UK: New Employer Debt Regulations, Revised Clearance Guidance And Changes To The Pensions Regulator´s Powers

The spring saw a burst of activity from the Pensions Regulator and Department of Work and Pensions. The long-awaited amendments to the Occupational Pension Schemes (Employer Debt) Regulations came into force on 6 April 2008. The Pensions Regulator has issued revised clearance guidance following the consultation which took place last September. Finally, the Department of Work and Pensions began consulting on changes to the Regulator's powers to issue contribution notices and financial support directions.

All of these changes will have an impact on corporate transactions or reorganisations where there is a defined benefit scheme in place.

Employer Debt Regulations

The Employer Debt Regulations apply when an employer in a defined benefit multi-employer occupational pension scheme has an "employer cessation event". If the scheme is in deficit on a buy-out basis that employer becomes liable to the trustees for a proportionate share of the buy-out deficit in the scheme under section 75 Pensions Act 1995 (called the "liability share" in the new regulations). The new regulations are more helpful in determining how this share should be calculated when, as often is the case, the scheme records are unclear as to which liabilities are attributable to which employer.

An employer cessation occurs when an employer ceases to employ at least one active member of the scheme, whilst there is at least one other participating employer employing an active member of the scheme. (This is a change from the previous regulations which referred to ceasing to employ "persons in the description of employment to which the scheme relates" - which was unclear as to whether a cessation event was triggered if the employer still employed deferred members of the scheme).

The new regulations introduce a "period of grace" which should prove useful for group re-organisations or even when an employer cessation event occurs inadvertently. The employer can give notice to the trustees, within one month of the employment cessation event, of its intention to employ active member(s) within 12 months of the cessation event. The debt is only triggered if the employer then fails to employ an active member again within the 12 month period or notifies the trustees of a change of its intention. When an active member is employed within the 12 month period then the employment cessation event is deemed never to have happened.

In addition to the employer paying its liability share of the debt, the new regulations provide four alternatives for dealing with the debt:

• a withdrawal arrangement;
  
  
• an approved withdrawal arrangement;
  
  
• a scheme apportionment arrangement; and
  
  
• a regulated apportionment arrangement.
  
  

Withdrawal arrangements and approved withdrawal arrangements

Under the previous regulations, withdrawal arrangements required Pensions Regulator approval, but the circumstances in which the Regulator could approve them were restricted which meant that they were often not a practical solution.

In the revised regulations, withdrawal arrangements do not require Pensions Regulator approval (although an employer may decide that it wants to obtain clearance in any event). A withdrawal arrangement is an agreement between the trustees, the ceasing employer and a guarantor (which could be the ceasing employer) under which:

• the ceasing employer pays an amount equal to or more than its liability share of the scheme specific debt (or where a scheme has yet to undergo its first scheme specific valuation under the Pensions Act 2004, the PPF debt). This is known as "Amount A". The withdrawal arrangement may provide for Amount A to be paid in instalments;
  
  
• the guarantor guarantees to pay "Amount B" when the scheme winds up or the last remaining employer has an insolvency event, or on the date agreed in the withdrawal arrangement. Amount B is based on the buy-out deficit for the ceasing employer calculated either as at the employment cessation event or when the payment falls due;
  
  
• the trustees must be satisfied that the guarantor has sufficient financial resources to be likely to be able to pay the Amount B which would arise on the date of the agreement. This will require an analysis of the financial strength of the guarantor; and
  
  
• the trustees must be satisfied that the funding test is met. The funding test requires the trustees to be reasonably satisfied that when the arrangement takes effect, the remaining participating employers will be reasonably likely to be able to fund the scheme, taking account of any changes in the "technical provisions" of the scheme which the trustees consider necessary as a result of the arrangement. The "technical provisions" are the actuarial assessment of the liabilities in the scheme. This will require an assessment of how the strength of the employer covenant will change as a result of the arrangement. If the covenant is weakened by the employer leaving, the trustees may reach the conclusion that more conservative assumptions should be used to calculate the technical provisions, making the funding test harder to meet for the remaining employers.
  
  

The requirements for an approved withdrawal arrangement are very similar, except that:

• as the name suggests, Regulator agreement is required. The regulations set out factors which the Regulator may take into account when deciding whether it is reasonable to do so, including the effect on the technical provision assumptions, the financial circumstances of the guarantors and the effect on the security of members' benefits;
  
  
• Amount A can be less than the ceasing employer's liability share of the scheme specific deficit; and
  
  
• the Regulator can give notice requiring Amount B to be paid.
  
  

Scheme apportionment arrangements

Under a scheme apportionment arrangement, the ceasing employer pays an agreed sum which is different to its liability share of the section 75 debt. Usually this will be a smaller sum, possibly even a nominal sum, but it is possible for the ceasing employer to agree to pay a sum which is larger than its liability share.

