Comment: Comply or get off the pension pots
Mayer Brown lawyers examine how defined benefit occupational pension schemes add an additional layer of complexity when a PE firm acquires a distressed business.
Defined benefit (DB) occupational pension schemes are protected by complex UK legislation and supported by The Pensions Regulator (TPR). The TPR has wide powers to impose financial and criminal penalties on parties involved in transactions that are detrimental to the scheme. The regulator has the ability to penalise lenders, the acquirer and its management, and professional advisers.
Taken together with the fact that a pension scheme can often be one of the distressed business’s largest creditors, any PE firm contemplating an acquisition (whether or not through a formal restructuring/insolvency process) will have to undertake careful advanced planning. Any DB scheme of which the seller or member of the wider group is an employer will be an important part of the buyer’s due diligence.
It is important to be aware that these protections could catch schemes that are not obviously DB schemes. For instance, profits and shared risk structures, and certain death benefits, can push a scheme into the regime that protects DB schemes.
Moral hazard powers
The TPR has wide anti-avoidance powers, known as ‘moral hazard’ powers, which it may exercise to protect the benefits of DB scheme members and ensure that pension liabilities are not avoided or left unsupported. These moral hazard powers include the power to issue contribution notices (CNs), which require a payment to be made to the pension scheme.
They can also issue financial support directions (FSDs), requiring financial support for the pension scheme (such as a guarantee from the target) to be put in place.
Examples where moral hazard powers may be exercised are:
• Disposal of a profitable part of the seller's business to a third party, with the seller passing the proceeds of the sale to its parent company (by way of a dividend or other capital return mechanism such as a share buy-back), thus adversely affecting the seller's ability to support the pension scheme.
• Leveraged acquisition by a PE fund of a parent company that has guaranteed its subsidiary's obligations to the pension scheme and that acquisition substantially reduces the parent company's ability to stand behind the guarantee.
• A ‘manufactured insolvency’ of an otherwise viable and solvent seller to facilitate the sale of its business out of an insolvency process (such as administration) without the scheme.
• A ‘pre-pack’ administration where there is significant overlap or connection between
the pre- and post-administration owners.
CNs and FSDs can be issued to a broad range of recipients. Where the buyer is a private equity house, a CN or an FSD could potentially be issued against the newly formed company and the private equity vehicle plus, in theory, the underlying funds.
Clearance applications and negotiations with the TPR
Parties to a corporate transaction – which may be potentially materially detrimental to the scheme's ability to meet its liabilities – may apply for clearance (such that the TPR will not use its CN and FSD powers). Although the conditions for clearance are not expressly prescribed, the TPR is likely to require cash or some form of contingent support to be put in place if clearance is to be given.
We would usually expect to see employers and pension scheme trustees engage with one
another, along with transaction parties where relevant, at an early stage to discuss the structure of the proposed acquisition. Consideration should also be given to its impact on the pension scheme and any support that is proposed, before engaging with the TPR. Clearance applications are relatively unusual because usually the parties are satisfied that the support put in place means that the DB scheme is properly protected, meaning that there is little risk of the TPR using its powers, rendering clearance unnecessary.
There are new upcoming powers that would require certain transactions to be notified to the TPR. If this legislation comes into force, we may see an uptick in formal clearance applications. It is important to note that clearance does not convey any wider approval of the transaction or limit the TPR's use of criminal penalties.
The TPR can investigate and pursue the following offences:
• Avoiding an employer debt (known as the ‘s75 debt’, the statutory debt owed by the
employer to the scheme that becomes payable in certain circumstances, including
where the employer suffers an insolvency event)
• Conduct risking accrued scheme benefits
• Failure to comply with a CN.
These offences are subject to a defence of ‘reasonable excuse’. They are punishable by unlimited fines and the first two can lead to a prison sentence. A wide range of entities and individuals are potentially within the scope of these penalties, including anyone involved in decisions that affect the pension scheme (such as directors, pension trustees and advisers). However, the TPR has indicated that it does not intend to prosecute behaviour that it considers to be ordinary commercial activity, but instead, it will investigate and prosecute the most serious examples of intentional or reckless conduct.
If a group sponsoring a DB scheme undergoes corporate activity that could have an effect on the covenants supporting the scheme, the group must take steps to prepare adequate documentation. Providing business rationale behind the activity, as well as proving that due advice was taken, will help evidence a ‘reasonable excuse’ defence – and, more importantly, make sure that sponsors of, and advisers to, pension schemes avoid committing any offence.