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Issues relating to pension schemes have been pushed up the corporate agenda over the past couple of years as companies wrestle with pension scheme deficits, face the impact on their accounts of FRS17 and try to restructure their pension benefits — normally by switching from defined benefit to defined contribution arrangements. Now, a new pension cloud has come up over the horizon and it is not just companies, but also corporate and corporate recovery lawyers, who will need to take notice.

The cloud is the Pensions Act 2004 or, to be specific, the ‘moral hazard’ sections in the Act.

Background to the moral hazard sections lies in the Act’s introduction of a Pension Protection Fund (PPF). If a company with a defined benefit scheme becomes insolvent and its pension scheme is in deficit, the members can look to the PPF for it, within certain limits, to compensate them for the shortfall of their pension benefits under the scheme.

But the weakness of the PPF is that it will have no form of government funding or guarantee. Funding will be via levies that will ultimately be borne by employers with defined benefit schemes — another penalty for companies that provide good arrangements for their staff and, until a risk-based levy is introduced, good low-risk companies will be subsidising high-risk companies.

This raises concerns that substantial claims on the PPF in its early years might make it insolvent. The Government has reserved emergency powers to slash compensation if the financing of the PPF requires it, but its main approach is to push companies to keep their schemes fully funded so as to avoid such claims. The moral hazard sections are weapons in the armoury.

The sections essentially give two powers to the pensions regulator in relation to defined benefit schemes — the power to give contribution notices and the power to issue financial support directions. A contribution notice may be issued if the regulator is of the opinion that a person was a party to an act, or a deliberate failure to act, for the purpose of preventing the recovery of the whole or part of a statutory debt — or, otherwise than in good faith, preventing it from becoming due or compromising or reducing the debt.

The statutory debt is the debt that arises under section 75 of the Pensions Act 1995 if a company sponsoring a defined benefit scheme becomes insolvent, if the scheme is wound up or if one employer of a group scheme ceases to participate. If the pension scheme of a solvent company is wound up, the debt is based on the full cost of buying annuities to secure accrued benefits. Because the cost of annuities is historically very high, that debt can be very large indeed, sometimes to the extent of putting a company’s existence at stake. So the issues are serious. The Government intends that the debt arising when a company is insolvent or ceases to participate will also normally be based on a buy-out basis.

The contribution notice could require the person on whom it is served to pay an amount equivalent to the debt to the trustees or, if relevant, to the PPF.

The notice may be served on the sponsoring employer or a person connected with or an associate of the employer. Because the definitions of ‘connected’ and ‘associated’ in the Insolvency Act 1986 are used, there is a very wide class of people who could be caught; provided it believes an avoidance action has been taken by the person, a notice could be served on directors of the sponsoring company, employees, other group companies or controlling shareholders. A notice could not be served on a person acting in accordance with his functions as an insolvency practitioner, but there is no exemption for someone who is acting as a turnaround specialist.

Although the sections will not come into force until April 2005, the regulator can look back to acts which occurred on or after 27 April this year (this was originally going to be 11 June, 2003) but cannot go back more than six years — still a substantial period.

The major problem with this new power, and a particular concern for companies, is the sheer breadth of the actions that could be caught. At the Commons Committee stage, examples given of actions that could be taken to have prevented the recovery of a statutory debt included withdrawing funding from the sponsoring employer, selling off its assets, paying a large dividend to strip out assets and transferring employees to another company that becomes the sponsoring employer, which does not trade or have any assets. So, the sale of a subsidiary or a business could be caught as could a private equity provider withdrawing funding from a company it has invested in.

True, the regulator has to be of the opinion that one of the main purposes of the Act was to prevent the recovery of the debt, but whenever there is a scheme with a deficit on the scene that purpose can always be argued. The regulator has to be of the opinion that it is reasonable to impose liability — and there are various matters that it must have regard to when deciding on reasonableness. Those matters include the person’s degree of involvement, his connection with the scheme, his financial circumstances and whether the Act was to prevent the loss of employment.

But massive discretion is being given here to the regulator — it not only decides whether to serve a notice, but whether the main purpose was to prevent recovery of the debt. It is the regulator who decides the weight to give to a prescribed ‘reasonableness’ matter and, even if a matter applies, whether a notice should still be issued. So, a great deal of power relating to commercial activities is being given to a regulator of pension schemes — and individuals such as directors who could be in the firing line may well feel justifiably nervous.

The Act provides for there to be a system under which prior clearance can be obtained from the regulator, but it will only be workable if the regulator has sufficient commercial expertise.

With the ‘catch-all’ nature of the moral hazard sections, the system could be over-whelmed, and companies and their advisers may not necessarily know for what activity advance clearance needs to be obtained. This could lead to companies seeking clearance to each and every activity where the argument might be raised that the activity may reduce the financial strength of the company and so may impair its ability to recover the statutory debt.

The second power given to the regulator is the issuing of financial support directions (FSD), either where the sponsoring employer is a service company or is ‘insufficiently resourced’. A company is insufficiently resourced if its resources are insufficient to enable it to meet a percentage (to be prescribed) of the estimated statutory debt, and there is a person connected with or associated with it who has sufficient resources to meet the difference between the employer’s assets and that prescribed percentage.

An FSD can be served on the employer or a person connected with or an associate of the employer — but in this case, individual directors and shareholders are normally excluded. The regulator must again be of the opinion that it is reasonable to serve an FSD and, again, there is a ‘pick list’ of matters the regulator must have regard to such as the value of any benefits received by that person from the employer.

An FSD requires the person to put ‘financial support’ in place for the scheme and to ensure that it remains in place while the scheme is in existence. There is no termination of liability if the person, for example, ceases to be associated or connected.

The financial support has to be agreed by the regulator and has to consist of all group companies becoming jointly and severally liable for the employer’s pensions liabilities or a suitable holding company becoming liable — although, as an alternative, a form of prescribed instrument, such as a bank guarantee, may be put in place. If the financial support is not put in place or maintained, the regulator may serve a contribution notice on the person who received the FSD which could require him to make a payment equivalent to the statutory debt to the trustees.

But there is a means, potentially, for avoiding this liability. Clearance from the regulator can be obtained if it would not be reasonable to impose an FSD on a particular person. That may be of help to someone who fears that he may be served with an FSD but manages to persuade the regulator that, for example, he is not in a position to implement it, or that he could not meet a contribution notice if one were subsequently served.

If the regulator is of the view that financial support should be provided, however, it will simply identify someone else to serve the direction on — a clearance statement will simply protect the applicant but will not necessarily avoid the group having to provide financial support.

The moral hazard sections of the Pensions Act 2004 are likely to be a major problem in commercial activities and advisers will need to be alive to the need, where appropriate, to seek pensions regulator clearance. Whenever a company has a defined benefit pension scheme, any activity that might with hindsight be said to have affected the ability of the sponsoring employer to meet a statutory debt could be caught. This may well impact on corporate disposals, business sales or corporate restructuring.

The concern will be heightened if individual directors feel that they personally can be in the firing line. FSDs do not even require a trigger event — it is enough that the regulator is satisfied that the sponsoring company is a service company or is insufficient resourced. Other group companies may then find themselves responsible for pension liabilities even if their employees have never been in the scheme. The wave of the pensions crisis is about to wash into unexpected corners of corporate activity.

Ron Thom is a partner in the pensions team at Lawrence Graham.

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