The anti-avoidance regime and clearance: a quick reminder

The Pensions Act 2004 gave the Regulator the power to issue contribution notices (CNs) and financial support directions (FSDs) in circumstances where pension liabilities would or might be avoided.

The Regulator may issue a CN which requires an amount up to and including the employer debt due from an employer to be paid to the scheme, where the Regulator considers that the main purpose (or one of the main purposes) of the act or failure to act was:

• To prevent the recovery of the whole or part of the employer debt which was, or might become, due from the employer in relation to the scheme; or
• otherwise than in good faith, to prevent an employer debt becoming due, or to compromise, reduce or otherwise settle such a debt.

The Regulator may issue an FSD to an entity connected or associated with an employer which is either a service company or insufficiently resourced and which participates in an underfunded defined benefit scheme. An FSD compels the recipient to put in place financial support (approved by the Regulator) for the employer's obligations where the recipient has sufficient resource in its own right to "plug the gap in funding".

Clearance is the (voluntary) process by which the Regulator confirms that, based on the information provided, the Regulator will not issue a CN or FSD in respect of a certain event, for example a corporate transaction. A clearance statement only binds the Regulator in relation to the circumstances set out in the application.

Why has the Regulator revised the guidance?

The Regulator revised the clearance guidance as a result of its experience of running the procedure over the past three years as well as significant developments in the marketplace, including the way the market has increasingly considered the scheme as a creditor and the impact of FRS17. It was also concerned that the previous guidance was being interpreted too prescriptively and was keen to broaden its scope.

The Regulator's approach

Rather than have a prescriptive approach to clearance, the Regulator has developed principles which are aimed at professional advisers rather than employers. The Regulator's guiding principles are that:

• The preferred outcome is an appropriately funded scheme with a solvent employer.
• It will deploy its resources in a risk-based manner, targeting risk in proportionate, responsive, flexible, pragmatic, constant, transparent and reasonable way.
• It will seek to protect members' benefits and reduce the risk of calls on the Pension Protection Fund while at the same time recognising business needs.

Who should seek clearance?

Clearance continues to be voluntary. However, the Regulator expects that employers (including those connected and associated with the scheme employer) or parties who may become the employer (or become connected and associated with the employer) should apply for clearance.

When should clearance be sought?

Clearance should be sought in relation to events which are materially detrimental to the scheme's ability to meet its pension liabilities (type A event). All type A events will have one or more of the following effects either immediately or in the future:

• Prevent recovery of the whole or part of the employer debt.
• Prevent the employer debt becoming due, compromise or settle the debt.
• Reduce the amount of the employer debt which would otherwise become due.
• Weaken the employer covenant because:
  • It has an impact on the employer's ability to meet its ongoing scheme funding commitments, or has an impact on those commitments.
  • It reduces the dividend that would be available to the scheme on employer insolvency.

There are employer-related events and scheme-related events. An employer-related event will only be a type A event if the scheme has a relevant deficit (see below). A scheme-related event may be a type A event, whether or not the scheme has a relevant deficit.

Examples of employer-related events

Examples of employer-related events are:

• Change in priority
• Return of capital including dividend payments, share buy-backs and repayment of subordinated debt
• Change to group structure including change in control which reduces the overall employer covenant
• Change to the employers in relation to the scheme
• "Phoenix event"
• Business/asset sales from the employer or wider group especially where the transaction is not at arms' length.

The guidance makes it clear that this is not a comprehensive list of employer-related events. The substantial effect of an event should be assessed to determine whether it is a type A event.

How are employer-related events assessed?

Trustees and employers need to reach a decision whether or not an employer-related event is a type A event. To do this they need to:

• Compare the pre and post event employer covenant
• Assess whether any covenant weakening is materially detrimental to the scheme's ability to meet its liabilities; and
• identify whether the scheme has a relevant deficit.

How should the employer's covenant be assessed?

The employer's covenant and its strength are determined by:

• The employer's legal obligations to the scheme pre and post event; and
• its financial position (both current and prospective).

To assess whether an event weakens the employer covenant, it is necessary to consider where the pension creditor sits on insolvency and then consider the impact of the event. Trustees and employers should also keep in mind the long-term nature of the employer's obligations and so the employer's long-term future. Factors which may point to a material weakening of the covenant includes the amount by which the covenant is weakened, the size of the employer/scheme after the event and the amount of the scheme's relevant deficit.

The guidance contains discussion of how to assess the employer covenant but much of the detail covered in the draft has been removed and will be dealt with in future Regulator guidance.

What is the relevant deficit?

An employer-related event will only be a type A event where the scheme has a relevant deficit. The relevant deficit will usually be the highest deficit on the following bases:

• FRS17.
• Section 179 for calculating the PPF risk-based pension protection levy.
• Scheme funding requirement.
• Ongoing funding basis.

Where the employer event is significantly materially detrimental to the scheme's ability to meet its liabilities or there are ongoing concern issues in relation to the employer, the deficit measure to be used is buy-out.

The guidance notes that the relevant deficit is a trigger for clearance and is not an indication that employers and trustees should fund to that level. In addition, if there is no relevant deficit, this is not an indication that the event is not detrimental to the scheme only that it is not a type A event.

What are scheme-related events?

