How the world of pensions and restructurings has changed. During the most recent wave of restructurings five years ago, pensions scarcely featured as an issue. Now, though, pension deficits are a critical issue and the trustees are key players.
Three key changes
Why have pensions become so important in restructurings? There are three primary reasons. First, deficits have grown enormously because of falling equity markets, low interest rates and increased longevity. Equities have largely recovered, but deficits remain high because interest rates and bond yields remain low and life expectancy keeps getting longer.
Second, how you calculate the Section 75 pension debt payable by an employer in an insolvency (and various other circumstances) has changed dramatically. Previously, you used the minimum funding requirement (MFR), which assumed good investment growth, reasonable interest rates and a modest mortality rate. Under new legislation, the debt is calculated on a buyout basis – ie how much an insurance company would charge to provide the scheme’s defined benefits. Insurance companies use conservative assumptions and, with the calculations running over decades, small changes result in much higher numbers.
Finally, there are new ‘moral hazard’ provisions in the Pensions Act 2004 in the form of financial support directions (FSDs) and contribution notices (CNs). Through these, the pensions regulator can potentially fix directors, shareholders, other group companies, purchasers and lenders with liability for the pensions deficit. While not automatic, if the conditions are met the corporate veil is no protection. Given the size of deficits, this potential liability is a serious issue. Under the Pensions Act 2004, a party can obtain clearance from the regulator, which in respect of a transaction gives the parties comfort (subject to some exceptions) that no FSD or CN will be issued. The trustees need to be involved in any clearance application.
What are pension trustees doing?
To set the scene, the regulator’s guidance has been clear that pension trustees are to act like large unsecured creditors – specifically, like a bank. This is another major change. Trustees must become more proactive and robust: they must retain independent advisers, assess an employer’s financial covenant, avoid conflicts, test the business plan, assess the level and timing of contributions and consider and suggest alternative options. Against this backdrop, pension trustees focus on two main goals. First, how much of the deficit can be filled and how quickly? Second, is the pension scheme being treated the same (or better) than other creditors of the same ranking?
Following the first goal, clearly in an ideal world the pension deficit would be filled. In the Marconi sale, £185m of Ericsson’s £1.2bn purchase price plugged the FRS17 deficit. A further £500m of the £1.2bn was paid into escrow to protect the pension deficit.
Two further situations need considering. First, where, with a restructuring/refinancing, the company can survive with the pension deficit. Second, where the company/business cannot do so.
In distressed restructurings ‘cash is king’ and it is generally used to pay wages rather than fill pension deficits. Trustees therefore often ask for the deficit to be given security. However, lenders only provide new money that is secured. Furthermore, they will want security for any historic unsecured debt. To avoid prejudicing the scheme, pension trustees and the regulator often insist on security which is pari passu with the old unsecured debt security, or separate security over separate assets.
It’s over for the pension scheme
A different approach is needed where the company simply cannot survive with the ongoing pension liability. Here, the new Pension Protection Fund (PPF) comes into play. It pays compensation to members of eligible defined-benefit pension schemes, when there is a qualifying insolvency event of the employer and where there are insufficient assets in the pension scheme to cover the PPF levels of compensation. If so, the PPF pays scheme members’ pensions (to the statutory levels), takes over the pension scheme’s assets and becomes a creditor of the continued #+ continued company. (For scheme members below normal pension age as at the PPF assessment date, the statutory levels are, broadly, 90 per cent of entitlement subject to a £26,050 cap for a pension at age 65.)
A prolonged insolvency process is value destructive, so creditors often favour a debt- for-equity swap. Pension trustees cannot hold more than 5 per cent by value of the scheme’s assets as shares in the employer, but the PPF can. This has led to the surprising new development of the PPF taking shares on a debt-for-equity swap – just as a bank would do.
This first happened in July 2005 in the Heath Lambert administration, where the scheme had a reported £210m deficit. The PPF took on the scheme and the underlying businesses were transferred to a new company (in which the PPF took shares). More recently, the PPF also took equity in Pittards. The Pittards pension scheme had a reported £33m deficit and entered the PPF through a company voluntary arrangement (CVA). In return, the PPF received 18.5 per cent of the equity and Pittards agreed to pay a further £3m over five years (secured over a factory). If the factory is sold before 2026, the PPF gets any windfall gain (up to £6.8m). Interestingly, under the CVA, all other liabilities were paid and the company Pittards survives, freed from the deficit.
So why did the PPF agree to this? As a PPF spokesman explained: “This company was clearly going bust… We got involved to maximise the assets of the scheme” – ie it was a commercial decision.
The PPF taking equity has been controversial. However, the PPF’s approach has both maximised value for it and enabled Heath Lambert and Pittards to survive. This should be seen as positive and is to be encouraged.
So the pension trustees most definitely have a seat at the negotiating table in restructurings. Where there is a deficit, the trustees, the regulator and the PPF are key players. Understandably, they will look for the best deal to protect the pensioners. However, experience shows that they also take commercial and creative approaches to enable successful restructurings.
Richard Tett is a partner and Catherine Derrick is an associate at Freshfields Bruckhaus Deringer