UK: US And UK Pension Funding Considerations In Corporate Transactions

Significant employee benefit obligations often arise in the context of corporate transactions. In particular, unfunded liabilities for defined benefit pension plans have the potential to add unexpected complications and costs to mergers and acquisitions, spin-offs, asset sales, stock sales and other corporate reorganizations. When these transactions affect defined benefit plans in which US or UK employees participate, some measure of interaction with the governmental authorities that oversee pension plans in these countries is often necessary. This article provides an overview of the different regulatory schemes to which US and UK pension plans are subject in the context of corporate transactions and briefly discusses some issues that participants in these transactions wishing to avoid 11th-hour surprises should consider.

UK Pension Oversight and Regulation in Corporate Transactions

The UK Pensions Regulator (the Regulator) was established in 2005 and given a wide remit to protect the members of defined benefit pension plans. In the context of corporate transactions, the Regulator seeks to achieve this objective by preventing companies and individuals from avoiding their pension debts mainly through powers known collectively as the "moral hazard" powers.

Measuring the Pension Deficit

There are various methods of valuing pension deficits in the UK. While the FRS17/IAS19 deficit figure appears on the company balance sheet and is often used by buyers in calculating the enterprise value of a target, the "scheme-specific" deficit and the "buy-out" deficit are more important from a pension liability perspective.

The scheme-specific deficit is calculated based on the plan's actual liabilities taking into account its asset profile and member profile. An actuarial valuation to determine whether there is a deficit on this basis is carried out every three years. If there is a deficit, the trustees and the plan sponsor enter into a "recovery plan" which sets out the contributions required to be paid to pay off the deficit by a particular date (10-year recovery plans are common). In the ordinary course, the sponsor's only financial obligation to the plan is to pay the contributions due under the recovery plan.

The buy-out deficit is calculated on the basis that all the plan's liabilities need to be bought out immediately with an insurance company — no allowance can be made for expected investment return or future employer contributions. The buy-out deficit will therefore be larger, often significantly, than the scheme-specific deficit.

The buy-out deficit is triggered as payable by the sponsor if the plan winds-up (trustees of some plans have the unilateral power to wind-up the plan in particular circumstances, which they will often use as a negotiating tool in discussions with the employer) or the sponsor becomes insolvent. In addition, if an employer that participates in a plan which has more than one employer ceases to participate in that plan (e.g., because it is sold out of the group) then its share of the buy-out deficit will become due and payable to the plan (unless the trustees agree otherwise).

Finally, the buy-out deficit is important because the legislation allows the Regulator to require the employer or parties "connected or associated" with the employer to either pay off the deficit or put in place support arrangements for the deficit. The definition of "connected or associated" is very wide, and includes all companies in the same group as the employer (above and below the employer in the chain) and any person that controls 33 percent or more of the voting power of the employer or its parent and may even, in some cases, include lenders to the group (if they meet the 33 percent test, have employees or directors in common with the group, or are shadow directors (i.e., if the employer or its parent is accustomed to act in accordance with the lender's instructions)).

The Regulator's "Moral Hazard" Powers

The Regulator's "moral hazard" powers consist of issuing contribution notices and financial support directions. Contribution notices (but not financial support directions unless the employer is an individual) can be served on entities or individuals (including directors of group companies or their families).

Contribution Notices
A contribution notice would be likely to take the form of a notice requiring the recipient to pay money to the pension plan. It could be an amount of up to the buy-out deficit in the plan. A contribution notice can be issued where the recipient was party to an act or deliberate failure to act and:

  • The Regulator considers that an act or omission has had a materially detrimental effect on the likelihood of plan members receiving their benefits (the "material detriment" test (see further below)); or
  • The main purpose or one of the main purposes of the act or failure was:
  • To prevent the recovery of the whole or part of a debt that was, or might become, due from the employer to the plan, or
  • To prevent such a debt becoming due, to compromise or otherwise settle such a debt, or to reduce the amount of such a debt which would otherwise become due.

