A Practical Guide to Private Equity Transactions

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237

Key issues and principles

below) rather than at the time of the employer cessation event. The second is

for amount B to be (broadly) the difference between the debt triggered under

the withdrawal arrangement and the debt which would have been triggered had

there been no withdrawal arrangement.

Amount B will be treated as a debt due by the guarantor at the ‘guaran-

tee time’ (broadly, the time of the scheme winding up, the occurrence of an

employer insolvency event, or an earlier date on which it has been agreed that

the guarantor will make payment).

Trustees may only enter into a withdrawal arrangement if they are sat-

ised that the guarantor would be able to pay the likely amount B were

amount B to be calculated at the date of the withdrawal arrangement. The

trustees must also be satised that the ‘funding test’ is met. This is the same

as the funding test set out in relation to scheme apportionment arrange-

ments above, except that the trustees need consider only the rst limb of

the test (continued ability to make payments under the scheme’s schedule

of contributions), not the second limb (effect on security of scheme ben-

ets). Therefore, the funding test is technically less onerous for a withdrawal

arrangement than for a scheme apportionment arrangement. This is because

under a withdrawal arrangement the cessation employer pays a prescribed

minimum amount (i.e. the amount of the decit calculated on the scheme

specic funding basis).

(iv) Approved withdrawal arrangements An ‘approved withdrawal arrange-

ment’ is broadly the same as a withdrawal arrangement, but the amount paid

by the cessation employer can be less (potentially nil). An approved with-

drawal arrangement, as the name suggests, is approved by the Pensions

Regulator.

As with a non-approved withdrawal arrangement, the cessation employer

pays a lower amount than would have been due as a debt in the absence of the

arrangement, and a guarantor guarantees to pay amount B in specied circum-

stances. However, there are the following key differences:

(a) in addition to the events which may trigger an obligation for the guaran-

tor to make payment under the guarantee for (non-approved) withdrawal

arrangements, the Pensions Regulator has the power to trigger an obliga-

tion to make payment under the guarantee; and

(b) the Pensions Regulator may release the guarantor from its obligation if pay-

ment has not yet fallen due and the Regulator considers that the approved

withdrawal arrangement is no longer required.

The Regulator may approve a withdrawal arrangement if satised that it is

reasonable to do so, and the trustees have notied it that the funding test (see

‘withdrawal arrangements’ above) is met. The 2008 Regulations contain a

(non-exhaustive) list of factors to which the Regulator may have regard for this

purpose; for example, this includes the effect of the arrangement on security of

scheme benets.

238

Pensions

The post 6 April 2008 mechanisms which might be applied in the context

of a purchase or exit are summarised in Figure 8.2.

Where a private equity rm is purchasing a participating employer, it

may be possible to put a scheme apportionment arrangement in place if there

is another participating employer that is suitably strong. Alternatively, the

seller could look at putting a withdrawal arrangement in place. A withdrawal

arrangement is unlikely to be an attractive solution for a private equity exit,

however, as a private equity investor is unlikely to be willing or able to provide

or procure the necessary guarantee. These possibilities are considered further

in section 4 below.

3 The Pensions Regulator and ‘moral hazard’

3.1 The Pensions Regulator and the Pension Protection Fund

The Pensions Regulator is a statutory body established by the Pensions Act

2004.

Its objectives are to:

(a) reduce the risk of claims on the Pensions Protection Fund;

Scheme

Apportionment

Arrangement

Withdrawal

Arrangement

Approved Withdrawal

Arrangement

Minimum initial

payment

None Deficit on:

• scheme

specific

funding basis

• PPF buy-out

basis

Expenses

Guarantor

required

No but

apportionment to a

participating

employer

YesYes

Regulator

approval required?

No Yes Yes

Figure 8.2 Section 75 arrangements

19 Section 1 of the Pensions Act 2004.

239

The Pensions Regulator and ‘moral hazard’

(b) protect the benets of members of occupational pension schemes; and

work-based pensions.

The Pension Protection Fund (PPF) is a fund, also established by the 2004

Act, that provides protection to beneciaries of underfunded dened bene-

t pension schemes whose employers become insolvent. The PPF is funded

by a levy paid by all dened benet schemes. The amount of levy a scheme

pays depends on a number of factors, including the strength of the sponsoring

employer (currently determined by a Dunn & Bradstreet score which attempts

to measure the likelihood of company failure), and the funding level of the

scheme on the PPF buyout basis.