The remainder of the ceasing employer's liability share is apportioned amongst the remaining employers in the scheme, and those employers to whom the liability share is apportioned must agree to the scheme apportionment arrangement. The arrangement may also provide for when the amounts so apportioned are to be paid. Trustees will therefore need to consider whether to require the remaining employers to make payments - in a similar manner to a recovery plan - or allow the sums apportioned only to fall due when that remaining employer's own section 75 debt is triggered.

The trustees must be reasonably satisfied that the funding test is met before they can agree to the arrangement which, unlike for withdrawal arrangements, has two limbs. The trustees must be reasonably satisfied that:

• the remaining employers will be able to fund the scheme (this is the same as for withdrawal arrangements); and
  
  
• the arrangement will not adversely affect the security of members' benefits, taking into account any changes in circumstances that would justify a change to the method or assumptions used to calculate technical provisions or a material revision to any existing recovery plan.
  
  

"Security" is not defined, but it is usually regarded that the security for members' benefits comes from a combination of the funding level of the scheme and the strength of the employer covenant. It is not entirely clear how much the second limb of the test really adds and it may have been simpler if the same funding test was used for both withdrawal arrangements and apportionment arrangements.

There is no requirement for approval from the Regulator. However, any decision by the trustees which is intended to result in a scheme apportionment arrangement is now a "notifiable event" which must be reported to the Regulator. Given the changes in the clearance guidance discussed below, this will almost force the employer into applying for clearance.

Regulated apportionment arrangements

A regulated apportionment arrangement is similar to a scheme apportionment arrangement, but if:

• the scheme is in a PPF assessment period (or the trustees believe it likely that the scheme will be in an assessment period in the next 12 months);
  
  
• the trustees consent to the arrangement (but only if the scheme is not yet in the PPF assessment period);
  
  
• the PPF does not object to the arrangement; and
  
  
• the Regulator approves the arrangement
  
  

these will be relevant to employer restructurings where insolvency is likely.

Comment

The amendments are an improvement on the original regulations and give a number of - albeit complex - options for dealing with the section 75 debt. Employers should carefully consider the most appropriate option for dealing with section 75 debt, and discuss it with the trustees, before the employer cessation event is triggered.

Employers must also consider if the arrangement contemplated will require Regulator clearance. Although the regulations themselves only envisage two arrangements which specifically require Regulator approval, withdrawal arrangements and scheme apportionment arrangements may both require clearance depending on exactly what is being proposed.

Revised Clearance Guidance

Clearance is a voluntary procedure that involves the Regulator providing assurance to an applicant that, based upon the information provided, it will not invoke its "moral hazard powers" and issue a contribution notice or financial support direction following a particular corporate transaction or scheme-related event.

The first clearance guidance was issued by the Regulator in April 2005 and this subsequent revision is issued in the light of the Regulator's increased knowledge about the practical operation of the clearance process and understanding of corporate transactions. The key difference to the original guidance is that the Regulator has moved away from giving specific circumstances of when clearance should be sought to a principles-based approach.

The Regulator only expects an application for clearance to be made where there is an event that is materially detrimental to the ability of the scheme to meet its pension liabilities. (This is still known as a "Type A event" - as in the original guidance - even though Type B and C events have now been dropped as they are seldom encountered in practice.) A distinction is made between employer-related Type A events and scheme-related Type A events, although it is possible for a set of events to be both employer- and scheme-related Type A events.

Employer-related events

Employer-related events are only Type A events if the scheme has a relevant deficit, based upon the highest of:

• FRS17/IAS19;
  
  
• PPF Valuation basis;
  
  
• scheme specific funding basis; or
  
  
• ongoing basis (where the scheme's technical provisions are not yet available).
  
  

The exception to this is where an employer-related event is significantly materially detrimental to the scheme's ability to meet its liabilities, in which case the deficit can be measured on a higher basis - although it is unclear exactly how that basis will be determined. A relevant deficit will also be measured on a buy-out basis if there are concerns as to whether there are issues about the employer as a "going concern" or if there is a proposal to abandon the scheme.

The guidance provides a non-exhaustive list of examples of employer-related Type A events, which include:

• a reduction in the assets of the employer or the employer group (for example, a special dividend payment);
  
  
• a change in group structure or a participating/principal employer;
  
  
• a change in the level of security given to creditors; and
  
  
• a business or asset sale.
  
  

In order to assess whether an employer-related event is a Type A event, the guidance suggests that employers and trustees should compare and contrast the pre- and post-event employer covenant and assess whether any weakening is to such an extent that the event could be considered to be materially detrimental to the ability of the scheme to meet its liabilities. This will usually require the trustees to obtain professional advice from accountants.

