or omission is required, but the Regulator may only issue a financial support direction if it considers it reasonable to do so.
In assessing whether it is reasonable to impose a financial support direction, the Regulator must have regard to a number of factors. These include the relationship between the person and the sponsoring employer and the value of any benefits received by the person from the employer (directly or indirectly).
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. The Regulator may not impose a financial support direction on individuals (such as directors), except in limited specified circumstances.
The Regulator may issue a financial support direction only if it is satisfied that the target was either a service company or insufficiently resourced at the “relevant time”, and that target was the employer, or associated or connected with the employer, at that time.
The “relevant time” is a time determined by the Regulator that falls within the two-year look-back period ending when the Regulator issues a warning notice to parties directly affected by the financial support direction under consideration.
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 (see Storm Funding decision above).
Following the Regulator’s decisions to issue financial support directions against companies in the Nortel and Lehman Brothers groups (please see below), the groups’ respective administrators applied to the High Court for directions as to the effect of financial support directions.
The Court’s decision allows the Regulator to impose significant liability on a financial support direction target, which will rank as an expense of a relevant insolvency process. This gives liabilities under a financial support direction priority over the target’s other liabilities and may render a restructuring strategy commercially unworkable.
In October 2011, an appeal in the Court of Appeal against this decision was unsuccessful. The decision has been further appealed in the Supreme Court, although the result of this appeal is not yet known.
The Regulator has decided to issue financial support directions on the following occasions
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.
The Regulator expects applications to be made by parties that may be issued with a contribution notice or financial support direction. The Regulator also 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.
The clearance procedure is entirely voluntary. Although the clearance guidance is not explicit, in our experience, the Regulator is likely to require some form of accelerated payment of the deficit in a scheme (not being limited to accelerated or alternative mitigation payment of a recovery plan) in return for granting clearance in respect of a given transaction.
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 so-called type A event.
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.
The 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. Examples of employer-related Type A events include a change in creditor priority, a return of capital and a change in the sponsoring employer of the scheme. Examples of scheme-related Type A events include apportionment arrangements (unless certain conditions are satisfied) and compromising scheme liabilities.
The Regulator aims to be sensitive to the commercial timescales of a deal and will try to meet any reasonable deadlines the applicant may have. However, the Regulator recommends informing it of a possible application as soon as possible. Adequate time should also be allowed to collate the detailed information required by the Regulator as part of the clearance application. Unless this information is readily available, this could take a significant amount of time. In addition, time allowances should be made for discussions between the employers and trustees of the scheme, which the Regulator will often expect to have taken place before any clearance application.
Appeals against determinations must be made within 28 days of the determination.
The Regulator has, to date, issued contribution notices and financial support directions in only a very limited number of circumstances. 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. Indeed, it is not known how often the Regulator has directly threatened to exercise its powers and where this has resulted in the parties concerned altering the structure of their transactions. However, one such example was in relation to a clearance application for a share sale of shares in Database Group, submitted in 2015. The Regulator concluded that the offer did not reflect the potential loss of covenant. It negotiated with the applicants to buy-out members’ benefits in full, thus avoiding either a possible contribution notice or a financial support direction.
The February 2017 pensions Green Paper on the security and sustainability of defined benefit schemes consults on possible stronger powers for the Regulator where schemes are considered to be treated “unfairly”. However, it now seems unlikely that any related legislation will progress during this Parliament, due to the pressure on the legislative timetable as a result of the Brexit referendum. Nevertheless, the receipt of a warning notice, together with press scrutiny, is sometimes enough to prompt an employer to offer additional scheme funding at a level acceptable to the Regulator, as was the case with the Coats Pension Plan and the BHS Scheme.
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.
Employers should 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. In addition, the Regulator has made it clear that employers and trustees should take appropriate action and protect the scheme as far as possible against any detriment.
On December 7, 2017, the Basel Committee on Banking Supervision (BCBS) published the Basel III: Finalising post-crisis reforms document.
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