There is a statutory defense to the material detriment test if the Regulator is satisfied that the party gave due consideration to the extent to which material detriment may arise, that the party took all reasonable steps to eliminate or minimize the potential detriment and that, having regard to all relevant circumstances, it was reasonable to conclude that material detriment would not arise. However, this defense is fairly complicated and would require detailed professional advice to determine whether it might work in a particular situation.

As well as requiring an act or omission that falls within the definitions outlined above, the Regulator cannot issue a contribution notice unless it would be "reasonable" to do so. In determining this, the Regulator will consider a number of issues including the degree of involvement the person had in the act or failure to act and any connection or involvement the person has or had with the plan itself.

There is a six-year "look-back" in relation to contribution notices meaning that if an act or omission occurred in the last six years, the Regulator can still take action, even if that person is no longer connected or associated with the plan. The Regulator has issued one contribution notice, against the Belgian parent company of a UK employer, where the Belgian parent had orchestrated the "pre-pack" administration of the UK employer in order to purchase the business of the employer and leave the pension liabilities behind. The Belgian entity appealed and the case eventually settled with it paying £60,000 to the pension plan (to be compared with a buy-out deficit in the plan of some £20m).

Financial Support Directions
There is no requirement for an "act or omission" before the Regulator can issue a financial support direction. Financial support directions can be issued at any time where the employer is a services company (meaning it obtains most of its revenue from providing the services of employees to other members of the group), or is "insufficiently resourced," meaning broadly that its net assets are less than half of its share of the plan deficit, and there are other connected or associated parties that have sufficient net assets to make up the difference.

As for contribution notices, the Regulator must be satisfied that it is reasonable to issue a financial support direction.

There is a two-year "look-back" in relation to financial support directions meaning that if a party ceased to be connected or associated with the plan, but this was less than two years ago, the Regulator can still take action against that party.

The Regulator has issued two financial support directions (in relation to two plans of the same employer). In that case, the recipient was the Bermudian parent company of a UK subsidiary. The Bermudian parent was about to enter into insolvency proceedings and the UK trustees were concerned about how that would affect the plan. The UK company was a services company and the Regulator held that it was reasonable to issue the financial support directions because, amongst other things, the parent had received significant benefit from the UK company providing services of employees to other group companies, and had given a written guarantee to cover all obligations towards employees of the UK company. The Regulator has also stated its intention to issue financial support directions against certain entities in high-profile insolvent groups, although the appeal process is not yet complete so the directions have not yet been formally issued.


The parties to a transaction (or another "corporate event" such as payment of a dividend, making a return of capital, granting a fixed or floating charge, sale and leaseback transactions or granting or forgiving inter-company loans) can choose to apply for a clearance statement from the Regulator that it will not use its powers in respect of a particular transaction. In practice, the trustees of the pension plan will need to support or at least not oppose the application, and will need their own legal and financial advice to determine whether they can do so. Clearance is always voluntary and is only appropriate where a transaction or corporate event is what is referred to in the Regulator's guidance as a "Type A event," meaning broadly that it is "materially detrimental" to a pension plan (i.e., it weakens the employer covenant to the plan) or the position of the plan on employer insolvency. The most common form of detriment is where a transaction is highly leveraged, meaning the amount of secured debt in the group, which would typically rank ahead of the pension deficit on an insolvency, is increased.

From engaging with the trustees to ultimately receiving the clearance, the process can take around six to eight weeks. In addition, applying for clearance will generally constitute an admission that the relevant transaction is detrimental to the pension plan. Therefore clearance is unlikely to be granted unless mitigation for that detriment is offered — such as paying a significant contribution to the plan (e.g., paying off the FRS17/scheme-specific deficit upon completion or shortly afterwards on an accelerated payment plan), or the buyer providing additional support for the plan, perhaps in the form of a parent company guarantee.

Asset Sales

Unless something different is commercially agreed, on an asset deal, the UK pension plan will remain behind with the seller group. The purchaser of assets will not become connected or associated with the UK plan by virtue of buying the assets — there will only be the risk of Regulator action against the purchaser if it is connected in some other way (e.g., directors in common with the seller group). However, if the deal involves assets in the UK but stock elsewhere, the entities in respect of which stock is purchased will remain connected with the UK plan for up to six years and therefore there will be some risk for the purchaser group.