There are a number of criteria a scheme must satisfy in order to be eligible

for the PPF. One of these is that the trustees must not have entered into a ‘com-

promise agreement’, for example by agreeing to compromise a section 75 debt

in a manner other than those set out in section 2.3 above. Therefore, scheme

trustees have to be careful not to exercise their powers in relation to scheme

funding or section 75 debts in a way that would prejudice eligibility.

The Pensions Regulator has a number of statutory powers. The most sig-

nicant for the purpose of the issues discussed in this chapter are those in

relation to scheme funding already outlined, and the so-called ‘moral hazard’

powers, which allow the Pensions Regulator to impose accelerated funding on

scheme employers, or even to pierce the corporate veil (in other words, look

beyond the employer to third parties). For obvious reasons, this further aspect

is of particular signicance in a private equity context, with private equity

rms being concerned to ensure that no liability attaches to those rms or their

managed funds as a consequence of any actions taken.

The Pensions Regulator’s moral hazard powers consist of powers to issue a

‘contribution notice’ or a ‘nancial support direction’ on a scheme employer,

or a person who is ‘connected’ with or an ‘associate’ of an employer partici-

pating in a dened benet pension scheme. Both powers are considered in the

following sections, as well as the meanings of ‘connected’ persons and ‘associ-

ates’ for these purposes.

3.2 Contribution notices

The Pensions Regulator can issue a contribution notice to a person, requir-

ing that person to pay a specied sum equal to all or part of the decit of the

scheme (calculated on a buyout basis) to the trustees of the scheme.

A contri-

bution notice can be issued in respect of acts or omissions which took place on

20 Section 5 of the Pensions Act 2004.

21 For the meaning of ‘PPF buyout basis’, see section 2.2(d) above.

22 Section 38 of the Pensions Act 2004.

240

Pensions

or after 27 April 2004, and can be issued for up to six years after the date of

the relevant act or omission.

The Pensions Act 2008 includes various amendments to the circum-

stances in which a contribution notice can be issued. The most substantive

changes were retrospective to 14 April 2008, the date on which they were rst

announced. Therefore, the position for acts or omissions occurring before or

after that date will differ.

(a) Pre 14 April 2008

In respect of an act or omission before 14 April 2008, the Pensions Regulator

can issue a contribution notice to a person where the Pensions Regulator is of

the opinion that the person was a party to a deliberate act or omission, which

rst occurred on or after 27 April 2004, and the Pensions Regulator is of the

opinion that the ‘main purpose’ (or one of the main purposes) of the act or

omission was:

(a) to prevent the recovery in whole or in part of a section 75 debt; or

(b) other than in good faith, to prevent a section 75 debt from becoming due,

to compromise or otherwise settle a section 75 debt, or reduce the amount

of a section 75 debt that will become due.

The persons who can be issued with a contribution notice are:

(a) a scheme employer; or

(b) any person who is an associate of or connected with

a scheme employer

(including individual directors), although a contribution notice cannot be

issued to an insolvency practitioner.

There has been uncertainty as to what would be required to satisfy the ‘main

purpose’ test. Would the Pensions Regulator need evidence to show that there

was a conscious intent, or would it be enough that the person was aware that the

pension scheme would be affected even though that was not actually the primary

purpose of the act or omission? In most commercial transactions, any negative

impact on the pension scheme will not be the primary purpose of the transaction,

even though this may well be a known (and perhaps even desirable) result. As a

result of this uncertainty, the Department of Work and Pensions conrmed on 14

April 2008 that the power to issue a contribution notice would be amended.

(b) Post 14 April 2008

For acts and omissions from 14 April 2008 onwards, the Pensions Regulator has

a power to issue a contribution notice on any person who is a party to an act or

omission (or series of acts or omissions) where: (a) the Pensions Regulator is of

the opinion that the act or omission has detrimentally affected in a material way

23 Section 38 of the Pensions Act 2004.

24 See section 3.5 below.

241

The Pensions Regulator and ‘moral hazard’

the likelihood of accrued scheme benets being received

(referred to as the

‘material detriment’ test); or (b) the Pensions Regulator is of the opinion that the

main purpose or one of the main purposes of the act or omission was to prevent

recovery in whole or in part of a section 75 debt or to prevent a section 75 debt

from becoming due to compromise or otherwise settle such a debt or reduce such

a debt.

