What is clearance?

Clearance is a process whereby a company provides compensation for the weakening in their covenant towards their pension scheme that makes the payment of pension benefits in full less likely. This is usually as a result of a corporate transaction, for example where a highly leveraged transaction occurs and/or the assets to which the scheme currently has recourse are being removed from the employer group. It is a voluntary process for companies considering corporate transactions, and Trustees cannot force a company to go for clearance if they do not wish to do so. Clearance is not an approval of a transaction as such, but an assurance that the Regulator will not use its moral hazard powers against the company in relation to that transaction.

When should companies seek clearance?

Deciding whether to go for clearance should be irrespective of the funding position of the pension scheme involved. If a scheme is 100% funded on an FRS17 basis the chance of paying all the benefits in full will still fall if the company is geared up. Even in this situation some “compensation” should still be provided to restore the equilibrium. There has never been a carve out whereby if a scheme was 100% funded on an FRS17 basis then clearance was irrelevant.

Funding is only one aspect of the security of members’ pension benefits. The covenant provided to the scheme by its sponsor as the ultimate guarantor that pensions will be paid, is also an extremely important factor that should be taken into consideration. It is the extent to which the covenant is changed which identifies the need for clearance.

When a company wishes to make a change that leads to a material reduction in the covenant provided to the scheme and has decided to go for clearance, it should negotiate with its Trustees to reach an equitable settlement that can be blessed by the Pensions Regulator. Situations such as these include leveraging, distributing capital or any other significant financial transaction.

The purpose of clearance is to ensure that a pension scheme should have the same financial position before and after any change to the sponsor. Therefore if the covenant is reduced then this should be compensated for by an increased funding within the scheme or an increase in contingent assets.

Recent published articles

On 3rd May, the Pensions Regulator announced that trustees have a duty to demand substantial assets up front to safeguard retirement benefits in the event of a leveraged buy-out.

The press have stated that the Pensions Regulator have issued new guidance which implies a change in the current practice. In actual fact this is not the case and it is clear from the guidance issued in 2005 that the overriding principle of the clearance process is that the Pensions Regulator is interested in cases where there is financial detriment to the pension scheme, whatever the current funding level.

This fact has been clear to the industry since the Marconi/Telent case. A large portion of the business was sold and Marconi applied for clearance to be allowed to distribute all the residual cash. The equity value of the sponsoring employer was reduced by a vast 80% and even though they fully funded the pension scheme on an FRS17 basis they were required to place an extra £500 million in escrow for the scheme in order to provide adequate compensation.

However this is not to say that FRS17 is never a suitable hurdle. It is clear that in many situations involving leveraged buy-outs then FRS 17 may well be the appropriate measure. If a scheme is currently 80% funded on FRS 17 and is funding to 90% FRS 17 over a period of ten years with its current sponsor and is then subject to a leveraged buy-out, then this causes a weakening of the covenant that requires compensation. If, for example, the leveraged buy-out meant that the company would now pay off the whole of the deficit over three years then this will still provide adequate compensation to the Trustees for the weakening of the covenant caused by the leveraging.

The press have also recently talked about a potential bid on Alliance Boots and have stated that the private equity firm Kohlberg Kravis Roberts is being threatened with a £1 billion demand from Boots’ pension scheme Trustees before any sort of bid would be agreed. This is therefore a similar case to the Marconi case. The purchase price for the company is £11.1 billion and £8 billion of this will be financed by debt. The Trustees envisage this will significantly reduce the covenant of the pension scheme and have asked for the large lump sum of £1 billion in spite of the group pension scheme only having a very small (£26 million) deficit at the start of 2007. Clearly a top up to fully funded on FRS 17 would be trivial and utterly insufficient.

Summary

The Pensions Regulator has not changed its advice; it is just correcting the misunderstanding by some market participants that FRS17 is the hurdle. In reality, the hurdle depends on the extent of the change in the covenant although in many cases FRS17 may still be adequate.

However, generally speaking, the cost of clearance is very high and the protection obtained is often worth very little. Unless the Trustees have the power to wind up the scheme or other contribution powers, then we feel that clearance provides little value to sponsors unless the change in covenant is dramatic. Nevertheless private equity firms often need certainty that when they have sold a company they are no longer responsible for the pension liability and clearance can guarantee this.

If you would like further information on this topic or have a specific query please contact or Richard Jones (020) 7533 6967 or Chris Parlour (020) 7533 1815.