Scheme-related events

Scheme-related events are always Type A events, regardless of whether the scheme has a deficit or not. Examples of scheme-related events, include:

• agreements to compromise the employer's section 75 debt;
  
  
• apportionment of a scheme's deficit (a regulated apportionment arrangement may be a Type A event);
  
  
• non-payment of all or any part of a section 75 debt for an unreasonable time; and
  
  
• an arrangement that has the result of preventing a section 75 debt from triggering.
  
  

Assessment of the impact of a scheme-related event can be complex because, unlike employer-related events, the detriment to the scheme cannot usually be assessed purely by reference to the employer covenant before and after the proposed event. Trustees may need to consider both the immediate impact the event may have on the scheme and its members, as well as any potential future impact. It is also worth noting that, although under the new Employer Debt Regulations the approval of the Regulator for a scheme apportionment arrangement is not required, the Regulator expects the employer to make a clearance application in respect of the arrangement.

Mitigation and the clearance application

Trustees are expected to obtain "mitigation" for the Type A event. Examples of mitigation include extra cash contributions; provision of security; parental or inter-group guarantees; or changing the scheme rules to shift the balance of power in the scheme towards the trustees. It is the provision of mitigation which means that it would be unreasonable for the Regulator to use its powers and accordingly make it possible for the Regulator to issue its clearance statement.

When negotiating with the employer over the mitigation, trustees are advised to adopt the approach of a bank that has advanced a large unsecured loan, and again they are advised to consider obtaining independent professional advisers to assist in the negotiation process.

Comment

The shift to a "principles-based" approach recognises the diversity of circumstances in which there could be a material detriment to the scheme, meaning that clearance is appropriate. Although the decision to apply for clearance is a question for the employer and any connected/associated parties, the revised guidance is aimed as much at the trustees - and the steps they should take - as it is to the employers. The emphasis on obtaining independent professional advice to assess the impact of the Type A event - and the need to deal with conflicts which may result in an independent trustee appointment - mean that time and cost of negotiating with trustees should be factored into any proposed action which may result in a clearance application.

Proposed changes to the "moral hazard" powers

There have been (and continue to be) considerable developments in the "buy-out" market. Broadly, there are two approaches. The insured route involves members' benefits being secured with policies issued by FSA regulated insurers. The second approach is a corporate solution where a new company effectively takes over the scheme with the intention of managing the investment of the scheme better and therefore, over the long term, making a profit. This involves the scheme remaining within the pensions - as opposed to the FSA - regulatory regime and therefore still within the ambit of the PPF.

Some of the corporate route business models have concerned the Pensions Regulator, so the Government has proposed a number of changes to the Regulator's contribution notice and financial support direction powers in order that the PPF remains protected. The changes proposed are:

• Amending the test for a financial support direction so that the Regulator can look to the resources of the entire group, rather than trying to identify one sufficiently well-resourced company. At present, the test requires a single group company which is sufficiently well-resourced to make up for the insufficiently-resourced employer. Once the test is met, then any group company can be subject to the financial support direction.
  
  
• One of the current tests for imposing a contribution notice is that a person carries out an act/deliberate omission with the purpose of, otherwise than in good faith, preventing the section 75 debt becoming due, compromising or otherwise settling such a debt, or reducing the amount of such a debt which would otherwise become due. It is proposed to remove the "otherwise in good faith" requirement.
  
  
• A new test will be added for contribution notices: if an act/failure to act was materially detrimental to the scheme's ability to pay current and future benefits. There will be no requirement for the Regulator to prove intent under this test. A defence will be included that the person could not have reasonably foreseen that their actions could have had a materially detrimental effect on the scheme.
  
  

Amendments to the Pensions Act 2004 will be required, but the Government has announced that these will be backdated to 14 April 2008 when they were first announced.

The Government also proposes clarifying that contribution notices can be imposed as a result of a course of conduct rather than a single act or omission. This change will be backdated to 27 April 2004, the effective date of the introduction of the moral hazard powers, although it will not undermine any clearance statement already given.

Comment

The changes to the contribution notice powers represent a significant shift as, previously, the Regulator had to show intent on the part of the would-be recipient of the notice. The Regulator has issued a statement that - pending the actual amendment of the Act - it will not seek to use these new powers unless the actions involve:

• moving the employer or pension scheme to another jurisdiction;
  
  
• splitting the operating company from the scheme without appropriate mitigation for the scheme;
  
  
• splitting the assets from the operating company without appropriate mitigation for the scheme;
  
  
• transferring assets/liabilities to another scheme, which did not have adequate support from an employer;
  
  
• running a scheme without taking adequate account of member interests; or
  
  
• business models where the risk is borne by the scheme members, but high investment returns benefit investors.
  
  

These are all characteristics of the corporate buy-out models which concern the Regulator and the Government. However, "splitting the operating company from the scheme" or "the assets from the operating company" could equally be describing normal business activities and the Regulator could seek to use the powers outside of the corporate buy-out model which has caused concern. It is likely that there will be an increase in clearance applications at least over the short term.

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.