EMPLOYERS CAN SEEK CLEARANCE FROM THE PENSIONS REGULATOR THAT SPECIFIED CORPORATE ACTIVITIES WILL NOT RESULT IN THE IMPOSITION OF A CONTRIBUTION NOTICE OR A FINANCIAL SUPPORT DIRECTION. WE EXAMINE THE NEW GUIDANCE ISSUED BY THE REGULATOR ON HOW IT OPERATES THE PROCESS AND THE ROLE IT EXPECTS TRUSTEES TO PLAY.

SUMMARY OF KEY POINTS

• The Pensions Regulator has issued revised guidance on its clearance process for corporate activities that are "materially detrimental" to a DB scheme and its members.
• If clearance is given, the companies involved can be sure that the regulator will not subsequently use its anti-avoidance powers in relation to the particular transaction or event for which it was sought.
• The government's current plan to extend the regulator's powers does not change the clearance process.
• The guidance has been revised to adopt a principles-based approach and to concentrate on what are called type A events - those that will be financially detrimental to a DB scheme.
• Type A events have been divided into employer-related and scheme-related events. Employer-related events will be relevant only where the scheme is in deficit.
• Employers and trustees are advised to consider and agree suitable mitigation for events where there is material detriment and trustees are urged to negotiate even where clearance has not been sought.

THE PENSIONS REGULATOR has substantially revised its guidance1 on the clearance process it operates so that employers can be reassured that corporate activities will not incur its wrath, either immediately or at some time in the future. There has been a move from a prescriptive to a principles-based approach and there is now a greater onus on trustees to take the initiative in raising issues with employers and to negotiate to counteract any detrimental effect of corporate activities on an employer’s defined-benefit (DB) pension scheme. The guidance is primarily intended for professional advisers, but companies and trustees will need to be aware of its implications.

What clearance offers

The Pensions Regulator has two so-called antiavoidance powers that it can deploy: contribution notices and financial support directions. The imposition of the first requires funding for a scheme, while the second requires companies to put financial support in place for a scheme. To date the only occasion on which either of these powers has been used is in relation to Sea Containers Ltd (see OP, August 2007 and March 2008). Various corporate activities could lead to the regulator using these powers if it considers that they may be detrimental to the ability of a company’s DB pension scheme to meet its liabilities or to the benefits of members. This might arise, for example, if a company was subject to a leveraged acquisition (with the purchase being financed by loans). In such circumstances the strength of the employer covenant (effectively the employer’s legal and financial support for a scheme) and, therefore, the security of members’ benefits may be diminished. In order to operate successfully, companies needed to know in advance whether a given transaction would prompt the regulator to use its powers in relation to a DB scheme. As a consequence the clearance process was developed. It is a voluntary process that allows companies and their advisers to apply for clearance for their activities before they are completed. If a transaction or activity (or what the regulator prefers to call an "event") is given clearance, this does not entail approval of the transaction; it simply means that the regulator will not use its antiavoidance powers in relation to that event. A clearance statement does not bind the regulator if the circumstances turn out to be materially different from those set out in the application. The government has just announced that it plans to extend the regulator's powers to issue contribution notices and financial support directions (see p.1). However, the regulator says that the proposals do not change its established clearance process.

Types of event

Clearance is relevant for those concerned with events that are "materially detrimental" to a DB scheme and its members. The original clearance guidance covered three types of events:

• type A events, which affect the pension creditor and are financially detrimental to the ability of a DB scheme to meet its pension liabilities, and for which it may be appropriate to seek clearance;
• type B events, which do not affect the pension creditor and for which clearance is not necessary; and
• type C events, which might affect the pension creditor and are events that point towards a deterioration in the employer's covenant but may be outside the control of the employer, and for which clearance is not available if they do not also fall within type A.

