Extensions to the UK Pensions Regulators “Moral Hazard” Powers

April 22, 2008

Changes to the UK Pensions Regulator anti-avoidance powers have been announced by the Department for Work and Pensions, to take effect immediately.

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The new legislation follows the release by TPR at the end of March 2008 of revised guidance relating to applications for Clearance Statements under which TPR confirms, to successful applicants, that it will not use those anti-avoidance powers in relation to the relevant event.

TPR’s regulatory anti-avoidance powers include the ability to force a company or an individual to make a payment to, or to put in place financial support for, an “underfunded” defined benefit (or final salary) pension scheme.  These so called moral hazard powers are aimed at discouraging corporate structures being used to avoid pension liabilities and to reduce calls being made on the Pension Protection Fund (similar to the US Pension Benefit Guaranty Corporation).  The principal events which historically triggered TPR to consider whether or not to exercise its powers were corporate merger and acquisition activity and restructurings.  To these “typical” events may now be added pension scheme buyouts.

At a Glance – the Announced New Legislation

To date, TPR’s anti-avoidance powers have only been exercised once, in relation to a Bermuda registered company which had filed for Chapter II protection in the United States.  However, if actually enacted along the lines announced, the new legislation will materially expand the circumstances under which TPR will be able to exercise its anti-avoidance powers and the persons who may be subject to the exercise of them.

At a Glance – the New Guidance

The approach of the new guidance removes some of the certainty as to which transactions or events may have been of a type which would expose the relevant parties to the risk of TPR exercising its anti-avoidance powers.

The Announced New Legislation

The moral hazard powers of TPR consist of contribution notices (CNs) and financial support directions (FSDs).  A CN can require the employer, or a person connected with, or an associate of, the sponsoring employer, to contribute up to the full buyout (Section 75 Pensions Act 1995) deficit of a defined benefit pension scheme.  An FSD requires the employer, or a person connected with, or an associate of, the employer, to effectively guarantee in full or in part the pension liabilities of the sponsoring employer of an underfunded pension scheme where the employer is either a service company or is “insufficiently resourced” to meet its pension liabilities.

There are five key elements to the new legislation:

• CNs may now be issued “where the effect of an act is materially detrimental to a scheme’s ability to pay member’s current and future benefits”.  Previously, TPR had to prove “intent” on the part of a party to avoid liability for pension scheme funding.
• The new legislation now reflects the tenor of the revised new guidance (see below) more closely than the historic legislation did.  The practical effect is the removal of a hindrance to TPR’s ability to issue a CN. The Government’s intention is that the new legislation should now more easily facilitate a CN being issued in circumstances where an employer’s pension liabilities are either reduced or the employer’s ability to meet them is weaker than in the past.  Even greater attention should be paid to ‘pensions risk’ than in the past in connection with transactional and restructuring work.
• Historically, a CN could only be issued to a person who had acted to prevent a liability falling due, or to compromise or reduce the amount of debt which would otherwise have become due, where that party had acted otherwise than in good faith.  The Government has described the good faith “defence” as “an unhelpful hurdle which would present the power being used in situations where parties have simply not considered impacts on pension schemes”.  The good faith defence has now been removed.
• Relevant parties, and in particular employers sponsoring defined benefit schemes, will now need to consider the impact on the pension scheme of any material event in order to determine whether an “unintended consequence” could expose them to the risk of a CN.
• The Government has now confirmed that a CN can be triggered by a series of acts or events and not just a single act or event aimed at avoiding a debt to a pension scheme.  This element is introduced retrospectively to 27 April 2004.
• Whilst TPR’s revised guidance indicates that a CN will be considered in relation to a series of acts or events, the legislative basis for this was less clear.  The new legislation removes the doubt and will be retrospective to 27 April 2004.  No details have, however,  been made available.  There is no indication, for example, as to what the maximum time period is between each act for them to form a series of acts. Equally, there is no indication as to whether the six year time limit within which a CN can be issued will be measured from the first or last act in the series.  An ongoing review of the effects of corporate activity or a pension scheme may be necessary to manage the moral hazard risk with the review extending back to April 2004 where appropriate.
• In relation to FSDs, the new legislation is amended so that in determining “insufficiently resourced”, the resources of the whole group of companies (rather than just the company sponsoring the scheme) may be considered when judging whether to issue one.  This will broaden the scope of companies within a group which could be subject to an FSD. A more detailed analysis of the financial circumstances of a greater number of group companies will need to be undertaken in relation to any risk assessment.
• In addition, the Government has proposed new measures to ensure that bulk transfers of members between schemes are not used as a means to frustrate the ability of TPR to use its anti-avoidance powers. There is no indication of how this will be achieved by the legislation.