A scheme-related event may have a direct impact on the employer's legal obligations to the scheme. However, the detriment resulting from a scheme-related event cannot usually be assessed solely by reference to the employer covenant. The guidance gives examples of scheme-related events which could be type A events including:

• Agreements to compromise an employer debt - always type A events irrespective of the level of the scheme's debt before and after the compromise;
• apportionment of a scheme's deficit pursuant to scheme apportionment rules and any scheme apportionment arrangement. In addition, a regulated apportionment arrangement may also be a type A event. Circumstances where there will not be a type A event include where the apportionment increases the employer debt which is immediately payable by an employer who can afford to pay the increased amount;
• non-payment of all or any part of an employer debt for an unreasonable period (for example, more than 12 months); or
• an arrangement which has the result of preventing an employer debt from triggering.

The guidance also states that sometimes an event can be composed of several distinct or related events. Where this is the case, as well as assessing the overall effect of the events, trustees and employers should assess each component event separately to establish whether it could be a type A event.

How are scheme-related events assessed?

The method for assessing whether a scheme-related event is a type A event will vary depending on the specific event. Employers and trustees should consider an event in terms of its immediate impact on the scheme and members' benefits and the possible impact of the event into the future. It will often be appropriate for employers and trustees to take professional advice.

What should happen where there is a type A event?

Where the employers and trustees have identified a possible type A event they should consider and agree the most appropriate mitigation. The level and type of mitigation will vary depending on the nature, circumstances and impact of the event and the scheme's funding level. Trustees should seek appropriate independent professional advice to enable them to assess their powers and duties and to ascertain what mitigation may be appropriate. Examples of types of mitigation include:

• Additional contributions of cash or other assets.
• Improvement in priority for the pension creditor.
• Escrow accounts to ensure additional funds are paid to the scheme under certain conditions.
• Standby letters of credit, guarantees or insurance to cover scheme contributions or employer debt.
• Parental or intra-group guarantees.
• Scheme rule changes.

It may be possible for the employers and trustees to agree mitigation which changes the event itself, for example, the scope of an apportionment arrangement. However, trustees should be cautious about this especially when the mitigation is being agreed far in advance of the event itself.

Mitigation will be agreed by negotiation between employers and trustees. When negotiating with the employer, trustees should generally adopt the approach of a bank creditor of the employer. In addition the guidance comments that trustees should consider whether they have the necessary negotiation skills or whether they should instruct professional advisers to assist them. Throughout negotiations, trustees and employers must be aware of the need to maintain confidentiality and ensure that conflicts of interest are identified and managed appropriately.

What is the role of trustees in clearance?

Trustees should be involved in any clearance application as soon as reasonably practicable and as part of the process be asked to comment on whether or not they support the application and, if so, why. For the application to proceed efficiently, the Regulator will expect trustees to have had the opportunity to assess the impact of the event, to consider appropriate mitigation and negotiate where necessary taking appropriate professional advice. The guidance is clear that trustee support for an application does not mean clearance will be granted. At the same time, the lack of trustee support does not guarantee that clearance will not be given.

Clearance is voluntary. Where trustees become aware of an event which they believe could be a type A event, they should raise their concerns with the employers. Where a clearance application is not being considered and the trustees are concerned that no mitigation is being offered (or it is in inadequate), they should consider contacting the Regulator, together with the other powers available to them.

Applying for clearance

The guidance sets out how clearance should be applied for and how the clearance process is handled by the Regulator.

Comments

The finalised guidance is radically different to the 2005 guidance. The clearance regime in the 2005 guidance was rather divorced from the anti-avoidance requirements. This resulted in market practice swinging from always seeking clearance in relevant cases to not seeking clearance where the parties were satisfied that some mitigation for the scheme was in place, usually based largely on rule of thumb evidence from Regulator cases. In contrast, the guidance seems to have been specifically designed to tie the clearance requirements to those of the anti-avoidance provisions. However, at the same time it is a pity that the finalised guidance is rather inconsistent with the new employer debt requirements.

The finalised guidance is in much the same form as the draft guidance. However, the emphasis has shifted so that the guidance is addressed to professional advisers rather than employers. Is this a result of employers moving away from applying for clearance?

One of the major changes from the draft guidance is that the detail concerning assessment of employer covenant has been removed (although the guidance is clear that trustees cannot ignore covenant issues). The Regulator's consultation report makes it clear that this is because assessment of employer covenant is fundamental to trustees with the result that the Regulator is going to issue separate guidance on employer covenant sometime later this year. We await this guidance with interest to see whether or not it will fulfil the Regulator's aim. It is worth noting that appendix A to the guidance does provide some guidance on covenant assessment. It concentrates on the types of information which trustees may need to consider and that employers should share information with trustees. Appendix A does not focus on what evidence might point to a weakening/strengthening in the covenant. Time will tell whether or not the awaited guidance covers these issues.

One consequence of the regulatory regime since 2005 is the increasing polarisation between employers and trustees potential. The finalised guidance might increase this polarisation because of a lack of certainty as to when clearance should be sought (and, therefore, the potential for disagreement between employers and trustees) and the strong steer to trustees to negotiate with employers. In 2005 the Regulator stood strongly behind trustees (a player rather than a referee) but has altered its position over time. Time will tell whether or not this pattern is repeated.

The finalised guidance maintains a strong push towards clearance in appropriate cases. We think that this is because of the market's changed attitude to clearance since its first introduction. When clearance was first introduced it was market practice for clearance to be sought in all relevant circumstances. As time went on and there was greater awareness of the Regulator's attitude and level of mitigation required, parties became more bullish about not seeking clearance. It will be interesting to see whether this new guidance will see a further shift in market practice.

This analysis is based on the Regulator's clearance guidance published on 20 March 2008 and the Regulator's revised clearance guidance: consultation report also published on 20 March 2008.