The 2021 outlook for regulation – Increased litigation and regulatory intervention
Schemes and sponsors must have their eyes open to the risks ahead.
In the pensions industry, regulatory intervention, disputes and litigation arise generally (but not always!) when schemes are wound up and losses are crystallised. While such cases can become very complex, the fundamentals of most covenant-related disputes are fairly simple: through a restructuring, M&A, misjudgement of advice, or distribution of assets away from the scheme sponsor(s),did something happen that caused covenant to weaken and result in a worse outcome for scheme members or the PPF than would otherwise have been the case?
Through the stresses and strains of the COVID-19 crisis, we have seen the Regulator press pause on changing the policy around funding levels, but with the new DB funding code and Pension Scheme Bill set to reconfigure the regulatory backdrop and widespread post-COVID restructuring anticipated, we expect to see increased litigation and regulatory intervention towards the end of this year and beyond.
We have, in fact, already seen an uptick in businesses taking advice in relation to the risk of pensions regulatory intervention under the proposed new legislation in the Pension Schemes Bill, where new tests for Contribution Notices and new powers for the Regulator to pursue criminal and civil sanctions represent a key shift in the landscape.
Risk of criminal punishment
Under the proposed new legislation, management teams undertaking M&A, restructuring or other corporate actions in the knowledge that these are damaging to the likelihood of pension benefits being received face the risk of criminal punishment, including possible jail time, and/or significant financial penalties. That said, particularly in the current environment, it is important to remember that the Regulator’s powers have been extended to prevent mistreatment of schemes, rather than punish people acting in good faith and with due consideration!
It is nevertheless clear that, as corporate options are assessed in 2021, the treatment of any potentially affected pension scheme must remain front of mind for all parties. Not only is this good practice to minimise the risk of regulatory intervention, it will actually become a legal requirement for certain events, with a statement to be provided to the Regulator and pension trustees setting out the impact of the event and any steps taken to mitigate that impact.
We see three key scenarios under which the risks of regulatory intervention and/or other litigation are elevated. These scenarios ring true in a benign economic environment, but are particularly relevant against the backdrop of the economic challenges we face as a country in the months ahead.
The first of these scenarios is financial restructuring, which could range from a simple refinancing and securitisation agreement through to major changes in debt structure. To understand the potential impact of such changes on a pension scheme, it is important to understand both the purpose and structure of any new borrowing. Are changes to debt structure expected to benefit the pension scheme or its immediate sponsors, or will the scheme find itself prejudiced in a downside scenario?
The second scenario which may elevate the risks of pension disputes are group re-organisations. Whilst pension schemes are legally supported by corporate entities, larger groups are often run on divisional lines, a disconnect that can cause challenges; for example operational changes at group level can precipitate a string of unintended consequences for sponsor entities and their pension schemes. As such, taking appropriate advice ahead of executing reorganisations can mitigate potential impacts and avoid disputes. Multiple-employer schemes present acute risks in this regard, simply because the direct covenant support can be distributed throughout the group, increasing the risk of unexpected impacts.
Finally, any case in which assets are distributed away from pension scheme employers warrants consideration, particularly in the context of the Regulator’s new powers and tests. While the key focus here will be supernormal dividends and share buybacks, which will continue to warrant particular scrutiny, distribution of value goes much wider than shareholders and should be interpreted in the very broadest sense – for example intercompany loans that cannot easily be recovered or non-market rate transfer pricing.
Think to the future
Corporates and trustees should also be mindful of how acts (such as distributions) may be perceived in the future. For example, a transaction followed by a large shareholder distribution two years ago may not have caused concern at the time, but in the context of the COVID-19 crisis, looks quite different if the reduced business is no longer able to support its pension scheme. In short, the scheme was exposed to greater risk and that risk has materialised.
The Regulator has the power to look back up to six years when considering a Contribution Notice and even further when making its case for a Financial Support Direction. Corporates looking to negotiate with pension schemes and the Regulator in the coming months should be prepared to deal with questions about any historical acts that may have exposed the scheme to additional risk.
In summary, 2021 may present something of a perfect storm: the recovery from a black swan health and economic crisis, significant regulatory change and the acceleration of long-term secular shifts away from traditional industries with a hard footprint of assets, towards faster leaner businesses, without DB pension schemes.
While innovation across the pensions industry has (thankfully!) delivered a range of new funding solutions and endgame routes for schemes, these will not be available to all and disputes will be inevitable. Whilst this article has focused on events weakening covenant and the growing likelihood of regulatory intervention, there will no doubt be other routes to recovery (e.g. negligence claims) and schemes and sponsors must have their eyes open to the risks ahead.
Luke Hartley, Director