The new legislation under which the Government is to effect the proposals in its announcement is yet to be published, even in draft form.  However, the new legislation is stated as being introduced with effect from 14 April 2008.

The Revised Clearance

To bring certainty to persons who could be affected by the moral hazard provisions, TPR introduced a clearance procedure in April 2005.  Those who were potentially at risk of a CN or an FSD being issued were, after offering appropriate mitigation, able to apply for a clearance statement giving assurance TPR would not exercise its moral hazard powers.

At the end of March 2008, TPR substantially amended its guidance as to the clearance procedure in terms of its approach to considering applications.  TPR states the guidance “has been updated in light of our experience of operating clearance and reflects the way that both [TPR] and the market have developed since clearance was introduced in April 2005”.

The Key Changes

There are five key changes to the clearance guidance:

• The application process:  although documentation supporting an application under the 2005 guidance was required, it typically did not relate to the “heart” of the employer’s business.  TPR now expects, as a matter of course, high level and potentially sensitive business information to be made available to it, for example management accounts, details of debt, intra-group balances and guarantees, and summaries of related party transactions not disclosed in the statutory accounts.  The disclosure requirement clearly becomes more onerous.
• Employers will also need to consider confidentiality issues more closely than previously.  Whilst there is no requirement that the above documentation is disclosed to the scheme trustees, their ability to comment on the application and negotiate appropriate mitigation (which TPR expects) will be limited without sight of it, which can be expected to be taken into account by TPR in deciding whether to grant clearance.
• New definition of “type A” event:  clearance remains only appropriate for what are defined as type A events.  However, type A events are now (more widely) defined as all events that are materially detrimental to the ability of the scheme to meet its pension liabilities.  In addition, certain events will now be type A events regardless of the funding position of the scheme.
• This represents a material shift in determining whether an event is type A, from analysing the nature of the event or transaction, to analysing its effects.  This may mean that a transaction that was not a type A event for the purposes of the old guidance (for example a business sale carried out at arm’s length) may now be a type A event.  Applying for clearance may now be appropriate in circumstances where it was not previously, and more complex and detailed consideration of pensions issues will be required in relation to transactions than was the case. 
• Funding triggers: historically a scheme had to be underfunded on an FRS17/IAS19 basis in order for an event to be type A.  The funding trigger will now be calculated as the higher of (i) FRS17/IAS19, (ii) Section 179 Pensions Act 2004 (Pensions Protection Fund), (iii) Section 222 Pensions Act 2004 (Scheme’s technical provisions) and (iv) the scheme’s ongoing valuation basis (where provisions are not available).  However, where the relevant event is significantly materially detrimental (for example there are going-concern issues) the relevant deficit will be measured on the higher Section 75 Pensions Act 1995 (buyout) basis.
• While the funding benchmark has been finessed, what is more material is that under the new guidance, certain (scheme-related) events will be type A events regardless of the funding position of the scheme.  The new funding trigger, however, remains relevant for “employer-related” events, for example corporate restructuring and mergers and acquisitions.
• Mitigation:  considerable detailed guidance has now been provided in relation to forms of mitigation that may be provided, as an alternative to a cash contribution to fund the scheme up to the level of the funding trigger.
• When the clearance regime was first introduced, mitigation most usually comprised of ensuring the scheme was fully funded on an FRS17/IAS19 basis.  As TPR became more comfortable with analysing transactions or events, so it became more comfortable with agreeing to alternative forms of mitigation, but exploring possible forms with TPR was time consuming.  The expanded list of example forms of mitigation that may be acceptable is to be welcomed as being practical and extensive.
• Focus on principles-based regulatory approach:  the historic prescriptive-test based approach to clearance applications has been replaced by guidance overlaid by guiding principles to be applied by trustees and employers, and separate guiding principles to be applied by TPR, removing some of the certainty provided under the historic guidance.

What This Means

The wider practical implications for employers and trustees with defined benefit pension schemes are material.  TPR has effectively stated that a potentially far greater category of transactions or events will potentially fall to be scrutinised by TPR with a view to issuing a CN or an FSD than previously.  This position is backed up by legislation.

Employers and trustees will need to undertake more complex and therefore more costly and time-consuming analyses of the effects of day-to-day corporate activity than previously.

The full text of TPR’s revised guidance may be found, along with the application form and other supporting regulatory material, here . 

In addition, a detailed summary of the revised guidance, prepared by McDermott Will & Emery UK LLP, may be found here.

Contact(s)

• Nicholas Donnithorne

Practice Areas & Industries:

• Employee Benefits & Pensions
• Employment - London
• London
• Pensions & Incentives - London

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