If significant assets of one or more of the plan employers are sold, this will potentially be detrimental to the pension plan because the entity itself will have fewer resources and therefore may be less likely to be able to pay the contributions due under the recovery plan. The seller may therefore wish to seek clearance from the Regulator for an asset deal, and the purchaser will want any entities in respect of which stock is to be purchased to also be a party to that clearance.

The mitigation that the trustees or the Regulator will require will depend on the materiality of the detriment. If detriment is significant, with the plan employers being left with nominal or no assets, we would expect the trustees to require at least the scheme-specific deficit to be paid off in full out of the sale proceeds, with a seller parent company guarantee also being put in place. The trustees may also have powers under the trust deed and rules of the plan to wind-up the plan in these circumstances, and they will therefore use the buy-out deficit as their starting point in negotiations.

Stock Sales

Unless something different is commercially agreed, on a stock deal, where the plan sponsor is sold, the pension plan will transfer with the stock to the purchaser group. The sale of the sponsor will generally need to be "notified" to the Regulator. Notification is a different process to clearance — it is mandatory and consists of completing a simple online form.

Typically, a deduction from the purchase price will be agreed to reflect the deficit in the UK pension plan. Historically, in most deals, this would be the FRS17 deficit, and sellers will still push for that figure to be used. However, the scheme-specific deficit may well be higher than the FRS17 deficit and is in real terms the amount that the purchaser group will be required to pay off over time. In addition, if the transaction is materially detrimental to the plan, the trustees may bring forward the next valuation and use more conservative assumptions which would lead to that deficit increasing. Further, if the detriment is acute, the trustees may wish to target funding which is closer to the buy-out deficit. It is therefore critical that a purchaser engages a covenant review expert and an actuary to assess these risks and determine the appropriate deduction to be sought from the purchase price, or factored in to the price offered for the stock.

If there is a detriment, the parties may also wish to seek clearance for the deal. Clearance is most often sought by sellers as, if granted, it provides them with a "clean break" from their association with the pension plan. For purchasers, it is less useful because it only relates to the transaction and would not stop the Regulator taking action in respect of future corporate events such as the payment of a large dividend. Clearance is therefore generally only recommended for purchasers where the detriment is particularly material – the trustees are likely to be concerned if the purchaser does not apply for clearance in those circumstances and it is important to ensure the relationship between the purchaser and the trustees starts off as positive as possible. Of course, if the seller is applying anyway, the purchaser should also join the application as a party. Consideration will need to be given as to whether the clearance will be a condition precedent to the sale closing and as to how the risk of the Regulator requiring additional payments or other mitigation to be provided in return for the clearance will be allocated.

Planning Considerations

In both asset and stock sales, in particular where the trustees have the power to wind-up the pension plan unilaterally, it is essential that the transaction is discussed in advance with the trustees, whether or not an application for clearance to the Regulator will be made. Ideally, these discussions would take place before signing so the parties can ascertain the trustees' likely position before entering into binding documentation. However if this is not possible (e.g., for reasons of confidentiality) the deal could be made conditional on agreement with the trustees, on terms acceptable to the seller and purchaser, being reached. If neither option is possible, the purchaser will need to be sure it has factored the "worst case" on pensions into the price it is prepared to pay.

US Pension Oversight and Regulation in Corporate Transactions

The Pension Benefit Guaranty Corporation (PBGC) was established in 1974 with the passage of the Employee Retirement Income Security Act of 1974 (ERISA) to insure and oversee the maintenance of private pension plans in the United States. In contrast to the UK Pensions Regulator, the PBGC generally lacks the power to force contributions to pension plans as long as the sponsors of such plans comply with minimum funding standards imposed by the US Internal Revenue Code and ERISA. However, significant risks can still apply with respect to US pension plans that are affected by corporate transactions.