The more extensive nature of the Regulator’s powers, and in particular

the introduction of the material detriment test, has led to widespread concern that

these powers might be exercised in an increasingly wide set of circumstances.

In deciding whether the material detriment test is met, the Pensions

Regulator must have regard to such matters as it considers relevant, including:

(a) the value of the assets and liabilities of the scheme;

(b) the effect of the act or omission on the value of those assets or liabilities;

(d) the effect of the act or omission on any of those obligations (including

where the act or omission would result in those obligations being enforce-

able in a different country);

(e) the extent to which any person is likely to be able to discharge any obliga-

tions to support the scheme;

(f) the extent to which the act or omission has affected or might affect the

extent to which any person is likely to be able to discharge its obligations

to support the scheme; and

(g) such other matters as may be prescribed.

There will be a statutory defence

where:

(a) before becoming a party to the act or failure, the person gave due consider-

ation to the extent to which the act or failure might detrimentally affect in

a material way the likelihood of accrued scheme benets being received;

this requires the person to have made the enquiries, and carried out the

other acts, that a reasonably diligent person would have made and carried

out in the circumstances; and

(b) either:

where, as a result of that consideration, the person considered that the act •

or failure might have such an effect, the person took all reasonable steps to

eliminate or minimise the potential detrimental effects that the act or failure

might have on the likelihood of accrued scheme benets being received; or

having regard to all relevant circumstances (of which the person was •

aware or ought reasonably to have been aware) prevailing at the time at

which the act occurred or the failure to act rst occurred at the relevant

25 Section 38A of the Pensions Act 2004.

26 This second limb is the same as the pre 14 April 2008 except that ‘otherwise than in good

faith’ has been removed.

27 Section 38A(4) of the Pensions Act 2004.

28 Under section 38B of the Pensions Act 2004.

242

Pensions

time, it was reasonable for the person to conclude that the act or failure

would not detrimentally affect in a material way the likelihood of

accrued scheme benets being received.

A more subtle change to the test with effect from 14 April 2008 was to

clarify that the powers apply to a series of acts and/or omissions, and not only

single acts or omissions. The Pensions Regulator’s powers have also been

extended where there is a transfer from one scheme (the initial scheme) to

another scheme (the transferee scheme). If the Pensions Regulator would have

had power to issue a contribution notice to a person in respect of the initial

scheme, the power is extended to enable a notice to be issued to such person in

respect of the transferee scheme, even though that person may not be a scheme

employer of the transferee scheme or connected to or an associate of such a

scheme employer.

For acts or omissions from 14 April 2008 to 6 April 2009 (the date on

which the wider powers came into effect) the Regulator issued a statement to

the effect that it will not operate the wider powers unless one of the actions or

situations below is the subject of the proposed use of the power:

(a) moving the employer or pension scheme to another jurisdiction;

(b) splitting the operating company from the pension scheme without appro-

priate mitigation for the pension scheme;

gation for the pension scheme;

(d) transferring scheme assets and liabilities to another scheme which did not

have adequate support from an employer;

(e) running a scheme for prot without adequate account being taken of mem-

ber interests; or

(f) business models in which risk is predominantly borne by scheme mem-

bers, but high investment returns would benet investors.

The Pensions Act 2004 (as modied by the Pensions Act 2008) offers some

guidance on the factors which the Pensions Regulator will take into account

in deciding whether to issue a contribution notice. A contribution notice

will be issued only if the Pensions Regulator is of the opinion that it is

reasonable to impose liability on the person

to pay the sum specied in

the notice, having regard to the extent to which, in all the circumstances,

it was reasonable for the person to act, or fail to act, in the way that the

person did,

and such other matters as the Regulator considers relevant,

including:

(a) the degree of involvement of the person in the act or omission;

29 Section 38(3)(d) of the Pensions Act 2004.

30 For acts or omissions on or after 14 April 2008 only. See section 38(3)(d) of the Pensions Act

2004 which was repla ced with ef fect from 26 November 2008 by the Pensions Act 2008.