The revised guidance has been simplified and deals only with type A events, as types B and C were rarely used. To be categorised as type A, events need to be materially detrimental to the ability of a scheme to meet its pension liabilities. Events include transactions, agreements, decisions and other acts and failures to act. Events over which an employer has no control, such as the loss of a major supplier or customer, are not covered. Under the updated guidance, type A events are divided into employer-related and scheme-related events. Employer-related events are only type A events if the scheme has a "relevant deficit", but scheme-related events are always type A if the detriment is material. Trustees are given a strong steer towards seeking independent professional advice on assessing the impact of corporate events, and, if they choose not to do so, are advised to document their reasons.

Employer-related type A events

The guidance gives numerous examples of employer-related events that could be materially detrimental, although these are not intended to be comprehensive. These include a change of security given to creditors (such as granting a charge over company assets), returning capital from the company to shareholders (for example, through a special dividend or a share buy-back arrangement), a change in group structure, the sale of a substantial part of the operating business or a company merger. Most clearance applications do not become public knowledge, but one high-profile case that did involved a planned share buy-back by Sherwood Group. The plan eventually went ahead but in a much restricted form (OP, February 2006). The strength of the employer covenant is regarded as central to determining whether an employer-related event is a type A event, in other words whether the event is materially detrimental to a scheme. The guidance says the employer covenant is measured by the employer's legal obligation to the scheme and its financial position (both current and prospective). To make this assessment it is often necessary to consider how the pension scheme would fare as a creditor (usually an unsecured creditor) in the event of the employer's insolvency. The draft version of the revised guidance contained a great deal more advice on assessing the employer covenant. Although this has been reduced in the final guidance, there is still a five-page appendix, far more than in the original version introduced three years ago. More guidance on the subject is promised for later in the year. To gauge whether an employer-related event is a type A event, employers and trustees are advised to:

• compare the employer covenant before and after the event for which clearance is being sought or considered;
• assess whether any weakening of the employer covenant is such that the event could be considered materially detrimental to the scheme; and
• identify whether the scheme has a "relevant deficit".

Normally the relevant deficit is the highest deficit assessed using the company accounting standards FRS17 or IAS19, the Pension Protection Fund levy basis and the technical provisions basis as provided for in the Pensions Act 2004 (or the ongoing funding basis where this is not yet available). However, a higher measure may be necessary in some circumstances, such as the full buyout basis where there are concerns about the employer's viability, the scheme is being wound up or the scheme is being "abandoned".

Scheme-related type A events

The examples of scheme-related events in the guidance all concern employers' s.75 debts. These are the debts owed by employers to a scheme and calculated on a buyout basis. Scheme-related-events that could be type A events include compromise agreements (those that reduce the s.75 debt payable to a scheme and that will only be appropriate in limited circumstances), the apportionment of a multiemployer scheme’s deficit between employers, for example when an employer ceases to participate in the scheme or the scheme winds up (see p.10), the non-payment of a s.75 debt for an unreasonable period, and an arrangement that prevents a s.75 debt from triggering. The guidance says that the detriment resulting from scheme-related events cannot usually be assessed solely by reference to the employer’s covenant. It says that a compromise of a s.75 debt will always be a type A event. A compromise must also be notified by the employer and trustees under its Notifiable Events code of practice (see OP, August 2005).

Mitigation

The Pensions Regulator says that where employers and trustees have identified a type A event they should consider and agree the most appropriate mitigation. By mitigation, the regulator means that the employer should offer a quid pro quo in return for clearance of the event. Numerous examples of the types of possible mitigation are included in the guidance. These include the contribution of additional cash or other assets to the scheme, using an escrow account (paying funds into a special account that will become payable to the scheme in specified circumstances), guarantees from a parent company, increasing the pension fund’s priority over other creditors and amending the scheme rules to adjust the balance of power between the employer and the trustees. Employers and trustees are advised to consider both the immediate and possible future impacts of scheme-related events. The regulator also points out that for some scheme-related events mitigation that changes the nature of the event itself may be possible.

