Pension update: Super priority for pension liabilities on insolvency

In brief

The Court of Appeal confirmed on Friday that pension schemes will, in some cases, have to be paid before floating charge holders, preferential creditors, unsecured creditors and even the administrators themselves where companies become insolvent. This depends on the Pensions Regulator having issued a contribution notice against the company, the timing of the notice and other factors. So each case will depend on its own facts.

Owners of floating charges will want to review the value of their security where they have lent to groups with defined benefit pension schemes which may now be given priority.

It is doubtful whether Parliament intended this effect and the Government can be expected to review the current law if the decision is not successfully appealed.

In more detail

A contribution notice can be issued where the Regulator considers that an employer has acted so as to reduce the amount that its pension scheme trustees can recover as a statutory debt under section 75 of the Pensions Act 1995. He can also issue a contribution notice after he has issued a financial support direction to the employer or other group companies. The direction requires them to put in place arrangements to support the employer’s pension scheme financially. If the Regulator is not satisfied by the arrangements, he can issue a contribution notice against the companies.

The contribution notice specifies an amount which the recipient must pay to the scheme. This can be up to the full statutory debt under section 75 (ie the amount of the scheme underfunding calculated on the buy out basis).

Although the Court of Appeal was looking only at contribution notices issued following financial support directions, the same principles would appear to apply to the other type of contribution notice.

What did the Court decide?

We already know that debts arising under section 75 are treated as arising immediately before the insolvency and are not treated as preferential debts. The Pensions Act 1995 says as much. So the pension scheme ranks alongside other unsecured creditors. But the Court of Appeal noted that, in contrast with section 75, the legislation introducing contribution notices does not say how they should be treated on insolvency. So the Court of Appeal has now decided that normal insolvency rules should apply.

The critical point is whether it can be said at the start of its insolvency that the company may become subject to a contribution notice by reason of an obligation incurred before the insolvency. If so, the obligation is provable in the insolvency and is treated like a section 75 debt. If not, it is an expense of the insolvency and must be paid before the holders of floating charges, preferential and unsecured creditors and even the administrators or liquidators themselves.

If the contribution notice is issued before the insolvency, there can be no argument - the obligation will be a provable debt.

If the Regulator has issued only the financial support direction that precedes the contribution notice before the insolvency, then the contribution notice will be a provable debt. It is referable to an obligation existing before the insolvency.

But if the Regulator has not taken any steps towards issuing the financial support direction before the insolvency starts, then the obligation under the contribution notice will be treated as first arising during the insolvency. When the insolvency starts, there is no more than the possibility that the Regulator will use his powers at all and, if he does, it is not clear which companies in a group he will use his powers against. The Court of Appeal decided that this is not sufficient for a company to be treated as under a legal obligation, even a contingent one, before the insolvency. The obligation under any eventual contribution notice will therefore be an expense of the insolvency and have priority accordingly.

Decision creates anomalies

The Court’s decision creates anomalies – it recognised as much. A scheme with a weak employer may recover more in an eventual insolvency if the trustees delay asking the Regulator to issue a financial support direction until after the insolvency starts. It is also odd that some or all of the section 75 debt, which has no priority, can be given effective priority by being included in a contribution notice (as long as the process leading to the notice starts after the insolvency).

The Court of Appeal did not rule on the position if the Regulator has issued only the warning notice that precedes the financial support direction before the insolvency. In the case before it, the Regulator had not taken any steps at all.

What are the implications of the judgment?

Trustees cannot really do anything to take advantage of the ruling save to note that in the unfortunate event of employer insolvency there will be every reason to see if the Regulator can be persuaded to use his financial support direction and contribution notice powers.

However, where there are a number of schemes in a group, the trustees of each scheme should note, when assessing the strength of their own employer’s covenant (which includes a review of the extent to which any section 75 debt would be recovered on insolvency), that the other schemes could achieve priority over them. This would no doubt be taken into account by the Regulator when considering whether to issue a contribution notice after the employer’s insolvency for the benefit of another group scheme.

The more immediate concern is for lenders with floating charges who are now at risk of their security becoming worthless because of actions taken by the Regulator after the borrower has become insolvent. Lenders will probably want to undertake more detailed pensions due diligence before lending, including as to the size of any pension scheme in the borrowing group and the extent of any underfunding. A critical factor will be whether the scheme employer is a service company providing employees to other companies in the group. This makes it more likely that the Regulator will issue a financial support direction.

What next?

We understand that leave to appeal to the Supreme Court has been requested. But it is taking up to two years for the Supreme Court to hear appeals.

In any case, it is doubtful that it was Parliament’s intention to give any form of priority to obligations under contribution notices, whenever issued. If there is not a successful appeal, we would expect the Government to review the present law.

This judgment is unlikely to be the end of the story.

For more information please contact Michael Calvert or David Gallagher at Fieldfisher.