31 Section 38(7) of the Pensions Act 2004.

243

The Pensions Regulator and ‘moral hazard’

(b) the relationship which the person has or has had with the scheme employer

(including whether the person has or has had control of the scheme

employer);

scheme;

(d) if the act or failure to act was a notiable event for the purposes of sec-

tion 69 of the Pensions Act 2004 (which is a duty to notify the Regulator

of certain events), a failure by the person to notify the Regulator of that

event;

(e) all the purposes of the act or failure to act (including whether a purpose of

the act or failure was to prevent or limit loss of employment);

(f) the nancial circumstances of the person; and

(g) for acts or omissions on or after 14 April 2008:

the value of any benets which directly or indirectly the person •

receives, or is entitled to receive, from the scheme employer or under

the scheme;

the likelihood of creditors of the scheme employers and any other per-•

sons with liabilities to support the scheme being paid, and the extent to

which they are likely to be paid.

3.3 Financial support directions

The Pensions Regulator can issue a nancial support direction on a person

where a scheme employer is a service company or is insufciently resourced.

A nancial support direction requires the person or persons to whom it is

issued to ensure that:

(a) nancial support is put in place within a specied period;

(b) nancial support is then maintained for so long as the scheme exists;

and

nancial support.

The ‘prescribed events’ for these purposes are:

(a) if any person to whom a nancial support direction has been issued has

a duty to notify the Regulator of a notiable event (under section 69 of

the Pensions Act 2004, which is a duty to notify the Regulator of certain

events

), a failure by that person to do so;

32 Section 38(7)(ea) and (eb), inserted with effect from 26 November 2008 by the Pensions Act

2008.

33 Section 43(2) of the Pensions Act 2004.

34 Section 43 of the Pensions Act 2004.

35 Notiable events include a decision for a scheme employer to cease to carry on business, a

breach by a scheme employer of banking covenants and a decision to sell a scheme employer.

244

Pensions

(b) any insolvency event

in relation to a person to whom a nancial support

direction has been issued; or

place.

A scheme employer is a ‘service company’ if it is a company within the mean-

ing given by section 735(1) of the Companies Act 1985,

it is a member of a

group of companies, and its turnover as shown in the latest accounts prepared

for the purposes of its statutory accounts is solely or principally derived from

amounts charged for the provision of the services of its employees to other

members of that group.

The test as to whether or not a scheme employer is ‘insufciently resourced’

is more complex. In essence, it is satised where:

(a) the value of the resources of the scheme employer is less than a prescribed

percentage, currently 50 per cent,

of the estimated section 75 debt of the

scheme; and

(b) there is a person or there are two or more persons connected or associ-

ated with each other

(but not an individual) who is associated with or

connected to the scheme employer, and the value of the resources of that

person is not less than an amount equal to the difference between the esti-

mated section 75 debt of the scheme and the value of the resources of the

insufciently resourced employer (i.e. there is an associated or connected

person or persons which is capable of making up the shortfall).

Working out the value of the resources of a scheme employer for these pur-

poses can be complicated.

The rst step is to look at the net assets, being the

aggregate of the employer’s assets less the aggregate of the liabilities (includ-

ing all liabilities reected in the employer’s accounts).

For these purposes,

36 An insolvency event is dened in section 121(2) of the Pensions Act 2004 and paragraph 5 of

the Pension Protection Fund (Entry Rules) Regulations 2005, and includes administration,

creditors’ voluntary arrangements and administrative receivership.

37 Regulation 4 of the Pensions Regulator (Financial Support Directions etc.) Regulations 2005

( SI 2005/21 88).

38 To be replaced from 1 October 2009 by Schedule 1, Part 1, to the Companies Act 2006 and

replaced by section 1 of the Companies Act 2006, although section 44 of the Pensions Act

2004 has not been amended a ccordingly.

39 Section 44 of the Pensions Act 2004.

40 Regulation 6 of the Pensions Regulator (Financial Support Directions etc.) Regulations 2005

( SI 2005/21 88).

41 As amended by the Pensions Act 2008, which removed an anomaly to the effect that the

Pensions Regulator could not have issued a nancial support direction where a group con-

sisted of a number of relatively small companies, none of which could individually meet the

shortfall, but which could do so collectively.

42 See Regulations 7–12 of the Pensions Regulator (Financial Support Directions etc.)

Reg u l a t i o n s 2 0 0 5 ( S I 2 00 5 / 2 1 88 ) .

43 Regulation 9(4) of the Pensions Regulator (Financial Support Directions etc.) Regulations

2005 (SI 2005/2188).