Applications for clearance

Applications for clearance may normally be made only by those parties who could be subject to a contribution notice or a financial support direction. This covers the employer and others connected with the employer, and parties that may become an employer or connected with an employer, such as a purchaser of a business. Although the regulator expects trustees to be involved in any clearance application, trustees will not usually apply for clearance. The regulator expects trustees to be involved as soon as reasonably practical. The guidance says that, for a clearance application to proceed smoothly, it expects the trustees to have had the opportunity to assess the impact of the event, to have considered appropriate mitigation and to have negotiated over the terms. However, trustee support or opposition will not necessarily determine an application’s success. In order to assess an event, trustees will need to be given confidential information. The regulator suggests that employers and trustees may wish to enter into a confidentiality agreement, and that this should be in place before an event arises. Trustees should still be able to pass information to their advisers and speak openly to the regulator. Trustees may also need to manage conflicts of interest and the regulator is currently consulting on separate guidance in this area (OP, April 2008).

Onus on trustees

Employers are not required to seek clearance before an “event”. However, the new guidance states that if trustees become aware of an event that they believe could be a type A event, they should raise their concerns with the employer and other relevant parties to ensure that suitable mitigation is considered and to ascertain whether a clearance application is being considered. It goes on to say that, where an application is not being considered and the trustees are concerned that no, or inadequate, mitigation is being offered, the trustees should contact the regulator. This begins to place a rather different complexion on the voluntary nature of the clearance process. Indeed, Chris Smith of the consultancy Hewitt Associates says: “It is worth noting that while clearance is termed ‘voluntary’, the Pensions Regulator has essentially imposed [the clearance] system via the back door by placing the onus on trustees to initiate negotiations, regardless of whether a formal clearance application has been made.” He adds: “While trustees will be in a strong position to negotiate if the company is applying for clearance, the reality is that in many situations clearance will not be pursued … This puts trustees in the unenviable position of being expected to negotiate, but having limited powers to do so.” Given the encouragement given to trustees to seek mitigation, Smith makes a further point about the possible impact of the clearance guidance. He says: “The guidance appears to give little credit to companies that fund their schemes on a more prudent basis – meaning that companies could end up paying twice for any change in security. This could discourage companies from negotiating agreements with their trustees that are overly prudent, as part of normal funding discussions.”

Process of providing clearance

Applications for clearance are expected to be made using a form that is available on the regulator’s website. Following discussions with the various parties, the regulator reaches a decision (it says normally within two to three weeks of receiving all the necessary information) and issues a “warning notice”, if it is minded to grant clearance. The parties then have an opportunity to respond before the statement is issued. Anecdotal evidence from professional advisers suggests that the process works well, although some believe that the relatively small number of applications is because companies do not feel the time and effort is worthwhile. Applications are handled by the corporate risk management team at the regulator. It is prepared to handle preliminary enquiries from potential applicants and trustees, if necessary on a no-names basis. ?

REGULATOR’S NEW GUIDING PRINCIPLES ON CLEARANCE

• Trustees and employers
• Trustees and employers should recognise and understand that a scheme in deficit on any basis should be treated in the same way as any other material creditor.
• Trustees should recognise and understand their powers and duties and act appropriately, including managing any conflicts.
• Trustees should consider taking independent professional advice where appropriate.
• Trustees and employers should work together in relation to events that may be detrimental to the ability of the scheme to meet its liabilities or to the benefits of the scheme members, communicating and sharing appropriate information.
• Trustees and employers should understand the nature and the impact of the potentially detrimental event and the appropriate mitigation for the event.
• Trustees and employers should recognise that the regulator will wish to know about all events that have a materially detrimental effect on the ability of a scheme to meet its liabilities. The Pensions Regulator
• The regulator’s preferred outcome is an appropriately funded scheme with a solvent employer.
• The regulator will deploy its resources in a risk-based manner, targeting risk in a proportionate, responsive, flexible, pragmatic, consistent, transparent and reasonable way.
• The regulator will seek to protect members’ benefits and reduce the risk of calls on the [Pension Protection Fund], while at the same time recognising commercial activity and business needs.”

Source: Pensions Regulator’s “Clearance Guidance”.