The PBGC's Early Warning Program

Under its "Early Warning Program," the PBGC routinely monitors plan sponsors to identify corporate transactions that could impact the plans it insures. The PBGC is increasingly seeking to negotiate additional plan protections in connection with transactions it identifies as detrimental to a plan or the PBGC's interests as the plan's insurer. Not all transactions will receive attention from the PBGC, but if the PBGC becomes aware of a transaction, sponsors of underfunded pension plans can expect to be contacted if the transaction could be viewed as weakening the financial support for the plan. The PBGC has suggested that examples of such transactions would include the breakup of a controlled group, a transfer of significantly underfunded pension liabilities in connection with the sale of a business, or a leveraged buyout.

Once the PBGC becomes aware of a transaction that it considers detrimental to a plan, it will seek to engage with the plan sponsor's management to negotiate additional contributions or security for the pensions in the context of the transaction. Although the PBGC does not have broad power to cause additional contributions to be made or security to be granted to the plan, it does possess certain statutory weapons that it can use as leverage in such negotiations.

Asset Sales: ERISA Section 4062(e)

Many transactions will trigger liability for a plan sponsor under Section 4062(e) of ERISA, which allows the PBGC to seek protection from a plan sponsor when an employer ceases operations at a facility and, as a result of such cessation of operations, more than 20 percent of the total number of its employees who are participants in a plan are dismissed from employment. The amount of the potential liability equals the amount of the plan's underfunding multiplied by the percentage reduction in active participants. For this purpose the amount of underfunding is measured based upon a conservative "plan termination" basis, which can cause the potential liabilities to be substantial, even where a plan has been safely meeting its ongoing funding requirements.

The application of Section 4062(e) to most corporate transactions is a relatively new phenomenon. Generally, prior to 2006, it was unclear how the amount of liability under Section 4062(e) was calculated, whether in connection with corporate transactions or otherwise. In 2006, the US Department of Labor established final regulations setting forth a formula for calculating such liability. Moreover, the PBGC had historically taken the position that when one employer sells the assets of a business unit to a buyer who continues the operations of the relevant facilities and the employment of the related employees, no 4062(e) event occurred in connection with the sale, based on the simple theory that no overall cessation of operations has occurred. However, a literal interpretation of the statutory language can yield a different result, since the seller is technically an employer who has ceased operations at the sold facilities and terminated the employment of the related employees. As a result, and likely due to increased demands on PBGC resources in connection with the economic downturn, the PBGC began changing its position on this point a few years ago. More recently, proposed regulations issued by the Department of Labor in 2010 made clear that the PBGC will treat an asset sale transaction as triggering potential liability under Section 4062(e), even where the buyer continues the business uninterrupted.

Importantly, liability under Section 4062(e) is not self-executing. Rather, the PBGC must seek actively to pursue it and the typical resolution is a negotiated agreement between the PBGC and the plan sponsor. The types of protections in such negotiated agreements can vary and may not necessarily involve immediate cash payments to the plan. Agreements that involve total payments of up to the full Section 4062(e) liability amount amortized over a period of several years are typical. Other alternatives are to escrow the liability amount or to purchase a bond to protect the plan against a distress termination, subject to reversion of the escrowed amount or cancellation of the bond after some period of time, typically five years. Arrangements can also involve the provision of additional collateral in the form of a mortgage or security interest on company assets to secure the liability amount.

One important factor in the negotiated agreement will be the extent to which the transaction triggering the Section 4062(e) event could be viewed as detrimental to the plan. If pension assets and liabilities are transferred to a buyer in a transaction, the transaction parties may argue that there is no detriment suffered because the plan continues to operate in the same manner with the same number of active participants as before. It is not clear how the PBGC would view such an argument, though it is likely in this circumstance that the PBGC would analyze the relative financial strength of the buyer and seller. If the buyer is potentially weaker financially than the seller, the PBGC would likely seek additional protection for the plan.