245

The Pensions Regulator and ‘moral hazard’

any pension scheme surplus or decit is not taken into account to avoid effect-

ive double counting. The second step is to apply any ‘fair value difference’,

meaning that any difference between the market value of the employer’s

assets and the value reected on the balance sheet is to be taken into account.

The nal step is then to add the ‘entity value difference’ to such amount,

being the value of resources after the fair value adjustment. If the value of

the resources of the employer, after any of these steps, is less than 50 per cent

of the estimated section 75 debt of the scheme, then the employer is insuf-

ciently resourced.

It is possible to apply to the Pensions Regulator to ask for conrmation that

an employer is not insufciently resourced.

However, if the value of the em-

ployer and the amount of the scheme decit are such that this seems necessary,

any conrmation from the Pensions Regulator will probably be of relatively lit-

tle value, given that the test can be undertaken at any point in time. Therefore,

the position could change; the employer could become insufciently resourced

shortly after such a conrmation is given.

The Pensions Regulator can issue a nancial support direction on any per-

son who is an associate of or connected with a scheme employer (see section

3.5 below). Where the scheme employer is a company, a nancial support dir-

ection cannot be issued on an individual. This means that, unlike contribution

notices, nancial support directions cannot be issued on individual directors.

A nancial support direction can be issued up to two years after a person

ceases to be associated with a scheme employer.

This was increased from one

year on 6 April 2009. There is a transitional period until April 2010, where the

relevant period is reduced by the number of complete months remaining until

April 2010.

As with contribution notices, the Regulator can only issue a nancial

support direction where the Regulator is of the opinion that it is reason-

able to impose the requirements of the direction on that person.

The mat-

ters which the Regulator must take into account, where relevant, are similar.

They are:

(a) the relationship which the person has or has had with the scheme employer

(including whether the person has or has had control of the scheme

employer);

(b) the value of any benets received directly or indirectly by that person from

the scheme employer;

scheme; and

44 See Regulations 9(2) and 10 of the Pensions Regulator (Financial Support Directions etc.)

Reg u l a t i o n s 2 0 0 5 ( S I 2 00 5 / 2 1 88 ) .

45 Section 43(9) of the Pensions Act 2004, and Regulation 5 of the Pensions Regulator (Financial

Support Directions etc.) Regulations 2005 (SI 2005/2188).

46 Section 43(5) of the Pensions Act 2004.

47 Section 43(7) of the Pensions Act 2004.

246

Pensions

(d) the nancial circumstances of the person.

A nancial support direction requires the person on whom it is issued to

put nancial support in place for the scheme. This may consist of:

(a) an arrangement whereby all of the companies in the group are jointly and

severally liable for the scheme liabilities;

(b) an arrangement whereby the ultimate holding company of the employer’s

group is liable for the whole or part of the employer’s liabilities in relation

to the scheme;

nancial resources are provided; or

(d) other arrangements as may be prescribed.

As the power to issue a nancial support direction relies on objective tests and,

in particular, has never required the Pensions Regulator to show any fault, this

power has been of greater concern to private equity buyers who are concerned

about the possibility of being required to provide support for a pension scheme

of one of its investee companies.

At the time of writing, only one nancial support direction has been issued,

on 18 June 2007. It was issued against Sea Containers Limited, a Bermuda-

based passenger transport and marine leasing company. It required Sea

Containers Limited to provide nancial support for two pension schemes of

its UK subsidiary, Sea Containers Services Limited, a service company. The

nancial support direction was upheld by the American bankruptcy court in

September 2008. This has curbed speculation that contribution notices and

nancial support directions issued by the Pensions Regulator may not be

enforced abroad, particularly outside the European Union, although there is

still some uncertainty on this point depending on the particular situation and

jurisdiction.

In the autumn of 2008, it was widely reported that Duke Street Capital paid

£8 million into the pension scheme of Focus DIY, a company that it had sold

almost twelve months previously. Although no information was made publicly

available, there was widespread speculation in the media that this payment

was made as a result of threats by the Pensions Regulator to issue a nancial

support direction to Duke Street. As there has only been one nancial sup-

port direction issued, there is no precedent for the arrangements that might be

put in place in response to the issue of a nancial support direction. In prac-

tice, the Pensions Regulator encourages companies to provide resources for

their schemes, such that the actual enforcement of its moral hazard powers is

unnecessary.

48 Section 45 of the Pensions Act 2004.