Legal Briefing

Pension deficits and refinancing negotiations

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Human resources | 13 June 2016

With BHS going into administration with an estimated £571m pension deficit and various parties connected to BHS facing questions from the Work and Pensions Select Committee (the Committee) about their role in the sale of the business and the escalation of the pension deficit, the business and political spotlight is firmly on pension deficits and who should be held accountable. It has also been announced that the government is considering a radical plan for a restructuring of the British Steel pension scheme.

There are a number of questions being asked by the Committee including:

a) How did the pension deficit feature in negotiations over BHS’s recent change
in ownership?

b) Does the law, or rather the enforcement of the law, require reform to prevent similar episodes occurring in the future?

It is perhaps important to begin by looking at the role of pension scheme trustees and the tightrope that they walk. Pension scheme trustees and shareholders of the relevant sponsoring employer company have, not surprisingly, conflicting objectives and duties. The pension trustees owe their duties to the beneficiaries of the pension scheme, the employees and retired employees and accordingly have the objective of maximising the beneficiaries’ financial return. The trustees should not act in their own interests, but instead owe fiduciary duties to exercise their powers in a way they think will promote the success of the trust. On the other hand, the shareholders may wish to minimise the amount that the company has to pay into any pension scheme in order to maximise their own return.

The Pensions Act 2004 established a statutory fund, The Pension Protection Fund (PPF), which will pay compensation to members of eligible pension schemes if a series of requirements are met. However, The Pensions Regulator has the power to issue a financial support directive and a contribution notice for a deficit liability if it believes that a financial support directive has not been complied with. This power is designed to prevent abuses of the PPF. Pension deficits have the potential to impact the sustainability of businesses. As at the end of April 2016 it was estimated that the aggregate deficit of the 5,945 defined-benefit schemes eligible for the PPF was £270bn, with only 1,141 of those schemes being in surplus.

The Pensions Act 2004 introduced a statutory funding objective (SFO) for each pension scheme which means that each pension scheme must have sufficient funds to meet its liabilities. In the event that there is a funding shortfall the company and the trustees must discuss the issue and set up a recovery plan containing a contribution rate from the company over a specified period of time. In certain circumstances this plan will need to be approved by The Pensions Regulator. Usually the regulator will investigate any proposed recovery plan of over ten years with struggling companies given longer to make up the shortfall. In the case of BHS a 23-year recovery plan was agreed between the BHS pension trustees and the company prior to the sale last year.

The pension scheme trustees control the funding process and the investment strategy of the fund but how the fund is funded is down to an agreement between a company and the trustees. The current Committee inquiry into the BHS pension deficit has exposed the inherent potential conflict of interest between the shareholders of a company and a company’s pension trustees. Reports appear to indicate a difference of approach between BHS and the trustees. It has been indicated that the ballooning deficit was the result of bad investment choices by the pension trustees and that the company had kept its side of the contract by adhering to the terms of the agreed pension recovery plan. The alternative view was that despite pressure from the pension trustees the company would not put more than the agreed £10m per year into the pension fund or revisit the schedule of payments in the recovery plan to shorten the deficit period.

Any potential purchaser of a company, particularly a distressed company, should establish what pension arrangements have been made by the target company, including any pension deficit and any pension recovery contribution scheme. In-depth investigations into pensions should be an integral part of any due diligence procedure prior to an acquisition. It is emerging in the Committee inquiry that the purchaser of BHS last year was apparently not aware of the extent of the pension deficit according to the trustees and the advisers on the deal. The purchasers of BHS appear to have done very limited due diligence on the BHS pension scheme, amid claims that the purchaser’s advisers’ access to the pension trustees was denied in the run up to the acquisition and there is an on-going investigation into the reasons for this limited due diligence.

The size of a pension deficit may be a stumbling block in any acquisition of a distressed company as a going concern and for the provision of any debt financing connected with the acquisition. The Supreme Court decision in the Re Nortel Companies & ors [2013] case confirmed that financial support directions and contribution notices did not have ‘super priority’ as a debt in an insolvency process but were provable debts. This helps to erase a concern that sponsoring employers of defined-benefit schemes might struggle to borrow money if lenders were concerned a pension scheme deficit would rank ahead of their security on an insolvency.

In recent acquisitions and capital restructurings of distressed companies, practitioners have seen pension trustees and The Pensions Regulator strengthening their position and influence and being more bullish throughout the transaction process. One such recent example was the capital restructuring and refinancing of the Premier Foods Group. The pension deficit was a significant part of the refinancing negotiations and was clearly addressed in the prospectus to new investors. The company and the pension trustees had agreed a schedule of contributions which was not permitted to be altered until the end of 2019. These pension deficit contributions, represented by the pension trustees were secured by the same security package as the banks providing the debt refinancing up to a maximum amount of £450m with this amount set to amortise after 1 April 2016 to a minimum secured amount of £350m.