Stock Sales and Mergers: ERISA Section 4062(e)

The PBGC may also seek to apply Section 4062(e) liability in a "carve-out transaction" whereby a parent company divests one but not all of its operating subsidiaries in a stock sale or merger. This is particularly true in transactions that result in some employees ceasing to participate in a plan or portions of a larger plan being "spun off" with the sold entities. While it would initially appear there is no cessation of operations in a stock sale or merger where the direct employer (or its corporate successor by operation of law) simply continues to operate the relevant facilities and employ the related employees, "employer" for purposes of the relevant provisions of ERISA includes not only the direct employing entity, but also all of the entities that are in the same "control group" as the direct employer. A "control group" generally includes all entities that are commonly owned at a level of 80 percent or greater. If the PBGC views a transaction involving the break-up of a control group as detrimental to the affected plan(s), the PBGC may take the position that a cessation of operations by one or more of the remaining entities in the group (i.e., the remaining "employers") has occurred, thereby triggering liability under Section 4062(e). In addition, it is worth noting that an even more aggressive reading of "employer" could be taken, for example, to find that a holding company that divests all of its operating subsidiaries is an "employer" that has ceased operations and triggered Section 4062(e) liability.

Other Transactions

As described above, Section 4062(e) is susceptible to a very broad interpretation, but it cannot cover the entire universe of all corporate transactions. For example, a stock sale or merger of a business that is owned by two or more unrelated stockholders (with no single 80 percent owner) will not involve the break-up of a controlled group and often will not result in the cessation of operations at any facilities. A typical example of this would be a leveraged buyout of a public company by a private equity firm. However, transactions of this type raise concerns for the PBGC because they frequently involve an increase in the debt load of the target company, making it a financially weaker sponsor of the plan. In these circumstances, the PBGC's negotiating position in seeking protection for the plan is relatively weaker than in 4062(e) transactions, but the PBGC is not without bargaining power. There are clear business risks for a plan sponsor in refusing to engage or compromise with the PBGC, given its continuing regulatory authority over the plan. The PBGC also possesses an "ultimate threat" of forcing an involuntary termination of the plan in connection with the transaction, which would require immediately funding the full deficit of the plan on a conservative plan termination basis (often a substantial amount, even for plans that are otherwise well funded) and is a potential risk for any corporate transaction.

On this latter point, the PBGC faces two substantial obstacles: (i) a high legal standard that must be met to force a plan termination; and (ii) a limited time within which to show that the standard has been met. To force a plan termination in the context of a pending corporate transaction, the PBGC must demonstrate that its possible long-run loss with respect to the plan may reasonably be expected to increase unreasonably as a result of the relevant transaction. The PBGC must make this showing prior to the transaction's closing. Once a transaction is consummated, any potential increase in risk resulting from the transaction has passed; the increase has already occurred. In many cases, the PBGC will simply not be able to meet this high standard, even through its internal administrative channels, before the transaction is completed. Nonetheless, the PBGC has still been successful in negotiating some increased pension plan protection in recent buyout transactions.

Planning Considerations

It is important that parties to a transaction consider potential pension funding issues early to avoid any surprise costs, including costs associated with future divestitures of all or a portion of the acquired business. Parties to corporate transactions in the United States should consider the extent to which it is likely that the PBGC will learn of a transaction in time to seek protections and should keep in mind that many, but not all, transactions will involve notification obligations to the PBGC. In addition, if parties act quickly, there may be planning opportunities to mitigate any potential increase in plan funding obligations. Depending on the circumstances, such opportunities can include, for example, merging plans to avoid triggering the 20 percent separation threshold under Section 4062(e) or structuring a transaction to minimize any apparent detriment to the affected plans.


Companies exploring strategic transactions should be mindful of the often delicate and complicated interactions with governmental regulatory authorities that may arise when transactions affect defined benefit pension plans in which US or UK employees participate. While the US and UK pension regulatory landscapes differ markedly, regulators in both countries may have the authority, directly or indirectly, to demand substantial contributions be made to underfunded plans in connection with these transactions. Early consideration of potential issues, including issues that could arise with respect to potential future divestitures or other transactions, can minimize the likelihood of costly and unwanted delays and surprises.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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