Banking Briefing: In practice - Pension Schemes Act 2021 implications for lending transactions

There are indirect, and potential direct, implications for lending transactions from the Pension Schemes Act 2021. Both lenders and borrowers, as well as pensions trustees, have an interest in knowing what's changed and how that might impact their deals.

The Act received Royal Assent on 11 February 2021 and updates the Pensions Act 2004. It primarily relates to funding and security of Defined Benefit or ‘Final Salary’ Schemes (‘DB Schemes’). The 2021 Act deals at a high level with the Pension Regulator’s powers and the detail of how these powers will be implemented will come in a series of regulations (expected to come into force in October) and in guidance notes from the Regulator. Whilst the powers themselves will not be retrospective, some of the new provisions will allow the Regulator to look back at evidence which preceded events in question if, for instance, it would be relevant to “intention”.

The main thrust of the legislation is to deter companies from undertaking transactions which could jeopardise the security of DB Schemes and, where that fails, to give the Regulator increased powers to demand contribution to a deficit DB Scheme where an action (or failure to take action) does or could materially and detrimentally impact the funding of that scheme. In more serious cases, the 2021 Act also gives the Regulator the power to prosecution those involved in conduct which has that result.

The key responsibility for ensuring that a DB Scheme is properly funded lies with the employer company and the pension trustees. However, the Regulator can issue seek contribution (via a Contribution Notice) from other connected and associated persons, and its new criminal powers go even further. Those powers potentially capture any person involved in conduct which materially and detrimentally impacts a DB Scheme’s funding, and this could include lenders. Although the Regulator has said it is not intended to attack commercial transactions and lenders are not in the line of fire, there are certain practical issues that might impact transactions and might make it more difficult or expensive for companies to get finance.

What has changed?

The Act does not really change anything fundamentally, but it does extend the circumstances in which and the parties against whom the Pensions Regulator can take action.

• Firstly, there are two new grounds on which the Regulator can issue a Contribution Notice: when the employer’s insolvency (or hypothetical insolvency) as a result of an act or failure to act would detrimentally impact the outcome for its pension scheme (the ‘employer insolvency test’), and when the value of the employer’s resources is materially reduced (the ‘employer resource test’). That might occur if security or a guarantee is granted for borrowing. A Contribution Notice can only be issued to a DB Scheme employer or a person who is connected to or an associate of the employer, so it is unlikely to affect lenders directly.
• Secondly, the Act introduces two new offences under which criminal liability could extend to third parties. There is no requirement in the Act for those third parties to be connected to or associated with the DB Scheme employer (as is required for the targets of a Contribution Notice).  As drafted, the provisions allow the Regulator to prosecute lenders, and basically anyone involved in the act or failure in question (except insolvency practitioners acting within their appointment).
• The changes are designed to encourage employers to engage with pension trustees at an earlier stage in order to avoid the need for Regulator intervention. The criminal sanctions in particular might give employers pause for thought and are likely to make Pension trustees more nervous when considering employer proposals. This could increase the number of referrals to the Regulator for Clearance (discussed below) and might include more borrowing and security referrals.
• That said, there are a number of hurdles for the Regulator to jump through before a prosecution can be brought. There is a statutory defence of “reasonable excuse”, and the burden of proof on the Regulator is a high one. The Regulator itself has indicated that the intention is not to prevent commercial transactions in the normal course of business but to catch significant reckless and intentional behaviour that leads to underfunding of a DB Scheme. However, the Regulator’s statements are not binding and the interpretation of the provisions and the Regulator’s intentions can change.

Implications for lending transactions?

The prospect of claims by the Regulator against a lender is still uncertain. Therefore, it may be worth applying to have borrowing and/or security or guarantees, and possibly also Asset Based Lending (‘ABL’) financing contracts, cleared by the Regulator, where there is any concern over the funding of the DB Scheme, even though this may not safeguard against eventual claim by the Regulator. This process is known as ‘Clearance’ and it can help avoid a Contribution Notice and other penalties available to the Regulator, but it does not apply to the new criminal sanctions.

Getting trustee consent to borrowing and/or security or guarantees, or ABL financing, will not remove the risk, although it might make a subsequent claim against the lender less likely. However, pension trustees are unlikely to be keen to give this and their independent legal advice is likely to advise against it.

Even if it were technically permissible, asking pension trustees to agree to postponement of the obligations to the DB Scheme to those to the lender would be a difficult one for the trustees concerned to agree to, and there’s nothing in it for them.

The underlying theme of the two new Contribution Notice grounds is to prevent the deterioration of the sponsoring employer's covenant. However, the application of the employer resources test may cause problems for the payment of dividends, which in turn may affect the ability of companies in the Group to meet financial obligations and/or covenants.

There is now a risk that the directors of DB Scheme sponsoring employers will have (or at least will feel under pressure to prioritise) a “superior” responsibility to the pension scheme as a creditor, than they do to other creditors. This could be relevant when taking on new borrowing or considering competing repayment obligations.

It is likely that there will be a surge in applications for Clearance, which will incur costs and cause delays, although the Regulator has said it has the resources to cope. In any event, an application may not provide the clearance sought, and a Clearance statement does not bind the Regulator if the circumstances change and become materially different to those in the application, in which case the Regulator is not prohibited from taking further action or prosecuting under the Act. It is also important to note that the clearance procedure does not apply to the new criminal offences at all.

There are likely to be more questions from trustees, and requests to be involved in the negotiation of the banking transactions of the employer company.

Conclusion – how to approach the issue?

In most commercial transactions in the normal course of business there will not be an issue, but dealing with it at lending stage (or when there is a refinancing or additional borrowing is sought) is the best way to address it. Of course, it is possible that this will cause delays as it will require all parties to engage, and it may require a Clearance application to the Regulator, so build in time to allow for this.